**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

**FORM 10-Q**
| **(Mark One)**                                              | ** ** | ** **                                                                                    |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| **x**                                                       | ** ** | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                  | ** ** | ** **                                                                                    |
| **For the  quarterly period ended September 30, 2006** |
| ** **                                                  | ** ** | ** **                                                                                    |
| **OR**                                                      |
| ** **                                                  | ** ** | ** **                                                                                    |
| **o**                                                       | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from            to          **

**COMMISSION FILENUMBER 000-29661**

**UTSTARCOM,INC.**

(Exact name of registrant as specified in itscharter)

| **DELAWARE**                              |   | **52-1782500**                        |
|-------------------------------------------|--------|---------------------------------------|
| (State of  Incorporation)                 |   | (I.R.S. Employer  Identification No.) |
|                                      |   |                                  |
| **1275  HARBOR BAY PARKWAY**              |   | ** **                            |
| **ALAMEDA,  CALIFORNIA**                  |   | **94502**                             |
| (Address of  principal executive offices) |   | (zip code)                            |

 

Registrant’s telephone number, including areacode: **(510) 864-8800**

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

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

Large accelerated filer x  Accelerated filer o Non-accelerated filer o

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act) Yes o No x

As of September 30, 2007 there were 121,294,645 shares ofthe registrant’s common stock outstanding, par value $0.00125.

 

----

**TABLE OFCONTENTS**
| EXPLANATORY NOTE                                                                                        |   |   |
|---------------------------------------------------------------------------------------------------------|--------|--------|
| PART I—FINANCIAL INFORMATION                                                                       |   | 3      |
| ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                                 |   | 12     |
| ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS |   | 59     |
| ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISKS                                |   | 93     |
| ITEM 4—CONTROLS AND PROCEDURES                                                                     |   | 94     |
| PART  II—OTHER INFORMATION                                                                         |   | 106    |
| ITEM  1—LEGAL PROCEEDINGS                                                                          |   | 106    |
| ITEM  1A—RISK FACTORS                                                                              |   | 109    |
| ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE  OF PROCEEDS                                |   | 128    |
| ITEM 3—DEFAULTS UPON SENIOR SECURITIES                                                             |   | 128    |
| ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                        |   | 128    |
| ITEM  5—OTHER INFORMATION                                                                          |   | 129    |
| ITEM  6—EXHIBITS                                                                                   |   | 130    |
| SIGNATURES                                                                                              |   | 132    |

 

2

----

**EXPLANATORY NOTE**

**The Company was unable to file timelyits Form 10-Q for the quarterly period ended September 30, 2006 because we hadcommenced a voluntary review of historical stock option practices and theresults of that review were not known at the date the Form 10-Q filing was due.We are filing the Form 10-Q for such period concurrently with filing of theCompany’s Form 10-K Annual Report for the year ended December 31, 2006.Information contained herein about the restatements of previously issuedfinancial statements has been taken from the 2006 Annual Report. The 2006Annual Report contains additional information about the restatements which isnot included herein.**

Our consolidated financialstatements and related financial information included in this Quarterly Reporton Form 10-Q for accounting periods prior to the third quarter of 2006 havebeen restated, as described below.

***Summary***

In July 2007, theCompany announced the Audit Committee was conducting an independentinvestigation of historical sales with certain customers in China and statedthat it could not rule out the possibility that the outcome of theinvestigation could impact revenue recognized for certain of such contracts asrecorded in previously issued financial statements. In September 2007, theCompany announced the investigative phase of the Audit Committee’sinvestigation had been completed. After consultation with and upon therecommendation of management, the Audit Committee determined revenue in theCompany’s Western Region of China was recognized earlier than it should havebeen and that the financial statements for the affected periods should berestated. The Company also announced that its previously issued financialstatements for each of the fiscal years ended December 31 in the period 2000through 2005, the financial statements for the interim periods contained in theQuarterly Reports on Form 10-Q filed with respect to each of these years, andthe quarterly reports on Form 10-Q filed with respect to each of the quarterlyperiods ended March 31 and June 30, 2006 should not be relied upon. In this Quarterly Reportwe have corrected for the effects of net sales and related costs of net salesthat were recorded earlier than they should have been. The net effect for thethree and nine months ended September 30, 2005 was to reduce and deferpreviously recognized revenue and gross profit of $34.6 million and $15.1million, respectively, and $63.7 million and $29.4 million, respectively.

We also conducted a voluntaryreview of historical stock option practices under the direction of theNominating and Corporate Governance Committee of our Board of Directors (“GovernanceCommittee”). This review considered all option grant awards made in the periodfrom February 29, 2000, shortly before the initial public offering of ourCommon Stock, through August 2006 for compliance with the various stock-basedcompensation accounting standards applicable during this period as well as therules of our stock option plans. We found that in a number of instances we didnot use the proper date as the measurement date in determining whether stockoptions had been issued with exercise prices below the fair value of our commonstock. Therefore, we have restated our previously issued financial statementsfor the years ended December 31, 1998 through 2005 to account for an additional$25.5 million of stock compensation expense that should have been recognizedover the period together with an equal increase in additional paid-in capitalto recognize the intrinsic value assigned to these issuances of equitysecurities. Related adjustments of payroll and income taxes resulted in anadditional $0.5 million of expense being recognized for the 1998 through 2005period and total stockholders’ equity being reduced by a total of $2.1 millionat December 31, 2005. During the first six months of 2006 an additional $1.2million of stock compensation expense was recognized, which reduced ourpreviously reported operating results for this period. During the three andnine months ended September 30, 2005 (in thousands), stock compensation expensetotalling $76 and ($1,470), respectively, was recognized.

Inrestating our previously issued financial statements for the investigationsdescribed above, we also corrected other previously reported amounts. We corrected our reporting for $80.3 million ofnet sales to certain third party resellers and $41.2 million of associated costof net sales in 2005 to classify these amounts as related party net sales andrelated party cost of net sales classifications, respectively, because in 2006we determined that sales to these entities were, in substance, sales to one ofour significant shareholders, SOFTBANK CORP. The accounts receivable from thesesales was similarly reclassified into accounts receivable from related partiesin our 2005 balance sheets. We also corrected our reporting of $6.3million of time deposits at March 31 and June 30, 2006 because they did notmature within three months. Formerly the time deposits had been reported inerror as cash equivalents, but now these amounts are included in short-terminvestments in these balance sheets and in the statements of cash flows for theMarch and June 2006 reporting periods. The corrections for the three and ninemonths ended September 30, 2005 interim periods have been recorded in thecondensed consolidated financial statements included herein. See also Exhibit99.1 of our Annual Report on Form 10-K for the year ended December 31, 2006 forthe impact of the restatement on all quarterly periods for 2005 and 2006. 

Noneof these restatements had any effect on any of our December 31 cash balances;however, cash equivalents were reduced in the March and June 2006 periods dueto the reclassifications described above.

3

----

Additionalinformation about these restatements and their effects on our financialstatements is presented below as well as in the Notes to Consolidated FinancialStatements.

***ChinaSales Investigation***

The Audit Committee of the Company’s Board of Directors (“Audit Committee”)engaged independent counsel to conduct an investigation of sales in Chinafollowing a determination by the Internal Audit group that allegations ofimproper activities in a sales office in the Western Region were credible. Theallegations were made by a Company employee using the Company’s whistle blowerprogram. The independent counsel engaged forensic accountants, and this groupis collectively referred to as the Investigating Team in the rest of thisdiscussion.

In conducting its procedures, the Investigating Team found instances wherethe customer contracts that evidenced the arrangement contained obligations forthe Company to deliver software upgrades when and if made available for theequipment sold for no additional consideration and for an unspecified periodthat could extend over the term of the contract. This additional contractobligation is an element of “post contract support.” In these cases, theInvestigating Team found that the contract documentation for the sametransaction submitted by the sales office to the Company’s China headquartersfor accounting purposes and utilized by the Company in determining the amount ofrevenue recognized did not include evidence of such post contract supportobligations.

Accounting standards governing revenue recognition for system sales requireall revenue to be deferred while there are undelivered elements under thearrangement unless the seller has established vendor specific objectiveevidence (“VSOE”) of fair value for such contract elements. Because thesearrangements included such undelivered elements, revenue should be deferredbased on the VSOE of the fair value of the underlying elements. VSOE of fairvalue represents the price charged when the same element is sold separately.Since the Company does not sell this element separately, it has not establishedVSOE for such undelivered elements, and as such the revenue from such contractsis required to be deferred and recognized over the period the Company isobligated to provide the post contract support.

The China salesinvestigation covered each of the seven years in the period ended December 31,2006 and included: investigating approximately 1,200 contracts in all of ourfive regions in China; reviews of the electronic files of 45 employees; andformal interviews of 96 employees in China. Additionally, the China salesinvestigation included reviewing contract files, performing various financialanalyses including comparison of payments received per our accounting recordsto the contract terms, and computer forensic procedures where destruction ofelectronic documents was suspected. In the aggregate, the Investigating Teamexpended approximately 25,000 hours in conducting this investigation, whichcommenced in February 2007 and was completed in September 2007 when theindependent counsel and forensic accountants presented their final report tothe Audit Committee. In July 2007, we announced the Audit Committee wasconducting an independent investigation of historical sales with certaincustomers in China and we stated that we could not rule out the possibilitythat the outcome of the investigation could impact revenue recognized forcertain of such contracts as recorded in our previously issued financialstatements.

Upon completion ofthe investigative phase of the independent investigation by the AuditCommittee, our management:

·                  conductedfollow-up procedures to attempt to locate any additional relevant informationto ensure the Company considered all available information and documents;

·                  evaluatedthe accounting for identified system sales using the contract template anddocumentation found in the sales contract files from the Western Regionoffices. This included calculating the financial statement effects ofcorrecting the accounting for all system sales where the contract templatefound at our sales offices contained post contract support obligations torecognize revenue and cost of net sales over estimated period of post contractsupport;

·                  concludedthat as a result of the existence of this undelivered post contract supportobligation our previously issued financial statements should be restated to defersystem sales contract revenue and the related cost of net sales over theestimated period of post contract support when a contract contained unspecifiedsoftware upgrade rights.

The AuditCommittee concurred with management’s decisions.

The effect of correctingimproperly recognized revenue and cost of net sales is to (reduce) increasepreviously

4

----

reported net sales, grossprofit and net income by the following amounts (in thousands of dollars):
| Year ended   December 31, | ** ** | **Net sales** | ** ** | **Gross profit** | ** ** | **Net income** | ** ** |
|-------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------------|------------|
|                                |       |               |       |                  |       |                |       |
| 2000                                |       | $                  | (12,408    | )                     | $          | (5,294              | )          | $ | (4,781 | ) |
| 2001                                |       | (17,154            | )          | (6,330                | )          | (5,779              | )          |
| 2002                                |       | (64,732            | )          | (22,924               | )          | (19,697             | )          |
| 2003                                |       | (21,060            | )          | (8,014                | )          | (6,382              | )          |
| Totals through December 31, 2003    |       | (115,354           | )          | (42,562               | )          | (36,639             | )          |
| 2004                                |       | (104,965           | )          | (27,241               | )          | (18,594             | )          |
| 2005                                |       | (58,232            | )          | (27,863               | )          | (42,433             | )          |
| 2000 - 2005 Total                   |       | (278,551           | )          | (97,666               | )          | (97,666             | )          |
| 2006 quarter ended                  |       |               |       |                  |       |                |       |
| March 31                            |       | 5,410              |       | 1,360                 |       | 1,360               |       |
| June 30                             |       | 2,380              |       | (371                  | )          | (371                | )          |
| Total China  Sales Restatement      |       | $                  | (270,761   | )                     | $          | (96,677             | )          | $ | (96,677 | ) |

 

The cumulativeeffect of all of the China sales restatement adjustments to our consolidatedbalance sheet as of December 31, 2003 resulted in a decrease in retainedearnings of $36.6 million, an increase in deferred revenue of $115.4 million toaccount for previously recognized sales, an increase in deferred costs of $75.7million to account for previously recognized cost of net sales, and an increasein deferred tax assets of $3.0 million. In our consolidated balance sheet at December31, 2006, deferred revenue is $275.7 million, of which $35.6 million isclassified as current and $240.1 million as non-current, and the deferred costsbalance is $176.6 million. These amounts will be recognized in our consolidatedstatements of operations over the estimated remaining period of post contractsupport.

Due to thisrestatement, we decreased net sales, gross profit, and net income (inthousands) for the three and nine month periods ended September 30, 2005 asfollows: $34,610 and $63,671; $15,062 and $29,429; and $29,186 and $43,999,respectively.  In our consolidatedbalance sheet at September 30, 2006 the net reduction in previously recognizednet sales is accounted for as deferred revenue, of which $34.5 million isclassified as current and $240.3  millionas non-current, and the related net reduction in cost of net sales of $177.0million is accounted for as deferred costs. These amounts will be recognized inour consolidated statements of operations over the estimated remaining periodof post contract support.

Uponcompleting its investigation, the Audit Committee concluded that the conditionsand practices relating to systems contracts prevalent in the Western Regionresulted primarily from the failure to prevent or detect instances of overriderelated to controls in China over customer agreements, lack of propermanagement oversight, unclear record retention policies and procedures relatingto systems contracts, and inadequate employee training. The Investigating Teamand the Audit Committee also concluded that with respect to four regions otherthan the Western Region there was no evidence of fraud or misconduct or reasonto suspect such occurred. The Investigating Team and the Audit Committee alsoconcluded that there was no credible evidence of knowledge by senior managementin China or the United States of the conditions and practices related to theWestern Region of China that were discovered in the investigation. The AuditCommittee concluded that local management in several of the sales offices inthe Western Region of China did not submit appropriate information to theCompany’s senior management in China and the United States. Therefore, in prioryears, neither the Company’s management nor the Company’s independent registeredaccounting firm were able to properly evaluate the effect of that informationon revenue recognition. The Audit Committee also concluded that certain membersof management in China bear varying degrees of responsibility for inadequateoversight of activities. As a result, certain employees in China have eitherbeen terminated or placed on suspension for failure to provide adequateoversight of activities.

We haverestructured the management of the Western Region sales organization and areworking to identify and implement changes to our policies and procedures andenhance employee training to improve internal control consciousness and lessenthe possibility of accounting errors occurring in the future.

5

----

***StockOption Accounting***

In November 2006,we announced we had commenced a voluntary review of historical stock optionpractices under the leadership of the Governance Committee following apreliminary review by management which identified potential deficiencies anddiscrepancies in the documentation of stock option grants. The reviewconsidered all option grant awards made in the period from February 29, 2000,shortly before the initial public offering of our Common Stock, through August2006 (“Review Period”) for compliance with the various stock-based compensationaccounting standards applicable during the Review Period as well as the rulesof our stock option plans. The Governance Committee engaged independent outsidelegal counsel to assist in the review who, in turn, engaged forensic accountants.(Separate law firms and separate forensic accounting firms were engaged by theAudit Committee and the Governance Committee for the China sales investigationand the stock option accounting review.) In the rest of this discussion, thisgroup collectively is referred to as the Stock Option Review Team and theiractions and activities are referred to as the Stock Option Review. The StockOption Review Team members spent over 11,000 hours in this review, and theGovernance Committee met with the Stock Option Review Team on more than a dozenoccasions to receive, discuss, and consider the Stock Option Review Team’sinformation and findings.

At the time thereview commenced, the Governance Committee consisted of three members of theBoard of Directors, all of whom are independent directors. The Committeedecided to delegate supervision of the review to Mr. Jeff Clarke, its Chairman,who joined our Board in 2005 and had not served on the Compensation Committeeof the Board of Directors (“Compensation Committee”) during the period underreview. The Governance Committee also consisted of two other independentdirectors, Mr. Larry D. Horner and Mr. Thomas Toy, who also serve on the Board’sCompensation Committee. Mr. Allen Lenzmeier was appointed to the Governance Committeeon April 27, 2007.

Review procedures included:

·                  interviewsof individuals involved with granting, advising, administering, or accountingfor stock options, including current and former: management, members of theBoard of Directors, employees, and non-employee professionals;

·                  reviewof relevant stock administration, human resource, legal, and finance departmentfiles and records;

·                  reviewof stock option grant information in select employee personnel files;

·                  reviewby at least 30 attorneys and 15 forensic accountants of approximately 250,000potentially relevant e-mails and documents in electronic format selectedthrough electronic discovery techniques from over 1.8 million electronicdocuments processed;

·                  reviewof the electronic database of the Company’s stock option activity maintained bya third party along with communications to and from this service provider;

·                  reconciliationof grant activity from approval documents executed by the CompensationCommittee with the electronic database;

·                  reconciliationof stock option grant, exercise, and cancellation information from SEC filingswith select employee personnel files and the electronic database;

·                  statisticaland judgmental pattern analysis;

·                  follow-upon matters raising questions about the option granting process and its history,conduct of those involved with granting, advising, administering, or accountingfor stock options, or the accounting treatment for stock options; and

·                  follow-upon items or issues requested or identified by management or the Company’sindependent registered public accounting firm.

The Stock OptionReview Team, management, and the Governance Committee decided to group stockoption grants into six award categories based on differences in whatconstituted substantive approval for each category under our stock optiongranting practices as well as giving consideration to the risk of intentionalmisstatement of the grant date. Guidance in a September 19, 2006 letterpublicly issued by the SEC’s Chief Accountant focuses on the concept that ameasurement date under Accounting Principles Board Opinion No. 25 *Accounting for Stock Issued to Employees*(“APB 25”), theaccounting standard governing our stock option accounting through 2005, doesnot occur until the number of shares an individual employee is entitled toreceive and the exercise price is determined with finality (i.e., no longersubject to change). This is the

6

----

date on which substantiveapproval occurred, and depending on a company’s facts and circumstances theguidance from the SEC discussed above recognizes a company may determine thatthe measurement date for some stock option grants may occur before all requiredgranting actions have occurred — such as final approval by the CompensationCommittee. This alternative is available only when a review of all facts andcircumstances supports a conclusion that substantive approval occurs earlierthan when all required granting actions have occurred and there is no evidenceof fraudulent or manipulative conduct in the company’s option grantingpractices.

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

For 12 tested grant dates where a correctedmeasurement date was required, the Stock Option Review Team and management wereunable to locate sufficient evidence to establish a corrected measurement dateusing our established criteria for the applicable option grant type. In thesesituations alternative available evidence was used to establish the correctedmeasurement date.

During the period covered by the Stock Option Review,we granted stock options on approximately 34 million shares of our Common Stockat 197 grant dates. The review specifically examined the appropriateness of thestated grant date for approximately 90% of the stock options granted, includingall stock option grants made to directors and officers, all broadbase grantsand all option grants made in connection with business acquisitions.

7

----

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

 

----

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

(2) The number of grantsexceeds the number of grant dates because on certain grant dates more than onecategory of stock option grants were approved.

In late January2007 the Governance Committee reported its interim findings concerning the useof incorrect measurement dates in our stock option accounting under APB 25 toour Board of Directors. On February 1, 2007, the Audit Committee of the Boardof Directors then concluded, in consultation with and upon the recommendationof management, that we should correct for errors in previously reportedstock-based compensation expense through restatement of our previously issuedfinancial statements and that our previously issued financial statements forall periods should no longer be relied upon. We communicated this decision in aFebruary 1, 2007 public announcement.

A non-cashcompensation charge, to be recognized as an expense over a grantee’s serviceperiod, arises under APB 25 if a stock option has intrinsic value at itsmeasurement date. This intrinsic value is measured by the excess, if any, ofthe fair value at the date of grant of the underlying common stock over thestock option’s exercise price. Our practice has been to grant stock optionswith exercise prices equal to the closing price of our Common Stock at eachgrant date, to use the grant date as the measurement date for stock-basedcompensation purposes, and as such previously we had determined the grantedstock options had no intrinsic value at their grant dates and no compensationexpense was recognized. However, APB 25 states the measurement date does notoccur until all essential actions necessary to grant the option are completed,including the final determination of both the number of shares to be granted toeach employee or director and the exercise price, and the option grant isapproved by those with requisite authority. This is reinforced by the September19, 2006 letter issued by the SEC’s Chief Accountant which focuses on the needfor the number of shares and exercise price of an award to an individual to be finalizedto have a measurement date. This letter clarifies the SEC staff’s view that ifit is possible that those terms could change, a measurement date has notoccurred, even if the award’s terms are not actually changed.

Based on theavailable evidence, the review found that the number of shares an individualemployee was entitled to receive and/or the exercise price was not determinedwith finality at the stated grant date on 53 tested grant dates, and we shouldhave used a later date as the measurement date. The principal reasons for thestated grant date not qualifying as the measurement date under APB 25 include:

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

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

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

During the reviewthe Company also discovered a stock option grant to a former officer that wasmodified in 1998 in connection with his termination of employment. This changewas never included in the Company’s stock option grant records and theadditional compensation expense resulting from the change in the option’sterms  (approximately $1.2 million)  was not recorded previously. This discoveryis consistent with the Stock Option Review Team’s finding that in certaininstances there was a lack of formal documentation in the stock option grantingprocess and/or expected documentation is missing from the stock optionadministration files. In addition, the Stock Option Review Team found that, inmany instances, there was a lack of self-authenticating evidence to corroboratethat cash exercises were contemporaneous. As a result, the findings on theissue of backdating of cash exercises were inconclusive.

8

----

We are restatingour consolidated financial statements to recognize additional non-cashstock-based compensation expense arising from using corrected measurement datesfor certain stock option grants made during the years 2000 through 2005 and toreflect the modification of the 1998 grant described above. Consistent with ourhistorical accounting policy this additional stock-based compensation expenseis being recognized on an accelerated basis by treating each vesting tranche asa separate stock option grant (graded vesting).

Our accounting forstock-based compensation changed to a fair value based method in 2006 when, asrequired by accounting standards, we ceased accounting for stock-basedcompensation under the intrinsic value method pursuant to APB 25 and beganaccounting for stock-based compensation under Statement of Financial AccountingStandards 123(R) *Share-Based Payments*(“SFAS123(R)”). Under this method all stock option grants have a fair valuedetermined using an option pricing model, and such fair value is used torecognize non-cash stock-based compensation expense. We restated our unauditedcondensed consolidated financial statements for the first and second fiscalquarters of 2006, included in Exhibit 99.1 in our Annual Report on Form 10-Kfor the year ended December 31, 2006 (and as reflected in our results for thethree and nine months ended September 30, 2006 included in this Form 10-Q), torecognize changes in non-cash stock-based compensation expense that arose froma re-determination of the fair value of stock options granted in 2005 and priorwhere the Governance Committee’s review resulted in a corrected measurementdate. By January 1, 2006, of the 17.9 million options granted in 2000 - 2005where corrections were made to the measurement dates in the Stock OptionReview, 4.4 million options with corrected measurement dates granted in 2000and 2001 had fully vested. Therefore, the fair values of the outstanding andunvested portion of the remaining 13.5 million stock options granted in2002-2005 with incorrect measurement dates were recalculated. We are alsorecording additional non-cash stock-based compensation expense in the first twoquarters of 2006 arising from correcting the measurement date for stock optiongrants to three individuals in this period. We recognize stock compensationexpense on a straight-line basis under SFAS 123(R).

Those stock optiongrants with corrected measurement dates have also been restated using the fairvalue based measurement principles of Statement of Financial AccountingStandards 123 *Accounting for Stock-Based Compensation*(“SFAS123”) to present, in Note 2, “Restatement of Financial Statements” of Notes toConsolidated Financial Statements contained in Item 8 of our Annual Report onForm 10-K for the year ended December 31, 2006, the pro forma effect onstock-based compensation expense, net income (loss), and earnings (loss) pershare amounts in 2004 and 2005 of using the fair value based method todetermine stock-based compensation expense rather than using APB 25’s intrinsicvalue method. Such disclosure is required in financial statements for periodsprior to the adoption of SFAS 123(R).

In addition torestating the consolidated financial statements in response to the GovernanceCommittee’s findings, we are recording additional non-cash adjustments toaccount for the modification in 1998 of a stock option grant to a formerofficer in connection with his termination of employment and to record in thefirst two quarters of 2006 corrections relating to accounting for performancerelated stock options and restricted stock grants, all of which were previouslyidentified and considered immaterial.

Correcting themeasurement date for previously granted stock options in some cases results inadditional taxable income to employees on which additional payroll taxes aredue from the employees as well as us. We have provided for all additionalpayroll taxes plus related penalties and interest arising from the restatementof stock-based compensation, including amounts otherwise payable by stockoption recipients, and our restated financial statements include an accrual inall affected years of approximately $1.5 million for all estimated payroll taxrelated expenses.

9

----

The correctionsfor the stock option restatement are to increase (reduce) previously reportednon-cash compensation expense, payroll taxes, income taxes and net income bythe following amounts (in thousands of dollars):
| Year ended  December 31, | ** ** | **Non-cash stock  compensation** | ** ** | **Payroll taxes** | ** ** | **Income taxes** | ** ** | **Net income** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
|                               |       |                                  |       |                   |       |                  |       |                |       |
| 1998                               |       | $                                     | 1,244      |                   | $          | —                |       | $                   | (448       | ) | $ | (796 | ) |
| 1999                               |       | —                                |       | —                 |       | —                |       | —              |       |
| 2000                               |       | 556                                   |       | —                 |       | (104                  | )          | (452                | )          |
| 2001                               |       | 4,870                                 |       | —                 |       | (942                  | )          | (3,928              | )          |
| 2002                               |       | 8,110                                 |       | —                 |       | (1,550                | )          | (6,560              | )          |
| 2003                               |       | 12,470                                |       | 900                    |       | (2,281                | )          | (11,089             | )          |
| Totals through December 31, 2003   |       | 27,250                                |       | 900                    |       | (5,325                | )          | (22,825             | )          |
| 2004                               |       | (410                                  | )          | 541                    |       | 250                   |       | (381                | )          |
| 2005                               |       | (1,290                                | )          | 60                     |       | 4,083                 |       | (2,853              | )          |
| 2000-2005 Total                    |       | 25,550                                |       | 1,501                  |       | (992                  | )          | (26,059             | )          |
| 2006 quarter ended                 |       |                                  |       |                   |       |                  |       |                |       |
| March 31                           |       | 662                                   |       | 9                      |       | —                |       | (671                | )          |
| June 30                            |       | 504                                   |       | 6                      |       | —                |       | (510                | )          |
|                               |       | $                                     | 26,716     |                   | $          | 1,516                 |       | $                   | (992       | ) | $ | (27,240 | ) |

 

The GovernanceCommittee’s review found 17.9 million stock options of the 28.8 million optionsgranted on our Common Stock during 2000 through 2005 had incorrect measurementdates. Using the corrected measurement dates, 7.6 million stock options hadexercise prices that exceeded the closing price of our Common Stock andtherefore had no intrinsic value to be accounted for under APB 25, and 10.3million stock options had intrinsic value because their exercise prices werebelow the closing price of our Common Stock. These 10.3 million stock optionsresulted in an increase in additional non-cash stock-based compensation expenseof $24.3 million, and an additional $1.5 million of payroll tax related expensesduring 2000-2005 partially offset by $0.5 million of income tax benefit asshown in the above table. Of the 10.3 million stock options resulting inadditional non-cash stock-based compensation expense, 2.0 million options weregranted to officers and directors and resulted in $6.1 million of additionalnon-cash stock-based compensation expense.

The total effectof the stock option restatement and the amounts for 2006, as shown in the abovetable, have been reflected in the September 30, 2006 financial statements. As aresult of this restatement, net income decreased by $3.7 million and $2.6million, respectively,for the three and nine months ended September 30, 2005.

Upon completingits review, the Governance Committee concluded it found no evidence of intentto manipulate the Company’s operating results or financial statements. A keyfinding of the Governance Committee was that there were deficiencies with theprocess by which stock options were granted during the period from our initialpublic offering in 2000 through at least 2005, which resulted in accountingerrors. The Governance Committee concluded that certain members of managementbear varying degrees of responsibility for the deficiencies in the process bywhich options were granted. The Governance Committee’s review also concludedthat none of the current or former employees or directors of the Companyengaged in intentional wrongdoing.

In determining theabove restatement amounts, management used all reasonably available relevantinformation to form conclusions it believes are reasonable as to the mostlikely option granting actions that occurred, the dates when such actionsoccurred, and the determination of grant dates for financial accountingpurposes based on when the requirements of the accounting standards were met.In light of significant judgment used in establishing revised measurementdates, alternative approaches to those used by the Stock Option Review Team andmanagement could have resulted in different compensation charges than thoserecorded in the restatement. The Stock Option Review Team and managementconsidered various alternatives throughout the course of the review andrestatement, and management believes the adjustments to measurement dates usedin our review of stock option grant accounting and restatement of our financialstatements are reasonable and appropriate in our circumstances.

10

----

***Summaryof Restatement Amounts***

Thefollowing table presents the decrease in net earnings from the restatement foreach restated year:
| Year ended                  | ** ** | **Net income (loss),**     | ** ** | **Restatement adjustments** | ** ** | **Net income (loss),** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **December 31,**            | ** ** | **as previously reported** | ** ** | **China Sales**             | ** ** | **Stock Options**           | ** ** | **Total** | ** ** | **as restated** | ** ** |
| ** **                       | ** ** | ** **                           | ** ** | **(in thousands)**          | ** ** | ** **                       | ** ** |
| ** **                       | ** ** | ** **                           | ** ** | **(Decrease)  Increase**         | ** ** | ** **                       | ** ** |
|                             |       |                                 |       |                             |       |                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| 1998                             |       |                                 |       | $                                | —     |                             | $          | (796 | ) | $ | (796 | ) | ** ** | ** ** |
| 1999                             |       |                                 |       | —                           |       | —                           |       | — | ** ** | ** ** | ** ** |
| 2000                             |       |                                 |       | (4,781                           | )          | (452                             | )          | (5,233 | ) | ** ** | ** ** |
| 2001                             |       |                                 |       | (5,779                           | )          | (3,928                           | )          | (9,707 | ) | ** ** | ** ** |
| 2002                             |       | $                                    | 107,862    |                             | (19,697    | )                                | (6,560     | ) | (26,257 | ) | $ | 81,605 |   |
| 2003                             |       | $                                    | 209,856    |                             | (6,382     | )                                | (11,089    | ) | (17,471 | ) | $ | 192,385 |   |
| Totals through December 31, 2003 |       |                                 |       | (36,639                          | )          | (22,825                          | )          | (59,464 | ) |   |   |
| 2004                             |       | $                                    | 69,824     |                             | (18,594    | )                                | (381       | ) | (18,975 | ) | $ | 50,849 |   |
| 2005                             |       | $                                    | (487,359   | )                                | (42,433    | )                                | (2,853     | ) | (45,286 | ) | $ | (532,645 | ) |
| 2000 - 2005 Total                |       |                                 |       | (97,666                          | )          | (26,059                          | )          | (123,725 | ) | ** ** | ** ** |
| 2006 quarter ended               |       |                                 |       |                             |       |                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| 2006 Q1                          |       |                                 |       | 1,360                            |       | (671                             | )          | 689 | ** ** | ** ** | ** ** |
| 2006 Q2                          |       |                                 |       | (371                             | )          | (510                             | )          | (881 | ) | ** ** | ** ** |
|                             |       |                                 |       | $                                | (96,677    | )                                | $          | (27,240 | ) | $ | (123,917 | ) |   |   |

 

The effect thesecorrections on diluted earnings (loss) per share for 2002 to 2005 are asfollows:
|                       | ** ** | **Diluted earnings**            | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** **                 | ** ** | **Diluted earnings** | ** ** |
|-----------------------|------------|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|----------------------------|------------|---------------------------|------------|
| **Year ended**   | ** ** | **(loss) per share,**      | ** ** | **Restatement amounts** | ** ** | **(loss) per share,** | ** ** |
| **December 31,** | ** ** | **as previously reported** | ** ** | **China sales**         | ** ** | **Stock options**          | ** ** | **Total restatement** | ** ** | **as restated**      | ** ** |
|                  |       |                                 |       |                         |       |                            |       |                       |       |                      |       |
| 2002                  |       | 0.94                                 |       | (0.17                        | )          | (0.06                           | )          | (0.23                      | )          | 0.71                      |       |
| 2003                  |       | 1.70                                 |       | (0.05                        | )          | (0.09                           | )          | (0.14                      | )          | 1.56                      |       |
| 2004                  |       | 0.54                                 |       | (0.14                        | )          | (0.00                           | )          | (0.14                      | )          | 0.40                      |       |
| 2005                  |       | (4.16                                | )          | (0.36                        | )          | (0.03                           | )          | (0.39                      | )          | (4.55                     | )          |

 

The cumulative effect on stockholders’ equity atDecember 31, 2003 from the above corrections is as follows (in thousands):

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

 

In restating thepreviously issued financial statements for the investigations discussed above,the Company also corrected other previously reported amounts. It corrected the reporting of $7.2 million and$62.7 million, respectively, of net sales to certain third party resellers and $7.7million and $24.6 million, respectively, of associated cost of net sales forthe three and nine months ended September 30, 2005 to classify these amounts asrelated party net sales and related party cost of net sales classifications,respectively, because in 2006 the Company determined that sales to theseentities were, in substance, sales to a significant shareholder, SOFTBANK CORP.The classification of the accounts receivable from these sales was similarlychanged to include them in accounts receivable from related parties in the September30, 2005 consolidated balance sheet.

11

----

**PART I—FINANCIALINFORMATION**

**ITEM 1—CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

**(In thousands, except share data)**
| ** **                                                                                                                                                                        | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | ** **                   | ** ** | **(As Restated)**      | ** ** |
| **ASSETS**                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                   |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                         |       | $                            | 604,410    |                        | $          | 645,571 |   |
| Short-term investments                                                                                                                                                            |       | 12,330                       |       | 13,266                      |       |
| Accounts receivable, net of allowances for doubtful  accounts of $61,184 and $67,789 at September 30, 2006 and December 31, 2005,  respectively                                   |       | 391,259                      |       | 439,597                     |       |
| Accounts receivable, related parties, net of  allowances for doubtful accounts of $0 and $5 at September 30, 2006 and  December 31, 2005, respectively                            |       | 37,827                       |       | 83,367                      |       |
| Notes receivable                                                                                                                                                                  |       | 8,532                        |       | 2,065                       |       |
| Inventories                                                                                                                                                                       |       | 463,390                      |       | 425,955                     |       |
| Deferred costs                                                                                                                                                                    |       | 209,230                      |       | 239,876                     |       |
| Prepaids and other current assets                                                                                                                                                 |       | 126,179                      |       | 99,062                      |       |
| Short-term restricted cash and investments                                                                                                                                        |       | 23,835                       |       | 53,680                      |       |
| Total current assets                                                                                                                                                              |       | 1,876,992                    |       | 2,002,439                   |       |
| Property, plant  and equipment, net                                                                                                                                               |       | 212,093                      |       | 233,403                     |       |
| Long-term  investments                                                                                                                                                            |       | 44,954                       |       | 26,023                      |       |
| Goodwill                                                                                                                                                                          |       | 3,063                        |       | 3,063                       |       |
| Intangible  assets, net                                                                                                                                                           |       | 60,747                       |       | 75,313                      |       |
| Long-term  deferred costs                                                                                                                                                         |       | 177,007                      |       | 185,279                     |       |
| Other long-term  assets                                                                                                                                                           |       | 27,817                       |       | 25,811                      |       |
| Total assets                                                                                                                                                                      |       | $                            | 2,402,673  |                        | $          | 2,551,331 |   |
|                                                                                                                                                                              |       |                         |       |                        |       |
| **LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’  EQUITY**                                                                                                                 |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                             |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                  |       | $                            | 308,189    |                        | $          | 320,677 |   |
| Short-term debt                                                                                                                                                                   |       | 105,010                      |       | 198,826                     |       |
| Income taxes payable                                                                                                                                                              |       | 31,147                       |       | 34,229                      |       |
| Customer advances                                                                                                                                                                 |       | 286,630                      |       | 221,301                     |       |
| Deferred revenue                                                                                                                                                                  |       | 95,786                       |       | 101,912                     |       |
| Other current liabilities                                                                                                                                                         |       | 234,621                      |       | 291,368                     |       |
| Total current liabilities                                                                                                                                                         |       | 1,061,383                    |       | 1,168,313                   |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Long-term  deferred revenue                                                                                                                                                       |       | 255,714                      |       | 273,131                     |       |
| Long-term debt                                                                                                                                                                    |       | 274,900                      |       | 274,900                     |       |
| Other long-term  liabilities                                                                                                                                                      |       | 13,843                       |       | —                      |       |
| Total liabilities                                                                                                                                                                 |       | 1,605,840                    |       | 1,716,344                   |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Commitments and  contingencies (Note 16)                                                                                                                                          |       |                         |       |                        |       |
| Minority  interest in consolidated subsidiaries                                                                                                                                   |       | 7,500                        |       | 8,338                       |       |
| Stockholders’  equity:                                                                                                                                                       |       |                         |       |                        |       |
| Common stock: $0.00125 par value; authorized:  750,000,000 shares; issued and outstanding: 121,284,976 and 121,018,036 at  September 30, 2006 and December 31, 2005, respectively |       | 152                          |       | 152                         |       |
| Additional paid-in capital                                                                                                                                                        |       | 1,202,072                    |       | 1,192,201                   |       |
| Deferred stock-based compensation                                                                                                                                                 |       | —                       |       | (3,591                      | )          |
| Accumulated deficit                                                                                                                                                               |       | (452,214                     | )          | (376,899                    | )          |
| Accumulated other comprehensive income                                                                                                                                            |       | 39,323                       |       | 14,786                      |       |
| Total  stockholders’ equity                                                                                                                                                  |       | 789,333                      |       | 826,649                     |       |
| Total  liabilities, minority interest and stockholders’ equity                                                                                                               |       | $                            | 2,402,673  |                        | $          | 2,551,331 |   |

 

See accompanying notes to the condensedconsolidated financial statements.

12

----

**UTSTARCOM, INC.**

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

**(In thousands,except per share data)**
| ** **                                                                              | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                              | ** ** | ** **                                               | ** ** | **As restated**                                    | ** ** | ** ** | ** ** | **As restated** | ** ** |
| Net sales                                                                               | ** ** | ** **                                               |       | ** **                                              |       |   |   |   |   |
| Unrelated party                                                                         |       | $                                                        | 569,826    |                                                    | $          | 584,072 |   | $ | 1,640,761 |   | $ | 1,794,895 |   |
| Related party                                                                           |       | 31,073                                                   |       | 13,363                                                  |       | 113,645 |   | 395,123 |   |
|                                                                                    |       | 600,899                                                  |       | 597,435                                                 |       | 1,754,406 |   | 2,190,018 |   |
| Cost of net  sales                                                                      |       |                                                     |       |                                                    |       |   |   |   |   |
| Unrelated party                                                                         |       | 503,618                                                  |       | 548,686                                                 |       | 1,379,316 |   | 1,645,793 |   |
| Related party                                                                           |       | 22,480                                                   |       | 10,862                                                  |       | 67,548 |   | 171,044 |   |
| Gross profit                                                                            |       | 74,801                                                   |       | 37,887                                                  |       | 307,542 |   | 373,181 |   |
| Operating  expenses:                                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Selling, general and administrative                                                     |       | 80,076                                                   |       | 86,414                                                  |       | 246,908 |   | 297,390 |   |
| Research and development                                                                |       | 46,305                                                   |       | 60,817                                                  |       | 139,310 |   | 192,297 |   |
| Amortization of intangible assets                                                       |       | 4,821                                                    |       | 6,643                                                   |       | 14,567 |   | 20,391 |   |
| Gain on sale of semiconductor design assets                                             |       | (12,291                                                  | )          | —                                                  |       | (12,291 | ) | — |   |
| Impairment of long-lived assets                                                         |       | —                                                   |       | 218,094                                                 |       | — |   | 218,094 |   |
| Restructuring                                                                           |       | —                                                   |       | 3,378                                                   |       | — |   | 18,505 |   |
| In-process research and development                                                     |       | —                                                   |       | —                                                  |       | — |   | 660 |   |
| Total operating  expenses                                                               |       | 118,911                                                  |       | 375,346                                                 |       | 388,494 |   | 747,337 |   |
|                                                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Operating loss                                                                          |       | (44,110                                                  | )          | (337,459                                                | )          | (80,952 | ) | (374,156 | ) |
|                                                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest income                                                                         |       | 3,214                                                    |       | 1,673                                                   |       | 10,693 |   | 4,474 |   |
| Interest expense                                                                        |       | (2,620                                                   | )          | (3,876                                                  | )          | (9,287 | ) | (12,864 | ) |
| Gain on  extinguishment of subordinated notes                                           |       | —                                                   |       | 20,297                                                  |       | — |   | 31,392 |   |
| Other income  (expense), net                                                            |       | 1,835                                                    |       | 7,352                                                   |       | 12,289 |   | (1,723 | ) |
|                                                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Loss before  income taxes, minority interest and equity in loss of affiliated companies |       | (41,681                                                  | )          | (312,013                                                | )          | (67,257 | ) | (352,877 | ) |
| Income tax  expense                                                                     |       | (1,459                                                   | )          | (125,222                                                | )          | (8,966 | ) | (134,041 | ) |
| Minority  interest in losses of consolidated subsidiaries                               |       | 92                                                       |       | 3                                                       |       | 907 |   | 94 |   |
| Equity in loss  of affiliated companies                                                 |       | —                                                   |       | (786                                                    | )          | — |   | (1,818 | ) |
| Net loss                                                                                |       | $                                                        | (43,048    | )                                                       | $          | (438,018 | ) | $ | (75,316 | ) | $ | (488,642 | ) |
|                                                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Loss per share -  Basic and diluted                                                     |       | $                                                        | (0.36      | )                                                       | $          | (3.70 | ) | $ | (0.62 | ) | $ | (4.22 | ) |
|                                                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  shares used in per-share calculation:                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| - Basic and  diluted                                                                    |       | 120,676                                                  |       | 118,262                                                 |       | 120,628 |   | 115,902 |   |

 

See accompanying notes to the condensedconsolidated financial statements.

13

----

**UTSTARCOM, INC.**

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

**(In thousands)**
| ** **                                                                                 | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                                                 | ** ** | ** **                                              | ** ** | **(As restated)** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                     |       |                                                    |       |   |   |
| Net loss                                                                                   |       | $                                                       | (75,316    | ) | $ | (488,642 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                                                    |       |   |   |
| Depreciation and amortization                                                              |       | 51,547                                                  |       | 78,489 |   |
| Gain on sale of semiconductor design assets                                                |       | (12,291                                                 | )          | — |   |
| Net loss on sale of assets                                                                 |       | 2,183                                                   |       | 3,870 |   |
| Loss on asset impairment                                                                   |       | —                                                  |       | 218,094 |   |
| Non-cash restructuring charges                                                             |       | —                                                  |       | 12,389 |   |
| Stock-based compensation expense                                                           |       | 13,143                                                  |       | 191 |   |
| (Recovery of) provision for doubtful accounts                                              |       | (6,948                                                  | )          | 38,115 |   |
| (Recovery of) provision for deferred costs reserves                                        |       | (5,103                                                  | )          | 14,564 |   |
| Deferred income taxes                                                                      |       | (671                                                    | )          | 192,383 |   |
| Gain on extinguishment of debt                                                             |       | —                                                  |       | (31,392 | ) |
| Other                                                                                      |       | (102                                                    | )          | 3,164 |   |
| Changes in operating assets and liabilities:                                               |       |                                                    |       |   |   |
| Accounts receivable                                                                        |       | 105,466                                                 |       | 202,650 |   |
| Inventories                                                                                |       | (35,659                                                 | )          | 116,028 |   |
| Deferred costs                                                                             |       | 51,324                                                  |       | (55,974 | ) |
| Other assets                                                                               |       | (15,585                                                 | )          | 84,956 |   |
| Accounts payable                                                                           |       | (16,027                                                 | )          | (120,472 | ) |
| Income taxes payable                                                                       |       | (3,408                                                  | )          | (118,615 | ) |
| Customer advances                                                                          |       | 61,761                                                  |       | (164,814 | ) |
| Deferred revenue                                                                           |       | (24,740                                                 | )          | 93,138 |   |
| Other current liabilities                                                                  |       | (71,452                                                 | )          | 5,504 |   |
| Net cash  provided by operating activities                                                 |       | 18,122                                                  |       | 83,626 |   |
|                                                                                       |       |                                                    |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                     |       |                                                    |       |   |   |
| Additions to property, plant and equipment                                                 |       | (17,176                                                 | )          | (60,904 | ) |
| Investment in affiliates, net of cash acquired                                             |       | (302                                                    | )          | (3,550 | ) |
| Purchase of business, net of cash acquired                                                 |       | —                                                  |       | (24,326 | ) |
| Proceeds from sale of semiconductor design assets                                          |       | 19,965                                                  |       | — |   |
| Proceeds from disposal of property                                                         |       | 136                                                     |       | 695 |   |
| Change in restricted cash and long-term investments                                        |       | 26,536                                                  |       | 176 |   |
| Purchase of short-term investments                                                         |       | (40,182                                                 | )          | (149,469 | ) |
| Proceeds from sale of short-term investments                                               |       | 42,121                                                  |       | 270,672 |   |
| Other                                                                                      |       | 1,538                                                   |       | (750 | ) |
| Net cash  provided by investing activities                                                 |       | 32,636                                                  |       | 32,544 |   |
|                                                                                       |       |                                                    |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                     |       |                                                    |       |   |   |
| Issuance of stock, net of expenses                                                         |       | 319                                                     |       | 4,327 |   |
| Proceeds from borrowing                                                                    |       | 63,259                                                  |       | 346,284 |   |
| Payments on borrowings                                                                     |       | (159,251                                                | )          | (478,081 | ) |
| Cash paid to extinguish debt                                                               |       | —                                                  |       | (57,136 | ) |
| Other                                                                                      |       | (683                                                    | )          | 1,801 |   |
| Net cash used in  financing activities                                                     |       | (96,356                                                 | )          | (182,805 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                              |       | 4,437                                                   |       | 229 |   |
| Net decrease in  cash and cash equivalents                                                 |       | (41,161                                                 | )          | (66,406 | ) |
| Cash and cash  equivalents at beginning of period                                          |       | 645,571                                                 |       | 562,532 |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                       | 604,410    |   | $ | 496,126 |   |
|                                                                                       |       |                                                    |       |   |   |
| Supplemental  disclosure of cash flow information:                                         |       |                                                    |       |   |   |
| Cash paid:                                                                                 |       |                                                    |       |   |   |
| Interest                                                                                   |       | $                                                       | 8,542      |   | $ | 11,294 |   |
| Income taxes                                                                               |       | $                                                       | 7,839      |   | $ | 10,872 |   |
| Non-cash  operating activity                                                               |       |                                                    |       |   |   |
| Accounts receivable transferred to notes receivable                                        |       | $                                                       | 19,023     |   | $ | 40,210 |   |
| Property, plant  and equipment exchanged for long-term investment                          |       | $                                                       | 5,550      |   | $ | — |   |

 

See accompanying notes to the condensedconsolidated financial statements.

14

----

**UTSTARCOM, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

**1.****             BASIS OF PRESENTATION AND LIQUIDITY**

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of UTStarcom, Inc. (“Company”)and its wholly and majority owned subsidiaries. All significant intercompany accounts and transactions have beeneliminated in the preparation of the condensed consolidated financialstatements.  The minority interests inconsolidated subsidiaries and equity in affiliated companies are shownseparately in the condensed consolidated financial statements.

The accompanying unaudited condensed consolidatedfinancial statements as of September 30, 2006 and for the three and nine monthsended September 30, 2006 and 2005 have been prepared by the Company pursuant tothe rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to suchrules and regulations.  TheDecember 31, 2005 balance sheet was derived from restated auditedfinancial statements, but does not include all disclosures required bygenerally accepted accounting principles. These condensed consolidated financial statements should be read inconjunction with the Company’s audited financial statements, including thenotes thereto, and other information set forth in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2006, which is beingfiled concurrently with this Quarterly Report.

In the opinion of management, theaccompanying unaudited condensed consolidated financial statements reflect alladjustments 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 ofoperations for the three and nine months ended September 30, 2006 are notnecessarily indicative of the operating results for the full year.

The Company reported net losses in each quarter in the period beginningApril 1, 2005 and continuing through September 30, 2006, which has resulted inan accumulated deficit of $452.2 million and total stockholders’ equity beingreduced to $789.3 million at September 30, 2006. Additionally, at September 30,2006, the Company had short-term debt in China under its lines of credit of$105.0 million maturing in 2007 and long-term debt outside of China in the formof its 7/8% convertible subordinated notes with a principal balance of $274.6million that matures in March 2008. Subsequent to December 31, 2006, the Company and the holders of theconvertible subordinated notes entered into two agreements to prevent covenantdefaults occurring from the Company’s inability to timely file requiredperiodic reports containing financial statements with the SEC; the firstagreement increased the interest rate on the convertible subordinated notesfrom 7/8% to 7.625% effective as of January 9, 2007 and the second agreementincreased the interest rate to 10.875% effective as of July 26, 2007. Foradditional information concerning the Company’s Supplemental Indentures seeNote 25.

The Company’s cashand short-term investments aggregated $616.7million (of which $455.4 million are held in China) at September 30, 2006.

Credit facilitiesin China at September 30, 2006 totaled $789.5 million, with $498.5 million ofthis amount available for working capital purposes, of which the Company haddrawn $105.0 million in outstanding borrowings, and $291.0 million wasavailable for use in support of letters of credit and corporate guarantees.These facilities expire primarily in November and December of 2007, and theCompany believes that based upon its recent financial performance and financialposition its lenders may reduce the total available credit when it negotiatesrenewals of these lines. Furthermore, each borrowing under the creditfacilities is subject to the bank’s current favorable opinion of the credit worthinessof the Company’s China subsidiaries, as well as the bank having funds availablefor lending and other Chinese banking regulations. However, the Companybelieves the amounts of credit its lenders may make available and theborrowings made under the renewed lines of credit will be sufficient to meetplanned uses of these credit facilities.

To meet liquidityneeds outside of China, the Company’s subsidiaries in China have the ability totransfer cash to the Company under China’s current exchange controlregulations.  The amount of cashavailable for transfer from the Company’s China subsidiaries is limited both bythe Company’s liquidity needs in China and by Chinese government requirementsthat the China subsidiaries retain adequate capital levels in China to protectcreditors and to have funds available for mandated employee benefits.  The Company believed the China subsidiariescould freely transfer at least $200 million to the Company as of December 31,2006, and during the nine months ended September 30, 2007 its Chinasubsidiaries have made such transfers totaling $150 million.

15

----

Althoughmanagement believes the Company has a sufficient amount of cash resources tofinance the Company’s anticipated working capital and capital expenditurerequirements for the next 12 months, the Company does not have enough cashoutside of China to repay the convertible notes due on March 1, 2008.Management’s liquidity plans include a partial or complete refinancing of theconvertible notes, renewal of the lines of credit in China, transfers of morecash from its subsidiaries in China to the extent necessary, and, if needed,liquidation of  certain investmentsand/or seeking new financing arrangements. The Company’s ability to maintainsufficient liquidity is also dependent on achieving projected sales andoperating margin forecasts.

 

If additionalsources of liquidity were needed, the Company would consider new debt or equityofferings or obtaining cash from asset sales, but there is no assurance thatsuch transactions could be consummated on acceptable terms or at all. Failureto raise sufficient capital when needed could have a material adverse effect onthe business, results of operations and financial position of the Company.

**2.****             RESTATEMENT OF FINANCIAL STATEMENTS**

The consolidatedfinancial statements for the three and nine months ended September 30, 2005included herein have been restated.  Thereasons for the restatement are discussed below.

***China Sales Investigation***

The Audit Committee of the Company’s Board of Directors (“Audit Committee”)engaged independent counsel to conduct an investigation of sales in Chinafollowing a determination by the Internal Audit group that allegations ofimproper activities in a sales office in the Western Region were credible. Theallegations were made by a Company employee using the Company’s whistle blowerprogram. The independent counsel engaged forensic accountants, and this groupis collectively referred to as the Investigating Team in the rest of thisdiscussion.

In conducting its procedures, the Investigating Team found instances wherethe customer contracts that evidenced the arrangement  contained obligations for the Company todeliver software upgrades when and if made available for the equipment sold forno additional consideration and for an unspecified period that could extendover the term of the contract. This additional contract obligation is anelement of “post contract support.”  Inthese cases, the Investigating Team found that the contract documentation forthe same transaction submitted by the sales office to the Company’s Chinaheadquarters for accounting purposes and utilized by the Company in determiningthe amount of revenue recognized did not include evidence of such post contractsupport obligations.

Accounting standards governing revenue recognition for system sales requireall revenue to be deferred while there are undelivered elements under thearrangement unless the seller has established vendor specific objectiveevidence (“VSOE”) of fair value for such contract elements. Because thesearrangements included such undelivered elements, revenue should be deferredbased on the VSOE of the fair value of the underlying elements. VSOE of fairvalue represents the price charged when the same element is soldseparately.  Since the Company does notsell this element separately, it has not established VSOE for such undeliveredelements, and as such the revenue from such contracts is required to bedeferred and recognized over the period the Company is obligated to provide thepost contract support.

Upon completion ofthe investigative phase of the independent investigation by the AuditCommittee, management:

·                  conductedfollow-up procedures to attempt to locate any additional relevant informationto ensure the Company considered all available information and documents;

·                  evaluatedthe accounting for identified system sales using the contract template anddocumentation found in the sales contract files from the Western Regionoffices. This included calculating the financial statement effects ofcorrecting the accounting for all system sales where the contract templatefound at the sales offices contained post contract support obligations torecognize revenue and cost of net sales over estimated period of post contractsupport;

·                  concludedthat as a result of this undelivered post contract support obligation theCompany’s previously issued financial statements should be restated to defersystem sales contract revenue and the related cost of net sales over theestimated period of post contract support when a contract contained unspecifiedsoftware upgrade rights.

The AuditCommittee concurred with management’s decisions.

16

----

The effect ofcorrecting improperly recognized revenue and cost of net sales is to (reduce)increase previously reported net sales, gross profit and net income by thefollowing amounts (in thousands of dollars):
| Year ended  December 31, | ** ** | **Net sales** | ** ** | **Gross profit** | ** ** | **Net income** | ** ** |
|------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------------|------------|
| ** **                         | ** ** | ** **         | ** ** | ** **            | ** ** | ** **          | ** ** |
| 2000                               |       | $                  | (12,408    | )                     | $          | (5,294              | )          | $ | (4,781 | ) |
| 2001                               |       | (17,154            | )          | (6,330                | )          | (5,779              | )          |
| 2002                               |       | (64,732            | )          | (22,924               | )          | (19,697             | )          |
| 2003                               |       | (21,060            | )          | (8,014                | )          | (6,382              | )          |
| Totals through December 31, 2003   |       | (115,354           | )          | (42,562               | )          | (36,639             | )          |
| 2004                               |       | (104,965           | )          | (27,241               | )          | (18,594             | )          |
| 2005                               |       | (58,232            | )          | (27,863               | )          | (42,433             | )          |
| 2000 - 2005  Total                 |       | $                  | (278,551   | )                     | $          | (97,666             | )          | $ | (97,666 | ) |

 

In theconsolidated balance sheets at September 30, 2006 and December 31, 2005, thenet reduction in previously recognized net sales is accounted for as deferredrevenue, of which $34.5 million and $32.9 million, respectively, is classifiedas current, $240.3 million and $252.1 million, respectively as non-current, andthe related net reduction in cost of net sales of $177.0 million and $185.3million, respectively, is accounted for as deferred costs. These amounts willbe recognized in the Company’s consolidated statements of operations over theestimated remaining period of post contract support.

Due to thisrestatement, the Company decreased net sales, gross profit, and net income (inthousands) for the three and nine month periods ended September 30, 2005 asfollows: $34,610 and $63,671; $15,062 and $29,429; and $29,186 and $43,999,respectively.

*Audit Committee Findings*

Upon completingits investigation, the Audit Committee concluded that the conditions andpractices relating to systems contracts prevalent in the Western Regionresulted primarily from the failure to prevent or detect instances of overriderelated to controls in China over customer agreements, lack of propermanagement oversight, unclear record retention policies and procedures relatingto systems contracts, and inadequate employee training.  The Investigating Team and the AuditCommittee also concluded that with respect to four regions other than theWestern Region there was no evidence of fraud or misconduct or reason to suspectsuch occurred. The Investigating Team and the Audit Committee also concludedthat there was no credible evidence of knowledge by senior management in Chinaor the United States of the conditions and practices related to the WesternRegion of China that were discovered in the investigation. The Audit Committeeconcluded that local management in several of the sales offices in the WesternRegion of China did not submit appropriate information to the Company’s seniormanagement in China and the United States. Therefore, in prior years, neitherthe Company’s management nor the Company’s independent registered accountingfirm were able to properly evaluate the effect of that information on revenuerecognition. The Audit Committee also concluded that certain members ofmanagement in China bear varying degrees of responsibility for inadequateoversight of activities. As a result, certain employees in China have eitherbeen terminated or placed on suspension for failure to provide adequateoversight of activities.

***GovernanceCommittee Review of Historical Stock Option Accounting***

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

17

----

The Review Team,management, and the Governance Committee decided to group stock option grantsinto six award categories based on differences in what constituted substantiveapproval for each category under the Company’s stock option granting practicesas well as giving consideration to the risk of intentional misstatement of thegrant date.  Guidance in the September19, 2006 letter on determining the date when substantive approval of a stockoption grant occurs recognizes that depending on a company’s facts andcircumstances a company may determine that the measurement date for some stockoption grants may occur before all required granting actions have occurred –such as final approval by the Compensation Committee. This alternative isavailable only when a review of all facts and circumstances supports aconclusion that substantive approval occurs earlier than when all requiredgranting actions have occurred and there is no evidence of fraudulent ormanipulative conduct in the company’s option granting practices.

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

 

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

18

----

The findings of this review are summarized as follows:

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

 

----

| (1)    | Under APB 25 there is no expense adjustment arising  from using the corrected measurement date for these grants because the amount  the employee would have to pay to exercise these stock option grants exceeded  the quoted market price of the Company’s Common Stock at the corrected  measurement date, and therefore, these stock option grants contained no  intrinsic value at the corrected measurement date. |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                        |
| (2)    | The number of grants  exceeds the number of grant dates because on certain grant dates more than  one category of stock option grants were approved.                                                                                                                                                                                                                                                                        |

 

A non-cash compensation charge, to be recognized as anexpense over a grantee’s service period, arises under Accounting PrinciplesBoard Opinion No. 25 *Accounting for StockIssued to Employees*(“APB 25”), the accounting standard governingthe Company’s stock option accounting through 2005, if a stock option hasintrinsic value at its measurement date. This intrinsic value is measured bythe excess, if any, of the fair value at the date of grant of the underlyingcommon stock over the stock option’s exercise price. The Company’s practice hasbeen to grant stock options with exercise prices equal to the closing price ofthe underlying Company common stock at each grant date, to use the grant dateas the measurement date for stock-based compensation purposes, and as suchpreviously the Company had determined the granted stock options had nointrinsic value at their grant dates and no compensation expense wasrecognized.  However, APB 25 states themeasurement date does not occur until all essential actions necessary to grantthe option are completed, including the final determination of both the numberof shares to be granted to each employee or director and the exercise price,and the option grant is approved by those with requisite authority. A September19, 2006 letter publicly issued by the SEC’s Chief Accountant focused companiesregistered with the SEC on the need for the number of shares and exercise priceof an award to an individual to be finalized to have a measurement date. Thisletter clarifies the SEC staff’s view that if it is possible that those termscould change, a measurement date has not occurred, even if the award’s termsare not actually changed.

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

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

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

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

A total of 17.9million stock options were granted at the 53 tested grant dates during 2000through 2005 where the Governance Committee’s review found the Company usedincorrect measurement dates. Using the corrected measurement dates, 10.3million stock options had intrinsic value because their exercise prices werebelow the closing price of the Company’s Common Stock at the correctedmeasurement date, and 7.6 million stock options had exercise prices thatexceeded the closing price of the Company’s Common Stock and therefore had nointrinsic value to be accounted for under APB 25. These 10.3 million stockoptions resulted in an increase in non-cash stock-based compensation expense of$24.3 million during 2000 to 2005.  Ofthe 10.3 million stock options resulting in additional non-cash stock-basedcompensations expense, 2.0 million options were granted to officers anddirectors and resulted in $6.1 million of additional non-cash stock-basedcompensation expense.

In some cases, incorrecting the measurement date for previously granted stock options additionaltaxable income to employees arises on which additional payroll taxes are duefrom the employee as well as the Company. The Company has 

19

----

assumed responsibilityfor all additional payroll taxes plus related penalties and interest arisingfrom the restatement of stock-based compensation, including amounts otherwisepayable by stock option recipients, and the Company’s restated financialstatements include a $1.5 million accrual for this estimated expense.

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

The Company isconsidering how to deal with exercises of 409A Affected Options that occur in2007 and beyond.  One alternative wouldbe to offer to amend all 409A Affected Options to change the exercise price tothe fair market price of the Company’s common stock on the correctedmeasurement date. These amended options would not be subject to taxation underIRC Section 409A.  Under IRSregulations, option amendments had to be completed by December 31, 2006for anyone who was an executive officer or member of the Board of Directorswhen he or she received 409A Affected Options. Therefore, prior to December 31,2006 eight of the Company’s current and former executive officers and directorsexecuted an irrevocable Protective Amendment Election Form whereby any of theirstock options will be automatically amended to restate the exercise price tothe fair market value of the Company’s common stock at the correctedmeasurement date if in the future such stock options would otherwise bedetermined to be 409A Affected Options. A similar offer to amend all 409A Affected Options held by non-officer employeesis currently under consideration, but no decision has been reached and such anoffer cannot be made until the Company is current with its SEC reportingobligations.

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

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

20

----

The table belowshows the effects of correcting the consolidated financial statements for theGovernance Committee’s findings and the modification in 1998 of a stock optiongrant to a former officer in connection with his termination of employment.Consistent with its historical accounting policy, this additional stock-basedcompensation expense is being recognized on an accelerated basis by treatingeach vesting tranche as a separate stock option grant (graded vesting).  Additionally, the table gives effect tocorrections of the accounting for performance related stock options andrestricted stock grants in the first two quarters of 2006, all of which werepreviously identified and considered immaterial. The effects of correcting theerrors in the Company’s previous stock option accounting are to increase(reduce) previously reported non-cash compensation expense, payroll taxes,income taxes and net income by the following amounts (in thousands of dollars):
| Year ended  December 31, | ** ** | **Non-cash stock  compensation** | ** ** | **Payroll taxes** | ** ** | **Income taxes** | ** ** | **Net income** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
|                               |       |                                  |       |                   |       |                  |       |                |       |
| 1998                               |       | $                                     | 1,244      |                   | $          | —                |       | $                   | (448       | ) | $ | (796 | ) |
| 1999                               |       | —                                |       | —                 |       | —                |       | —              |       |
| 2000                               |       | 556                                   |       | —                 |       | (104                  | )          | (452                | )          |
| 2001                               |       | 4,870                                 |       | —                 |       | (942                  | )          | (3,928              | )          |
| 2002                               |       | 8,110                                 |       | —                 |       | (1,550                | )          | (6,560              | )          |
| 2003                               |       | 12,470                                |       | 900                    |       | (2,281                | )          | (11,089             | )          |
| Totals through December 31, 2003   |       | 27,250                                |       | 900                    |       | (5,325                | )          | (22,825             | )          |
| 2004                               |       | (410                                  | )          | 541                    |       | 250                   |       | (381                | )          |
| 2005                               |       | (1,290                                | )          | 60                     |       | 4,083                 |       | (2,853              | )          |
| 2000-2005 Total                    |       | 25,550                                |       | 1,501                  |       | (992                  | )          | (26,059             | )          |
|                                    |            |                                       |            |                        |            |                       |            |                     |            |  |  |  |  |

 

The followingtable shows the Company’s stock-based compensation expense as previouslyreported and the impact of the restatement (excluding payroll taxes) onstock-based compensation for periods prior to fiscal 2006, net of income tax:
|                                                                                          | ** ** | **Stock-Based Compensation Expense (Net of Tax)** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **(in thousands)**                                                    | ** ** |
| **Year ended December 31,**                                               | ** ** | **As Reported**                                                       | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| 1998 (net of  income tax benefit/(expense) of $118, $448 and $566, respectively)         |       | $                                                                          | 294        |   | $ | 796 |   | $ | 1,090 |   |
| 1999 (net of  income tax benefit/(expense) of $1,596, $0 and $1,596, respectively)       |       | 3,957                                                                      |       | — |   | 3,957 |   |
| 2000 (net of  income tax benefit/(expense) of $3,323, $104 and $3,427, respectively)     |       | 8,238                                                                      |       | 452 |   | 8,690 |   |
| 2001 (net of  income tax benefit/(expense) of $1,495, $942 and $2,437, respectively)     |       | 3,706                                                                      |       | 3,928 |   | 7,634 |   |
| 2002 (net of  income tax benefit/(expense) of $891, $1,550 and $2,441, respectively)     |       | 2,209                                                                      |       | 6,560 |   | 8,769 |   |
| 2003 (net of  income tax benefit/(expense) of $1,212, $2,281 and $3,493, respectively)   |       | 3,071                                                                      |       | 10,189 |   | 13,260 |   |
| 2004 (net of  income tax benefit/(expense) of $149, ($250) and ($101), respectively)     |       | 370                                                                        |       | (160 | ) | 210 |   |
| 2005 (net of income tax  benefit/(expense) of $105, ($4,083) and ($3,978), respectively) |       | 2,154                                                                      |       | 2,793 |   | 4,947 |   |
|                                                                                          |            |                                                                            |            |  |  |  |  |  |  |  |

 

*Governance Committee Findings*

Upon completingits review, the Governance Committee concluded it found no evidence of intentto manipulate the Company’s operating results or financial statements. A keyfinding of the Governance Committee was that there were deficiencies with theprocess by which stock options were granted during the period from the Company’sinitial public offering in 2000 through at least 2005, which resulted inaccounting errors.  The GovernanceCommittee concluded that certain members of management bear varying degrees ofresponsibility for the deficiencies in the process by which options weregranted.  The Governance Committee’sreview also concluded that none of the current or former employees or directorsof the Company engaged in intentional wrongdoing.

21

----

***Restatementand Impact on Financial Statements***

Thefollowing table presents the decrease in net income, by year, as a result ofrestating for the results of the China sales investigation and the historicalstock option accounting review:
| **Year ended**                         | ** ** | **Net income (loss),**     | ** ** | **Restatement adjustments** | ** ** | **Net income (loss),** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **December 31,**                       | ** ** | **as previously reported** | ** ** | **China Sales**             | ** ** | **Stock Options**           | ** ** | **Total** | ** ** | **as restated** | ** ** |
| ** **                                  | ** ** | ** **                           | ** ** | **(in thousands)**          | ** ** | ** **                       | ** ** |
| ** **                                  | ** ** | ** **                           | ** ** | **(Decrease) Increase**     | ** ** | ** **                       | ** ** |
| ** **                                  | ** ** | ** **                           | ** ** | ** **                       | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| 1998                                        |       |                                 |       | $                                | —     |                             | $          | (796 | ) | $ | (796 | ) |   |   |
| 1999                                        |       |                                 |       | —                           |       | —                           |       | — |   |   |   |
| 2000                                        |       |                                 |       | (4,781                           | )          | (452                             | )          | (5,233 | ) |   |   |
| 2001                                        |       |                                 |       | (5,779                           | )          | (3,928                           | )          | (9,707 | ) |   |   |
| 2002                                        |       |                                 |       | (19,697                          | )          | (6,560                           | )          | (26,257 | ) |   |   |
| 2003                                        |       |                                 |       | (6,382                           | )          | (11,089                          | )          | (17,471 | ) |   |   |
| Totals through December 31, 2003            |       |                                 |       | (36,639                          | )          | (22,825                          | )          | (59,464 | ) |   |   |
| 2004                                        |       | $                                    | 69,824     |                             | (18,594    | )                                | (381       | ) | (18,975 | ) | $ | 50,849 |   |
| 2005                                        |       | $                                    | (487,359   | )                                | (42,433    | )                                | (2,853     | ) | (45,286 | ) | $ | (532,645 | ) |
| 2000 - 2005  Total                          |       |                                 |       | (97,666                          | )          | (26,059                          | )          | (123,725 | ) |   |   |
| Three months  ended September 30, 2005 |       | $                                    | (405,126   | )                                | (29,185    | )                                | (3,707     | ) | (32,892 | ) | $ | (438,018 | ) |
| Nine months  ended September 30,2005   |       | $                                    | (442,029   | )                                | (43,997    | )                                | (2,616     | ) | (46,613 | ) | $ | (488,642 | ) |
|                                             |            |                                      |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |

 

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

***OtherChanges***

Inrestating the previously issued financial statements for the investigationsdiscussed above, the Company also corrected other previously reported amounts. It corrected the reporting of $7.2 million and$62.7 million, respectively, of net sales to certain third party resellers and $7.7million and $24.6 million, respectively, of associated cost of net sales forthe three and nine months ended September 30, 2005 to classify these amounts asrelated party net sales and related party cost of net sales classifications,respectively, because in 2006 the Company determined that sales to theseentities were, in substance, sales to a significant shareholder, SOFTBANK CORP.The classification of the accounts receivable from these sales was similarlychanged to include them in accounts receivable from related parties in the September30, 2005 consolidated balance sheet.

22

----

***Restated Financial Information***

The following tables summarize the impact of therestatement adjustments on the condensed consolidated statement of operationsfor the three and nine months ended September 30, 2005 and the condensedconsolidated statement of cash flows for the nine months ended September 30,2005:

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**
| ** **                                                                              | ** ** | **Three months ended September 30, 2005**    | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **As previously  reported**                                      | ** ** | **Adjustments** | ** ** | **As restated** | ** ** |
| ** **                                                                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net sales                                                                               |       |                                                                  |       |   |   |   |   |
| Unrelated party                                                                         |       | $                                                                     | 625,902    |   | $ | (41,830 | ) | $ | 584,072 |   |
| Related party                                                                           |       | 6,144                                                                 |       | 7,219 |   | 13,363 |   |
|                                                                                    |       | 632,046                                                               |       | (34,611 | ) | 597,435 |   |
| Cost of net  sales                                                                      |       |                                                                  |       | — |   |   |   |
| Unrelated party                                                                         |       | 575,907                                                               |       | (27,221 | ) | 548,686 |   |
| Related party                                                                           |       | 3,185                                                                 |       | 7,677 |   | 10,862 |   |
| Gross profit                                                                            |       | 52,954                                                                |       | (15,067 | ) | 37,887 |   |
| Operating  expenses:                                                                    |       |                                                                  |       |   |   |   |   |
| Selling, general and administrative                                                     |       | 86,362                                                                |       | 52 |   | 86,414 |   |
| Research and development                                                                |       | 60,797                                                                |       | 20 |   | 60,817 |   |
| Amortization of intangible assets                                                       |       | 6,643                                                                 |       | — |   | 6,643 |   |
| Impairment of long-lived assets                                                         |       | 218,094                                                               |       | — |   | 218,094 |   |
| Restructuring costs                                                                     |       | 3,378                                                                 |       | — |   | 3,378 |   |
| Total operating  expenses                                                               |       | 375,274                                                               |       | 72 |   | 375,346 |   |
|                                                                                    |       |                                                                  |       | — |   |   |   |
| Operating loss                                                                          |       | (322,320                                                              | )          | (15,139 | ) | (337,459 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Interest income                                                                         |       | 1,673                                                                 |       | — |   | 1,673 |   |
| Interest expense                                                                        |       | (3,876                                                                | )          | — |   | (3,876 | ) |
| Gain on  extinguishment of subordinated notes                                           |       | 20,297                                                                |       | — |   | 20,297 |   |
| Other income,  net                                                                      |       | 7,352                                                                 |       | — |   | 7,352 |   |
| Loss before  income taxes, minority interest and equity in loss of affiliated companies |       | (296,874                                                              | )          | (15,139 | ) | (312,013 | ) |
| Income tax  expense                                                                     |       | (107,469                                                              | )          | (17,753 | ) | (125,222 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Minority  interest in losses of consolidated subsidiaries                               |       | 3                                                                     |       | — |   | 3 |   |
| Equity in loss  of affiliated companies                                                 |       | (786                                                                  | )          | — |   | (786 | ) |
| Net loss                                                                                |       | $                                                                     | (405,126   | ) | $ | (32,892 | ) | $ | (438,018 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Loss per share -  Basic and diluted                                                     |       | $                                                                     | (3.43      | ) | $ | (0.27 | ) | $ | (3.70 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Weighted average  shares used in per-share calculation:                                 |       |                                                                  |       |   |   |   |   |
| - Basic and  diluted                                                                    |       | 118,262                                                               |       | 118,262 |   | 118,262 |   |

 

23

----

| ** **                                                                              | ** ** | **Nine months ended September 30, 2005**     | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **As previously  reported**                                      | ** ** | **Adjustments** | ** ** | **As restated** | ** ** |
| ** **                                                                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net sales                                                                               |       |                                                                  |       |   |   |   |   |
| Unrelated party                                                                         |       | $                                                                     | 1,921,264  |   | $ | (126,369 | ) | $ | 1,794,895 |   |
| Related party                                                                           |       | 332,425                                                               |       | 62,698 |   | 395,123 |   |
|                                                                                    |       | 2,253,689                                                             |       | (63,671 | ) | 2,190,018 |   |
| Cost of net sales                                                                       |       |                                                                  |       |   |   |   |   |
| Unrelated party                                                                         |       | 1,704,751                                                             |       | $ | (58,958 | ) | 1,645,793 |   |
| Related party                                                                           |       | 146,422                                                               |       | 24,622 |   | 171,044 |   |
| Gross profit                                                                            |       | 402,516                                                               |       | (29,335 | ) | 373,181 |   |
| Operating expenses:                                                                     |       |                                                                  |       |   |   |   |   |
| Selling, general  and administrative                                                    |       | 298,384                                                               |       | (994 | ) | 297,390 |   |
| Research and  development                                                               |       | 192,678                                                               |       | (381 | ) | 192,297 |   |
| Amortization of  intangible assets                                                      |       | 20,391                                                                |       | — |   | 20,391 |   |
| Impairment of  long-lived assets                                                        |       | 218,094                                                               |       | — |   | 218,094 |   |
| Restructuring                                                                           |       | 18,505                                                                |       | — |   | 18,505 |   |
| In-process  research and development                                                    |       | 660                                                                   |       | — |   | 660 |   |
| Total operating  expenses                                                               |       | 748,712                                                               |       | (1,375 | ) | 747,337 |   |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Operating loss                                                                          |       | (346,196                                                              | )          | (27,960 | ) | (374,156 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Interest income                                                                         |       | 4,474                                                                 |       | — |   | 4,474 |   |
| Interest expense                                                                        |       | (12,864                                                               | )          | — |   | (12,864 | ) |
| Gain on extinguishment  of subordinated notes                                           |       | 31,392                                                                |       | — |   | 31,392 |   |
| Other expense, net                                                                      |       | (1,723                                                                | )          | — |   | (1,723 | ) |
| Loss before income  taxes, minority interest and equity in loss of affiliated companies |       | (324,917                                                              | )          | (27,960 | ) | (352,877 | ) |
| Income tax expense                                                                      |       | (115,388                                                              | )          | (18,653 | ) | (134,041 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Minority interest in  losses of consolidated subsidiaries                               |       | 94                                                                    |       | — |   | 94 |   |
| Equity in loss of  affiliated companies                                                 |       | (1,818                                                                | )          | — |   | (1,818 | ) |
| Net loss                                                                                |       | $                                                                     | (442,029   | ) | (46,613 | ) | $ | (488,642 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Loss per share - Basic  and diluted                                                     |       | $                                                                     | (3.81      | ) | $ | (0.41 | ) | $ | (4.22 | ) |
|                                                                                    |       |                                                                  |       |   |   |   |   |
| Weighted average shares  used in per-share calculation:                                 |       |                                                                  |       |   |   |   |   |
| - Basic and diluted                                                                     |       | 115,902                                                               |       | 115,902 |   | 115,902 |   |

 

24

----

**CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)**
| ** **                                                                                 | ** ** | **Nine months ended September 30, 2005** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **As previously  reported**                                  | ** ** | **Adjustments** | ** ** | **As restated** | ** ** |
| ** **                                                                                 | ** ** | **(In thousands)**                                           | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                     |       |                                                              |       |   |   |   |   |
| Net loss                                                                                   |       |                                                              |       |   |   |   |   |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       | $                                                                 | (442,029   | ) | $ | (46,613 | ) | $ | (488,642 | ) |
| Depreciation and amortization                                                              |       | 78,489                                                            |       |   |   | 78,489 |   |
| Net loss on disposal of property                                                           |       | 3,870                                                             |       |   |   | 3,870 |   |
| Loss on asset impairment                                                                   |       | 218,094                                                           |       |   |   | 218,094 |   |
| Non-cash restructuring charges                                                             |       | 12,389                                                            |       |   |   | 12,389 |   |
| Stock-based compensation expense                                                           |       | 1,712                                                             |       | (1,521 | ) | 191 |   |
| Provision for doubtful accounts                                                            |       | 38,115                                                            |       |   |   | 38,115 |   |
| Provision for deferred costs                                                               |       | 14,564                                                            |       |   |   | 14,564 |   |
| Deferred income taxes                                                                      |       | 173,730                                                           |       | 18,653 |   | 192,383 |   |
| Gain on extinguishment of debt                                                             |       | (31,392                                                           | )          |   |   | (31,392 | ) |
| Other                                                                                      |       | 3,164                                                             |       |   |   | 3,164 |   |
| Changes in operating assets and liabilities:                                               |       |                                                              |       |   |   |   |   |
| Accounts receivable                                                                        |       | 202,650                                                           |       |   |   | 202,650 |   |
| Inventories                                                                                |       | 116,028                                                           |       |   |   | 116,028 |   |
| Deferred costs                                                                             |       | (21,389                                                           | )          | (34,585 | ) | (55,974 | ) |
| Other current and non-current assets                                                       |       | 84,956                                                            |       |   |   | 84,956 |   |
| Accounts payable                                                                           |       | (120,472                                                          | )          |   |   | (120,472 | ) |
| Income taxes payable                                                                       |       | (118,615                                                          | )          |   |   | (118,615 | ) |
| Customer advances                                                                          |       | (164,814                                                          | )          |   |   | (164,814 | ) |
| Deferred revenue                                                                           |       | 29,125                                                            |       | 64,013 |   | 93,138 |   |
| Other current liabilities                                                                  |       | 5,451                                                             |       | 53 |   | 5,504 |   |
| Net cash  provided by operating activities                                                 |       | 83,626                                                            |       | — |   | 83,626 |   |
|                                                                                       |       |                                                              |       |   |   |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                     |       |                                                              |       |   |   |   |   |
| Additions to property, plant and equipment                                                 |       | (60,904                                                           | )          |   |   | (60,904 | ) |
| Investment in affiliates, net of cash acquired                                             |       | (3,550                                                            | )          |   |   | (3,550 | ) |
| Purchase of business, net of cash acquired                                                 |       | (24,326                                                           | )          |   |   | (24,326 | ) |
| Proceeds from disposal of property                                                         |       | 695                                                               |       |   |   | 695 |   |
| Change in restricted cash and long-term investments                                        |       | 176                                                               |       |   |   | 176 |   |
| Purchase of short-term investments                                                         |       | (149,469                                                          | )          |   |   | (149,469 | ) |
| Proceeds from sale of short-term investments                                               |       | 270,672                                                           |       |   |   | 270,672 |   |
| Other                                                                                      |       | (750                                                              | )          |   |   | (750 | ) |
| Net cash  provided by investing activities                                                 |       | 32,544                                                            |       | — |   | 32,544 |   |
|                                                                                       |       |                                                              |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                     |       |                                                              |       |   |   |   |   |
| Issuance of stock, net of expenses                                                         |       | 4,327                                                             |       |   |   | 4,327 |   |
| Proceeds from borrowing                                                                    |       | 346,284                                                           |       |   |   | 346,284 |   |
| Payments on borrowings                                                                     |       | (478,081                                                          | )          |   |   | (478,081 | ) |
| Cash paid to extinguish debt                                                               |       | (57,136                                                           | )          |   |   | (57,136 | ) |
| Other                                                                                      |       | 1,801                                                             |       |   |   | 1,801 |   |
| Net cash used in  financing activities                                                     |       | (182,805                                                          | )          | — |   | (182,805 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                              |       | 229                                                               |       |   |   | 229 |   |
| Net decrease in  cash and cash equivalents                                                 |       | (66,406                                                           | )          | — |   | (66,406 | ) |
| Cash and cash  equivalents at beginning of period                                          |       | 562,532                                                           |       | — |   | 562,532 |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                                 | 496,126    |   | $ | — |   | $ | 496,126 |   |
|                                                                                       |       |                                                              |       |   |   |   |   |
| Supplemental  disclosure of cash flow information:                                         |       |                                                              |       |   |   |   |   |
| Cash paid:                                                                                 |       |                                                              |       |   |   |   |   |
| Interest                                                                                   |       | $                                                                 | 11,294     |   | $ | — |   | $ | 11,294 |   |
| Income taxes                                                                               |       | $                                                                 | 10,872     |   | $ | — |   | $ | 10,872 |   |
| Non-cash  operating activity                                                               |       |                                                              |       |   |   |   |   |
| Accounts receivable transferred to notes receivable                                        |       | $                                                                 | 40,210     |   | $ | — |   | $ | 40,210 |   |

 

25

----

**3.****             SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*Use of Estimates:*

The preparation of consolidated financial statements inconformity with generally accepted accounting principles in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of revenues and expenses during the reporting period.  Estimates are used for revenue recognition,allowance for doubtful accounts and sales returns, tax valuation allowances,reserves for inventory, deferred costs, accrued product warranty costs,provisions for contract losses, goodwill and other long-lived assetimpairments, stock-based compensation, loss contingencies and restructuringexpenses  among others.  Actual results could differ from thoseestimates.

*Revenue Recognition:*

Revenues from sales of telecommunications equipment andhandsets are recognized when persuasive evidence of an arrangement exists,delivery has occurred, the fee is fixed or determinable and collectibility isprobable.  If the payment due from thecustomer is not fixed or determinable due to extended payment terms, revenue isrecognized as payments become due and payable by the customer, assuming allother criteria for revenue recognition are met. Any payments received prior to revenue recognition are recorded ascustomer advances.  Normal payment termsdiffer for various reasons amongst different customer regions, depending uponcommon business practices for customers within a region.  Billing to customers for shipping andhandling are recorded as revenues and the associated costs are recorded ascosts of revenues.  Any expected losseson contracts are recognized when identified on an individual basis inaccordance with the prevailing accounting guidance for the respective contract.

Sales may be generated from complex contractualarrangements that require significant revenue recognition judgments,particularly in the area of contracts with multiple deliverable elements(multiple element arrangements).  Wheremultiple elements exist in an arrangement, the contract price is allocated tothe different elements based upon and in proportion to verifiable objectiveevidence of the fair value of the various elements, as governed under EmergingIssues Task Force Issue (“EITF”) No. 00-21, “Accounting for RevenueArrangements with Multiple Deliverables,” and SEC Staff Accounting BulletinNo. 104, “Revenue Recognition.” Multiple element arrangements primarily involve the sale of equipment,installation, training and post-contract support.  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) has beendetermined, the delivered element(s) has stand-alone value, there is noright of return on delivered element(s), and the Company is in control of theundelivered element(s).  For arrangementsthat include service elements, including promotional support and installation,for which verifiable objective evidence of the fair value does not exist,revenue is deferred until such services are deemed complete, or until the timethe Company can establish verifiable objective evidence of the fair value.

Final acceptance is required for revenue recognition wheninstallation services are not considered perfunctory.  Final acceptance indicates that the customerhas fully accepted delivery of equipment and the Company is entitled to fullpayment.  The Company does not recognizerevenue before final acceptance is granted by the customer if acceptance isconsidered substantive to the transaction.

Where multiple elements exist in an arrangement thatincludes software, and the software is considered more than incidental to theequipment or services in the arrangement, software and software relatedelements are recognized under the provisions of Statement of Position 97-2, “SoftwareRevenue Recognition,” as amended, and EITF No. 03-05, “Applicability of SOP97-2 to Non-software Deliverables Containing More Than Incidental Software.”  The Company allocates revenues to eachelement of software arrangements based on vendor specific objective evidence (“VSOE”)of fair value.  VSOE of fair value ofeach element is based on the price charged when the same element is soldseparately.  The Company uses theresidual method to recognize revenue when an arrangement includes one or moreelements to be delivered at a future date and VSOE of the fair value of all theundelivered elements exists.  Under theresidual method, the fair value of the undelivered elements is deferred and theremaining portion of the contract price is recognized as revenue when all otherrevenue recognition criteria are met.  IfVSOE of fair value of one or more undelivered elements does not exist, allrevenue for delivered and undelivered elements is deferred until delivery ofall elements occurs or when VSOE of fair value of the undelivered elements canbe established.  In some cases theCompany has agreed to give software upgrade rights on a “when and if madeavailable” basis for equipment sold for no additional consideration and for anunspecified period which could extend over the term of the contract.  This additional contract obligation is anelement of “post contract support.”  TheCompany has not established VSOE for such contract element.  Accordingly, the revenues from such contractsare recognized ratably over the period during which the post contract supportis expected to be provided.  The expectedperiod of support is generally the term of the contract.  In some cases where there is no 

26

----

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

Contract accounting is utilized for contracts that includea requirement for significant software modification or customization; whenutilized the Company generally accounts for such contracts using the completedcontract method of accounting, whereby no revenue is recognized prior to thecompletion of the project, because for contracts involving unique requirementsthe Company is unable to make reasonably dependable estimates of its progresstowards meeting contractual requirements. In the event estimated total projectcosts exceed estimated total project revenues, the entire estimated loss ischarged to operations in the period in which the loss becomes probable and canbe reasonably estimated. The complexity of the estimation process and judgmentsabout internal and external factors including labor utilization, changes tospecifications and testing requirements, time required for performance andresulting incurrence of contract penalties, and the performance ofsubcontractors affect the estimation process.

The Company recognizes revenue for system integration,installation and training upon completion of performance and if all otherrevenue recognition criteria are met. Other service revenue, principally related to maintenance and supportcontracts, is recognized ratably over the maintenance term.  Revenues from services were less than 10% ofrevenues for all periods presented.

The Company also sells products through resellers.  Revenue is generally recognized when thestandard price protection period, which ranges from 30 to 90 days, haslapsed.  If collectibility cannot bereasonably assured in a reseller arrangement, revenue is recognized upon sellthrough to the end customer and receipt of cash.  There may be additional obligations inreseller arrangements such as inventory rotation, or stock exchange rights onthe product.  As such, revenue isrecognized in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 48, “Revenue Recognition When Right of Return Exists.”  In most cases, the Company has developedreasonable estimates for stock exchanges based on historical experience withsimilar types of sales of similar products.

The Company has sales agreements with certain wireless customersthat provide for a rebate of the selling price to such customers if theparticular product is subsequently sold at a lower price to such customers orto a different customer.  The rebateperiod extends for a relatively short period of time.  Historically, the amounts of such rebatespaid to customers have not been material. The Company estimates the amount of the rebate based upon the terms ofeach individual arrangement, historical experience and future expectations ofprice reductions and then records its estimate of the rebate amount at the timeof the sale.  The Company also entersinto sales incentive programs, such as co-marketing arrangements, with certainwireless and handset customers.  TheCompany records the incurred incentive as a reduction of revenue when the salesrevenue is recognized.

The assessment of collectibility is also a factor indetermining whether revenue should be recognized.  The Company assesses collectibility based ona number of factors, including payment history and the credit worthiness of thecustomer.  The Company does not requestcollateral from its customers.  Ininternational sales, the Company may require letters of credit from its customersthat can be drawn on demand if the customer defaults on its payment.  If the Company determines that collection ofa payment is not reasonably assured, the Company defers revenue recognitionuntil collection becomes reasonably assured, which is generally upon receipt ofcash.

Occasionally, the Company enters into revenue sharingarrangements.  Under these arrangements,the Company collects payment only after its customer, the telecommunicationsservice provider, collects service revenues. When the Company enters a revenue sharing arrangement, the Company doesnot recognize revenue until collection is reasonably assured.

Because of the nature of doing business in China andother emerging markets, the Company’s billings and/or customer payments may notcorrelate with the contractual payment terms and the Company generally does notenforce contractual payment terms prior to final acceptance.  Accordingly, accounts receivable are notrecorded until the Company recognizes the related customer revenue.  Advances from customers are recognized whenthe Company has collected cash from the customer, prior to recognizingrevenue.  The Company had currentdeferred revenue of $95.8 million and $101.9 million, and long-term deferredrevenue of $255.7 million and $273.1 million at September 30, 2006 and December31, 2005, respectively.

27

----

*Inventories:*

Inventories consist of product held at the Company’smanufacturing facility and warehouses, as well as finished goods at customersites for which the customer has taken possession, but based on specificcontractual terms, title has not yet passed to the customer. The Company mayship inventory to existing customers that require additional equipment toexpand their existing networks prior to the signing of an expansion contract.Inventories are stated at the lower of cost or market value, net of write-downsfor excess, slow moving and obsolete inventory. With the exception of thehandset inventory for our Personal Communications Division (“PCD”), which isbased on weighted average cost, inventory cost is computed using standard cost,which approximates actual cost on a first-in, first-out basis.Inventory is written down for estimated obsolescence or unmarketable inventoryequal to the difference between inventory cost and the estimated market value.

*Deferred costs:*

Deferred costs consist of product shipped to the customerfor which the rights and obligations of ownership have passed to the customerbut revenue has not yet been recognized. Deferred costs also include the costsassociated with third party integrators and freight. All deferred costs are statedat cost. Management periodically assesses the recoverability of deferred costsand provides reserves against deferred cost balances when recovery of deferredcosts is not probable. Recoverability is evaluated based on various factorsincluding the length of time the product has been held at the customer site,the viability of payment, including assessment of product demand if a revenuesharing arrangement exists and/or the evaluation if a related transaction willresult in a gross margin loss. In a loss situation for a transaction, thedeferred cost balance is adjusted for an impairment equal to the value of theexcess of cost over the amount of revenue that will be eventually recognizedfor the transaction.  Revenue and cost ofsales are recorded when final acceptance is received from the customer. Withgreater concentration of product at customer sites with specific or individualcustomer, the financial conditions of any specific or individual customer mayresult in increased concentration risk exposure for the Company’s inventory.

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

*Stock-Based Compensation*

Prior to January 1, 2006, the Company accounted forshare-based payment awards under Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” (“APB 25”), andprovided the required pro forma disclosures under SFAS No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”). In accordance with APB 25, non-cash compensation expense was recognizedfor any options for which the exercise price was below the market price on theactual grant date, based on the difference between the exercise price and themarket price.  The expense was recognizedratably over the associated service period, which was generally the optionvesting term.

On January 1, 2006, the Company adopted SFASNo. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”),using the modified prospective transition method. Stock-basedcompensation expense recognized during the period is based on the value of theportion of share-based payment awards that is ultimately expected tovest.  Stock-based compensationexpense recognized in the consolidated statement of operations for the yearended December 31, 2006 included compensation expense for share-basedpayment awards granted prior to, but not yet vested as of December 31,2005 based on the grant date fair value estimated in accordance with the proforma provisions of SFAS 123 and compensation expense for the share-basedpayment awards granted subsequent to December 31, 2005 based on the grantdate fair value estimated in accordance with the provisions ofSFAS 123(R).  On November 10, 2005,the Financial Accounting Standards Board (“FASB”) issued FASB Staff PositionNo. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards.”  The Companyadopted the alternative transition method provided in the FASB Staff Positionfor calculating the tax effects of stock-based compensation pursuant to SFAS123(R).  The alternative transition methodincludes simplified methods for establishing the beginning balance of theadditional paid-in-capital pool (“APIC pool”) related to the tax effects ofemployee stock-based compensation, and to determine the subsequent impact onthe APIC pool and consolidated statements of cash flows of the tax effects ofemployee stock-based compensation awards that are outstanding upon adoption ofSFAS 123(R).  The Company accountsfor utilization of windfall tax benefits based on tax law ordering andconsidered only the direct effects of stock-based compensation for purposes ofmeasuring the windfall at settlement of an award.

28

----

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

***Stock Option Plans***

*2006 Equity Incentive Plan:*

The 2006 EquityIncentive Plan (“2006 Plan”) was implemented on July 21, 2006 after beingadopted by the Board of Directors on June 6, 2006 and approved by the Company’sstockholders on July 21, 2006.  The 2006Plan replaces the 1997 Plan, the 2001 Plan, and the 2003 Plan (collectively,the “Prior Plans”), and no further awards will be granted pursuant to the PriorPlans.   The 2006 Plan provides for thegrant of the following types of incentive awards: (i) stock options, (ii) stockappreciation rights, (iii) restricted stock, (iv) restricted stock units, (v)performance shares and performance units, and (vi) and other stock or cashawards (“Award,” collectively, “Awards”). Those who are eligible for Awards under the 2006 Plan include employees,directors and consultants who provide services to the Company and its affiliates.

The maximumaggregate number of shares that may be awarded and sold under the 2006 Plan is4,500,000 shares plus (i) any shares that have been reserved but remainunissued under the Prior Plans as of July 21, 2006, and (ii) any shares subjectto stock options or similar awards granted under the Prior Plans that expire orbecome exercisable without having been exercised in full and shares issuedpursuant to awards granted under the Prior Plans that are forfeited to orrepurchased by the Company. As of September 30, 2006, the number of sharestransferred from the Prior Plans to the 2006 plan totaled 5,638,708.  As of September 30, 2006 options to purchase41,750 shares of common stock were outstanding under the 2006 plan.

The Board ofDirectors or the Compensation Committee of the Board (“Compensation Committee”)administers the 2006 Plan (“Administrator”). Subject to the terms of the 2006 Plan, the Administrator has the solediscretion to select the employees, consultants, and directors who will receiveAwards, determine the terms and conditions of Awards, and to interpret theprovisions of the 2006 Plan and outstanding Awards.  Options granted under the 2006plan generally vest and become exercisable over four years.

Awardsgranted under the 2006 Plan are generally not transferable, and all rights withrespect to an Award granted to a participant generally may be exercised duringa participant’s lifetime only by the participant; provided, however, that withthe Administrator’s approval, a participant may (i) transfer an Award to aparticipant’s spouse or former spouse pursuant to a court-approved domesticrelations order which relates to the provision of child support, alimonypayments or marital property rights, or (ii) transfer an Award by gift to orfor the benefit of the participant’s immediate family.

Theexercise price of all stock options and stock appreciation rights granted underthe 2006 Plan must be at least equal to 100% of the fair market value of theCommon Stock on the date of grant (or at least 110% of such fair market valuefor an incentive stock option (“ISO”) granted to a stockholder with greaterthan 10% voting power of the Company’s stock). The maximum term of a stock option granted to any participant must notexceed seven years from the date of grant (or five years for an ISO granted toa stockholder with greater than 10% of the voting power of the CommonStock).  The Administrator will determinethe terms and conditions of all other Awards granted under the Plan.

In theevent of a “change in control” of the Company, each outstanding Award will beassumed or an equivalent option or right substituted by the successorcorporation or a parent or subsidiary of the successor corporation.  In the event that the successor corporation,or the parent or subsidiary of the successor corporation, refuses to assume orsubstitute for the Award, the participant will fully vest in and have the rightto exercise all of his or her outstanding options or stock appreciation rights,including shares as to which such Awards would not otherwise be vested orexercisable, all restrictions on restricted stock will lapse, and, with respectto restricted stock units, performance shares and performance units, allperformance goals or other vesting criteria will be deemed achieved at targetlevels and all other terms and conditions met. In addition, if an option orstock appreciation right is not assumed or substituted for in the event of achange of control, the Administrator will notify the participant in writing orelectronically that the option or stock appreciation right will be fully vestedand exercisable for a period of time determined by the Administrator in itssole discretion, and the option or stock appreciation right will terminate uponthe expiration of such period.

*PriorPlans –The 1997 Stock Plan, 2001 Director Option Plan, The 2003 Non-StatutoryStock Option Plan:*

*The 1997 Stock Plan*

Prior to the implementation of the 2006 Plan onJuly 21, 2006, officers, employees and consultants of the Company and itsaffiliates were eligible to receive options to purchase shares of common stockand stock purchase rights under the 1997 Stock Plan (“1997 Plan”).  On January 31, 1997, the Board ofDirectors adopted, and the Company’s stockholders approved, the 1997 Plan.  In December 1999, the Board of Directorsamended the 1997 Plan, which the Company’s stockholders approved inFebruary 2000.  The 1997 Plan wasterminated in July 2006 effective upon stockholder approval of the 2006Plan.  As of September 30, 2006, there wereoptions to purchase 19,446,566 shares of common stock outstanding under the1997 Plan.

29

----

Options granted under the 1997 Plan prior toJuly 21, 2006 were either ISOs intended to qualify for favorable federalincome tax treatment under the provisions of Section 422 of the InternalRevenue Code of 1986, as amended, or non-qualified stock options (“NSOs”),which did not so qualify.  TheCompensation Committee oversaw the selection of eligible persons for optiongrants and determined the grant date, amounts, exercise prices, vesting periodsand other relevant terms of the options, including whether the options would beISOs or NSOs.  The exercise price of ISOsgranted under the 1997 Plan could not be less than 100% of the fair marketvalue of common stock on the grant date, (or at least 110% of such fair marketvalue for an ISO granted to a stockholder with greater than 10% voting power ofthe Company’s stock), while the exercise price of NSOs could be determined bythe Compensation Committee in its discretion.  Options granted under the 1997 Plan weregenerally not transferable during the life of the optionee.

Under the 1997 Plan, options vest and become exercisableas determined by the Compensation Committee, generally over four years.  Options may generally be exercised at anytime after they vest and before their expiration date as determined by theCompensation Committee.  However, nooption may be exercised more than ten years after the grant date (or five yearsfor ISOs granted to a stockholder with greater than 10% voting power of theCommon Stock).  Options will generallyterminate (i) 12 months after the death or permanent disability of anoptionee and (ii) three months after termination of employment for anyother reason.  The aggregate fair marketvalue of the shares of common stock represented by ISOs that become exercisablein any calendar year by any one option holder may not exceed $100,000.  Options in excess of this limit are treatedas NSOs.

Prior to the implementation of the 2006 Plan, the Companycould also grant stock purchase rights to eligible participants under the 1997Plan.  Under the 1997 Plan, any sharespurchased pursuant to stock purchase rights were subject to a restricted stockpurchase agreement.  Unless theCompensation Committee determined otherwise, this agreement granted the Companya right to repurchase the restricted stock upon the voluntary or involuntarytermination of the employee for any reason, including death or disability priorto vesting.  The purchase price forrepurchased shares was the original price paid and could be paid bycancellation of any indebtedness owed to the Company.  The Company’s repurchase right lapsed at arate determined by the Compensation Committee.

In the event the Company is merged with or into anothercorporation, or all or substantially all of the Company’s assets are sold, eachoutstanding option and stock purchase rights will be assumed or an equivalentoption or stock purchase right will be substituted by the successor corporationor its parent or subsidiary.  If thesuccessor corporation refuses to assume or substitute for the option or right,the option or stock purchase right will automatically vest and becomeexercisable in full for a period of at least fifteen days, after which time theoption or right will terminate.

*2001 Director Option Plan:*

Prior to the implementation of the 2006 Plan onJuly 21, 2006, those directors who were not employees of the Company (“OutsideDirectors”) were eligible to receive options to purchase shares of common stockunder the 2001 Director Option Plan (“2001 Plan”).  The 2001 Plan was adopted by the Board ofDirectors on March 2, 2001 and was approved by the Company’s stockholdersin May 2001.  In July 2001, theBoard of Directors amended the 2001 Plan. The 2001 Plan was terminated in July 2006 effective upon stockholderapproval of the 2006 Plan. As of September 30, 2006, there were options topurchase 360,000 shares of common stock outstanding under the 2001 Plan.  The Compensation Committee has been the administratorof the 2001 Plan.

Under the terms of the 2001 Plan, each Outside Directorwas automatically granted an option to purchase eighty thousand shares ofcommon stock (“First Option”) on the date on which such person first became anOutside Director (“Anniversary Date”).  Adirector who was an employee of the Company and ceased employment with theCompany to become an Outside Director could receive an option to purchasetwenty thousand shares of common stock (“Subsequent Option”) at the Company’sfirst annual meeting of stockholders following such conversion to an OutsideDirector and at each subsequent annual stockholder meeting thereafter, providedthat he or she was serving as an Outside Director on each such date.  As such time as each Outside Director’s FirstOption was fully vested, each Outside Director was automatically granted aSubsequent Option on the Anniversary Date of each year provided that he or shewas then an Outside Director.

Under the terms of the 2001 Plan, the exercise price ofeach option granted equaled the market value of the common stock on the date ofgrant.  Such options have terms of tenyears, but terminate earlier if the individual ceases to serve as a director.  The First Option grants vest as to 25% ofshares subject to the First Option on each of the first four anniversaries ofits date of grant, subject to the Outside Director continuing to serve as adirector on such dates.  The SubsequentOption grants vest as to 100% of the shares subject to the Subsequent Option onthe first anniversary of its date of grant.

30

----

*The 2003 Nonstatutory Stock Option Plan:*

Prior to the implementation of the 2006 Plan onJuly 21, 2006, directors, officers, employees and consultants of theCompany and its affiliates were eligible to receive options to purchase sharesof the Company’s common stock under the 2003 Nonstatutory Stock Option Plan (“2003Plan”).  The 2003 Plan was adopted by theBoard of Directors on April 15, 2003. Only nonstatutory stock options, which would not qualify for favorablefederal income tax treatment under the provisions of Section 422 of theInternal Revenue Code of 1986, as amended, could be granted under the 2003Plan.  The 2003 Plan was terminated inJuly 2006 effective upon stockholder approval of the 2006 Plan.  As of September 30, 2006, options to purchase929,035 shares of common stock were outstanding under the 2003 Plan.

The 2003 Plan has been administered by the CompensationCommittee.  The Compensation Committeeoversaw the selection of the eligible persons to whom options would be grantedand determined the number of shares subject to the option, exercise prices,vesting periods and other terms applicable to each option.

Options granted under the 2003 Plan generally vest andbecome exercisable over four years, and may be exercised at any time after theyvest but before their expiration date. Options will generally terminate (i) 12 months after the deathor employment termination due to disability of an option holder and(ii) three months after termination of an option holder’s service for anyother reason other than for disability or due to the option holder’sdeath.  No option, however, may beexercised more than ten years after the grant date.

In the event of the Company’s “change in control,” the2003 Plan provides for each outstanding option to be assumed or an equivalentoption or right to be substituted by the successor corporation or its parent orsubsidiary.  If the successor corporationrefuses to assume or substitute for the option, the option will automaticallyvest and become exercisable in full for a period determined by the compensationcommittee, after which time the option will terminate.

*Issanni Communications, Inc. Incentive Program:*

The Issanni plan was established for the issuance of upto a total of 39,876 shares of UTStarcom’s common stock to specified formeremployees of Issanni Communications, Inc. (“Issanni”) who became UTStarcom’semployees in connection with UTStarcom’s acquisition of Issanni.  The Issanni plan is administered by the Boardof Directors or the Compensation Committee. A participant in the Issanni plan is eligible to earn and vest in adesignated number of shares that are subject to the award of shares made to aparticipant under the plan, based upon the attainment of one of six milestonesrelated to the amount of revenue generated from Issanni products in 2002 and2003 and subject to the participant’s continued employment with Issanni, theCompany or one of their subsidiaries through the day of the determination thatthe applicable milestone has been satisfied. In addition, each participant isentitled to receive the unearned shares, if any, on the fifth anniversary ofthe acquisition of Issanni if the employee continues to be employed withIssanni, the Company or any of their subsidiaries on such date regardless ofwhether any milestone is attained.  Theshares subject to an award will in any event become issuable, whether or notthe milestones were achieved and whether or not the five-year vesting schedulehas elapsed, upon (i) the sale or the discontinuation of the Company orUTStarcom International Products Inc., (ii) the sale of substantiallyall or any of the technology acquired by UTStarcom InternationalProducts Inc. in connection with the acquisition of Issanni, or (iii) theemployment termination of certain Issanni principals.

If, prior to the date on which all of a participant’sshares are earned, the participant’s service with Issanni, the Company or oneof their subsidiaries is terminated (i) voluntarily or for cause, theCompany may exercise its repurchase option with respect to any of theparticipant’s unearned shares, (ii) other than voluntarily or for cause,death or disability, the participant will be entitled to receive the sharesthat the participant would have otherwise earned with respect to milestonesachieved within 24 months of the participant’s termination, or(iii) as a result of death or disability, the participant (or his estate)will be entitled to receive the unearned portion of his shares with respect toall milestones.

*Advanced Communication Devices Corporation IncentiveProgram:*

In February, 2006 the Company sold substantially all ofthe assets and selected liabilities of its semiconductor design operations,including the assets related to its prior acquisition of ACD. As a result, allparticipants’ service with the Company was voluntarily terminated and allshares subject to award that were not yet earned or distributed were cancelled.

31

----

***Stock Award and Stock Option Activity***

A summary of activity under all Plans follows:
|                                          | ** ** | **Shares available  for grant** | ** ** | **Number of   options   outstanding** | ** ** | **Weighted average  exercise price** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------------------|------------|------------------------------------------------|------------|
| Options  outstanding, December 31, 2005  |       | 6,345,767                                 |       | 19,908,010                                           |       | $                                              | 18.34      |   |
| Options authorized in 2006               |       | 4,900,000                                 |       |                                                 |       | —                                         |       |
| Options granted                          |       | (5,410,057                                | )          | 5,410,057                                            |       | 6.12                                           |       |
| Options exercised                        |       | —                                    |       | (266,940                                             | )          | 1.20                                           |       |
| Options forfeited or expired             |       | 4,264,291                                 |       | (4,264,291                                           | )          | 20.10                                          |       |
| Options outstanding,  September 30, 2006 |       | 10,100,001                                |       | 20,786,836                                           |       | $                                              | 15.01      |   |

 

During the nine months ended September 30, 2006, theCompany granted restricted stock awards to its employees under the 2006 Planand the 1997 Plan.  Such awards generallyvest over a period of one to four years from the date of grant.  The restricted stock awards have the votingrights of common stock and the shares underlying the restricted stock awardsare considered issued and outstanding. The Company expenses the cost of the restricted stock awards, which isdetermined to be the fair market value of the shares at the date of grant,ratably over the period during which the restrictions lapse.  The grant of restricted stock awards isdeducted from the shares available for grant under the Company’s stock optionplan.  Nonvested restricted stockactivity as of September 30, 2006 and changes during  the nine months endedSeptember 30, 2006 is summarized below:
|                                                                                      | ** ** | **Shares** | ** ** | **Weighted average  grant date fair  value** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|
| Restricted  shares granted under 2006 and 1997 Plans                                 |       |       |       |                                                        |       |
| Nonvested at December 31, 2005                                                       |       | 150,000    |       | $                                                           | 8.15       |   |
| Granted                                                                              |       | 174,884    |       | 7.69                                                        |       |
| Vested                                                                               |       | (36,221    | )          | 7.81                                                        |       |
| Forfeited                                                                            |       | —     |       | —                                                      |       |
| Nonvested at September 30, 2006                                                      |       | 288,663    |       | $                                                           | 7.93       |   |
|                                                                                 |       |       |       |                                                        |       |
| Restricted stock  related to acquisition in 2002, included in issued and outstanding |       | 282,878    |       | $                                                           | 17.50      |   |
|                                                                                 |       |       |       |                                                        |       |
| Total nonvested at  September 30, 2006                                               |       | 571,541    |       | $                                                           | 12.67      |   |

 

During the year ended December 31, 2005, the Companygranted 150,000 shares of restricted stock with a weighted average grant datefair value of $8.15, all of which was nonvested as of December 31, 2005.  The shares of restricted stock are subject tothe Company’s right of repurchase, which lapse over a period of one to fouryears. Repurchased shares are recorded as treasury stock on an average costbasis.  During the nine months endedSeptember 30, 2006, 174,844 shares of restricted stock subject to suchrepurchase right of the Company were purchased by employees and directors. Thetotal intrinsic value of restricted stock vested during the nine months endedSeptember 30, 2006 was $0.3 million. The Company also granted rights topurchase 301,133 shares of restricted stock to executive officers of theCompany which were allowed to lapse unexercised in March 2006.  In their place, on February 1, 2007, theCompensation Committee of the Board of Directors of the Company determined thatcertain executive officers, based on their level of performance during theCompany’s 2006 fiscal year, are eligible to receive 203,000 shares of commonstock in the aggregate.  The Committee’sdetermination is subject to compliance with applicable law, and the Committeewill issue the Performance Stock after the Company is in compliance with allSEC reporting requirements   ThePerformance Stock is included in the Company’s computation of stock-basedcompensation expense for the nine months ended September 30, 2006.

In connection with the October 2002 acquisition ofShanghai Yi Yun Telecom Technology Co. Ltd. (“Shanghai Yi Yun”),  the Company issued 514,290 shares ofrestricted stock valued at that time at $9.0 million to the Shanghai YiYun employees that were hired by one of the Company’s subsidiaries. Such sharesof restricted stock cliff vests over five years through 2007, with acceleratedvesting upon the achievement of specified milestones. The Company has treatedthese 514,290 shares of restricted stock as deferred compensation. During 2003,226,302 of these shares vested upon achievement of specified milestones. As ofSeptember 30, 2006, 5,110 shares have been forfeited resulting in 282,878remaining shares outstanding.  No furthervesting has occurred through September 30, 2006.

32

----

Information regarding the stock options outstanding atSeptember 30, 2006, is summarized below:
|                                                              | ** ** | **Options Outstanding**                  | ** ** | **Options Exercisable**           | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------|------------|
| **Range of  exercise  price**                           | ** ** | **Outstanding  at  September 30,  2006** | ** ** | **Weighted  average  exercise  price** | ** ** | **Intrinsic  value** | ** ** | **Weighted  average  remaining  contractual  life** | ** ** | **Exercisable  at  September 30,  2006** | ** ** | **Weighted  average  exercise  price** | ** ** | **Intrinsic  value** | ** ** |
| ** **                                                   | ** ** | ** **                                    | ** ** | ** **                             | ** ** | **(in thousands)** | ** ** | **(in years)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
| $  0.06 - $ 4.50                    |       | 840,442                                       |       | $                                      | 3.75       |   | $ | 4,299 |   | 2.5 |   | 840,442 |   | $ | 3.75 |   | $ | 4,299 |   |
|   4.71 -   6.25                |       | 4,366,737                                     |       | 6.24                                   |       | 11,467 |   | 9.4 |   | 3,088 |   | 5.56 |   | 10 |   |
|   6.31 -   7.50                          |       | 2,201,753                                     |       | 6.63                                   |       | 4,925 |   | 9.2 |   | 49,972 |   | 6.90 |   | 99 |   |
|   7.52 - 11.07                           |       | 2,806,721                                     |       | 9.94                                   |       | 551 |   | 8.2 |   | 1,133,365 |   | 9.91 |   | 185 |   |
| 11.11 - 16.34                                      |       | 2,195,483                                     |       | 14.21                                  |       | — |   | 5.2 |   | 2,017,565 |   | 14.21 |   | — |   |
| 16.54 - 20.25                                      |       | 3,172,860                                     |       | 19.24                                  |       | — |   | 6.2 |   | 2,770,819 |   | 19.41 |   | — |   |
| 20.48 - 26.34                                      |       | 2,902,314                                     |       | 25.29                                  |       | — |   | 7.0 |   | 2,851,399 |   | 25.35 |   | — |   |
| 26.34 - 37.46                                      |       | 2,131,206                                     |       | 31.18                                  |       | — |   | 7.0 |   | 2,130,790 |   | 31.18 |   | — |   |
| 37.49 - 43.02                                      |       | 119,320                                       |       | 40.11                                  |       | — |   | 6.9 |   | 119,320 |   | 40.11 |   | — |   |
| 45.21 - 45.21                                      |       | 50,000                                        |       | 45.21                                  |       | — |   | 6.9 |   | 50,000 |   | 45.21 |   | — |   |
| $ 0.06 - $ 45.21                                   |       | 20,786,836                                    |       | $                                      | 15.01      |   | $ | 21,242 |   | 7.4 |   | 11,966,760 |   | $ | 20.30 |   | $ | 4,593 |   |
|                                                         |       |                                          |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Options exercisable and  expected to vest September 30, 2006 |       | 19,229,712                                    |       | $                                      | 15.02      |   | $ | 18,315 |   |   |   |   |   |   |   |   |   |

 

The intrinsic value represents the total pre-taxintrinsic value and is calculated as the difference between the market value asreported by NASDAQ on September 30, 2006 and the exercise price of thein-the-money shares.  The total intrinsicvalue of options exercised was $0.4 million and the amount of cash received forthe exercise of options was $0.3 million during the nine months ended September30, 2006.  The weighted average remainingcontractual life of options exercisable was 6.0 years, and the weightedaverage remaining contractual life of options expected to vest was 9.1 years asof September 30, 2006.

*2000 Employee Stock Purchase Plan:*

In February 2000, the Company’s stockholdersapproved the 2000 Employee Stock Purchase Plan. The purchase plan is intended to qualify as an employee stock purchaseplan under Section 423 of the Internal Revenue Code.

The Company had reserved 1,914,934 shares of common stockfor sale under the stock purchase plan at September 30, 2006.  The number of shares reserved for sale underthe plan will be increased annually on the first day of each fiscal yearbeginning in 2001 by an amount equal to 2.0 million shares, or 2% of theoutstanding shares of the Company’s common stock on that date, or a lesseramount determined by the Board of Directors. The stock purchase plan is administered by the Board or a committeeappointed by the Board.

The stock purchase plan is implemented by concurrentoffering periods, the duration of which may not exceed 24 months.  An offering period may contain up to fourinterim purchase periods.  Sharespurchased under the stock purchase plan will be held in separate accounts foreach participant.  The first offeringperiod began in March 2000 and ended on the last trading day beforeApril 30, 2002.  There were noshares issued in May 2006 as the Company was not current with the filingsof its annual report on Form 10-K for the year ended December 31,2005 and quarterly report on Form 10-Q for the quarter endedMarch 31, 2006.  The May 2006offering period commenced on June 29, 2006, and terminates on May 14,2008.  Subsequent consecutive overlappingoffering periods begin on May 15 and November 15 annually.  These offering periods end twenty-four monthsthereafter.

Employees will be eligible to participate in the stockpurchase plan if they are employed by the Company for more than 20 hoursper week and more than five months in a calendar year.  The stock purchase plan permits eligibleemployees to purchase the Company’s common stock through payroll deductions,which may not exceed 15% of the employee’s total compensation.  Stock may be purchased under the plan at aprice equal to 85% of the fair market value of the Company’s stock on eitherthe date of purchase or the first day of the offering period, whichever islower.  However, the Board of Directorsmay 

33

----

in its discretion provide that the price at which shares of common stockare purchased under the plan shall be 85% of the fair market value of theCompany’s shares on the date of purchase. Participants may not purchase shares of common stock having a valuegreater than $25,000 during any calendar year.

Participants may increase or decrease their payrolldeductions at any time during an offering period, subject to limits imposed bythe Board of Directors.  If a participantwithdraws from the stock purchase plan, any contributions that have not beenused to purchase shares shall be refunded. A participant who has withdrawn may not participate in the stockpurchase plan again until the next offering period.  In the event of retirement or cessation ofemployment for any reason, any contributions that have not yet been used topurchase shares will be refunded to the participant, or to the participant’sdesignated beneficiary in the case of death, and a certificate will be issuedfor the full shares in the participant’s account.

The Board of Directors may terminate or amend the stockpurchase plan, subject to stockholder approval in some circumstances.  Unless terminated earlier by the Board, thestock purchase plan will have a term of ten years.

***Stock-Based Compensation***

SFAS123(R) requires the use of option-pricing models that were not developed foruse in valuing employee stock options. The Company has used the Black-Scholes option pricing model (“Black-Scholesmodel”)  method of valuation forshare-based awards granted prior to December 31, 2005, and has continued to usethe Black-Scholes model for subsequent share-based payment awards.  The Black-Scholes model was developed for usein estimating the fair value of short-lived exchange traded options that haveno vesting restrictions and are fully transferable.  In addition, option pricing models requirethe input of highly subjective assumptions, including the expected stock price volatility over the term ofthe awards, actual and projected employee stock option exercise behaviors,risk-free interest rate and expected dividends. The Company uses historicalvolatility as management believes it is more representative of future stockprice trends than implied volatility due to the relatively small number ofactively traded options on our common stock available to determine impliedvolatility. The Company estimates an expected term of options granted basedupon the Company’s historical exercise and cancellation data for vestedoptions. In addition, separate groups of employees that have similar exercisebehavior are considered separately. The expected term of employee stockpurchase plan shares is the average of the remaining purchase periods undereach offering period. The Company bases the risk free interest rate used in theoption valuation model on U.S. Treasury zero-coupon issues with remaining termssimilar to the expected term on the options. The Company does not anticipatepaying any cash dividends in the foreseeable future and therefore uses anexpected dividend yield of zero in the option valuation model. The Company isrequired to estimate forfeitures at the time of grant and revise thoseestimates in subsequent periods if actual forfeitures differ from thoseestimates. The Company uses historical data to estimate pre-vesting optionforfeitures and record stock-based compensation expense only for thoseawards that are expected to vest. Prior to January 1, 2006, stock basedawards were amortized on an accelerated basis by treating each vesting trancheas a separate stock option grant (graded vesting).  Upon adoption of SFAS 123(R) on January 1,2006, all stock based payment awards areamortized on a straight-line basis over the requisite service periods of theawards, which are generally the vesting periods.

The fair value of share based payment awards wasestimated using the Black-Scholes option pricing model with the followingassumptions:
|                                           | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Expected term in  years                   |       | 4.0                                                      |       | 4.0                                                     |       | 4.0 |   | 3.2 |   |
| Weighted average  risk-free interest rate |       | 4.9                                                      | %          | 4.0                                                     | %          | 4.7 | % | 3.8 | % |
| Expected  dividend rate                   |       | 0.0                                                      | %          | 0.0                                                     | %          | 0.0 | % | 0.0 | % |
| Volatility                                |       | 56.0                                                     | %          | 71.0                                                    | %          | 56.9 | % | 65.7 | % |

 

34

----

|                                           | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Expected term in years                    |       | 0.5-2.0                                                  |       | 0.5-2.0                                                 |       | 0.5-2.0 |   | 0.5-2.0 |   |
| Weighted average  risk-free interest rate |       | 4.4                                                      | %          | 2.7                                                     | %          | 4.4 | % | 2.7 | % |
| Expected dividend rate                    |       | 0.0                                                      | %          | 0.0                                                     | %          | 0.0 | % | 0.0 | % |
| Volatility                                |       | 63.0                                                     | %          | 52.0                                                    | %          | 63.0 | % | 52.0 | % |

 

At September 30, 2006, there was $30.2 million oftotal unrecognized compensation cost, as measured, related to non-vested stockoptions and restricted stock, which is expected to be recognized over aweighted-average period of 2.7 years.  The weighted average fair value of optionsgranted under the stock option plans during the nine months ended September 30,2006 was $3.06 per share.

The total stock-based compensation cost recognizedin income for the three and nine month periods ended September 30, 2006 was asfollows:
|                                                               | ** ** | **Three months  ended September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                             | ** ** | **2006**                                            | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                              | ** ** |
| Stock-based  compensation expense by type of award:           |       |                                                 |       |                                                |       |
| Employee stock options                                        |       | $                                                    | 3,787      |                                                | $          | 11,180 |   |
| Employee stock purchase plan                                  |       | 416                                                  |       | 1,150                                               |       |
| Restricted stock                                              |       | 1,401                                                |       | 3,206                                               |       |
| Forfeitures related to disposal of a component of a  business |       | —                                               |       | (2,393                                              | )          |
| Tax effect                                                    |       | —                                               |       | —                                              |       |
| Total                                                         |       | $                                                    | 5,604      |                                                | $          | 13,143 |   |

 

Stock-based compensation expense for the nine monthsended September 30, 2006 was reduced by $2.4 million related to optionsforfeited in connection with the disposal of the Company’s semiconductor designoperations discussed in Note 11.  As aresult of adopting SFAS 123(R) on January 1, 2006, the Company’s income beforeincome taxes and net income for the three and nine months ended September 30, 2006 were approximately $3.3 million and$8.9 million lower than if it had continued to account for stock incentivecompensation under the intrinsic value method. Had the Company continued to usethe intrinsic value method, the effect on basic and diluted earnings per sharewould have been an increase of approximately $0.03 and  $0.07 per share during the three and ninemonths ended September 30, 2006, respectively.

35

----

*Prior to the adoption of SFAS 123(R)*

The pro forma information required under SFAS 123for the three and nine months ended September 30, 2005 was as follows:
|                                                                                                                         | ** ** | **Three months   ended   September 30,**       | ** ** | **Nine months   ended   September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                                                           | ** ** | **2005**                                                    | ** ** |
| ** **                                                                                                              | ** ** | **as restated**                                               | ** ** | **as restated**                                        | ** ** |
| ** **                                                                                                              | ** ** | **(in thousands, except per share data)** | ** ** |
| Basic and  diluted                                                                                                      |       |                                                               |       |                                                        |       |
| Net loss:                                                                                                               |       |                                                               |       |                                                        |       |
| As reported                                                                                                             |       | $                                                                  | (438,018   | )                                                           | $          | (488,642 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss, net of related tax effects               |       | 4,172                                                              |       | 3,857                                                       |       |
| Deduct: Total compensation expense determined under  fair value based method for all awards, net of related tax effects |       | (4,044                                                             | )          | (11,661                                                     | )          |
| Pro forma net  loss                                                                                                     |       | $                                                                  | (437,890   | )                                                           | $          | (496,446 | ) |
| Basic and  diluted loss per share:                                                                                      |       |                                                               |       |                                                        |       |
| As reported                                                                                                             |       | $                                                                  | (3.70      | )                                                           | $          | (4.22 | ) |
| Pro forma                                                                                                               |       | $                                                                  | (3.70      | )                                                           | $          | (4.28 | ) |

 

**5.****                                      LOSS PER SHARE**

Basic EPS is computed by dividing net loss available tocommon stockholders by the weighted average number of shares of the Company’scommon stock outstanding during the period, which excludes unvested restrictedshares. Diluted EPS presents the amount of net loss available to each share ofcommon stock outstanding during the period plus each share of common stock thatwould have been outstanding assuming the Company had issued shares of commonstock for all potentially dilutive common shares outstanding during the period.The Company’s potentially dilutive common shares include employee stockoptions, unvested restricted shares, a written call option, warrants,convertible subordinated notes and vested acquisition-related stockoptions.

The following is a summary of the calculation of basicand diluted EPS:
|                                                                    | ** ** | **Three months ended September 30,**          | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                                          | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | ** **                                                        | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                                                         | ** ** | **(in thousands except per share data)** | ** ** |
| **Numerator:**                                                     | ** ** | ** **                                                        | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss for basic EPS  computation                                |       | $                                                                 | (43,048    | )                                                       | $          | (438,018 | ) | $ | (75,316 | ) | $ | (488,642 | ) |
| Effect of dilutive  securities 7/8% convertible subordinated notes |       | —                                                            |       | —                                                  |       | — |   | — |   |
| Net loss adjusted for  dilutive securities                         |       | $                                                                 | (43,048    | )                                                       | $          | (438,018 | ) | $ | (75,316 | ) | $ | (488,642 | ) |
|                                                               |       |                                                              |       |                                                    |       |   |   |   |   |
| **Denominator:**                                                   | ** ** | ** **                                                        | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Shares used to compute  basic EPS                                  |       | 120,676                                                           |       | 118,262                                                 |       | 120,628 |   | 115,902 |   |
| Dilutive common stock  equivalent shares                           |       | —                                                            |       | —                                                  |       | — |   | — |   |
| Shares used to compute  diluted EPS                                |       | 120,676                                                           |       | 118,262                                                 |       | 120,628 |   | 115,902 |   |
|                                                               |       |                                                              |       |                                                    |       |   |   |   |   |
| Loss per share - basic  and diluted                                |       | $                                                                 | (0.36      | )                                                       | $          | (3.70 | ) | $ | (0.62 | ) | $ | (4.22 | ) |

 

For the three and nine months ended September 30, 2006and 2005, there were no potentially dilutive common shares because of the netloss in each of these periods, and basic and dilutive EPS are the same. Thefollowing table summarizes the total potential shares of common stock that wereexcluded from the diluted per share calculation, because to include them wouldhave been anti-dilutive for the period.

36

----

 
|                                               | ** ** | **Three months ended September 30,**          | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                                          | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                    | ** ** | ** **                                                        | ** ** | **As restated**                                    | ** ** | ** ** | ** ** | **As restated** | ** ** |
| ** **                                    | ** ** | **(in thousands except per share data)** | ** ** |
| Stock options                                 |       | 20,787                                                            |       | 19,401                                                  |       | 20,787 |   | 19,231 |   |
| Conversion of  convertible subordinated notes |       | 11,543                                                            |       | 12,941                                                  |       | 11,543 |   | 15,415 |   |
| Other                                         |       | 827                                                               |       | 474                                                     |       | 744 |   | 430 |   |
|                                          |       | 33,157                                                            |       | 32,816                                                  |       | 33,074 |   | 35,076 |   |

 

**6.****                                      COMPREHENSIVE LOSS**

The reconciliation of net loss to comprehensive loss forthe three and nine months ended September 30, 2006 and 2005 is as follows:
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | **As restated**                                    | ** ** | ** ** | ** ** | **As restated** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| Net loss                               |       | $                                                        | (43,048    | )                                                       | $          | (438,018 | ) | $ | (75,316 | ) | $ | (488,642 | ) |
| Unrealized gain (loss)  on investments |       | 15,719                                                   |       | (22                                                     | )          | 15,721 |   | (30 | ) |
| Foreign currency  translation          |       | 5,553                                                    |       | 10,718                                                  |       | 8,817 |   | 10,163 |   |
| Total comprehensive loss               |       | $                                                        | (21,776    | )                                                       | $          | (427,322 | ) | $ | (50,778 | ) | $ | (478,509 | ) |

 

**7.****                                      CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS**

Cash and cash equivalents consist of instruments withmaturities of three months or less at the date of purchase.  There were no available for sale securitiesincluded in cash and cash equivalents at September 30, 2006 orDecember 31, 2005.  Short-terminvestments, consisting entirely of available-for-sale securities, were$12.3 million and $13.3 million at September 30, 2006 andDecember 31, 2005, respectively. These available-for-sale securities currently consist of bank timedeposits, but can consist of government-backed notes, commercial paper,floating rate corporate bonds and fixed income corporate bonds.  These investments are recorded at fairvalue.  Any unrealized holding gains orlosses are reported as a component of other comprehensive income.  Realized gains and losses are reported inearnings.

The Company accepts bank notes receivable with maturitydates of between three and six months from its customers in China in the normalcourse of business.  The Company maydiscount these bank notes with banking institutions in China.  A sale of these notes is reflected as areduction of cash and cash equivalents or short-term investments and theproceeds of the settlement of these notes are included in cash flows fromoperating activities in the consolidated statement of cash flows.  There were no bank notes sold during thethree and nine months ended September 30, 2006.

Any notes that have been sold are not included in theCompany’s consolidated balance sheets as the criteria for sale treatmentestablished by SFAS No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishment of Liabilities” (“SFAS 140”), havebeen met.  Under SFAS 140, upon atransfer, the transferor or entity must de-recognize financial assets whencontrol has been surrendered and the transferee obtains control over theassets.  In addition, the transferredassets have been isolated from the transferor, beyond the reach of itscreditors, and the transferee has the right, without conditions or constraints,to pledge or exchange the assets it has received.

**8.****                                      RESTRICTED CASH AND INVESTMENTS**

At September 30, 2006, the Company had short-termrestricted cash and investments of $23.8 million and long-term restrictedcash of $3.6 million included in other long-term assets.  At December 31, 2005, the Company hadshort-term restricted cash and investments of $53.7 million and long-termrestricted cash of $0.3 million included in other long-term assets.  These amounts primarily collateralize theCompany’s issuance of standby and commercial letters of credit.

37

----

**9.****                                      ACCOUNTS AND NOTES RECEIVABLE**

The Company accepts bank notes and commercial notesreceivable from its customers in China in the normal course of business.  The notes are typically non-interest bearing,with maturity dates between three and six months.  Bank notes are included in short-terminvestments.  Commercial notes receivableavailable for sale were $8.5 million and $2.1 million at September30, 2006 and December 31, 2005, respectively.  The Company may discount these notes withbanking institutions in China.  A sale ofthese notes is reflected as a reduction of notes receivable and the proceeds ofthe 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 receivable sold duringthe three and nine months ended September 30, 2006 and 2005.

In August 2005, the Company entered into a CommittedReceivables Purchase Agreement (“Agreement”) with a commercial bank, wherebythe Company may sell up to $100.0 million of its eligible accountsreceivable, as defined in the Agreement. The Agreement contains provisions customary in transactions of thisnature including certain commitment fees. During the three and nine months ended September 30, 2006, noreceivables have been sold pursuant to provisions of the Agreement, and theCompany recorded commitment fees of $0.4 million. In March 2007, theAgreement was amended and restated to reflect that the purchase of tradereceivables shall be at the sole discretion of the commercial bank, with noassociated commitment fees.

**10.****                               INVENTORIES**

As of September 30, 2006 and December 31, 2005,total inventories consisted of the following:

|                   | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|-------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **        | ** ** | **(in thousands)** | ** ** |
| Raw materials     |       | $                       | 84,566     |                  | $          | 70,608 |   |
| Work-in-process   |       | 36,704                  |       | 27,582                |       |
| Finished goods    |       | 342,120                 |       | 327,765               |       |
| Total inventories |       | $                       | 463,390    |                  | $          | 425,955 |   |

 

**11.****                               SALE OF ASSETS**

*Marvell Technology Group Ltd.:*

In February 2006, the Company sold substantially allof the assets and selected liabilities of its semiconductor design businessdivision to Marvell Technology Group Ltd. (“Marvell”).  The Company received $35.4 million incash, net of $0.6 million of transaction costs, and an additional$4.3 million in cash was paid by Marvell to the Company inAugust 2007.  Included in the cashreceived was $16.0 million earned by the Company as a result of achievingcertain defined milestones. The Company received payment of this $16.0 millionin October 2006.  The assets sold includethe assets related to the prior acquisition of Advanced Communications DevicesCorporation in 2001, and other system-on-chip semiconductors.  In connection with the sale of assets, theCompany has entered into a supply agreement with Marvell.  Pursuant to the supply agreement, the Companyhas agreed to purchase chipsets supplied by Marvell for a period of fiveyears.  These chipsets will be includedin certain handset products designed and manufactured by the Company.

The Company recognized a gain on this sale of assets of $12.3 millionduring the three months ended September 30, 2006.  The gain was determined based upon total netproceeds less the net book value of assets sold of $2.9 million and the valueof the supply agreement of $20.2 million. The value allocated to the supply agreement is included in other currentand long-term liabilities and is being amortized in proportion to thequantities of chipsets purchased under the supply agreement over the next fiveyears.  As of September 30, 2006,approximately $1.1 million had been amortized against cost of sales.

**12.****                               GOODWILL AND INTANGIBLE ASSETS**

*Goodwill:*

Intangible assets classified as goodwill and those withindefinite lives are not amortized. The Company performs an annual impairmenttest of its goodwill during the fourth quarter of each year. The Company alsotests for impairment between 

38

----

annual tests if a “triggering” event occurs that may have the effect ofreducing the fair value of a reporting unit below their respective carryingvalues. When conducting its goodwill impairment analysis, the Companycalculates its impairment charges based on the two-step test prescribedin SFAS 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). The Companyuses the present value of future cash flows from the respective reporting unitsto determine the estimated fair value of the reporting unit and the impliedfair value of goodwill.

The Company held a series of planning meetings inSeptember 2005 to assess the current business forecasts for all of itsreporting units. This assessment analyzed various factors including a reductionin the rate of growth of PAS subscribers in the third quarter, a delay of theexpected granting of 3G licenses in China and Japan, challenges with productquality primarily in the Company’s Broadband reporting unit, a narrowing of theCompany’s strategic focus related to the Company’s product offerings andgreater than expected revenue and margin decline due to continued pricingpressures for several of the Company’s key markets. The Company concluded thesefactors combined represented a “triggering” event.

The Company determined that the significant adversechanges in the business outlook could indicate the carrying value of certain ofits long-lived assets groups may not be recoverable and could indicatethe fair value of the Company’s reporting units may be below their fair value.As a result, the Company performed interim impairment tests on goodwill andcertain other long-lived tangible and intangible assets.

The Company performed an impairment analysis pursuant toSFAS 142 as of September 30, 2005 for all of its reporting units. TheCompany compared the fair value of the reporting units to their carrying value.The Company 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 the reporting units were reconciled to theCompany’s overall market capitalization at September 30, 2005.

Based on the impairment assessment noted above, agoodwill impairment charge of $192.9 million was recorded during thethree months ended September 30, 2005 to write off the full value ofgoodwill for the Wireless, Broadband, Handsets and PCD business units. Thesecond step of the goodwill impairment test for Broadband and Handsets segmentswas completed in the third quarter and for the Wireless and PCD units wasperformed in the fourth quarter of 2005, which reaffirmed the estimate from thethird quarter that the goodwill was fully impaired. As such, there was noadjustment from the amount previously recorded. The changes to the carryingvalue of the Company’s goodwill from January 1, 2005 through September 30,2005 are reflected below:

|            | ** ** | **January 1,  2005** | ** ** | **Additions** | ** ** | **Exchange  rate changes** | ** ** | **Impairment** | ** ** | **September 30,  2005** | ** ** |
|------------|------------|---------------------------|------------|---------------|------------|---------------------------------|------------|----------------|------------|------------------------------|------------|
| ** ** | ** ** | **(in thousands)**   | ** ** |
| 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 |   |

 

As of September 30, 2006 and December 31, 2005,goodwill was $3.1 million, the entire amount of which was allocated to theservice operating segment.

*Long-lived Assets:*

The Company also tested its long-lived assets inall of the Company’s assets groups for potential impairment during the thirdquarter of 2005 in accordance with SFAS 144. Based on this analysis, theCompany determined that the undiscounted expected future cash flows for theBroadband and Handset asset groups were less than the carrying value of theirnet assets.

The Company determined the relative estimated fair valueof tangible assets through a comparison of similar assets, and whereverpractical, based on quoted market prices taking into consideration the assettype, age, condition, and physical location of the asset. As a result of thisanalysis, the Company recorded an impairment charge of $14.1 million during thethree months ended September 30, 2005 for long-lived tangible assetsrelated to the Broadband asset group and $9.4 million for long-livedtangible assets related to the Handset asset group.

39

----

In addition, the Company determined that the fair valueof technology intangible assets within the Broadband and Handset asset groupsas calculated using the discounted future cash flows was less than the carryingvalue of the net assets and, as such, the Company recorded a net asset write-offof $1.7 million during the three months ended September 30, 2005.

As of September 30, 2006 and December 31, 2005,intangible assets consisted of the following:
|                                | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                     | ** ** | **(in thousands)** | ** ** |
| Intangible assets:             |       |                    |       |                  |       |
|                           |       |                    |       |                  |       |
| Existing technology            |       | $                       | 39,530     |                  | $          | 39,530 |   |
| Less accumulated  amortization |       | (26,320                 | )          | (21,702               | )          |
|                           |       | $                       | 13,210     |                  | $          | 17,828 |   |
|                           |       |                    |       |                  |       |
| Customer relationships         |       | $                       | 57,220     |                  | $          | 57,220 |   |
| Less accumulated  amortization |       | (16,973                 | )          | (12,037               | )          |
|                           |       | $                       | 40,247     |                  | $          | 45,183 |   |
|                           |       |                    |       |                  |       |
| Supplier relationships         |       | $                       | 5,300      |                  | $          | 5,300 |   |
| Less accumulated  amortization |       | (5,079                  | )          | (3,092                | )          |
|                           |       | $                       | 221        |                  | $          | 2,208 |   |
|                           |       |                    |       |                  |       |
| Trade names                    |       | $                       | 4,940      |                  | $          | 4,940 |   |
| Less accumulated  amortization |       | (3,496                  | )          | (2,496                | )          |
|                           |       | $                       | 1,444      |                  | $          | 2,444 |   |
|                           |       |                    |       |                  |       |
| Non-compete agreement          |       | $                       | 10,800     |                  | $          | 10,800 |   |
| Less accumulated  amortization |       | (5,175                  | )          | (3,150                | )          |
|                           |       | $                       | 5,625      |                  | $          | 7,650 |   |
|                           |       |                    |       |                  |       |
| Total intangible assets        |       | $                       | 60,747     |                  | $          | 75,313 |   |

 

Amortization expense was $4.8 million and$6.6 million for the three months ended September 30, 2006 and 2005,respectively, and was $14.6 million and $20.4 million for the ninemonths ended September 30, 2006 and 2005, respectively.  The estimated aggregate amortization expensefor intangibles for the fourth quarter of 2006 is $4.3 million and  for each of the five years from the yearended December 31, 2007 through the year ended December 31, 2011 is$16.0 million, $12.7 million, $6.9 million, $5.1 millionand $5.1 million, and is $10.6 million thereafter.

The weighted average amortization period for each classof unamortized identifiable intangible assets include the following:
|                         | ** ** | **Weighted Average Life** | ** ** |
|-------------------------|------------|-------------------------------------|------------|
| ** **              | ** ** | **(in years)**                 | ** ** |
| Technology              |       | 2.3                                 |       |
| Customer  relationships |       | 7.1                                 |       |
| Supplier  relationships |       | 0.1                                 |       |
| Trade names             |       | 1.1                                 |       |
| Non-compete             |       | 2.1                                 |       |

 

40

----

**13.****                               LONG-TERM INVESTMENTS**

The Company’s investments are as follows:
|                            | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                 | ** ** | **(in thousands)** | ** ** |
| Gemdale                    |       | $                       | 16,451     |                  | $          | 1,321 |   |
| Cellon International       |       | 13,500                  |       | 8,000                 |       |
| Restructuring Fund No.  1  |       | —                  |       | 1,538                 |       |
| Global Asia Partners  L.P. |       | 1,700                   |       | 1,700                 |       |
| Fiberxon Inc.              |       | 3,000                   |       | 3,000                 |       |
| Immenstar                  |       | 2,000                   |       | 2,000                 |       |
| Matsushita Joint  Venture  |       | —                  |       | 465                   |       |
| GCT SemiConductor          |       | 3,000                   |       | 3,000                 |       |
| Xalted Networks            |       | 3,302                   |       | 3,000                 |       |
| Infinera                   |       | 1,902                   |       | 1,902                 |       |
| Others                     |       | 99                      |       | 97                    |       |
| Total                      |       | $                       | 44,954     |                  | $          | 26,023 |   |

 

*Gemdale*

In 1996, theCompany invested $1.3 million in Gemdale Co., Ltd.  (“Gemdale”) in return for 11 millionnon-negotiable shares of Gemdale. Gemdale is a real estate company that invests and develops properties inChina, primarily in Shanghai, Beijing, Shenzhen and Wuhan.  During 2004, the Company received anadditional 8.8 million non-negotiable shares in dividends.  This investment was accounted for under the costmethod through July 2006.

In August 2006,pursuant to a Split Share Structure Reform Agreement in China, the Companytransferred 6.0 million non-negotiable Gemdale shares to the holders ofnegotiable Gemdale shares in exchange for converting the remaining 13.8 millionnon-negotiable shares into negotiable shares, and a receivable for additionalshares valued at $0.6 million at September 30, 2006.  The negotiable Gemdale shares are traded onthe Shanghai Stock Exchange.  The 13.8million negotiable shares are subject to a transfer restriction through August2007.  As of September 30, 2006 theCompany had a 2% ownership interest in Gemdale. The investment is classified as equity securities available-for-sale andrecorded at fair value.  An unrealizedgain on investment of $15.7 million is included in other comprehensive incomeas of September 30, 2006.

*Cellon International*

In September 2001, the Company invested$2.0 million in Cellon International Holdings Corporation (“Cellon”) andmade additional investments of $3.0 million each in Cellon in April andDecember 2002.  Cellon designswireless terminals and related technology for handset manufacturers and privatedistributors.  In November 2005, theCompany and Cellon entered into an agreement under which the Company receivedconsideration in the form of preferred stock and warrants of Cellon valued at$5.5 million in exchange for the transfer of fixed assets with a net bookvalue of $3.0 million, a facilities lease and a workforce in place consistingof 156 employees.  This transaction wascompleted on May 31, 2006 and a gain on sale of assets of$2.5 million was recorded in other income. As of September 30, 2006, with the additional shares obtained in thepurchase transaction, the Company had an 11% ownership interest in Cellon.  This investment is accounted for under thecost method, and its carrying value has been evaluated for possible impairmentbased on the achievement of business objectives and milestones, the financialcondition and prospects of the Company and other relevant factors.  For more information regarding thisinvestment see Note 25.

In November 2005, the Company entered into a DevelopmentService Agreement with Cellon in which $5.0 million was prepaid inexchange for future product development. Approximately $0.7 million and $2.0 million of the prepaid amount hasbeen used in the three and nine months ended September 30, 2006 as payments fordesign services.  The Company may alsouse the $5.0 million prepayment in satisfaction of royalties Cellon may earnfrom sales by the Company of products Cellon designs under the DevelopmentServices Agreement.  This agreement alsoobligates Cellon to pay the Company a royalty if certain technology shared bythe Company to Cellon is used in products developed and sold to customers otherthan the Company through November 2007.

41

----

*Matsushita Joint Venture*

In December 2005 the parties agreed to dissolve thepartnership.  A final distribution wasmade in April 2006 that did not materially exceed the carrying value of theinvestment.

*Restructuring Fund No. 1*

During the first quarter of fiscal 2002, the Companyinvested $2.0 million in Restructuring Fund No. 1, a venture capitalinvestment limited partnership established by SOFTBANK INVESTMENT CORP., anaffiliate of SOFTBANK CORP. SOFTBANK America Inc., an entity affiliatedwith SOFTBANK CORP., is a significant stockholder of the Company.  The fund focuses on leveraged buyoutinvestments in companies in Asia undergoing restructuring or bankruptcyprocedures.  The fund has a separatemanagement team, and none of the Company’s employees are employed by thefund.  The Company accounted for thisinvestment under the equity method of accounting.  The Company received a cash distribution ofapproximately $0.7 million in March 2006 and an additional cashdistribution of $1.5 million in May 2006 and reduced the carrying value ofthe investment accordingly.  Income of$0.7 million in excess of our carrying value was recognized in otherincome in the quarter ended June 30, 2006. The partnership was dissolved in July 2006.  The Company received a final cashdistribution of approximately $0.7 million which was recorded as a gain oninvestment in September 2006. There were no cash distributions during the threeor nine months ended September 30, 2005.

*Xalted Networks*

In May 2005 and August 2005, the Companyinvested $2.0 million and $1.0 million, respectively, in XaltedNetworks (“Xalted”).  In March 2006the Company invested an additional $0.3 million in Xalted.  Xalted is a development stage companyproviding telecommunication operator customers with a comprehensive set ofnetwork systems, software solutions and service offerings.  The Company has a 10% ownership interest inXalted and accounts for the investment under the cost method.

**14.****                               DEBT**

The following represents the outstanding borrowings atSeptember 30, 2006 and December 31, 2005:
|                                                    | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| Bank loans                                         |       | $                       | 105,010    |                  | $          | 198,826 |   |
| Other                                              |       | 300                     |       | 300                   |       |
| Convertible  subordinated notes, due March 1, 2008 |       | 274,600                 |       | 274,600               |       |
| Total debt                                         |       | $                       | 379,910    |                  | $          | 473,726 |   |
| Long-term debt                                     |       | 274,900                 |       | 274,900               |       |
| Short-term debt                                    |       | $                       | 105,010    |                  | $          | 198,826 |   |

 

At September 30, 2006, the Company had loans with variousbanks totaling $105.0 million with interest rates of 5.02% per annum.  These bank loans mature during 2006 and 2007,and are included in short-term debt. There are no significant covenants associated with these loans.

The Company also had available credit facilities in Chinaat September 30, 2006 totaling $789.5 million, of which $498.5 million ofthis amount was available for working capital purposes, and the Company haddrawn $105.0 million in outstanding borrowings, and $291.0 million wasavailable for use in support of letters of credit and corporate guarantees.These facilities expire primarily in 2007.

On March 12, 2003, the Company completed an offeringof $402.5 million of 7/8% convertible subordinated notes due March 1,2008 to qualified buyers pursuant to Rule 144A under the Securities Act of1933. The notes are convertible into the Company’s common stock at a conversionprice of $23.79 per share and are subordinated to all present and future seniordebt of the Company. Holders of the notes may convert their notes only if:(i) the price of the Company’s common stock issuable upon conversion of anote reaches a specified threshold, (ii) specified corporate transactionsoccur, or (iii) the trading price for the notes falls below certainthresholds. At the initial conversion price, each $1,000 principal amount ofnotes will be convertible into approximately 42.0345 shares of common stock.Expenses associated with the convertible subordinated notes issuance were$11.7 million and have been recorded in other long-term assets andare being amortized over the life of the notes.

42

----

The Company has entered into a convertible bond hedge andcall option transaction.  The convertiblebond hedge allows the Company to purchase 11.5 million shares of itscommon stock at $23.79 per share from the other party to the agreement.  The written call option allows the holder topurchase 11.5 million shares of the Company’s common stock from theCompany at $32.025 per share.  Both thebond hedge and call option transactions may be settled at the Company’s optioneither in cash or net shares and expire on March 1, 2008.

The Company recorded these instruments at cost, and theircarrying value at September 30, 2006 equaled their original cost as adjustedfor amendments related to the early extinguishment of debt.  The convertible bond hedge and call optiontransactions are expected to reduce the potential dilution from conversion ofthe notes.  The options have beenincluded in stockholders’ equity in accordance with the guidance in EITFNo. 00-19, “Accounting for Derivative Financial Instruments Indexed to,and Potentially Settled in, a Company’s Own Stock.”

On November 15, 2006, the Company received a notice assertingthat its failure to timely file its Quarterly Report on Form 10-Q for theperiod ended September 30, 2006 had caused a default under the provisions ofthe indenture governing the convertible subordinated notes which, if not curedwithin 60 days, would cause an event of default.  For information regarding the subsequentsolicitations of consents from the holders of the notes see Note 25 entitled “SubsequentEvents” below.

**15.****                               WARRANTY OBLIGATIONS AND OTHER GUARANTEES**

The Company provides a warranty on its equipment andhandset sales for a period generally ranging from one to three years from thetime of final acceptance.  Very rarely,the Company has entered into arrangements to provide limited warranty servicesfor periods longer than three years.  Thelongest of such warranty periods is ten years. The Company provides for the expected cost of product warranties at thetime that revenue is recognized based on an assessment of past warrantyexperience.

Warranty obligations, included in other current liabilitiesare as follows:
| ** **                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                                               | ** ** | **As restated**                                    | ** ** | ** ** | ** ** | **As restated** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                                  | ** ** |
| Beginning of period                               |       | $                                                        | 64,108     |                                                    | $          | 58,586 |   | $ | 76,719 |   | $ | 46,596 |   |
| Accruals for warranties  issued during the period |       | 17,095                                                   |       | 15,260                                                  |       | 28,865 |   | 47,828 |   |
| Settlements made during  the period               |       | (16,265                                                  | )          | (18,196                                                 | )          | (40,646 | ) | (38,774 | ) |
| Balance at end of period                          |       | $                                                        | 64,938     |                                                    | $          | 55,650 |   | $ | 64,938 |   | $ | 55,650 |   |

 

During 2005, the Company recorded a special warrantycharge for equipment sold to Softbank during 2003 and 2004.  Since the agreement to repair these partsexceeds the Company’s normal warranty terms the Company  recorded an additional special warrantycharge of $11.7 million for certain asynchronous digital subscriber line (“ADSL”)products, $4.0 million primarily for NetRing equipment and$14.9 million for GEPON equipment.  Duringthe three months ended September 30, 2006, the Company recorded an additionalwarranty charge of $4.7 million, consisting of $2.9 million for the NetRingequipment and $1.8 million for the GEPON equipment sold to Softbank, based onthe results of the Company’s analysis of warranty costs incurred, and revisedestimates of the remaining liability.

Certain of the Company’s sales contracts includeprovisions under which customers would be indemnified by the Company in theevent of, among other things, a third-party claim against the customerfor intellectual property rights infringement related to the Company’sproducts.  There are no limitations onthe maximum potential future payments under these guarantees.  The Company has not accrued any amount inrelation to these provisions as no such claims have been made and the Companybelieves it has valid, enforceable rights to the intellectual property embeddedin its products.

43

----

**16.****                               COMMITMENTS AND CONTINGENCIES**

*Leases:*

The Company leases certain facilities undernon-cancelable operating leases that expire at various dates through 2013.  The minimum future lease payments under theleases at September 30, 2006 were as follows:
|                               | ** ** | **September 30,**  | ** ** |
|-------------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **2006**                | ** ** |
| ** **                    | ** ** | **(in thousands)** | ** ** |
| 1 year                        |       | $                       | 16,467     |   |
| 2 year                        |       | 11,319                  |       |
| 3 year                        |       | 8,630                   |       |
| 4 year                        |       | 3,609                   |       |
| 5 year and after              |       | 1,966                   |       |
| Total minimum lease  payments |       | $                       | 41,991     |   |

 

Rent expense for the three and nine months endedSeptember 30, 2006 were $4.8 million and $15.0 million,respectively.  Rent expense for the threeand nine months ended September 30, 2005 were $5.2 million and $16.2 million,respectively.

*Contractual obligations and commercial commitments:*

As of September 30, 2006 the Company’s obligations undercontractual obligations and commercial commitments are as follows:
|                                 | ** ** | **September 30, 2006**          | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **Payments Due by Period** | ** ** |
| ** **                      | ** ** | **Less than**                        | ** ** |
| ** **                      | ** ** | **Total**                                 | ** ** | **1 year** | ** ** | **1-3 years** | ** ** |
| ** **                      | ** ** | **(in thousands)**                   | ** ** |
| Bank loans                      |       | $                                         | 105,010    |   | $ | 105,010 |   | $ | — |   |
| Convertible  subordinated notes |       | $                                         | 274,600    |   | $ | — |   | $ | 274,600 |   |
| Interest payable  on debt       |       | $                                         | 37,850     |   | $ | 23,940 |   | $ | 13,910 |   |
| Letters of  credit              |       | $                                         | 53,281     |   | $ | 49,640 |   | $ | 3,641 |   |
| Purchase commitments            |       | $                                         | 730,216    |   | $ | 663,560 |   | $ | 66,656 |   |

 

*Letters of credit:*

The Company issues standby letters of credit primarily tosupport international sales activities outside of China.  When the Company submits a bid for a sale,often the potential customer will require that the Company issue a bid bond ora standby letter of credit to demonstrate its commitment through the bidprocess.  In addition, the Company may berequired to issue standby letters of credit as guarantees for advance customerpayments upon contract signing or performance guarantees.  The standby letters of credit usually expirewithout being drawn by the beneficiary thereof. Finally, the Company may issue commercial letters of credit in supportof purchase commitments.

*Purchase commitments:*

The Company is obligated to purchase raw materials andwork-in-process inventory under various orders from various suppliers, all ofwhich should be fulfilled without adverse consequences material to itsoperations or financial condition.  As ofSeptember 30, 2006, total purchase commitments, including cancelable and non-cancelable purchase orders, approximated$730 million.  Additionally, inconnection with the sale of assets to Marvell, the Company has agreed topurchase from Marvell certain chipsets that will be included in the Company’sPAS handsets through 2011.  Thesechipsets will be included in certain handset products designed and manufacturedby the Company.

*Investment commitments:*

As of September 30, 2006, the Company had invested atotal of $2.6 million in Global Asia Partners L.P.  The fund was formed to make private equityinvestments in private or pre-IPO technology and telecommunications companiesin Asia.  The Company had a commitment toinvest up to a maximum of $5.0 million. As the result of a reorganization of capital contributions by thepartners, reached in April 2005, the Company’s capital contribution of $0.5million in April 2005 was the final capital contribution to be made.  In addition, the agreement allows thepartnership to re-invest up to $2.5 million that otherwise would have beenavailable to us as future distributions. There were no cash distributions during the three or nine months endedSeptember 30, 2006 or 2005.

44

----

*Intellectual property:*

Certain sales contracts include provisions under whichcustomers would be indemnified by the Company in the event of, among otherthings, a third party claim against the customer for intellectual propertyrights infringement related to the Company’s products.  There are no limitations on the maximumpotential future payments under these guarantees.  The Company has not accrued any amounts inrelation to these provisions as no such claims have been made and the Companybelieves it has valid enforceable rights to the intellectual property embeddedin its products.

*Litigation*

*Securities Class Action Litigation*

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

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

OnSeptember 4, 2007, a second shareholder class action complaint captioned *Peter Rudolph v. UTStarcom, et al.*, Case No. C-07-4578SI, was filed in the United States District Court for the Northern District ofCalifornia against the Company and some of the Company’s current and formerdirectors and officers. The complaint alleges violations of the SecuritiesExchange Act of 1934 through undisclosed improper accounting practicesconcerning the Company’s historical equity award grants.  Plaintiff seeks unspecified damages on behalfof a purported class of purchasers of the Company’s common stock between July24, 2002 and September 4, 2007.

Due to the preliminary status of these lawsuits and uncertaintiesrelated to litigation, the Company is unable to evaluate the likelihood ofeither a favorable or unfavorable outcome. Accordingly, the Company is unable at this time to estimate the effectsof these complaints on the Company’s financial position, results of operations,or cash flows.

*GovernmentalInvestigations*

The Company hasreceived notice of a formal inquiry by the staff of the Securities &Exchange Commission (“SEC”) into certain aspects of the Company’s financialdisclosures during prior reporting periods and certain other issues.  In addition, in December 2005, the U.S.Embassy in Mongolia informed the Company that it had forwarded to theDepartment of Justice (“DOJ”) allegations that an agent of the Company’sMongolia joint venture had offered payments to a Mongolian government officialin possible violation of the Foreign Corrupt Practices Act (the “FCPA”).  The Company through our Audit Committee,authorized an independent investigation into possible violations of the FCPA,and the Company has  been in contact withthe DOJ and SEC regarding the investigation. The investigation has identified possible FCPA violations in Mongolia,Southeast Asia, India, and China, as well as possible violations of U.S.immigration laws. The DOJhas requested that the Company voluntarily produce documents related to theinvestigation and the SEC has subpoenaed the Company for documents.  TheCompany has executed tolling agreements extending the statute of limitationsfor the FCPA issues under investigation by the SEC and DOJ and the immigrationissues under investigation by the DOJ. At this time, the Company cannot predict when any inquiry will becompleted or what the outcome of any inquiry will be.

*Shareholder Litigation*

On November 17, 2006, a shareholder derivative complaint captioned *Ernesto Espinoza v. Ying Wu et al.*, Case No. RG06298775,was filed against certain of the Company’s current and former officers anddirectors in the Superior Court of the County of Alameda, California.  The complaint alleges that the individualdefendants, among other things, breached their duties, were unjustly enriched,and violated the California Corporations Code in connection with the timing ofstock option grants.  The complaint namesthe Company as a nominal defendant and seeks unspecified monetary damagesagainst the individual defendants and various forms of injunctive relief.  On February 2, 2007, the Company and theindividual defendants filed 

45

----

demurrersagainst the complaint.  On April11, 2007, the Court sustained the individual defendants’ demurrer, overruledthe Company’s demurrer, ordered the plaintiff to file an amended complaint, andordered the Company to answer the original complaint.  The plaintiff filed an amended complaint andthe Company has filed an answer to the amended complaint.  On August 21, 2007, the individual defendantsfiled demurrers against the amended complaint. The Court sustained the individual defendants’ demurrers and ordered theplaintiff to file a second amended complaint.

Due to the preliminary status ofthis complaint and uncertainties related to litigation, the Company is unableto evaluate the likelihood of either a favorable or unfavorable outcome.  Accordingly, the Company is unable at thistime to estimate the effects of this complaint on the Company’s financialposition, results of operations, or cash flows.

*IPOAllocation*

On October 31, 2001, a complaint was filed in United StatesDistrict Court for the Southern District of New York against the Company, someof the Company’s directors and officers and various underwriters for theCompany’s initial public offering. Substantially similar actions were filed concerning the initial publicofferings for more than 300 different issuers, and the cases were coordinatedas *In re Initial Public Offering SecuritiesLitigation*, 21 MC 92 for pretrial purposes.  In April 2002, a consolidated amendedcomplaint was filed in the matter against the Company, captioned *In re UTStarcom, Initial Public Offering SecuritiesLitigation*, 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 betweenMarch 2, 2000 and December 6, 2000. The Company’s directors and officers have been dismissed withoutprejudice pursuant to a stipulation.  OnFebruary 19, 2003, the Court granted in part and denied in part amotion to dismiss brought by defendants including the Company.  The order dismissed all claims against theCompany except for a claim brought under Section 11 of the Securities Actof 1933, which alleges that the registration statement filed in accordance withthe IPO was misleading.  InJune 2004, a stipulation of settlement and release of claims against theissuer defendants, including the Company, was submitted to the court forapproval.  The terms of the settlement,if approved, would have dismissed and released all claims against theparticipating defendants (including the Company).  In August 2005, the Court preliminarilyapproved the settlement.  In December2006, the Court of Appeals for the Second Circuit reversed the Court’s October2004 order certifying a class in six test cases that were selected by theunderwriter defendants and plaintiffs in the coordinated proceedings.  The Company’s case is not one of the test cases. Because classcertification was a condition of the settlement, it was unlikely that thesettlement would receive final Court approval. On June 25, 2007, the Court entered an order terminating the proposedsettlement based on a stipulation among the parties to the settlement.  Plaintiffs have filed amended masterallegations and amended complaints in the six test cases.  It is unclear whether there will be anyrevised or future settlement.  If thelitigation proceeds, the Company believes that the Company has meritoriousdefenses and intend to defend the action vigorously.  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.

*Passave Litigation*

In November 2005, the Company filed suit in theSuperior Court of California, County of Santa Clara, against Passave, Inc. (“Passave”)for breaches of contract and warranties in connection with a semiconductordevice sold by Passave, Ltd. (Passave’s wholly-­owned subsidiary) to theCompany.  The Company’s complaint allegesthat the Passave device, known as the PAS5001M3 chip, has exhibited certainoperational malfunctions within some of our Fiber-to-the-Home product line, andhas thereby caused damage to the Company. The parties entered into a settlement agreement, dated August 7, 2007,and have since dismissed all claims with prejudice.

*UTStarcom, Inc. v. Starent Patent InfringementLitigations*

The Company brought suit against Starent NetworksCorporation (“Starent”) for patent infringement in the U.S. District Court forthe Northern District of California.  TheComplaint was filed on March 22, 2004, and later amended.  In this action, the Company asserted thatStarent infringed the Company’s patent U. S. Reg. No. 6,628,671 through themanufacture, use, offer, for sale, and sale of Starent’s ST-16 IntelligentMobile Gateway.  The Company soughtdamages and injunctive relief.  Starentfiled its answer to the Amended Complaint and counterclaims, denying ourallegations and seeking a declaration that the patent-in-suit is not infringed,is invalid, and is unenforceable.  Amotion for a preliminary injunction against the making, using or selling ofinfringing products and methods was brought, but the Court denied it on June17, 2005.  After a claims constructionhearing and order, on September 20, 2005, Starent filed a motion for summaryjudgment of non-infringement and the Company filed a motion for summaryjudgment that Starent is estopped from asserting invalidity 

46

----

and unenforceability.  OnDecember 6, 2005, the Court granted Starent’s motion for summary judgment.  On February 2, 2006, the Court enteredjudgment in favor of Starent and dismissed the case.  On March 2, 2006 the Company filed an appealto the Federal Circuit.  On April 6,2007, after reviewing the parties’ briefs and hearing oral argument on April 2,2007, the Federal Circuit, without a written opinion, affirmed the DistrictCourt’s judgment and dismissal of the case. Althoughthe Federal Circuit ruled against the Company, this decision will not have amaterial adverse effect on the business, financial condition, or results of itsoperations.

On February 16, 2005, the Company filed a second suitagainst Starent for patent infringement in the U.S. District Court for theNorthern District of California.  In theComplaint, the Company asserts that Starent infringes UTStarcom patent U.S.Reg. No. 6,829,473 (“the ‘473 patent”) through Starent’s development andtesting of a software upgrade for its customer’s installed ST-16 IntelligentMobile Gateways.  The Company seeksdeclaratory and injunctive relief. Starent subsequently filed its answer and counterclaims, denying theCompany’s allegations and seeking a declaration that the patent-in-suit is notinfringed, is invalid, and is unenforceable. On June 16, 2005, the Company filed a motion to strike Starent’saffirmative defense and dismiss Starent’s counterclaim alleging inequitableconduct.  On July 19, 2005, the partiesstipulated that Starent would file an amended answer and counterclaim by July27, 2005 and that the Company  wouldwithdraw the Company’s motion to strike. On August 10, 2005, the Company responded to Starent’s amendedcounterclaim filed on July 27, 2005.  In early December 2006, the Company filed areissue application for the ‘473 patent with the United States Patent andTrademark Office.  Starent has also filedfor reexamination of the ‘473 patent. The reexamination and reissue are currently copending.  The litigation is still in a preliminarystage and its outcome cannot be predicted, although the Company believes thelitigation has merit.  Nonetheless, theCompany believes that any adverse judgment on Starent’s counterclaims will nothave a material adverse effect on the Company’s business, financial condition,or results of operations.

On May 8, 2007,the Company filed a third suit against Starent and sixteen individualdefendants (who were all former employees of 3Com’s CommWorks division whichthe Company acquired certain assets of in May of 2003) in the Northern Districtof Illinois.  The causes of actioninclude claims for patent infringement, misappropriation of trade secrets,intentional interference with business relations and prospective economicadvantage and declarations of ownership of certain patent rights.  In its Complaint, the Company asserts thatStarent infringes UTStarcom patents U. S. Reg. Nos. 7,173,905; 6,978,128;6,963,582; 6,975,900; and 6,684,256 through the manufacture, use, offer, forsale, and sale of Starent’s ST16 Intelligent Mobile Gateway and ST40 multimediacode platform, that the individual Defendants and Starent have misappropriatedvaluable Company trade secrets by improperly taking and using  the Company’s confidential and proprietaryinformation for the benefit of Starent, that the individual defendants andStarent have interfered with the Company’s business relations and prospectiveeconomic advantage by using the misappropriated information to obtain andenhance sales of Starent’s products, and that several of Starent’s patentapplications and one issued patent are based on information obtained by theformer employees while at the Company (CommWorks) and on that basis belong toUTStarcom.  The Company seekscompensatory damages, punitive damages and injunctive relief.  After the court denied the defendants motionto dismiss the misappropriation of trade secrets claims, on August 30, 2007, Starent answered the Company’s complaint, denyingthe Company’s allegations and asserting a number of affirmative defenses andcounterclaims, including non-infringement of the subject patents and allegedtortious interference with prospective economic advantage.  The Company has filed a motion to dismissmost of the counterclaims and the court has ordered appointment of a specialmaster to handle discovery, which is just beginning.  The Company believes that any adversejudgment on Starent’s counterclaims will not have a material adverse effect onthe Company’s business, financial condition or results of operations.

*Telemetrix, Inc. Arbitration*

On October 19, 2006, Telemetrix,Inc. (“Telemetrix”) filed a formal Request for Arbitration against the Companyto the World Intellectual Property Organization (“WIPO”) in Geneva,Switzerland.  The Request for Arbitrationsought unspecified damages arising from a contractbetween Telemetrix and Telos Technology, Inc., dated October 22, 2003.  The Company assumed Telos’ rights andobligations under this contract pursuant to the Company’spurchase of Telos’ assets on May 19, 2004.  Telemetrix alleged nine causes of action,including breach of contract, fraud, negligent misrepresentation, interferencewith contractual relations, and interference with prospective economicadvantage.  In December 2006, the Companyfiled a formal response to the Request for Arbitration, denying all materialfactual allegations asserted by Telemetrix. An arbitrator was selected by the parties, and, on August 2, 2007, the arbitrator granted a pleading motion in favor ofthe Company due to Telemetrix’s failure to allege sufficient facts in supportof a majority of its causes of action. On August 17, 2007, Telemetrix filed an Amended Statement of Claim,alleging six causes of action, including breach of contract, fraud,interference with contractual relations and interference with prospectiveeconomic advantage.  The previous hearingdate of December 11-13 has been vacated. No hearing date has been rescheduled. Discovery has begun.

47

----

*Telos Technology, Inc. Litigation*

OnNovember 22, 2005, plaintiffs Telos Technology, Inc., TelosTechnology (Canada), Inc., Telos Technology (Bermuda) Ltd., and TelosEngineering Limited (collectively, the “Telos Plaintiffs”) filed a Complaintagainst the Company in the Superior Court of California, County of SantaClara.  The Complaint alleges five causesof action, including breach of contract, breach of the implied covenant of goodfaith and fair dealing, fraudulent inducement, intentional misrepresentationand negligent misrepresentation, all of which arise from the Asset PurchaseAgreement between the parties dated April 21, 2004.  The Telos Plaintiffs assert that the Companybreached the express and implied terms of the Asset Purchase Agreement and maderepresentations to the Telos Plaintiffs during negotiations that it neverintended to fulfill.  The TelosPlaintiffs sought at least $19 million in damages, unspecified punitivedamages and attorneys’ fees.  The partiesexecuted a settlement agreement in the amount of $4.5 million on August 20,2007 and the case was dismissed on September 26, 2007 with prejudice.

*Other Litigation*

The Company is a party to other litigation matters andclaims that are normal in the course of operations, and while the results ofsuch litigation matters and claims cannot be predicted with certainty, theCompany believes that the final outcome of such matters will not have amaterial adverse impact on the Company’s financial position, results ofoperations or cash flows.

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

The Company has organized its business in a mannerconsistent with the chief operating decision makers’ view and management of thebusiness.  The Company offers productsand services through  four operatingunits, (i) Network Solutions, (ii) Personal Communications Division (“PCD”)(iii) Handsets and (iv) Service. The Network Solutions operating unit provides its products and servicesthrough two reporting segments; Broadband Infrastructure and WirelessInfrastructure.  Each reporting segmentand operating unit is responsible for managing its own performance.

The Company currently evaluates operating performance ofand allocates resources to the reporting segments based on segment gross profit.  Cost of sales and direct expenses in relationto productions are assigned to the reporting 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.

Summarized below are the Company’s segment sales revenueand gross profit for the three and nine months ended September 30, 2006 and2005, respectively.
| ** **                  | ** **   | **Three months ended September 30,** | ** **   | **Nine months ended September 30,** | ** **   |
|-----------------------------|--------------|----------------------------------------------------------|--------------|---------------------------------------------------------|--------------|
| ** **                  | ** **   | ** **                                               | ** **   | **% Net  **                              | ** **   | ** ** | ** ** | **% Net  ** | ** ** | ** ** | ** ** | **% Net  ** | ** ** | ** ** | ** ** | **% Net  ** | ** ** |
| ** **                  | ** **   | **2006**                                                 | ** **   | **sales**                                               | ** **   | **2005** | ** ** | **sales** | ** ** | **2006** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** |
| ** **                  | ** **   | ** **                                               | ** **   | ** **                                              | ** **   | **As restated** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **As restated** | ** ** | ** ** | ** ** |
| ** **                  | ** **   | **(in thousands)**                                  | ** **   |
| ***Net  Sales by Segment*** | *** *** | *** ***                                             | *** *** | *** ***                                            | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Broadband  Infrastructure   |         | $                                                        | 50,754       |                                                    | 8            | % | $ | 31,018 |   | 5 | % | $ | 152,774 |   | 9 | % | $ | 414,148 |   | 19 | % |
| Wireless  Infrastructure    |         | 110,299                                                  |         | 18                                                      | %            | 77,586 |   | 13 | % | 331,997 |   | 19 | % | 310,708 |   | 14 | % |
| Network Solutions           |         | 161,053                                                  |         | 26                                                      | %            | 108,604 |   | 18 | % | 484,771 |   | 28 | % | 724,856 |   | 33 | % |
| PCD                         |         | 328,701                                                  |         | 55                                                      | %            | 363,637 |   | 61 | % | 917,943 |   | 52 | % | 1,021,452 |   | 47 | % |
| Handsets                    |         | 93,163                                                   |         | 16                                                      | %            | 106,294 |   | 18 | % | 299,266 |   | 17 | % | 378,256 |   | 17 | % |
| Service                     |         | 17,982                                                   |         | 3                                                       | %            | 18,900 |   | 3 | % | 52,426 |   | 3 | % | 65,454 |   | 3 | % |
|                        |         | $                                                        | 600,899      |                                                    | 100          | % | $ | 597,435 |   | 100 | % | $ | 1,754,406 |   | 100 | % | $ | 2,190,018 |   | 100 | % |

 

48

----

 
|                                | ** ** | **Three months ended September 30,** | ** **   | **Nine months ended September 30,** | ** **   |
|--------------------------------|------------|----------------------------------------------------------|--------------|---------------------------------------------------------|--------------|
| ** **                     | ** ** | ** **                                               | ** **   | **Gross**                                               | ** **   | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                     | ** ** | **2006**                                                 | ** **   | **Profit %**                                       | ** **   | **2005** | ** ** | **Profit %** | ** ** | **2006** | ** ** | **Profit %** | ** ** | **2005** | ** ** | **Profit %** | ** ** |
| ** **                     | ** ** | ** **                                               | ** **   | ** **                                              | ** **   | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                  | ** **   |
| ***Gross  profit by Segment*** | * *   | *** ***                                             | *** *** | *** ***                                            | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Broadband  Infrastructure      |       | $                                                        | (837         | )                                                       | (2           | )% | $ | (13,875 | ) | (45 | )% | $ | 27,138 |   | 18 | % | $ | 166,958 |   | 40 | % |
| Wireless  Infrastructure       |       | 54,217                                                   |         | 49                                                      | %            | 16,332 |   | 21 | % | 158,835 |   | 48 | % | 77,661 |   | 25 | % |
| Network Solutions              |       | 53,380                                                   |         | 33                                                      | %            | 2,457 |   | 2 | % | 185,973 |   | 38 | % | 244,619 |   | 34 | % |
| PCD                            |       | (7,057                                                   | )            | (2                                                      | )%           | 13,199 |   | 4 | % | 19,653 |   | 2 | % | 42,881 |   | 4 | % |
| Handsets                       |       | 24,012                                                   |         | 26                                                      | %            | 13,633 |   | 13 | % | 88,521 |   | 30 | % | 48,972 |   | 13 | % |
| Service                        |       | 4,466                                                    |         | 25                                                      | %            | 8,598 |   | 45 | % | 13,395 |   | 26 | % | 36,709 |   | 56 | % |
|                           |       | $                                                        | 74,801       |                                                    | 12           | % | $ | 37,887 |   | 6 | % | $ | 307,542 |   | 18 | % | $ | 373,181 |   | 17 | % |

 

Assets by segment are as follows:
|                            | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------|------------|
| **Long-lived assets** | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                 | ** ** | **(in thousands)** | ** ** |
| Broadband                  |       | $                       | 43,211     |                  | $          | 47,480 |   |
| Wireless                   |       | 79,791                  |       | 87,673                |       |
| Network Solutions          |       | 123,002                 |       | 135,153               |       |
| PCD                        |       | 1,050                   |       | 1,512                 |       |
| Handsets                   |       | 43,651                  |       | 47,963                |       |
| Service                    |       | 44,390                  |       | 48,775                |       |
|                       |       | $                       | 212,093    |                  | $          | 233,403 |   |

 
|                       | ** ** | **September 30,**  | ** ** | **December 31,**  | ** ** |
|-----------------------|------------|-------------------------|------------|------------------------|------------|
| **Total assets** | ** ** | **2006**                | ** ** | **2005**               | ** ** |
| ** **            | ** ** | ** **              | ** ** | **(As restated)** | ** ** |
| ** **            | ** ** | **(in thousands)** | ** ** |
| Broadband             |       | $                       | 399,046    |                   | $          | 473,181 |   |
| Wireless              |       | 927,938                 |       | 1,015,699              |       |
| Network Solutions     |       | 1,326,984               |       | 1,488,880              |       |
| PCD                   |       | 424,378                 |       | 420,191                |       |
| Handsets              |       | 564,142                 |       | 546,910                |       |
| Service               |       | 87,169                  |       | 95,350                 |       |
|                  |       | $                       | 2,402,673  |                   | $          | 2,551,331 |   |

 

Sales are attributed to a geographical area based uponthe location of the customer.  Sales databy geographical areas are as follows:
|                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **             | ** ** | ** **                                               | ** ** | **% Net**                                          | ** ** | ** ** | ** ** | **% Net** | ** ** | ** ** | ** ** | **% Net** | ** ** | ** ** | ** ** | **% Net** | ** ** |
| ** **             | ** ** | **2006**                                                 | ** ** | **sales**                                               | ** ** | **2005** | ** ** | **sales** | ** ** | **2006** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** |
| ** **             | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | **As restated** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **As restated** | ** ** | ** ** | ** ** |
| ** **             | ** ** | **(in thousands)**                                  | ** ** |
| ***Sales  by region*** |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| United States          |       | $                                                        | 328,433    |                                                    | 54         | % | $ | 359,164 |   | 60 | % | $ | 924,548 |   | 53 | % | $ | 987,223 |   | 45 | % |
| China                  |       | 190,379                                                  |       | 32                                                      | %          | 175,410 |   | 29 | % | 595,505 |   | 34 | % | 660,821 |   | 30 | % |
| Japan                  |       | 30,745                                                   |       | 5                                                       | %          | 13,635 |   | 2 | % | 116,477 |   | 6 | % | 398,694 |   | 18 | % |
| Other                  |       | 51,342                                                   |       | 9                                                       | %          | 49,226 |   | 9 | % | 117,876 |   | 7 | % | 143,280 |   | 7 | % |
| Total net sales        |       | $                                                        | 600,899    |                                                    | 100        | % | $ | 597,435 |   | 100 | % | $ | 1,754,406 |   | 100 | % | $ | 2,190,018 |   | 100 | % |

 

49

----

Long-lived assets by geographical areas are as follows:
|                         | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **              | ** ** | **(in thousands)** | ** ** |
| U.S.                    |       | $                       | 14,939     |                  | $          | 16,676 |   |
| China                   |       | 190,102                 |       | 204,630               |       |
| Other                   |       | 7,052                   |       | 12,097                |       |
| Total long-lived assets |       | $                       | 212,093    |                  | $          | 233,403 |   |

 

**18.****                               TRANSACTIONS WITH RELATED PARTIES AND CERTAININVESTEES**

*Softbank and affiliates*

The Company recognized revenue of $29.7 million and$112.0 million for the three and nine months ended September 30, 2006,respectively, and revenue of $13.0 million and $394.6 million duringthe three and nine months ended September 30, 2005, as restated, respectively,with respect to sales of telecommunications equipment to affiliates of SOFTBANKCORP. (“Softbank”), a significant stockholder of the Company.  In the third quarter of 2006, the Companydetermined that certain sales to third party resellers are, in substance, salesto Softbank and therefore, the Company has included these amounts in relatedparty sales.    Softbank offersasynchronous digital subscriber line (“ADSL”) coverage throughout Japan, whichis marketed under the name “YAHOO! BB.” The Company supports Softbank’s fiber-to-the-home service through salesof our carrier class Gigabit Ethernet Passive Optical Network (“GEPON”) productas well as its multi-service optical transport product (“NetRingTM”).  In addition, the Company supports Softbank’snew internet protocol television (“IPTV”), through sales of our RollingStreamTMproduct.  Included in revenue for thenine months ended September 30, 2006 is a fee of $31.2 million charged forthe cancellation of orders for broadband products and $10.0 millioncharged for the cancellation of orders for wireless infrastructure products.

Included in accounts receivable at September 30, 2006 andDecember 31, 2005 were $35.2 million and $83.4 million,respectively, related to these agreements. Sales to Softbank include a three year service period and a penaltyclause if product failure rates exceed a certain level over a seven yearperiod.  There were $13.3 millionand $19.6 million included in long term deferred revenue with respect to theseagreements at September 30, 2006 and December 31, 2005, respectively.  Additionally, there were $11.2 millionand $8.0 million included in current deferred revenue at September 30,2006 and December 31, 2005, respectively. As of September 30, 2006 there were no customer advances, and as ofDecember 31, 2005 there were $5.4 million included in customer advancesrelated to Softbank agreements.  TheCompany has an outstanding purchase commitment with Softbank to purchasecomponent parts.  Purchases from Softbanktotaled $1.0 million and $1.4 million during the three and ninemonths ended September 30, 2006, respectively. There were no purchases from Softbank during the three andnine months ended September 30, 2005, respectively.  The Company has an outstanding accountspayable balance of $2.7 million with Softbank as of September 30, 2006.

During August 2004, the Company entered into severalagreements with Japan Telecom Co., Ltd (“JT”), a wholly owned subsidiaryof Softbank.  These agreements relate tothe sale of *i*AN-8000 equipmentwith specified value and delivery dates, as well as an oral agreement whichsubsequently converted into specific service contracts to manage a salespromotional program for JT.  The Companyhas determined that the service activities revenue should be recorded net ofexpected promotional spending.

Because the Company had not provided these activities inthe past and could not estimate the fair value of these services, the Companydetermined under the guidance of SAB 104 that all revenue related to theseagreements could not be recognized until all goods and services weredelivered.  The Company had delivered andreceived final acceptance for all equipment contemplated under these agreementsin the quarter ended March 31, 2005.

The promotional services discussed above involved contractingwith third party promotional vendors, who in turn, facilitated the marketingand subscriber recruitment for the JT fiber-to-the-home program.  During the fourth quarter of 2004, theCompany determined that it would end its involvement with the JT promotionalprogram after completion of the contract discussed above.  Accordingly, late in the fourth quarter of2004 and during the first quarter of 2005, the Company either cancelled orassigned to another party all third party contracts with promotional vendorsrelated to the JT contract.  Suchtermination or assignment of all third party promotional agreements, as well aseffective satisfaction of the Company’s obligations with JT under suchagreements, satisfied the revenue recognition criteria for these agreements andas such, the net value of the promotional services and the value of equipmentdelivered, which totaled $205.4 million, was reported in the quarter endedMarch 31, 2005.

50

----

The Company also entered into an agreement with JT duringthe third quarter of 2004 to supply chassis equipment.  The equipment shipped under this agreement isconsidered linked to the *i*AN-8000sale noted above and as such, was also deferred until the completion of theabove-mentioned promotional activities. The revenue recognition criteria related to the sale of the *i*AN-8000 equipment was satisfied in thefirst quarter of 2005 and as such, the revenue related to the chassis sale of$66.5 million was reported in the quarter ended March 31, 2005.

During the three and nine months ended September 30,2006, sales to Softbank included $2.0 million and $5.2 million,respectively, with regards to telecommunications equipment and services sold toJT.  During the three and nine monthsended September 30, 2005, sales to Softbank included $2.5 million and$278.6 million, respectively, with regards to telecommunications equipmentand services sold to JT.

In June 2006, the Company purchased advertisingspace and season tickets totaling $0.2 million from a sports franchiseowned by Softbank.

On July 17, 2003, the Company entered into aMezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”), an affiliate ofSoftbank.  Under the terms of theagreement, the Company loaned BB Modem $10.1 million at an effective interestrate of 12.01% per annum, for the purpose of investing in a portfolio of ADSLmodems and associated modem rental agreements, from Softbank. Softbank willcontinue to service such modems and modem rental agreements. The Company’s loanis subordinated to certain senior lenders of BB Modem, and repayments arepayable to the Company over a 42-month period through January 31,2007, with a substantial portion of the principal amount of the loan repaidduring the last 16 months of this period. During the three and nine monthsended September 30, 2006, the Company recorded $0.1 million and$0.5 million, respectively, in interest income in respect to thisloan.  The loan receivable at September30, 2006 and December 31, 2005 was approximately $2.4 million and$9.0 million, respectively and is included in other current assets.  The note receivable was paid in full inJanuary 2007.

As of September 30, 2006, Softbank beneficially ownedapproximately 12.1% of the Company’s outstanding stock.

*Acoustek Int’l, Inc.*

In 2005 and 2006, the Company received consultingservices from Acoustek Int’l Corp. (“Acoustek”), which employed Minnie Huang,spouse of William Huang, the Company’s former Senior Vice President and ChiefTechnology Officer.  Mr. Haung’semployment with the Company terminated on December 31, 2006.  The Company paid to Acoustek$0.1 million during each of the nine months ended September 30, 2006 and2005 for consulting services, and a negligible amount during the three monthsended September 30, 2006 or 2005.

*Audiovox*

One of the Company’s officers also serves as a directorfor Audiovox Corporation (“Audiovox”). During the three and nine months endedSeptember 30, 2006, the Company paid approximately $0.4 million and$1.1 million, respectively, of IT services from Audiovox.

*Cellon*

In September 2001, the Company invested$2.0 million in Cellon International Holdings Corporation (“Cellon”) andmade additional investments of $3.0 million each in Cellon in April andDecember 2002.  Cellon designswireless terminals and related technology for handset manufacturers and privatedistributors.  In November 2005, theCompany and Cellon entered into an agreement under which the Company receivedconsideration in the form of preferred stock and warrants of Cellon valued at$5.5 million in exchange for the transfer of fixed assets with a net bookvalue of $3.0 million, a facilities lease and a workforce in placeconsisting of 156 employees. This transaction was completed on May 31, 2006and a gain on sale of assets of $2.5 million was recorded in other income.As of September 30, 2006, with the additional shares obtained in the purchasetransaction, the Company had an 11% ownership interest in Cellon. Thisinvestment is accounted for under the cost method, and its carrying value hasbeen evaluated for possible impairment based on the achievement of businessobjectives and milestones, the financial condition and prospects of the Companyand other relevant factors.  Forinformation regarding the Company’s investment in Cellon see Note 25.

In November 2005, the Company entered into a DevelopmentService Agreement with Cellon in which $5.0 million was prepaid inexchange for future product development. Approximately $0.7 million and $2.0 million of the prepaid amount hasbeen used in the three and nine months ended September 30, 2006 as payments fordesign services.  The Company may also 

51

----

use the $5.0 million prepayment in satisfaction of royalties Cellon mayearn from sales by the Company of products Cellon designs under the DevelopmentServices Agreement.  This agreement alsoobligates Cellon to pay the Company a royalty if certain technology shared bythe Company to Cellon is used in products developed and sold to customers otherthan the Company through November 2007.

As of September 30, 2006, the Company had an accountspayable balance of $0.6 million, and an account receivable balance of$0.1 million with Cellon.

*Fiberxon, Ltd.*

The Company has an outstanding purchase commitment with Fiberxon,in which the Company has a 7% ownership interest, to purchase component partsfor optical networking products. Purchases from Fiberxon totaled$1.7 million and $2.1 million during the three and nine months endedSeptember 30, 2006, respectively.  Purchasesfrom Fiberxon totaled $0.5 million and $8.6 million during the threeand nine months ended September 30, 2005, respectively and the Company had$1.1 million and $0.3 million in accounts payable to Fiberxon atSeptember 30, 2006 and December 31, 2005, respectively.  As of September 30, 2006 the Company has $0.6million of open purchase commitments to Fiberxon.

*GCT Semiconductor, Inc.*

The Company has an outstandingpurchase commitment with GCT Semiconductor, Inc. (“GCT”), in which the Companyhas a 2% ownership interest, to purchase component parts.  Purchases from GCT for the three and ninemonths ended September 30, 2006 were $0.5 million and $4.9 million,respectively.  As of September 30, 2006,the Company had a $0.5 million accounts payable balance with GCT.  The Company had purchases of $0.3 million forthe nine months ended September 30, 2005.

*Global Asia Partners L.P.*

Global Asia Partners L.P. is a venture capital fundformed to make private equity investments in private or pre-IPO technology andtelecommunications companies in Asia. The general partner of this fund is also a sales agent of theCompany.  Between June 2002 andApril 2005, the Company invested a total of $2.6 million in thefund.  As of September 30, 2006 andDecember 31, 2005, the Company had 49% of the fund’s outstandingpartnership units.  The Company had acommitment to invest up to a maximum of $5.0 million.  As the result of a reorganization of capitalcontributions by the partners, reached in April 2005, our capital contributionof $0.5 million in April 2005 was the final capital contribution to bemade.  In addition, the agreement allowsthe partnership to re-invest up to $2.5 million that otherwise would have beenavailable to us as future distributions. There were no cash distributions during the three or nine months endedSeptember 30, 2006 or 2005.

*Immenstar*

The Company has an outstanding purchase commitment withImmenstar, in which the Company owns Series A preferred stock, to purchasecomponent parts.  The Company’s purchasesfrom Immenstar totaled $1.3 million and $1.8 million during the three andnine months ended September 30, 2006, respectively.  As of September 30, 2006, the Company had$0.3 million accounts payable balance and $4.5 million of open purchasecommitment to Immenstar.

*Matsushita Joint Venture*

In July 2002, the Company entered into a jointventure agreement with Matsushita Communication Industrial Co., Ltd. tojointly design and develop, manufacture and sell telecommunicationproducts.  The Company had a 49%ownership interest in the joint venture company.  As of December 31, 2005, the Company hada receivable of $0.1 million.  InDecember 2005, the partners agreed to dissolve the joint venture, whichwas completed by June 30, 2006.

*MDC Holding, Ltd.*

The Company had an outstandingaccounts receivable balance with MDC Holding, Inc. (“MDC”) related to a PASsystem purchase of $1.3 million at September 30, 2006.  There was no accounts receivable balance atDecember 31, 2005.  Certain employees ofthe Company were shareholders of MDC as of September 30, 2006.  MDC is in the business of providingvalue-added services, such as short message, voicemail or ring-tone servicesfor PAS telecom networks.

52

----

*ORG, Inc.*

As of September 30, 2006, the Company had a 49% ownershipin Global Asia Partners L.P. which in turn was a significant shareholder inORG, Inc.  During the three and ninemonths ended September 30, 2006, the Company had sales of $1.4 million and$1.6 million to ORG, Inc. During the three and nine months ended September 30, 2005 the Companyhad $0.3 million and $0.5 million in sales to ORG, Inc.  The Company had a $1.3 million and $0.2million receivable as of September 30, 2006 and December 31, 2005,respectively.

*StarcomProducts, Inc.*

The Companyobtains engineering consulting and employee placement services from StarcomProducts, Inc. (“Starcom”), which is 31% owned by an individual related to oneof the Company’s former officers who was also a member of the Company’s Boardof Directors.  In the three and ninemonths ended September 30, 2005, the Company obtained services from this entityin the amount of $0.1 million and $0.6 million, respectively.  There were no such services performed duringthe three and nine months ended September 30, 2006.

*Xalted Networks, Inc.*

The Company received purchase orders from XaltedNetworks, in which the Company owns preferred stock, totaling approximately$1.3 million in 2005 for telecommunications equipment that is for productnot typically sold by the Company to other customers.  The Company is charging a ten percentprocurement fee to Xalted for obtaining and reselling these products.  The equipment was delivered but revenue hasnot been recognized as the revenue recognition process had not been completed.

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

In 2005 the Company incurred $35.3 million inexpenses in relation to the restructuring plan actions, primarily consisting of(i) $15.2 million related to severance payments(ii) $14.5 million in asset impairments primarily related to thewrite-off of equipment and licenses associated with discontinued products,which are included in operating expenses and (iii) $5.6 million ininventory write-off associated with discontinued products.  Included in severance is a $1.8 millionnon-cash reversal of a housing allowance accrual in China.  As of September 30, 2006 andDecember 31, 2005, a total of 1,595 employees were terminated or placed inthe workforce reduction programs pursuant to the plan.

A summary of the restructuring accrual related to the 2005charge during the nine months ended September 30, 2006, is as follows:
| ** **          | ** ** | **December 31,**   | ** ** | ** **  | ** ** | ** **     | ** ** | **September 30,** | ** ** |
|---------------------|------------|-------------------------|------------|-------------|------------|----------------|------------|------------------------|------------|
| ** **          | ** ** | **2005**                | ** ** | **Cash**    | ** ** | **Non-cash**   | ** ** | **2006**               | ** ** |
| ** **          | ** ** | **Balance**             | ** ** | **payment** | ** ** | **settlement** | ** ** | **Balance**            | ** ** |
| ** **          | ** ** | **(in thousands)** | ** ** |
| **Broadband**       | ** ** | ** **              | ** ** | ** **  | ** ** | ** **     | ** ** | ** **             | ** ** |
| Severance payments  |       | $                       | 50         |        | $          | (50            | )          | $                      | —     |   | $ | — |   |
|                |       |                    |       |        |       |           |       |                   |       |
| **Handsets**        | ** ** | ** **              | ** ** | ** **  | ** ** | ** **     | ** ** | ** **             | ** ** |
| Severance payments  |       | 29                      |       | (29         | )          |           |       | —                 |       |
| Exit cost           |       | 350                     |       |        |       | (350           | )          | —                 |       |
|                |       |                    |       |        |       |           |       |                   |       |
| **Corporate**       | ** ** | ** **              | ** ** | ** **  | ** ** | ** **     | ** ** | ** **             | ** ** |
| Severance payments  |       | 207                     |       | (207        | )          |           |       | —                 |       |
| Exit cost           |       | 579                     |       |        |       | (274           | )          | 305                    |       |
|                |       |                    |       |        |       |           |       |                   |       |
| **Summary  Totals** | ** ** | ** **              | ** ** | ** **  | ** ** | ** **     | ** ** | ** **             | ** ** |
| Severance payments  |       | 286                     |       | (286        | )          | —         |       | —                 |       |
| Exit cost           |       | 929                     |       | —      |       | (624           | )          | 305                    |       |
| **Total**           |       | $                       | 1,215      |        | $          | (286           | )          | $                      | (624       | ) | $ | 305 |   |

 

53

----

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

The other income (expense) balances in the three and ninemonths ended September 30, 2006 and 2005 are comprised of the following items:
| ** **                            | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(in millions)**                                   | ** ** |
| Foreign exchange  gains (losses)      |       | $                                                        | 0.4        |                                                    | $          | 7.3 |   | $ | 6.1 |   | $ | (7.3 | ) |
| Dividend income                       |       | 1.0                                                      |       | —                                                  |       | 1.7 |   | — |   |
| Chinese  government financial subsidy |       | 0.5                                                      |       | —                                                  |       | 1.3 |   | 0.5 |   |
| Japan  consumption tax refund         |       | —                                                   |       | —                                                  |       | — |   | 6.0 |   |
| Gain on sale of  assets               |       | —                                                   |       | —                                                  |       | 2.5 |   |   |   |
| Other                                 |       | (0.1                                                     | )          | 0.1                                                     |       | 0.7 |   | (0.9 | ) |
| Total                                 |       | $                                                        | 1.8        |                                                    | $          | 7.4 |   | $ | 12.3 |   | $ | (1.7 | ) |

 

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

During the three months ended September 30, 2006 twocustomers accounted for approximately 17% and 12% of net sales.  In the nine months ended September 30, 2006two customers accounted for approximately 13% and 10% of net sales.  During the three months ended September 30,2005 two customers accounted for 17% and 10% of net sales.  For the nine months ended September 30, 2005two customers accounted for approximately 18% and 11% of net sales.  As of September 30, 2006 no customeraccounted for more than 10% of accounts receivable, while one customeraccounted for 13% of accounts receivable as of December 31, 2005.

Approximately 23% and 20% of the Company’s net salesduring the three months ended September 30, 2006 and 2005, respectively, andapproximately 32% and 22% of the Company’s net sales during the nine monthsended September 30, 2006 and 2005, respectively, were to entities affiliatedwith the government of China.  Accountsreceivable balances from these China government affiliated entities or state ownedenterprises were $263.8 million and $268.8 million, respectively, asof September 30, 2006 and December 31, 2005.  The Company extends credit to its customersin China generally without requiring collateral.  In global sales outside of China, the Companyoften requires letters of credit from its customers.  The Company monitors its exposure for creditlosses and maintains allowances for doubtful accounts.

Approximately 32% and 29% of the Company’s sales for thethree months ended September 30, 2006 and 2005, respectively, and approximately34% and 30% of the Company’s sales for the nine months ended September 30, 2006and 2005, respectively, were made in China. Accordingly, the political, economic and legal environment, as well asthe general state of China’s economy, may influence the Company’s business,financial condition and results of operations. The Company’s operations in China are subject to special considerationsand significant risks not typically associated with companies in the UnitedStates.  These include risks associatedwith, among others, the political, economic and legal environments and foreigncurrency exchange.  The Company’s resultsmay be adversely affected by, among other things, changes in the political,economic and social conditions in China, and by changes in governmentalpolicies with respect to laws and regulations, changes in China’stelecommunications industry and regulatory rules and policies,anti-inflationary measures, currency conversion and remittance abroad, andrates and methods of taxation.

Approximately 5% and 2% of the Company’s sales for thethree months ended September 30, 2006 and 2005, respectively, and approximately6% and 18% of the Company’s sales for the nine months ended September 30, 2006and 2005, respectively, were made in Japan. Accordingly, the political, economic and legal environment and thegeneral state of Japan’s economy may influence the Company’s business,financial condition and results of operations.

**22.****          INCOME TAX ASSETS AND LIABILITIES**

In establishing itsdeferred income 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.  The Company will maintain a full valuationallowance on its net deferred tax assets in China, the United States, and othercountries until an appropriate level of profitability that generates taxableincome is sustained or until it is  ableto develop tax strategies that would enable the Company to conclude that it ismore likely than not that a portion of our deferred tax assets will berealizable.  Any reversal of valuationallowances will favorably impact our results of operations in the period of thereversal.

54

----

The Company issubject to income taxes in both the United States and numerous foreignjurisdictions.  Significant judgment isrequired in evaluating the Company’s tax positions and determining the Company’sprovision for income taxes.  During theordinary course of business, there are many transactions and calculations forwhich the ultimate tax determination is uncertain.  The Company establishes reserves fortax-related uncertainties based on estimates of whether, and the extent towhich, additional taxes and interest will be due.  These reserves are established when, despitethe Company’s belief that its tax return positions are fully supportable, theCompany believes that certain positions are likely to be challenged and may notbe sustained on review by tax authorities. The Company adjusts these reserves in light of changing facts andcircumstances, such as the closing of a tax audit.  The provision for income taxes includes theimpact of reserve provisions and changes to reserves that are consideredappropriate, as well as the related net interest.   In the fourth quarter of 2006, the Company recordeda $29.0 million income tax benefit related to the settlement of a tax audit inChina on October 18, 2006 for the 2003 through 2005 tax years for UTStarcomTelecom Co., Ltd. (“HUTS”) and Hangzhou UTStarcom Telecom Co., Ltd (“HSTC”),two of the Company’s subsidiaries in China and the acceptance of its taxholiday for HSTC.

Income tax expense was $1.5 million and$125.2 million for the three months ended September 30, 2006 and 2005,respectively.  Income tax expense was$9.0 million and $134.0 million for the nine months ended September30, 2006 and 2005, respectively.  Thereare two primary reasons why the Company has tax expense while the Company haspretax losses.  First, the Company hasnot provided any tax benefit on the forecasted current year losses incurred andtax credits generated in the United States and other countries, becausemanagement believes that it is more likely than not that the tax benefitassociated with these losses will not be realized.  Second, the Company continues to accrue taxexpense in jurisdictions where the Company has been historicallyprofitable.  Estimates of the annualeffective tax rate at the end of the interim periods are based on evaluationsof possible future events and transactions and may be subject to subsequentrefinement or revision.

The Company’s income tax returns for 2003 though 2005are currently under audit by the Internal Revenue Service.  The Company is also under audit by the taxingauthorities in China on a recurring basis.

**23.****          VARIABLE INTEREST ENTITIES**

The FASB issued FASB Interpretation No. 46, “Consolidationof Variable Interest Entities”, and (“FIN 46”).  FIN 46 requires that if an entity is theprimary beneficiary of a variable interest entity (“VIE”), the assets,liabilities, and results of operations of the VIE should be included in theconsolidated financial statements of the entity.

During the fourth quarter of 2005, the Company providedan interest free, $12.4 million loan to a party in China as seed capitalfor a venture organized to participate in providing technical service,networking technology, and equipment to the emerging market for IPTV productsin China.  The loan is partially securedby an indirect ownership interest in the venture, is payable in 10 yearsand may be called early without penalty. As a result of the foregoing, and the fact that the venture’s continuingviability is heavily dependent on the further provision of network and terminalequipment by the Company, the Company has determined that the venture is a VIEand that the Company is the primary beneficiary of the venture.  Therefore, this venture is consolidated intothe Company’s results as of September 30, 2006. This VIE had insignificant revenue during the three and nine monthsended September 30, 2006, and had net losses of $0.3 million and $1.7 millionduring the three and nine months ended September 30, 2006.  The consolidation of this VIE represented$17.6 million and $18.9 million of both the total assets and totalliabilities and equity of the Company as of September 30, 2006 and December 31,2005.  The liabilities of the VIEconsolidated by the Company do not represent additional claims on the Company’sgeneral assets; rather they represent claims against the specific assets of theVIE.  Likewise, the assets of the VIEconsolidated by the Company do not represent additional assets available tosatisfy claims against the Company’s general assets.  The creditors’ of the VIE do not haverecourse to the Company thereby limiting the liability risks associated withthe Company’s variable interests in the VIE.

In the first quarter of 2005, the Company invested in anadditional entity, which is considered a VIE where the Company was the primarybeneficiary and did not hold a majority voting interest.  The VIE was established to install, developand operate a PAS network in Mongolia. The creditors of this VIE have no recourse to the Company.  In December 2005, the U.S. Embassy inMongolia informed the Company that it had forwarded to the Department ofJustice allegations that an agent of the joint venture had offered payments toa Mongolian government official, in possible violation of the Foreign CorruptPractices Act.  The Audit Committeeauthorized an independent investigation into the matter.  As a result of the investigation, the Companywrote off $1.2 million of intangibles and established a $2.6 millionVAT liability at December 31, 2005. The investigation is still ongoing. The consolidation of this entity resulted in a $6.0 millionincrease in both total assets and total liabilities and equity as ofDecember 31, 2005.  In the firstquarter of 2006, the Company decided to terminate the joint venture arrangementand wrote off the remaining net assets, of approximately $4.7 million.

55

----

**24.****          RECENT ACCOUNTING PRONOUNCEMENTS**

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109” (“FIN 48”). Theinterpretation contains a two-step approach to recognizing and measuringuncertain tax positions accounted for in accordance with SFAS No. 109, “Accountingfor Income Taxes.” The first step is to evaluate the tax position forrecognition by determining if the weight of available evidence indicates thatit is more likely than not that the position will be sustained on audit,including resolution of related appeals or litigation processes, if any. Thesecond step is to measure the tax benefit as the largest amount which is morethan 50% likely of being realized upon ultimate settlement. The Company adoptedthe provisions of FIN 48 as of January 1, 2007, which resulted in a $1.4million increase to the liability for uncertain tax positions offset by areduction to the opening balance of retained earnings.

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

In September 2006, the Securities and Exchange Commissionissued Staff Accounting Bulletin No. 108, “Considering the Effects of  Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements” (“SAB 108”).  SAB 108 requires analysis of misstatementsusing both an income statement (rollover) approach and a balance sheet (ironcurtain) approach in assessing materiality and provides for a one-time cumulativeeffect transition adjustment.  SAB 108 iseffective for annual financial statements for the first fiscal year endingafter November 15, 2006.  The Companyadopted SAB 108 during the fourth quarter of 2006.  The adoption of SAB 108 had no impact on the Company’sconsolidated financial statements.

In February 2007, The FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS 159”).    This statement permits, but does notrequire, companies to report at fair value the majority of recognized financialassets, financial liabilities and firm commitments. Under this standard,unrealized gains and losses on items for which the fair value option is electedare reported in earnings at each subsequent reporting date.  SFAS 159 becomes effective for the Company onJanuary 1, 2008. The Company is currently evaluating the effects ofSFAS 159 on its consolidated financial statements.

**25****           SUBSEQUENT EVENTS**

**First and Second Supplemental Indentures and Notice ofDefault**

After receiving the notice of default from the Trustee referredto in Note 14 above, the Company solicited and obtained the requisite consentsfrom holders of the convertible subordinated notes due in March 2008 to awaiver effective January 9, 2007 of any default which may have occurred priorto such date due to the delay in filing and non-compliance with certaincovenants, and the Company and the trustee entered into a First SupplementalIndenture, dated January 9, 2007, providing that any failure by the Company tocomply with certain covenants of the original indenture would not result in adefault or an event of default through May 31, 2007.  The First Supplemental Indenture provided foradditional interest at a rate of 6.75% per annum in special interest on thenotes from and after January 9, 2007 to the March 1, 2008 maturity date of thenotes, unless the notes are earlier repurchased or converted. Payments of thespecial interest were to be made in addition to and at the same time and in thesame manner as regularly scheduled payments of interest to holders entitled tosuch regularly scheduled payments of interest. As a result of the FirstSupplemental Indenture, the convertible subordinated notes accrued interest ata rate of 7.625% per annum as of January 9, 2007.

On May 31, 2007, the Company received a notice of defaultfrom the trustee for the notes asserting that a default had occurred due underthe indenture, as amended by the First Supplemental Indenture (“the Indenture”)with respect to the Company’s convertible subordinated notes due in March2008.  The specific purported defaultsreferred to in the notice of default were (1) the Company’s  failure to file its Quarterly Report on Form10-Q for the fiscal quarter ended September 30, 2006, its annual report on Form10-K for the year ended December 31, 2006 and its Quarterly Report on Form 10-Qfor the fiscal quarter ended March 31, 2007 and (2) the Company’s failure todeliver to the Trustee the officer’s certificate of compliance of the Companyrequired by the Indenture.

Subsequently, the Companysolicited and obtained the requisite consents from the holders of the notes toa waiver, effective July 26, 2007, of any default which may have occurred priorto such date due to the delay in filing and non-compliance with certaincovenants, and the Company entered into a Second Supplemental Indenture withthe trustee, dated July 26, 2007, after receiving consent from holders of morethan 50% of the outstanding aggregate principal amount of the convertible 

56

----

subordinated notes inconnection with the Company’s consent solicitation announced July 19,2007.  The Second Supplemental Indentureprovides that the convertible subordinated notes accrue additional interest ata rate of (a) 6.75% per annum in special interest from and after January 9,2007 to and including July 25, 2007, and (b) 10% per annum in special interestfrom and after July 26, 2007 to the date the notes are paid, prepaid, redeemedconverted or otherwise cease to be outstanding.    The special interest rate provided by theSecond Supplemental Indenture represents an increase of 3.25% per annum overthe special interest rate of 6.75% provided by the First SupplementalIndenture.  As a result of the SecondSupplemental Indenture, the convertible subordinated notes now bear a statedinterest rate of 10.875%.  Payments ofspecial interest will be made in addition to, and at the same time and in thesame manner as, regularly scheduled payments of interest to holders entitled tosuch regularly scheduled payments of interest.

The SecondSupplemental Indenture also provides that (i) during the period from andincluding July 26, 2007 to and including October 15, 2007 (“Covenant ReversionDate”), any failure by the Company to comply with the covenants contained inthe original agreement related to the filing of reports required to be filedwith the SEC, and the furnishing of copies of the SEC reports and certaincompliance certificates to the Trustee, will not constitute a default, and that(ii) if, but for the Second Supplemental Indenture, a default would be deemedto have occurred as a result of a failure to comply with such covenants andsuch default remains uncured and is continuing as of the Covenant ReversionDate, such default will be deemed to have occurred on the Covenant ReversionDate.

**ImmenStar**

In February 2007, ImmenStar was acquired by CortinaSystems, Inc.  In exchange for theCompany’s investment in ImmenStar, the Company received 4 million shares ofSeries D Preferred Stock of Cortina Systems, Inc., $1.8 million cash in March2007 and is entitled to receive an additional $0.2 million currently held inescrow.  As a result of the acquisition,the Company recorded a gain on investment of $2.8 million, in other income,net, and owns 1.3% interest of  CortinaSystems, Inc. on a fully diluted basis.

**Committed Receivables Agreement**

On March 30, 2007, the Company  amended and restated its committedreceivables purchase facility with Citibank, N.A., which provides for the saleof up to $100.0 million of trade accounts receivable of our PCD segment,to reflect that the purchase of trade receivables shall be at the solediscretion of Citibank, N.A.

**Impairment of Investment in Cellon and Liquidation ofAssets**

In the fourth quarter of 2006, the Company reviewed itslong-term investment in Cellon.  Thereview included, but was not limited to, a review of Cellon’s cash position,recent financing activities, financing needs, earnings/revenue outlook,operational performance, management/ownership changes, and competition.  Based on the deterioration of Cellon’sfinancial condition that resulted from significant adverse changes in Cellon’sbusiness in the fourth quarter of 2006, the Company determined that thecarrying value of the investment was at an amount above the fair value of theinvestment, and the decline was other-than temporary.  As of December 31, 2006, the Companyrecorded a $13.5 million other-than-temporary impairment charge for thisinvestment in other income, net and recorded an operating expense of $3.0million to write-off  a prepayment toCellon.  On June 18, 2007, a meeting ofCellon’s shareholders was held where a resolution was passed to place Cellon involuntary liquidation.

**Infinera Initial Public Offering**

On June 7, 2007,Infinera Corporation (“Infinera”) closed on its initial public offering of14,000,000 shares of common stock at a price of $13.00 per share. Infinera alsoannounced that the underwriters of the offering exercised in full their optionto purchase an additional 2,100,000 shares of Infinera common stock, bringingthe total initial public offering size to $209.3 million.  After the initial public offering, theCompany is entitled to convert its 669,643 shares of Series D and 2,500,000shares of Series E Preferred Stock into 792,410 shares of Infinera’s commonstock; subject to Rule 144 trading restrictions and 180 days lock up periodstarting June 2007 through December 2007.

As a result of theinitial public offering, the value of the Infinera shares owned by the Company wasreadily determinable and the investment was classified as an equity securityavailable-for-sale in accordance with SFAS No. 115, “Accounting for CertainInvestments in Debt and Equity Securities.” The closing price per share of Infinera common stock on June 29, 2007was $24.92 and the value of the Company’s investment was $19.7 million.  In the second quarter of 2007, the Companyrecorded an unrealized gain of $17.8 million, in other comprehensive income,representing the difference between the fair value of the investment on June29, 2007 and the initial investment amount of $1.9 million.

57

----

**Fiberxon merger with MRVCommunications**

On July 1, 2007, Fiberxon, an investment in which the Company has a 7%ownership interest, completed a merger with MRV Communications (“MRV”).  In exchange for the Company’s investment inFiberxon, the Company will receive approximately $1.5 million in cash, 1.5million shares of MRV common stock and deferred consideration of approximately$2.7 million.  The deferred considerationbecomes payable upon the completion of certain milestones and may be reduced bylegitimate claims of MRV for certain matters related to the merger.

58

----

**ITEM 2—MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**FORWARD-LOOKING STATEMENTS**

This Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of the federal securities laws.  These statements are based on informationthat is currently available to management. We intend such forward-looking statements to be covered by thesafe harbor provisions of the Private Securities Litigation Reform Act of 1995,and we are including this statement for purposes of complying with thoseprovisions.  The forward-lookingstatements include, without limitation, those concerning the following: ourexpectations regarding our compliance with SEC reporting requirements andNASDAQ listing requirements; our expectations as to the nature of possiblemarket trends; our expectations regarding continued growth in our business andoperations; our expectations regarding fluctuations in gross profit; our plansregarding payment of cash dividends; our plans regarding legal proceedings; ourexpectations regarding the effect of legal proceedings and governmentinquiries; our expectations regarding the functionality, performance andfeatures of our products; our expectation regarding Softbank’s continuedservice of certain modems and modem rental agreements; our plans andexpectations regarding relationships with vendors and suppliers; our plan tofulfill the purchase commitment under various orders from our suppliers; ourexpectations regarding the exchange rate risks with respect to accountablereceivables and payables in Renminbi, Japanese Yen and Euros; our plansregarding the use of financial instruments to hedge against certain foreigncurrency exchange rate risks; our plans regarding the discounting of certainbank notes and commercial notes; our expectations regarding our ability toraise funds, including the impact of late filing of our reports with the SEC onour ability to raise funds; our expectations regarding the availability offunding under the account receivable financing program with Citibank, N.A.; andour plan to continue service the account receivable; our expectations regardingour investment in Global Asia Partners L.P.; our expectations regarding ourright to intellectual property embedded in our products; our expectationsregarding our ability to protect our intellectual property; our expectationsregarding the effect of market risks on our operating results; our plans toimplement measures to remediate material weaknesses; our expectations regardingthe effectiveness of remediation measures; our plans to continue to reviewinternal controls; our expectations regarding competition and the competitiveadvantages of our competitors; our expectations regarding consolidation of thetelecommunications industry; our expectations regarding the development andintroduction of new and more advanced products; our expectations regardingdeployment of our products; our plans and expectations regarding our workforcerestructurings; our expectation regarding the adoption of environmental, healthand safety laws by countries world-wide; our expectations regarding the effectof the Sarbanes-Oxley Act on our corporate governance and disclosurepractices; our expectation regarding the expenses associated with compliancewith the Sarbanes-Oxley Act; our expectations regarding the impact of therestatement of our consolidated financial statements; our expectationsregarding the maturation of the PAS market and corresponding decrease in PASsubscriber growth; our expectations regarding the long-term demand for our PASproducts; our expectations regarding our ability to offset the decline in PASsales through pursuing other products; our expectations regarding PAS systemspending; our plan to pursue opportunities for our wireless infrastructureproducts in multiple markets; our expectations regarding our investment in anddevelopment of the IPTV market; our expectations regarding product margins; ourexpectations regarding our annual effective tax rate; our expectationsregarding the likelihood to realize the tax benefits in the U.S. and othercountries; our expectations regarding the effect of the China Corporate IncomeTax Law on our future tax expenses; our expectations regarding valuationallowance on our net deferred tax assets and its impact; our expectationsregarding our level of capital expenditures in China; our plans to maintainadequate liquidity levels through at least the next 12 months; our expectationsregarding the availability and sufficiency of credit lines from lenders; ourplans to issue new debt instruments, sell investments and assets; ourexpectations regarding refinancing of the convertible notes and access to cashin our China subsidiaries to meet our liquidity requirements outside of China;our expectations regarding interest rates; our expectations regardingsufficiency of cash resources; our expectations regarding our ability toreceive licenses for our products; our expectation that our business, financialcondition and results of operations will continue to be significantlyinfluenced by the political, economic, legal and social environment in Chinaand other international markets, including Japan, India and Europe; ourexpectations regarding the nature of political, economic and legal reform inChina; our expectations regarding the continued importance of the Chinesemarket for our technologies and development and the importance of sales inChina to our operating results; our expectations regarding future salesgenerated from China as a percentage of total sales; our expectations regardingthe impact of our receiving the license to sell GSM and CDMA handsets in Chinaon our ability to meet future market demands; our expectations regardingsubscriber growth in China; our 

59

----

expectations regarding global expansion of sales outside of China; ourexpectation that research and development expenses will be stable; ourexpectations regarding future amortization expenses; our expectations regardingthe impact of product defects or performance quality issues; our expectationsregarding the impact of international expansion on our management, operational,financial and other resources; our expectations regarding the impact of legislationthat restricts or prohibits the use of wireless handsets while driving on ourfuture sales; our plans regarding improvement of our internal supply chain andinventory management processes; our expectations regarding the reliability ofstock-based compensation valuation models and the impact ofSFAS 123R; and our expectations regarding our ability to implement andenhance our administrative infrastructure. Additional forward-lookingstatements may be identified by the words “anticipate,” “expect,” “believe,”“intend,” “will,” “may,” and similar expressions, as they relate to us or ourmanagement, or by the words “designed,” “intended” and similar expressions, asthey relate to our products and services. Investors are cautioned that these forward-looking statements areinherently uncertain.  These statementsare subject to risks and uncertainties that may cause actual results and eventsto differ materially.  For a detaileddiscussion of these risks and uncertainties, see Part II, Item 1A “Risk Factors”of this Form 10-Q.  We do notguarantee future results and undertake no obligation to update the forward-lookingstatements to reflect events or circumstances occurring after the date of thisForm 10-Q. 

**RESTATEMENT OF CONSOLIDATEDFINANCIAL STATEMENTS**

Our consolidated financialstatements and related financial information included in this Quarterly Reporton Form 10-Q for accounting periods prior to the third quarter of 2006 havebeen restated, as described below.

***Summary***

In July 2007, theCompany announced the Audit Committee was conducting an independentinvestigation of historical sales with certain customers in China and statedthat it could not rule out the possibility that the outcome of theinvestigation could impact revenue recognized for certain of such contracts asrecorded in previously issued financial statements. In September 2007, theCompany announced the investigative phase of the Audit Committee’sinvestigation had been completed. After consultation with and upon therecommendation of management, the Audit Committee determined revenue in theCompany’s Western Region of China was recognized earlier than it should havebeen and that the financial statements for the affected periods should berestated. The Company also announced that its previously issued financialstatements for each of the fiscal years ended December 31 in the period 2000through 2005, the financial statements for the interim periods contained in theQuarterly Reports on Form 10-Q filed with respect to each of these years, andthe quarterly reports on Form 10-Q filed with respect to each of the quarterlyperiods ended March 31 and June 30, 2006 should not be relied upon. In this Quarterly Reportwe have corrected for the effects of net sales and related costs of net salesthat were recorded earlier than they should have been. The net effect for thethree and nine months ended September 30, 2005 was to reduce and deferpreviously recognized revenue and gross profit of $34.6 million and $15.1 million,respectively, and $63.7 million and $29.4 million, respectively.

We also conducted a voluntaryreview of historical stock option practices under the direction of theNominating and Corporate Governance Committee of our Board of Directors(“Governance Committee”). This review considered all option grant awards madein the period from February 29, 2000, shortly before the initial public offeringof our Common Stock, through August 2006 for compliance with the variousstock-based compensation accounting standards applicable during this period aswell as the rules of our stock option plans. We found that in a number ofinstances we did not use the proper date as the measurement date in determiningwhether stock options had been issued with exercise prices below the fair valueof our common stock. Therefore, we have restated our previously issuedfinancial statements for the years ended December 31, 1998 through 2005 toaccount for an additional $25.5 million of stock compensation expense thatshould have been recognized over the period together with an equal increase inadditional paid-in capital to recognize the intrinsic value assigned to these issuancesof equity securities. Related adjustments of payroll and income taxes resultedin an additional $0.5 million of expense being recognized for the 1998 through2005 period and total stockholders’ equity being reduced by a total of $2.1million at December 31, 2005. During the first six months of 2006 an additional$1.2 million of stock compensation expense was recognized, which reduced ourpreviously reported operating results for this period. During the three andnine months ended September 30, 2005 (in thousands), stock compensation expensetotalling $76 and ($1,470), respectively, was recognized.

Inrestating our previously issued financial statements for the investigationsdescribed above, we also corrected other previously reported amounts. We corrected our reporting for $80.3 million ofnet sales to certain third party resellers and $41.2 million of associated costof net sales in 2005 to classify these amounts as related party net sales andrelated party cost of net sales classifications, respectively, because in 2006we determined that sales to these entities were, in substance, sales to one ofour significant shareholders, SOFTBANK CORP. The accounts receivable from thesesales was similarly reclassified into accounts receivable from related partiesin our 2005 balance sheets. We also corrected our reporting of $6.3million of time deposits at March 31 and June 30, 2006 because they did notmature within three months. Formerly the time deposits had been reported inerror as cash equivalents, but now these amounts are included in short-terminvestments in these balance sheets and in the statements of cash flows for theMarch and June 2006 reporting periods. The corrections for the three and ninemonths ended September 30, 2005 interim periods have been recorded in thecondensed consolidated financial statements included herein. See also Exhibit99.1 of our Annual Report on Form 10-K for the year ended December 31, 2006 forthe impact of the restatement on all quarterly periods for 2005 and 2006.

60

----

Noneof these restatements had any effect on any of our December 31 cash balances;however, cash equivalents were reduced in the March and June 2006 periods dueto the reclassifications described above.

Additionalinformation about these restatements and their effects on our financialstatements is presented below as well as in the Notes to Condensed ConsolidatedFinancial Statements.

***ChinaSales Investigation***

The Audit Committee of the Company’s Board of Directors (“Audit Committee”)engaged independent counsel to conduct an investigation of sales in Chinafollowing a determination by the Internal Audit group that allegations ofimproper activities in a sales office in the Western Region were credible. Theallegations were made by a Company employee using the Company’s whistle blowerprogram. The independent counsel engaged forensic accountants, and this groupis collectively referred to as the Investigating Team in the rest of thisdiscussion.

In conducting its procedures, the Investigating Team found instances wherethe customer contracts that evidenced the arrangement contained obligations forthe Company to deliver software upgrades when and if made available for theequipment sold for no additional consideration and for an unspecified periodthat could extend over the term of the contract. This additional contractobligation is an element of “post contract support.” In these cases, theInvestigating Team found that the contract documentation for the sametransaction submitted by the sales office to the Company’s China headquartersfor accounting purposes and utilized by the Company in determining the amountof revenue recognized did not include evidence of such post contract supportobligations.

Accounting standards governing revenue recognition for system sales requireall revenue to be deferred while there are undelivered elements under thearrangement unless the seller has established vendor specific objectiveevidence (“VSOE”) of fair value for such contract elements. Because thesearrangements included such undelivered elements, revenue should be deferredbased on the VSOE of the fair value of the underlying elements. VSOE of fairvalue represents the price charged when the same element is sold separately.Since the Company does not sell this element separately, it has not establishedVSOE for such undelivered elements, and as such the revenue from such contractsis required to be deferred and recognized over the period the Company isobligated to provide the post contract support.

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

Upon completion ofthe investigative phase of the independent investigation by the AuditCommittee, our management:

·                  conductedfollow-up procedures to attempt to locate any additional relevant informationto ensure the Company considered all available information and documents;

·                  evaluatedthe accounting for identified system sales using the contract template anddocumentation found in the sales contract files from the Western Regionoffices. This included calculating the financial statement effects ofcorrecting the accounting for all system sales where the contract templatefound at our sales offices contained post contract support obligations torecognize revenue and cost of net sales over estimated period of post contractsupport;

·                  concludedthat as a result of the existence of this undelivered post contract supportobligation our previously issued financial statements should be restated todefer system sales contract revenue and the related cost of net sales over theestimated period of post contract support when a contract contained unspecifiedsoftware upgrade rights.

61

----

The AuditCommittee concurred with management’s decisions.

The effect ofcorrecting improperly recognized revenue and cost of net sales is to (reduce)increase previously reported net sales, gross profit and net income by thefollowing amounts (in thousands of dollars):
| Year ended  December 31, | ** ** | **Net sales** | ** ** | **Gross profit** | ** ** | **Net income** | ** ** |
|------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------------|------------|
|                               |       |               |       |                  |       |                |       |
| 2000                               |       | $                  | (12,408    | )                     | $          | (5,294              | )          | $ | (4,781 | ) |
| 2001                               |       | (17,154            | )          | (6,330                | )          | (5,779              | )          |
| 2002                               |       | (64,732            | )          | (22,924               | )          | (19,697             | )          |
| 2003                               |       | (21,060            | )          | (8,014                | )          | (6,382              | )          |
| Totals through December 31, 2003   |       | (115,354           | )          | (42,562               | )          | (36,639             | )          |
| 2004                               |       | (104,965           | )          | (27,241               | )          | (18,594             | )          |
| 2005                               |       | (58,232            | )          | (27,863               | )          | (42,433             | )          |
| 2000 - 2005 Total                  |       | (278,551           | )          | (97,666               | )          | (97,666             | )          |
| 2006 quarter ended                 |       |               |       |                  |       |                |       |
| March 31                           |       | 5,410              |       | 1,360                 |       | 1,360               |       |
| June 30                            |       | 2,380              |       | (371                  | )          | (371                | )          |
| Total China  Sales Restatement     |       | $                  | (270,761   | )                     | $          | (96,677             | )          | $ | (96,677 | ) |

 

The cumulativeeffect of all of the China sales restatement adjustments to our consolidatedbalance sheet as of December 31, 2003 resulted in a decrease in retainedearnings of $36.6 million, an increase in deferred revenue of $115.4 million toaccount for previously recognized sales, an increase in deferred costs of $75.7million to account for previously recognized cost of net sales, and an increasein deferred tax assets of $3.0 million. In our consolidated balance sheet atDecember 31, 2006, deferred revenue is $275.7 million, of which $35.6 millionis classified as current and $240.1 million as non-current, and the deferredcosts balance is $176.6 million. These amounts will be recognized in ourconsolidated statements of operations over the estimated remaining period ofpost contract support.

Due to this restatement,we decreased net sales, gross profit, and net income (in thousands) for thethree and nine month periods ended September 30, 2005 as follows: $34,610 and$63,671; $15,062 and $29,429; and $29,186 and $43,999, respectively.  In our consolidated balance sheet atSeptember 30, 2006 the net reduction in previously recognized net sales isaccounted for as deferred revenue, of which $34.5 million is classified ascurrent and $240.3 million as non-current, and the related net reduction incost of net sales of $177.0 million is accounted for as deferred costs. Theseamounts will be recognized in our consolidated statements of operations overthe estimated remaining period of post contract support.

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

We haverestructured the management of the Western Region sales organization and areworking to identify and implement changes to our policies and procedures andenhance employee training to improve internal control consciousness and lessenthe possibility of accounting errors occurring in the future.

62

----

***StockOption Accounting***

In November 2006,we announced we had commenced a voluntary review of historical stock optionpractices under the leadership of the Governance Committee following apreliminary review by management which identified potential deficiencies anddiscrepancies in the documentation of stock option grants. The reviewconsidered all option grant awards made in the period from February 29, 2000,shortly before the initial public offering of our Common Stock, through August2006 (“Review Period”) for compliance with the various stock-based compensationaccounting standards applicable during the Review Period as well as the rulesof our stock option plans. The Governance Committee engaged independent outsidelegal counsel to assist in the review who, in turn, engaged forensicaccountants. (Separate law firms and separate forensic accounting firms wereengaged by the Audit Committee and the Governance Committee for the China salesinvestigation and the stock option accounting review.) In the rest of thisdiscussion, this group collectively is referred to as the Stock Option ReviewTeam and their actions and activities are referred to as the Stock OptionReview. The Stock Option Review Team members spent over 11,000 hours in thisreview, and the Governance Committee met with the Stock Option Review Team onmore than a dozen occasions to receive, discuss, and consider the Stock OptionReview Team’s information and findings.

At the time thereview commenced, the Governance Committee consisted of three members of theBoard of Directors, all of whom are independent directors. The Committeedecided to delegate supervision of the review to Mr. Jeff Clarke, its Chairman,who joined our Board in 2005 and had not served on the Compensation Committeeof the Board of Directors (“Compensation Committee”) during the period underreview. The Governance Committee also consisted of two other independentdirectors, Mr. Larry D. Horner and Mr. Thomas Toy, who also serve on the Board’sCompensation Committee.  Mr. AllenLenzmeier was appointed to the Governance Committee on April 27, 2007.

Review proceduresincluded:

·                  interviewsof individuals involved with granting, advising, administering, or accountingfor stock options, including current and former:  management, members of the Board ofDirectors, employees, and non-employee professionals;

·                  reviewof relevant stock administration, human resource, legal, and finance departmentfiles and records;

·                  reviewof stock option grant information in select employee personnel files;

·                  reviewby at least 30 attorneys and 15 forensic accountants of approximately 250,000potentially relevant e-mails and documents in electronic format selectedthrough electronic discovery techniques from over 1.8 million electronicdocuments processed;

·                  reviewof the electronic database of the Company’s stock option activity maintained bya third party along with communications to and from this service provider;

·                  reconciliationof grant activity from approval documents executed by the CompensationCommittee with the electronic database;

·                  reconciliationof stock option grant, exercise, and cancellation information from SEC filingswith select employee personnel files and the electronic database;

·                  statisticaland judgmental pattern analysis;

·                  follow-upon matters raising questions about the option granting process and its history,conduct of those involved with granting, advising, administering, or accountingfor stock options, or the accounting treatment for stock options; and

·                  follow-upon items or issues requested or identified by management or the Company’sindependent registered public accounting firm.

The Stock OptionReview Team, management, and the Governance Committee decided to group stockoption grants into six award categories based on differences in whatconstituted substantive approval for each category under our stock optiongranting practices as well as giving consideration to the risk of intentionalmisstatement of the grant date. Guidance in a September 19, 2006 letterpublicly issued by the SEC’s Chief Accountant focuses on the concept that ameasurement date under Accounting Principles Board Opinion No. 25 *Accounting for Stock Issued to Employees*(“APB 25”), theaccounting standard governing our stock option accounting through 2005, doesnot occur until the number of shares an individual employee is entitled toreceive and the exercise price is determined with finality (i.e., no longersubject to change). This is the 

63

----

date on which substantiveapproval occurred, and depending on a company’s facts and circumstances theguidance from the SEC discussed above recognizes a company may determine thatthe measurement date for some stock option grants may occur before all requiredgranting actions have occurred – such as final approval by the CompensationCommittee. This alternative is available only when a review of all facts andcircumstances supports a conclusion that substantive approval occurs earlierthan when all required granting actions have occurred and there is no evidenceof fraudulent or manipulative conduct in the company’s option grantingpractices.

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

 

For 12 testedgrant dates where a corrected measurement date was required, the Stock OptionReview Team and management were unable to locate sufficient evidence toestablish a corrected measurement date using our established criteria for theapplicable option grant type. In these situations alternative availableevidence was used to establish the corrected measurement date.

During the periodcovered by the Stock Option Review, we granted stock options on approximately34 million shares of our Common Stock at 197 grant dates. The reviewspecifically examined the appropriateness of the stated grant date forapproximately 90% of the stock options granted, including all stock optiongrants made to directors and officers, all broadbase grants and all optiongrants made in connection with business acquisitions.

64

----

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

 

----

(1)          Under APB 25 there is noexpense adjustment arising from using the corrected measurement date for thesegrants because the amount the employee would have to pay to exercise thesestock option grants exceeded the quoted market price of our Common Stock at thecorrected measurement date, and therefore, these stock option grants containedno intrinsic value at the corrected measurement date.

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

In late January2007 the Governance Committee reported its interim findings concerning the useof incorrect measurement dates in our stock option accounting under APB 25 toour Board of Directors. On February 1, 2007, the Audit Committee of the Boardof Directors then concluded, in consultation with and upon the recommendationof management, that we should correct for errors in previously reportedstock-based compensation expense through restatement of our previously issuedfinancial statements and that our previously issued financial statements forall periods should no longer be relied upon. We communicated this decision in aFebruary 1, 2007 public announcement.

A non-cashcompensation charge, to be recognized as an expense over a grantee’s serviceperiod, arises under APB 25 if a stock option has intrinsic value at itsmeasurement date. This intrinsic value is measured by the excess, if any, ofthe fair value at the date of grant of the underlying common stock over thestock option’s exercise price. Our practice has been to grant stock optionswith exercise prices equal to the closing price of our Common Stock at eachgrant date, to use the grant date as the measurement date for stock-basedcompensation purposes, and as such previously we had determined the grantedstock options had no intrinsic value at their grant dates and no compensationexpense was recognized. However, APB 25 states the measurement date does notoccur until all essential actions necessary to grant the option are completed,including the final determination of both the number of shares to be granted toeach employee or director and the exercise price, and the option grant isapproved by those with requisite authority. This is reinforced by the September19, 2006 letter issued by the SEC’s Chief Accountant which focuses on the needfor the number of shares and exercise price of an award to an individual to befinalized to have a measurement date. This letter clarifies the SEC staff’sview that if it is possible that those terms could change, a measurement datehas not occurred, even if the award’s terms are not actually changed.

Based on theavailable evidence, the review found that the number of shares an individualemployee was entitled to receive and/or the exercise price was not determinedwith finality at the stated grant date on 53 tested grant dates, and we shouldhave used a later date as the measurement date. The principal reasons for thestated grant date not qualifying as the measurement date under APB 25 include:

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

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

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

During the reviewthe Company also discovered a stock option grant to a former officer that wasmodified in 1998 in connection with his termination of employment. This changewas never included in the Company’s stock option grant records and theadditional compensation expense resulting from the change in the option’sterms  (approximately $1.2 million)  was not recorded previously. This discoveryis consistent with the Stock Option Review Team’s finding that in certaininstances there was a lack of formal documentation in the stock option grantingprocess and/or expected documentation is missing from the stock optionadministration files. In addition, the Stock Option Review Team found that, inmany instances, there was a lack of self-authenticating evidence to corroboratethat cash exercises were contemporaneous. As a result, the findings on theissue of backdating of cash exercises were inconclusive.

65

----

We are restatingour consolidated financial statements to recognize additional non-cashstock-based compensation expense arising from using corrected measurement datesfor certain stock option grants made during the years 2000 through 2005 and toreflect the modification of the 1998 grant described above. Consistent with ourhistorical accounting policy this additional stock-based compensation expenseis being recognized on an accelerated basis by treating each vesting tranche asa separate stock option grant (graded vesting).

Our accounting forstock-based compensation changed to a fair value based method in 2006 when, asrequired by accounting standards, we ceased accounting for stock-based compensationunder the intrinsic value method pursuant to APB 25 and began accounting forstock-based compensation under Statement of Financial Accounting Standards123(R) *Share-Based Payments*(“SFAS 123(R)”).Under this method all stock option grants have a fair value determined using anoption pricing model, and such fair value is used to recognize non-cashstock-based compensation expense. We restated our unaudited condensedconsolidated financial statements for the first and second fiscal quarters of2006, included in Exhibit 99.1 in our Annual Report on Form 10-K for the yearended Decemer 31, 2006 (and as reflected in our results for the three and ninemonths ended September 30, 2006 included in this Form 10-Q) to recognizechanges in non-cash stock-based compensation expense that arose from are-determination of the fair value of stock options granted in 2005 and priorwhere the Governance Committee’s review resulted in a corrected measurementdate. By January 1, 2006, of the 17.9 million options granted in 2000 – 2005where corrections were made to the measurement dates in the Stock OptionReview, 4.4 million options with corrected measurement dates granted in 2000and 2001 had fully vested. Therefore, the fair values of the outstanding andunvested portion of the remaining 13.5 million stock options granted in2002-2005 with incorrect measurement dates were recalculated. We are alsorecording additional non-cash stock-based compensation expense in the first twoquarters of 2006 arising from correcting the measurement date for stock optiongrants to three individuals in this period. We recognize stock compensationexpense on a straight-line basis under SFAS 123(R).

Those stock optiongrants with corrected measurement dates have also been restated using the fairvalue based measurement principles of Statement of Financial AccountingStandards 123 *Accounting for Stock-Based Compensation*(“SFAS123”) to present, in Note 2, “Restatement of Financial Statements” of Notes toConsolidated Financial Statements contained in Item 8 of our Annual Report onForm 10-K for the year ended December 31, 2006, the pro forma effect onstock-based compensation expense, net income (loss), and earnings (loss) pershare amounts in 2004 and 2005 of using the fair value based method todetermine stock-based compensation expense rather than using APB 25’s intrinsicvalue method. Such disclosure is required in financial statements for periodsprior to the adoption of SFAS 123(R).

In addition torestating the consolidated financial statements in response to the GovernanceCommittee’s findings, we are recording additional non-cash adjustments toaccount for the modification in 1998 of a stock option grant to a formerofficer in connection with his termination of employment and to record in thefirst two quarters of 2006 corrections relating to accounting for performancerelated stock options and restricted stock grants, all of which were previouslyidentified and considered immaterial.

Correcting themeasurement date for previously granted stock options in some cases results inadditional taxable income to employees on which additional payroll taxes aredue from the employees as well as us. We have provided for all additionalpayroll taxes plus related penalties and interest arising from the restatementof stock-based compensation, including amounts otherwise payable by stockoption recipients, and our restated financial statements include an accrual inall affected years of approximately $1.5 million for all estimated payroll taxrelated expenses.

66

----

The correctionsfor the stock option restatement are to increase (reduce) previously reportednon-cash compensation expense, payroll taxes, income taxes and net income bythe following amounts (in thousands of dollars):
| **Year ended**              | ** ** | **Non-cash stock** | ** ** | ** **             | ** ** | ** **            | ** ** | ** **          | ** ** |
|----------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
| **December 31,**            | ** ** | **compensation**        | ** ** | **Payroll taxes** | ** ** | **Income taxes** | ** ** | **Net income** | ** ** |
|                             |       |                    |       |                   |       |                  |       |                |       |
| 1998                             |       | $                       | 1,244      |                   | $          | —                |       | $                   | (448       | ) | $ | (796 | ) |
| 1999                             |       | —                  |       | —                 |       | —                |       | —              |       |
| 2000                             |       | 556                     |       | —                 |       | (104                  | )          | (452                | )          |
| 2001                             |       | 4,870                   |       | —                 |       | (942                  | )          | (3,928              | )          |
| 2002                             |       | 8,110                   |       | —                 |       | (1,550                | )          | (6,560              | )          |
| 2003                             |       | 12,470                  |       | 900                    |       | (2,281                | )          | (11,089             | )          |
| Totals through December 31, 2003 |       | 27,250                  |       | 900                    |       | (5,325                | )          | (22,825             | )          |
| 2004                             |       | (410                    | )          | 541                    |       | 250                   |       | (381                | )          |
| 2005                             |       | (1,290                  | )          | 60                     |       | 4,083                 |       | (2,853              | )          |
| 2000-2005 Total                  |       | 25,550                  |       | 1,501                  |       | (992                  | )          | (26,059             | )          |
| 2006 quarter ended               |       |                    |       |                   |       |                  |       |                |       |
| March 31                         |       | 662                     |       | 9                      |       | —                |       | (671                | )          |
| June 30                          |       | 504                     |       | 6                      |       | —                |       | (510                | )          |
|                             |       | $                       | 26,716     |                   | $          | 1,516                 |       | $                   | (992       | ) | $ | (27,240 | ) |

 

The GovernanceCommittee’s review found 17.9 million stock options of the 28.8 million optionsgranted on our Common Stock during 2000 through 2005 had incorrect measurementdates. Using the corrected measurement dates, 7.6 million stock options hadexercise prices that exceeded the closing price of our Common Stock andtherefore had no intrinsic value to be accounted for under APB 25, and 10.3million stock options had intrinsic value because their exercise prices werebelow the closing price of our Common Stock. These 10.3 million stock optionsresulted in an increase in additional non-cash stock-based compensation expenseof $24.3 million, and an additional $1.5 million of payroll tax relatedexpenses during 2000-2005 partially offset by $0.5 million of income taxbenefit as shown in the above table. Of the 10.3 million stock optionsresulting in additional non-cash stock-based compensation expense, 2.0 millionoptions were granted to officers and directors and resulted in $6.1 million ofadditional non-cash stock-based compensation expense.

The total effectof the stock option restatement and the amounts for 2006, as shown in the abovetable, have been reflected in the September 30, 2006 financial statements. As aresult of this restatement, net income decreased by $3.7 million and $2.6million,respectively, for the three and nine months ended September 30, 2005.

Upon completingits review, the Governance Committee concluded it found no evidence of intentto manipulate the Company’s operating results or financial statements. A keyfinding of the Governance Committee was that there were deficiencies with theprocess by which stock options were granted during the period from our initialpublic offering in 2000 through at least 2005, which resulted in accountingerrors. The Governance Committee concluded that certain members of managementbear varying degrees of responsibility for the deficiencies in the process bywhich options were granted. The Governance Committee’s review also concludedthat none of the current or former employees or directors of the Companyengaged in intentional wrongdoing.

In determining theabove restatement amounts, management used all reasonably available relevantinformation to form conclusions it believes are reasonable as to the mostlikely option granting actions that occurred, the dates when such actionsoccurred, and the determination of grant dates for financial accountingpurposes based on when the requirements of the accounting standards were met.In light of significant judgment used in establishing revised measurementdates, alternative approaches to those used by the Stock Option Review Team andmanagement could have resulted in different compensation charges than thoserecorded in the restatement. The Stock Option Review Team and managementconsidered various alternatives throughout the course of the review andrestatement, and management believes the approaches used were the mostappropriate in the circumstances, and the choices of measurement dates used inour review of stock option grant accounting and restatement of our financialstatements were reasonable and appropriate in our circumstances.

67

----

***Summaryof Restatement Amounts***

Thefollowing table presents the decrease in net earnings from the restatement foreach restated year:
|                                  | ** ** | ** **                           | ** ** | **Restatement adjustments**         | ** ** | ** **                       | ** ** |
|----------------------------------|------------|--------------------------------------|------------|------------------------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | ** **                           | ** ** | **China Sales**                     | ** ** | **Stock Options**           | ** ** | **Total** | ** ** | ** ** | ** ** |
| **Year ended**              | ** ** | **Net income (loss),**     | ** ** | **(in thousands)**                  | ** ** | **Net income (loss),** | ** ** |
| **December 31,**            | ** ** | **as previously reported** | ** ** | **(Decrease)   Increase** | ** ** | **as restated**             | ** ** |
|                             |       |                                 |       |                                     |       |                             |       |   |   |   |   |
| 1998                             |       |                                 |       | $                                        | —     |                             | $          | (796 | ) | $ | (796 | ) |   |   |
| 1999                             |       |                                 |       | —                                   |       | —                           |       | — |   |   |   |
| 2000                             |       |                                 |       | (4,781                                   | )          | (452                             | )          | (5,233 | ) |   |   |
| 2001                             |       |                                 |       | (5,779                                   | )          | (3,928                           | )          | (9,707 | ) |   |   |
| 2002                             |       | $                                    | 107,862    |                                     | (19,697    | )                                | (6,560     | ) | (26,257 | ) | $ | 81,605 |   |
| 2003                             |       | $                                    | 209,856    |                                     | (6,382     | )                                | (11,089    | ) | (17,471 | ) | $ | 192,385 |   |
| Totals through December 31, 2003 |       |                                 |       | (36,639                                  | )          | (22,825                          | )          | (59,464 | ) |   |   |
| 2004                             |       | $                                    | 69,824     |                                     | (18,594    | )                                | (381       | ) | (18,975 | ) | $ | 50,849 |   |
| 2005                             |       | $                                    | (487,359   | )                                        | (42,433    | )                                | (2,853     | ) | (45,286 | ) | $ | (532,645 | ) |
| 2000 - 2005 Total                |       |                                 |       | (97,666                                  | )          | (26,059                          | )          | (123,725 | ) |   |   |
| 2006 quarter ended               |       |                                 |       |                                     |       |                             |       |   |   |   |   |
| 2006 Q1                          |       |                                 |       | 1,360                                    |       | (671                             | )          | 689 |   |   |   |
| 2006 Q2                          |       |                                 |       | (371                                     | )          | (510                             | )          | (881 | ) |   |   |
|                             |       |                                 |       | $                                        | (96,677    | )                                | $          | (27,240 | ) | $ | (123,917 | ) |   |   |

 

Theeffect these corrections on diluted earnings (loss) per share for 2002 to 2005are as follows:
|                       | ** ** | **Diluted earnings**            | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** **                 | ** ** | **Diluted earnings** | ** ** |
|-----------------------|------------|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|----------------------------|------------|---------------------------|------------|
| **Year ended**   | ** ** | **(loss) per share,**      | ** ** | **Restatement amounts** | ** ** | **(loss) per share,** | ** ** |
| **December 31,** | ** ** | **as previously reported** | ** ** | **China sales**         | ** ** | **Stock options**          | ** ** | **Total restatement** | ** ** | **as restated**      | ** ** |
| 2002                  |       | 0.94                                 |       | (0.17                        | )          | (0.06                           | )          | (0.23                      | )          | 0.71                      |       |
| 2003                  |       | 1.70                                 |       | (0.05                        | )          | (0.09                           | )          | (0.14                      | )          | 1.56                      |       |
| 2004                  |       | 0.54                                 |       | (0.14                        | )          | (0.00                           | )          | (0.14                      | )          | 0.40                      |       |
| 2005                  |       | (4.16                                | )          | (0.36                        | )          | (0.03                           | )          | (0.39                      | )          | (4.55                     | )          |

 

68

----

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

 

Inrestating the previously issued financial statements for the investigationsdiscussed above, we also corrected other previously reported amounts. It corrected the reporting of $7.2 million and$62.7 million, respectively, of net sales to certain third party resellers and $7.7million and $24.6 million, respectively, of associated cost of net sales forthe three and nine months ended September 30, 2005 to classify these amounts asrelated party net sales and related party cost of net sales classifications,respectively, because in 2006 we determined that sales to these entities were,in substance, sales to a significant shareholder, SOFTBANK CORP. Theclassification of the accounts receivable from these sales was similarlychanged to include them in accounts receivable from related parties in the September30, 2005 consolidated balance sheet.

**ALL AMOUNTS IN THE FOLLOWINGSECTIONS OF THIS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS, EXCEPT THOSE IDENTIFIED “AS PREVIOUSLY REPORTED” INTABLES WITHIN THE QUARTERLY DATA (UNAUDITED), AS RESTATED CAPTION, REFLECT THEEFFECTS OF THE RESTATEMENT OF OUR FINANCIAL STATEMENTS TO CORRECT OUR REVENUERECOGNITION FOR CERTAIN SALES CONTRACTS IN CHINA AND OUR HISTORICAL STOCKOPTION ACCOUNTING, AS WELL AS CERTAIN 2005 SALES, COST OF SALES AND ACCOUNTSRECEIVABLES AMOUNTS DISCOVERED TO BE RELATED PARTY TRANSACTIONS AND THECORRECTION OF THE CLASSIFICATION OF A TIME DEPOSIT FROM CASH TO SHORT-TERMINVESTMENTS IN THE FIRST TWO QUARTERS OF 2006.**

**Late SEC Filings and NASDAQDelisting Proceedings**

As a result of theNominating and Corporate Governance’s Committee’s review of our historical stockoption accounting and the resulting restatements, we did not timely file ourQuarterly Report on Form 10-Q for the quarter ended September 30, 2006 (“Q32006 Form 10-Q”), our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2006 (“2006 Form 10-K”), and our Quarterly Report on Form 10-Q forthe quarter ended March 31, 2007 (“Q1 2007 Form 10-Q”) with the Securities andExchange Commission.  In addition, as aresult of the Audit Committee’s review of certain historical sales contracts inChina, we did not timely file our Quarterly Report on Form 10-Q for the quarterended June 30, 2007 (“Q2 2007 Form 10-Q”) with the Securities and ExchangeCommission.

In connection with ourfailure to timely file our periodic reports, we received four NASDAQ StaffDetermination letters, dated November 15, 2006, March 7, 2007, May 16, 2007 andAugust 13, 2007, respectively, stating that, as a result of each of thesenon-timely filings, we were not in compliance with the requirements ofMarketplace Rule 4310(c)(14) and, therefore, our stock was subject to delistingfrom the NASDAQ Stock Market. We appealed the November 15, 2006 determinationto the NASDAQ Listing Qualifications Panel (the “Panel”) and were granted aconditional extension to our request for continued listing until April 16,2007. On April 17, 2007, the Panel extended the deadline for filing our Q3 2006Form 10-Q to May 14, 2007.  The Panel also extended the deadline forfiling our 2006 Form 10-K until July 16, 2007.

69

----

On May 2, 2007, we asked the NASDAQ Listing andHearing Review Council (“Listing Council”) to review the April 17, 2007decision of the Panel.  On May 14, 2007,the Listing Council called the Panel’s decision for review and requested thatwe provide an update on our efforts to file our delinquent filings.  We have continued and continue to comply withthat request.  In addition, the Listing Council stayed the Panel’sdecision that required us to file our Q3 2006 Form 10-Q by May 14, 2007, and tofile our 2006 Form 10-K by July 16, 2007.  On August 23, 2007, the ListingCouncil granted the Company an extension until October 22, 2007 to file ourdelinquent periodic reports and restatements. As of the date of the filing of this Form 10-Q (which is filed concurrentlywith our 2006 Form 10-K), we will have two periodic reports still outstanding,our Q1 2007 Form 10-Q and our Q2 2007 Form 10-Q.  We expect to be able to complete the filingof our outstanding reports as soon as practicable.

**EXECUTIVE SUMMARY**

Wedesign, manufacture and sell telecommunications infrastructure, handsets andcustomer premise equipment and provide services associated with theirinstallation, operation, and maintenance. Our products are sold primarily to telecommunications service providersor operators.  We sell an extensive rangeof products that are designed to enable voice, data and video services for ouroperator customers and consumers around the world.  While historically the vast majority of oursales have been to service providers in China, we have expanded our focus tobuild a global presence and currently sell our products in several otherestablished and emerging growth markets, which include North America, Japan,India, Central and Latin America, Europe, the Middle East, Africa and Southeastand North Asia.

Wedifferentiate ourselves with products designed to reduce network complexity,integrate high performance capabilities and allow a simple transition to nextgeneration networks.  We design ourproducts to facilitate cost-effective and efficient deployment, maintenance andupgrades.

As of September 30, 2006 the Company was structuredacross four key operating units:

1.               Network Solutions: Our Network Solutions operating unit provides its products and servicesthrough two reporting segments; Wireless Infrastructure and BroadbandInfrastructure.  Our WirelessInfrastructure segment designs, builds and sells software and hardware productsthat enable end users, or subscribers, to send and receive voice and datacommunication in either a fixed or mobile environment by using wirelessdevices.  Our Broadband Infrastructuresegment designs, builds and sells software and hardware products that enableend users to access high-speed, cost effective fixed data, voice and mediacommunication;

2.               Personal Communications Division: Our PersonalCommunications Division (“PCD”) markets, sells and supports handsets other thanPAS handsets for markets other than China. Most of our handset sales prior to 2006 were designed and built by othermanufacturers, but beginning in 2006 and beyond future sales will include moreproducts built by our Handsets segment;

3.               Handsets: Our Handsets segment designs, builds andsells consumer devices that allow customers to access wireless services.  Revenues from worldwide PAS handsets and allhandset revenues within China are included in this segment; and

4.               Services: Our Services segment provides serviceand support for Wireless Infrastructure and Broadband Infrastructure customersin the areas of planning, deployment, operations and ongoing maintenance.

Our products within each of these categories, excludingservices, include multiple hardware and software subsystems that can be offeredin various combinations to suit individual carrier needs. Our system productsare based on widely adopted global communications standards and are designed toallow service providers to quickly and cost-efficiently integrate our systemsinto their existing networks and deploy our systems in new broadband, IP andwireless network rollouts. Our products are also designed for quick andcost-effective transition to future network technologies, enabling our customersto make the best use of their existing infrastructure.

Our largest market for the nine months ended September30, 2006 and the year ended December 31, 2005 was the United States ofAmerica, representing 54% and 46% of sales, respectively.  Prior to 2005, the majority of our sales wereto service providers in China. This shift in market concentration and revenueis due to the combination of China’s continued slow-down in its economy sincethe fourth quarter of 2004 and our ability to capture growth opportunitiesinternationally as well as the incremental sales contributed by PCD subsequentto its acquisition in November 2004.

70

----

China has been one of our largest markets and we believethat it will continue to be an important market for our current and future technologiesand development for the foreseeable future. However, we have 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 fromChina, as a percentage of total sales, may continue to decline as we continueto grow internationally.

We use subscriber growth statistics to gauge futureinventory purchasing requirements as well as to forecast our anticipatedrevenue growth. We expect this subscriber growth to continue throughout 2006 asChina’s teledensity rates, or the number of telephones per person in a region,remain low in comparison 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 pricing pressure, causing averageselling prices to decrease during the nine months ended September 30, 2006relative to those in the comparative period in 2005.  Our gross profit as a percentage of sales inboth our wireless infrastructure and handset product lines have improveddespite the decline in sales prices as a result of improved product costmanagement.  We expect gross profit as apercentage of sales to decline during the remainder of the year as costreduction measures are not likely to keep pace with price reductions.

We strive to develop products with more advanced featuresand to enhance the features of our existing products, which, we believe, willenable us to offer our customers more advanced products at higher averageselling prices than otherwise would be possible in the future.

Over the past few years, we have undertaken a significantglobalization program and we intend to continue to expand our global salesoutside of China in the current year.  Aswe expand, we will continue to improve our internal supply chain and inventorymanagement processes to ensure timely deliveries.  We will also continue to implement andenhance our administrative infrastructure to assist with our growth andglobalization transformation.

On October 2, 2007, our Board of Directors approved arestructuring plan (the “Plan”) to reduce operating costs, which includes aworldwide reduction in force of aproximately 11% of the Company’s headcount, orapproximately 700 employees. The workforce reduction will be based primarily inthe United States and China and, to a lesser degree, other internationallocations. Management expects the Plan to be completed in the fourth quarter offiscal year 2007. We expect to incur a restructuring charge in connection withthe Plan of approximately $10 million, comprised largely of cash paymentsassociated with one-time severance benefits, with the majority of the charge tobe taken in the fourth quarter of 2007. In addition, the Company expects torealize annual cost savings in salary and compensation related expenses ofapproximately $21 million on an annualized basis.

We will continue our efforts to evaluate certain operationsand will actively pursue opportunities to divest additional non-core assets andmay incur additional costs associated with future actions to further align ourbusiness operations and streamline our business processes.

**KEY TRANSACTIONS**

*Marvell Technology Group Ltd.*

In February 2006, we sold substantially all of theassets and selected liabilities of our semiconductor design business divisionto Marvell Technology Group Ltd. (“Marvell”).  We received $20.0 million in cash, netof $0.6 million of transaction costs, and an additional $4.3 million incash in August 2007.  At September30 2006, an additional $16.0 million was receivable from Marvell as aresult of achieving certain defined milestones. We received the $16.0 million cash payment in October 2006. The assetssold include the assets related to the prior acquisition of AdvancedCommunications Devices Corporation in 2001, and other system-on-chipsemiconductors.  In connection with thesale of assets, we have entered into a supply agreement with Marvell topurchase chipsets for our handset products over the next five years.  These chipsets will be included in certainhandset products designed and manufactured by the Company.

We recognized a $12.3 million gain on sale of assetsduring the three months ended September 30, 2006.  The gain was determined based upon total netproceeds less the net book value of assets sold of $2.9 million and the valueof the supply agreement of $20.2 million. The value allocated to the supplyagreement is included in other current and long-term liabilities and is beingamortized in proportion to the quantities of chipsets purchased under thesupply agreement over the next five years. As of September 30, 2006, approximately $1.1 million has beenamortized against cost of sales.

*Stock-based Compensation*

On January 1, 2006, we adopted the provisions of,and account for stock-based compensation in accordance with, FinancialAccounting Standards Board (“FASB”) Statement of Financial Accounting StandardsNo. 123—revised 2004 (“SFAS 123(R)”), “Share-Based Payment.”  We elected the modified-prospectivemethod, under which prior periods are not revised for comparativepurposes.  Under the fair valuerecognition provisions of this statement, stock-based compensation costis measured at the grant date based on the fair value of the award and isrecognized as expense on a straight-line basis over the requisite serviceperiod, which is the vesting period.

We currently use the Black-Scholes option pricingmodel to determine the fair value of stock options and employee stock purchaseplan shares.  The determination of thefair value of stock-based payment awards on the date of grant using anoption-pricing model is affected by our stock price as well asassumptions regarding a number of complex and subjective variables.  These variables include our expected stockprice volatility over the term of the awards, actual and projected employeestock option exercise behaviors, risk-free interest rate and expecteddividends.

71

----

We estimate the expected term of options granted basedupon our historical exercise and cancellation data for vested options.  We estimate the volatility of our commonstock by using historical volatility as management believes it is morerepresentative of future stock price trends than implied volatility due to therelatively small number of actively traded options on our common stockavailable to determine implied volatility. We base the risk free interest rate that we use in the option pricingmodel on U.S. Treasury zero-coupon issues with remaining terms similar to theexpected term on the options.  We do notanticipate paying any cash dividends in the foreseeable future and thereforeuse an expected dividend yield of zero in the option pricing model.  We are required to estimate forfeitures atthe time of grant and revise those estimates in subsequent periods if actualforfeitures differ from these estimates. We use historical data to estimate pre-vesting option forfeitures andrecord stock-based compensation expense only for those awards that areexpected to vest.  All share basedpayment awards are amortized on a straight-line basis over the requisiteservice periods of the awards, which are generally the vesting periods.

If factors change and we employ different assumptions forestimating stock-based compensation expense in future periods or if wedecide to use a different valuation model, the future periods may differsignificantly from what we have recorded in the current period and couldmaterially affect our operating income, net income and net income per share.

The Black-Scholes option-pricing model wasdeveloped for use in estimating the fair value of traded options that have novesting restrictions and are fully transferable, characteristics not present inour option grants and employee stock purchase plan shares.  Existing valuation models, including theBlack-Scholes and lattice binomial models, may not provide reliablemeasures of the fair values of our stock based compensation.  Consequently, there is a risk that ourestimates of the fair values of our stock-based compensation awards onthe grant dates may bear little resemblance to the actual values realized uponthe exercise, expiration, early termination or forfeiture of those stock-basedpayments in the future.  Certain stock-basedpayments, such as employee stock options, may expire worthless or otherwiseresult in zero intrinsic value as compared to the fair values originallyestimated on the grant date and reported in our financial statements.  Alternatively, value may be realized fromthese instruments that are significantly higher than the fair values originallyestimated on the grant date and reported in our financial statements.  There is not currently a market-basedmechanism or other practical application to verify the reliability and accuracyof the estimates stemming from these valuation models, nor is there a means tocompare and adjust the estimates to actual values.

The guidance in SFAS 123(R) is relatively new.  The application of these principles may besubject to further interpretation and refinement over time.  There are significant differences amongvaluation models, and there is a possibility that we will adopt differentvaluation models in the future.  This mayresult in a lack of consistency in future periods and materially affect thefair value estimate of stock-based payments.  It may also result in a lack of comparabilitywith other companies that use different models, methods and assumptions.

*Strategic Alliance Agreement*

On September 25, 2006, we entered into a StrategicAlliance Agreement with Pantech & Curitel Communications, Inc. (“Pantech”).  Pursuant to the Agreement, Pantech appointedus as its exclusive distributor for Pantech’s CDMA handsets and relatedproducts (the “CDMA Units”) in North America, Central America and South Americawith the exception of Brazil (the “Territory”), for a period of three (3)years.

Underthe terms of the Agreement, we may, upon satisfaction of certain terms andconditions of the Agreement, purchase from Pantech an aggregate of up to thirtymillion (30,000,000) CDMA Units over a three (3) year period, starting onOctober 1, 2006, for distribution in the Territory.

**TRANSACTIONS WITH RELATED PARTIES AND OTHERINFORMATION**

*Softbank and affiliates*

We recognized revenue of $29.7 million and$112.0 million for the three and nine months ended September 30, 2006,respectively, and revenue of $13.0 million and $394.6 million duringthe three and nine months ended September 30, 2005, as restated, respectively,with respect to sales of telecommunications equipment to affiliates of SOFTBANKCORP. (“Softbank”), a significant stockholder of the Company.  In the third quarter of 2006, we determinedthat certain sales to third party resellers are, in substance, sales toSoftbank and therefore, we have included these amounts in related partysales.   Softbank offers asynchronousdigital subscriber line (“ADSL”) coverage throughout Japan, which is marketedunder the name “YAHOO! BB.”  We supportSoftbank’s fiber-to-the-home service through sales of our carrier class GigabitEthernet Passive Optical Network (“GEPON”) product as well as our multi-serviceoptical transport product (“NetRingTM”). In addition, we support Softbank’s new internet protocol television (“IPTV”),through sales of our RollingStreamTM product. Included in revenue for the nine 

72

----

months ended September 30, 2006 is a fee of $31.2 million chargedfor the cancellation of orders for broadband products and $10.0 millioncharged for the cancellation of orders for wireless infrastructure products.

Included in accounts receivable at September 30, 2006 andDecember 31, 2005 were $35.2 million and $83.4 million,respectively, related to these agreements. Sales to Softbank include a three-year service period and a penaltyclause if product failure rates exceed a certain level over a seven-yearperiod.  There were $13.3 millionand $19.6 million included in long term deferred revenue with respect tothese agreements at September 30, 2006 and December 31, 2005,respectively.  Additionally, there were$11.2 million and $8.0 million included in current deferred revenueat September 30, 2006 and December 31, 2005, respectively.  As of September 30, 2006 there were nocustomer advances, and as of December 31, 2005, there were$5.4 million included in customer advances related to Softbankagreements.  We have an outstandingpurchase commitment with Softbank to purchase the component parts.  Purchases from Softbank totaled$1.0 million and $1.4 million during the three and nine months endedSeptember 30, 2006, respectively.  Therewere no purchases from Softbank during the three and nine months endedSeptember 30, 2005, respectively.  We hadan outstanding accounts payable balance of $2.7 million with Softbank as ofSeptember 30, 2006.

During August 2004, we entered into severalagreements with Japan Telecom Co., Ltd (“JT”), a wholly owned subsidiaryof Softbank.  These agreements relate tothe sale of *i*AN-8000 equipmentwith specified value and delivery dates, as well as an oral agreement whichsubsequently converted into specific service contracts to manage a salespromotional program for JT.  We havedetermined that the service activities revenue should be recorded net of expectedpromotional spending.

Because we had not provided these activities in the pastand could not estimate the fair value of these services, we determined underthe guidance of SAB 104 that all revenue related to these agreements couldnot be recognized until all goods and services were delivered.  We had delivered and received finalacceptance for all equipment contemplated under these agreements in the quarterended March 31, 2005.

The promotional services discussed above involvedcontracting with third party promotional vendors, who in turn, facilitated themarketing and subscriber recruitment for the JT fiber-to-the-home program.  During the fourth quarter of 2004, wedetermined that we would end our involvement with the JT promotional programafter completion of the contract discussed above.  Accordingly, late in the fourth quarter of2004 and during the first quarter of 2005, we either cancelled or assigned toanother party all third party contracts with promotional vendors related to theJT contract.  Such termination orassignment of all third party promotional agreements, as well as effectivesatisfaction of our obligations with JT under such agreements, satisfied therevenue recognition criteria for these agreements and as such, the net value ofthe promotional services and the value of equipment delivered, which totaled$205.4 million, was reported in the quarter ended March 31, 2005.

We also entered into an agreement with JT during thethird quarter of 2004 to supply chassis equipment.  The equipment shipped under this agreement isconsidered linked to the *i*AN-8000sale noted above and as such, was also deferred until the completion of theabovementioned promotional activities. The revenue recognition criteria related to the sale of the *i*AN-8000 equipment was satisfied in thefirst quarter of 2005 and as such, the revenue related to the chassis sale of$66.5 million was reported in the quarter ended March 31, 2005.

During the three and nine months ended September 30,2006, sales to Softbank included $2.0 million and $5.2 million,respectively, and during the three and nine months ended September 30, 2005,sales to Softbank included $2.5 million and $278.6 million,respectively, with regards to telecommunications equipment and services sold toJT.

In June 2006, we purchased advertising space andseason tickets totaling $0.2 million from a sports franchise owned bySoftbank.

On July 17, 2003, we entered into a Mezzanine LoanAgreement with BB Modem Rental PLC (“BB Modem”), an affiliate of Softbank.Under the terms of the agreement, we loaned BB Modem $10.1 million at aneffective interest rate of 12.01% per annum, for the purpose of investing in aportfolio of ADSL modems and associated modem rental agreements, from Softbank.Softbank will continue to service such modems and modem rental agreements. Ourloan is subordinated to certain senior lenders of BB Modem, and repayments arepayable to the Company over a 42-month period through January 31,2007, with a substantial portion of the principal amount of the loan repaidduring the last 16 months of this period. During the three and nine monthsended September 30, 2006, we recorded $0.1 million and $0.5 million,respectively, in interest income in respect to this loan.  The loan receivable at September 30, 2006 andDecember 31, 2005 was approximately $2.4 million and$9.0 million, respectively and is included in other current assets. Thenote receivable was paid in full in January 2007.

As of September 30, 2006, Softbank beneficially ownedapproximately 12.1% of our outstanding stock.

73

----

*Acoustek Int’l, Inc.*

In 2005 and 2006, we received consulting services fromAcoustek Int’l Corp. (“Acoustek”), which employed Minnie Huang, spouse ofWilliam Huang, our former Senior Vice President and Chief TechnologyOfficer.  Mr. Haung’s employment with theCompany terminated on December 31, 2006. We paid to Acoustek $0.1 million during each of the nine months endedSeptember 30, 2006 and 2005 for consulting services, and a negligible amountduring the three months ended September 30, 2006 and 2005.

*Audiovox*

One of our officers also serves as a director forAudiovox Corporation (“Audiovox”). During the three and nine months ended September 30, 2006, we paidapproximately $0.4 million and $1.1 million, respectively, of ITservices from Audiovox.

*Cellon*

In September 2001, we invested $2.0 million inCellon International Holdings Corporation (“Cellon”) and made additionalinvestments of $3.0 million each in Cellon in April andDecember 2002.  Cellon designswireless terminals and related technology for handset manufacturers and privatedistributors.  In November 2005, weentered into an agreement with Cellon under which we received consideration inthe form of preferred stock and warrants of Cellon valued at $5.5 millionin exchange for the transfer of fixed assets with a net book value of$3.0 million, a facilities lease and a workforce in place consisting of156 employees.  This transaction wascompleted on May 31, 2006 and a gain on sale of assets of$2.5 million was recorded in other income. As of September 30, 2006, with the additional shares obtained in thepurchase transaction, we had an 11% ownership interest in Cellon.  This investment is accounted for under thecost method, and its carrying value has been evaluated for possible impairmentbased on the achievement of business objectives and milestones, the financialcondition and prospects of the Company and other relevant factors.

In November 2005, we entered into a Development ServiceAgreement with Cellon in which $5.0 million was prepaid in exchange forfuture product development. Approximately $0.7 million and $2.0 million of the prepaid amount hasbeen used in the three and nine months ended September 30, 2006 as payments fordesign services.  We may also use the$5.0 million prepayment in satisfaction of royalties Cellon may earn from salesby us of products Cellon designs under the Development Services Agreement.  This agreement also obligates Cellon to payus a royalty if certain technology shared by us to Cellon is used in productsdeveloped and sold to customers other than us through November 2007.

In the fourth quarter of 2006, we reviewed our long-terminvestment in Cellon.  The reviewincluded, but was not limited to, a review of Cellon’s cash position, recentfinancing activities, financing needs, earnings/revenue outlook, operationalperformance, management/ownership changes, and competition.  Based on the deterioration of Cellon’sfinancial condition that resulted from significant adverse changes in Cellon’sbusiness in the fourth quarter of 2006, we determined that the carrying valueof the investment was at an amount above the fair value of the investment, andthe decline was other-than temporary.  Asof December 31, 2006, we recorded a $13.5 million other-than-temporaryimpairment charge for this investment in other income, net and recorded anoperating expense of $3.0 million to write-off a prepayment to Cellon.  On June18, 2007, a meeting of Cellon’s shareholders was held where a resolution waspassed to place Cellon in voluntary liquidation.

As of September 30, 2006 we had an accounts payablebalance of $0.6 million, and a minimal accounts receivable balance.

*Fiberxon, Ltd.*

We have an outstanding purchase commitment with Fiberxon,in which we have a 7% ownership interest, to purchase component parts foroptical networking products.  Purchasesfrom Fiberxon totaled $1.7 million and $2.1 million during the three andnine ended September 30, 2006, respectively. Purchases from Fiberxon totaled $0.5million and $8.6 million during thethree and nine months ended September 30, 2005, respectively, and we had$1.1 million and $0.3 million in accounts payable to Fiberxon atSeptember 30, 2006 and December 31, 2005, respectively.  As of September 30, 2006, the Company had$0.6 million of open purchase commitments to Fiberxon.

74

----

*GCT Semiconductor, Inc.*

We have an outstandingpurchase commitment with GCT Semiconductor, Inc. (“GCT”), in which we have a 2%ownership interest, to purchase component parts.  Purchases from GCT for the three and ninemonths ended September 30, 2006 were $0.5 million and $4.9 million,respectively.  As of September 30, 2006,we had a $0.5 million accounts payable balance with GCT.  We had purchases of $0.3 million for the ninemonths ended September 30, 2005.

*Global Asia Partners L.P.*

Global Asia Partners L.P. is a venture capital fundformed to make private equity investments in private or pre-IPO technology andtelecommunications companies in Asia. The general partner of this fund is also one of our sales agents.  Between June 2002 and April 2005,we invested a total of $2.6 million in the fund.  As of September 30, 2006 andDecember 31, 2005, we had 49% of the fund’s outstanding partnershipunits.  We had a commitment to invest upto a maximum of $5.0 million.  Asthe result of a reorganization of capital contributions by the partners,reached in April 2005, our capital contribution of $0.5 million in April 2005was the final capital contribution to be made. In addition, the agreement allows the partnership to re-invest up to$2.5 million that otherwise would have been available to us as futuredistributions.  There were no cashdistributions during the three or nine months ended September 30, 2006 or 2005.

*Immenstar*

We have an outstanding purchase commitment withImmenstar, in which we own Series A preferred stock, to purchase componentparts.  Purchases from Immenstar totaled$1.3 million and $1.8 million during the three and nine months endedSeptember 30, 2006, respectively.  As ofSeptember 30, 2006, the Company had a $0.3 million accounts payable balance and$4.5 million of open purchase commitments to Immenstar.

*Matsushita Joint Venture*

In July 2002, we entered into a joint ventureagreement with Matsushita Communication Industrial Co., Ltd. to jointlydesign and develop, manufacture and sell telecommunication products.  We had a 49% ownership interest in the jointventure company.  As of December 31,2005, we had a receivable of $0.1 million. In December 2005, the partners agreed to dissolve the jointventure, which was completed by June 30, 2006.

*MDC Holding, Ltd.*

We had an outstanding accountsreceivable balance with MDC Holding, Inc. (“MDC”) related to a PAS systempurchase of $1.3 million at September 30, 2006. There was no accounts receivable balance at December 31, 2005. Certainof our employees were shareholders of MDC as of September 30, 2006.  MDC is in the business of providingvalue-added services, such as short message, voicemail or ring-tone servicesfor PAS telecom networks.

*ORG, Inc.*

We have a 49% ownership in Global Asia Partners L.P.which in turn is a significant shareholder in ORG, Inc.  During the three and nine months endedSeptember 30, 2006, we had sales of $1.4 million and $1.6 million toORG, Inc.  During the three and ninemonths ended September 30, 2005 we had sales of $0.3 million and $0.5 million,respectively, to ORG, Inc.  We had $1.3million and $0.2 million receivable as of September 30, 2006 and December 31,2005, respectively.

*StarcomProducts, Inc.*

We obtainengineering consulting and employee placement services from Starcom Products,Inc. (“Starcom”), which is 31% owned by an individual related one of our formerofficers who was also a member of our Board of Directors.  We obtained services amounted to $0.1 millionand $0.6 million, respectively, from this entity in the three and nine monthsended September 30, 2005.  There were nosuch services performed during the three and nine months ended September 30,2006.

*Xalted Networks, Inc.*

We received purchase orders from Xalted Networks, inwhich the Company owns preferred stock, totaling approximately$1.3 million in 2005 for telecommunications equipment that is for productnot typically sold by us to other customers. We are charging a ten percent procurement fee to Xalted for obtainingand reselling these products.  Theequipment was delivered but revenue has not been recognized as the revenuerecognition process had not been completed.

75

----

**RESULTS OF OPERATIONS**

As mentioned in the Executive Summary, we manage ourbusiness based principally upon product families of four operating units,(i) Network Solutions, which includes the Broadband Infrastructure andWireless Infrastructure reporting segments, (ii) PCD, (iii) Handsets and(iv) Service.  A summary of thefinancial results of each of the segments are as follows:

**NET SALES**
|                             | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                  | ** ** | ** **                                               | ** ** | **% Net **                                    | ** ** | ** ** | ** ** | **% Net** | ** ** | ** ** | ** ** | **% Net ** | ** ** | ** ** | ** ** | **% Net ** | ** ** |
| ** **                  | ** ** | **2006**                                                 | ** ** | **sales**                                               | ** ** | **2005** | ** ** | **sales** | ** ** | **2006** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** |
| ** **                  | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                  | ** ** |
| ***Net  Sales by Segment*** |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Broadband  Infrastructure   |       | $                                                        | 50,754     |                                                    | 8          | % | $ | 31,018 |   | 5 | % | $ | 152,774 |   | 9 | % | $ | 414,148 |   | 19 | % |
| Wireless  Infrastructure    |       | 110,299                                                  |       | 18                                                      | %          | 77,586 |   | 13 | % | 331,997 |   | 19 | % | 310,708 |   | 14 | % |
| Network Solutions           |       | 161,053                                                  |       | 26                                                      | %          | 108,604 |   | 18 | % | 484,771 |   | 28 | % | 724,856 |   | 33 | % |
| PCD                         |       | 328,701                                                  |       | 55                                                      | %          | 363,637 |   | 61 | % | 917,943 |   | 52 | % | 1,021,452 |   | 47 | % |
| Handsets                    |       | 93,163                                                   |       | 16                                                      | %          | 106,294 |   | 18 | % | 299,266 |   | 17 | % | 378,256 |   | 17 | % |
| Service                     |       | 17,982                                                   |       | 3                                                       | %          | 18,900 |   | 3 | % | 52,426 |   | 3 | % | 65,454 |   | 3 | % |
|                        |       | $                                                        | 600,899    |                                                    | 100        | % | $ | 597,435 |   | 100 | % | $ | 1,754,406 |   | 100 | % | $ | 2,190,018 |   | 100 | % |

 
|                    | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **         | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **         | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **         | ** ** | **(in thousands)**                                  | ** ** |
| *Sales  by region* |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| United States      |       | $                                                        | 328,433    |                                                    | 54         | % | $ | 359,164 |   | 60 | % | $ | 924,548 |   | 53 | % | $ | 987,223 |   | 45 | % |
| China              |       | 190,379                                                  |       | 32                                                      | %          | 175,410 |   | 29 | % | 595,505 |   | 34 | % | 660,821 |   | 30 | % |
| Japan              |       | 30,745                                                   |       | 5                                                       | %          | 13,635 |   | 2 | % | 116,477 |   | 6 | % | 398,694 |   | 18 | % |
| Other              |       | 51,342                                                   |       | 9                                                       | %          | 49,226 |   | 9 | % | 117,876 |   | 7 | % | 143,280 |   | 7 | % |
| Total Net Sales    |       | $                                                        | 600,899    |                                                    | 100        | % | $ | 597,435 |   | 100 | % | $ | 1,754,406 |   | 100 | % | $ | 2,190,018 |   | 100 | % |

 

*Three months ended September 30, 2006 and 2005*

Net sales increased by 1% to $600.9 million duringthe quarter ended September 30, 2006 compared to the same period in 2005.  Net sales increased 48% in the NetworkSolutions segment, but sales declined in all other operating segments.  The reported sales of the remaining segmentswere between 5% and 12% lower during the three months ended September 30, 2006than the same period in the prior year. Broadband Infrastructure segment sales are concentrated with onecustomer, Softbank in Japan, and as such fluctuate based upon the magnitude andtiming of revenue recognition on certain contracts.  As we have been experiencing in the recentquarters, our PAS/iPAS wireless infrastructure products as well as our PAS/iPASbased handsets in the China market continued to mature which resulted in lowerunit demand offset by the sale of higher priced units.  In our PCD operating segment, net salesdecreased 10% during the three months ended September 30, 2006  from the comparable period in the prior year,due to a decline in the number of handsets sold, partially offset by an increasein our average price per unit.  During2005, the Company recorded restatement adjustments to defer $49.6 million ofrevenue as all conditions necessary for revenue recognition had not beenachieved.  Net sales in the nine monthsended September 30, 2006 include approximately $16.5 million of the revenuedeferred as part of the 2005 restatement; adjustments.  For additional discussion of our businesssegments see “Segment Reporting.”

*Nine months ended September 30, 2006 and 2005*

Net sales were $1,754.4 million in the nine monthsended September 30, 2006, a decrease of 20% from $2,190.0 million in thecorresponding period of 2005.  Theoverall decrease in net sales was largely due to a decrease in sales in theBroadband Infrastructure segment of 63%, from the nine months ended September30, 2005 compared to the same period ended September 30, 2006.  Broadband Infrastructure segment sales duringthe nine months ended September 30, 2005 included one large transaction withSoftbank totaling $271.9 million of revenue on certain agreements enteredinto with Japan Telecom primarily for iAN8000 product.  As we have been experiencing in the recentquarters, our PAS/iPAS wireless infrastructure products and our PAS/iPAS basedhandsets in the China market continued to mature, which resulted in lower unitdemand.  This led to a decrease in ourhandset segment sales of 21%, respectively, from the nine months endedSeptember 30, 2005 compared to the same period ended September 30, 2006.  In our PCD operating segment, our unit salesand average price per unit declined during the nine months ended September 30,2006 from the comparable period in the prior year, leading to a 10% decline insegment revenue.  For additionaldiscussion of our business segments see “Segment Reporting.”

76

----

Net sales revenue by geography shifted in comparison tothe corresponding period of 2005. Revenue derived from China accounted for approximately 34% of our netsales revenue in the nine months ended September 30, 2006, in comparison toapproximately 30% in the corresponding period last year due to lower demand forPAS/iPAS  products.  Revenue derived from the United Statesaccounted for approximately 53% of our net sales revenue in the nine monthsended September 30, 2006, in comparison to approximately 45% in thecorresponding period last year as PCD sales in the United States become proportionatelybigger compared to total Company sales. Revenue from Japan accounted for approximately 6% of our net salesrevenue in the nine months ended September 30, 2006, in comparison to approximately18% for the comparable period in the prior year due to the completion of alarge contract during 2005.

**GROSS PROFIT**
|                                | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                     | ** ** | ** **                                               | ** ** | **Gross**                                               | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                     | ** ** | **2006**                                                 | ** ** | **Profit %**                                       | ** ** | **2005** | ** ** | **Profit %** | ** ** | **2006** | ** ** | **Profit %** | ** ** | **2005** | ** ** | **Profit %** | ** ** |
| ** **                     | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                  | ** ** |
| ***Gross  profit by Segment*** |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Broadband Infrastructure       |       | $                                                        | (837       | )                                                       | (2         | )% | $ | (13,875 | ) | (45 | )% | $ | 27,138 |   | 18 | % | $ | 166,958 |   | 40 | % |
| Wireless Infrastructure        |       | 54,217                                                   |       | 49                                                      | %          | 16,332 |   | 21 | % | 158,835 |   | 48 | % | 77,661 |   | 25 | % |
| Network Solutions              |       | 53,380                                                   |       | 33                                                      | %          | 2,457 |   | 2 | % | 185,973 |   | 38 | % | 244,619 |   | 34 | % |
| PCD                            |       | (7,057                                                   | )          | (2                                                      | )%         | 13,199 |   | 4 | % | 19,653 |   | 2 | % | 42,881 |   | 4 | % |
| Handsets                       |       | 24,012                                                   |       | 26                                                      | %          | 13,633 |   | 13 | % | 88,521 |   | 30 | % | 48,972 |   | 13 | % |
| Service                        |       | 4,466                                                    |       | 25                                                      | %          | 8,598 |   | 45 | % | 13,395 |   | 26 | % | 36,709 |   | 56 | % |
|                           |       | $                                                        | 74,801     |                                                    | 12         | % | $ | 37,887 |   | 6 | % | $ | 307,542 |   | 18 | % | $ | 373,181 |   | 17 | % |

 

Cost of sales consists primarily of material and laborcosts, including stock-based compensation, associated with manufacturing,assembly and testing of products, costs associated with installation andcustomer training, warranty costs, fees to agents, inventory provision andoverhead.  Cost of sales also includesimport taxes and tariffs on components and assemblies.  Some components and materials used in ourproducts are purchased from a single supplier or a limited group of suppliersand, in some cases, are subject to our obtaining Chinese import permits andapprovals.  We also rely on third partymanufacturers to manufacture and assemble most of our CDMA handsets.

Our gross profit has been affected by average sellingprices, material costs, product mix, the impact of warranty charges andcontract loss provisions as well as inventory reserves and release of deferredrevenues and related cost pertaining to prior years.  Our gross profit, as a percentage of netsales, varies among our product families. We expect that our overall gross profit, as a percentage of net sales,will fluctuate from period to period as a result of shifts in product mix,stage of product life cycle, anticipated decreases in average selling pricesand our ability to reduce cost of sales.

*Three months ended September 30, 2006 and 2005*

Gross profit was $74.8 million, or 12% of net sales, in thethree months ended September 30, 2006, compared to $37.9 million, or 6% ofnet sales in the corresponding quarter of 2005. The overall gross profit increased in real terms even though net salesremained relatively constant, due to significant increase in gross profitpercentages in our Broadband Infrastructure, Wireless Infrastructure, andHandsets segments.  For additionaldiscussion of our business segments see “Segment Reporting.”

*Nine months ended September 30, 2006 and 2005*

Gross profit was $307.5 million, or 18% of netsales, in the nine months ended September 30, 2006, compared to$373.2 million, or 17% of net sales in the corresponding period of2005.  While the total Company grossprofit percentage remained relatively constant, Broadband Infrastructure grossprofit dollars decreased $139.8 million due to a decline in sales of $261.4million and a decrease in the gross profit percentage from 40% during the ninemonths ended September 30, 2005 to 18% in the corresponding period of 2006.  As mentioned previously, revenue from theBroadband Infrastructure segment is concentrated with one customer in Japan anda significant contract was recognized as revenue during the first quarter of2005.  There was no similar-sizedtransaction in the Broadband Infrastructure segment during the nine monthsended September 30, 2006.  The decreasein gross profit resulting from the Broadband Infrastructure segment waspartially offset by increased gross profit dollars resulting from improvementin gross profit percentages in the Wireless Infrastructure and Handsetsegments.  For additional discussion ofour business segments see “Segment Reporting.”

77

----

**OPERATING EXPENSES**

The following table summarizes our operating expenses:
|                                                  | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                       | ** ** | ** **                                               | ** ** | **% Net **                                    | ** ** | ** ** | ** ** | **% Net ** | ** ** | ** ** | ** ** | **% Net ** | ** ** | ** ** | ** ** | **% Net ** | ** ** |
| ** **                                       | ** ** | **2006**                                                 | ** ** | **sales**                                               | ** ** | **2005** | ** ** | **sales** | ** ** | **2006** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** |
| ** **                                       | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                                  | ** ** |
| Selling, general  and administrative             |       | $                                                        | 80,076     |                                                    | 13         | % | $ | 86,414 |   | 15 | % | $ | 246,908 |   | 14 | % | $ | 297,390 |   | 14 | % |
| Research and  development                        |       | 46,305                                                   |       | 8                                                       | %          | 60,817 |   | 10 | % | 139,310 |   | 8 | % | 192,297 |   | 8 | % |
| Amortization of  intangible assets               |       | 4,821                                                    |       | 1                                                       | %          | 6,643 |   | 1 | % | 14,567 |   | 1 | % | 20,391 |   | 1 | % |
| Gain on the sale  of semiconductor design assets |       | (12,291                                                  | )          | (2                                                      | )%         | — |   | 0 | % | (12,291 | ) | (1 | )% | — |   | 0 | % |
| Impairment of  long-lived assets                 |       | —                                                   |       | 0                                                       | %          | 218,094 |   | 37 | % | — |   | 0 | % | 218,094 |   | 10 | % |
| Restructuring  costs                             |       | —                                                   |       | 0                                                       | %          | 3,378 |   | 0 | % | — |   | 0 | % | 18,505 |   | 1 | % |
| In-process  research and development             |       | —                                                   |       | 0                                                       | %          | — |   | 0 | % | — |   | 0 | % | 660 |   | 0 | % |
| Total operating  expenses                        |       | $                                                        | 118,911    |                                                    | 20         | % | $ | 375,346 |   | 63 | % | $ | 388,494 |   | 22 | % | $ | 747,337 |   | 34 | % |

 

Selling, general and administrative expenses (“SG&A”)include compensation and benefits, professional fees, sales commissions,provision for doubtful accounts receivable and travel and entertainment costs.Research and development expenses consist primarily of compensation andbenefits of employees engaged in research, design and development activities,costs of parts for prototypes, equipment depreciation and third partydevelopment expenses. We believe that continued and prudent investment inresearch and development is critical to our long-term success, and willaggressively evaluate appropriate investment levels.  A portion of our costs are fixed and aredifficult to quickly reduce in periods of lower sales.

*SELLING, GENERAL AND ADMINISTRATIVE*

*Three months ended September 30, 2006 and 2005*

Selling, general and administrative expenses decreased$6.3 million during the three months ended September 30, 2006 compared tothe same period in 2005.  The decrease inSG&A expenses was primarily due to a $14.7 million decrease in ourprovision for doubtful accounts compared to the same period in 2005.  Days sales outstanding was 64 days atSeptember 30, 2006 as compared to 86 days at September 30, 2005.  The shorter days sales outstanding andresulting decrease in provision for doubtful accounts was the result ofimproved cash collections in the three months ended September 30, 2006 relativeto the comparable period in 2005.  Inaddition, there were reductions in expenses due to expense controls.  These cost savings were partially offset by avalue added tax expense of $7.9 million resulting from an audit of our 2003through 2005 tax years by China tax authorities.

*Nine months ended September 30, 2006 and 2005.*

SG&A expenses were $246.9 million and$297.4 million in the nine months ended September 30, 2006 and 2005, respectively.  SG&A expenses as a percentage of netsales were 14% and 14% for the nine months ended September 30, 2006 and 2005,respectively.  The decrease in SG&Aexpenses was primarily due to a $45.1 million decrease in our provisionfor doubtful accounts compared to the same period in 2005 resulting from cashcollections on previously reservedreceivables in China.  Days salesoutstanding was 69 days at September 30, 2006 as compared to 95 daysat September 30, 2005.  The shorter dayssales outstanding and resulting decrease in provision for doubtful accounts wasthe result of improved cash collections in the nine months ended September 30,2006 relative to the comparable period in 2005. In addition, there were reductions in expenses due to expensecontrols.  These cost savings was partiallyoffset by a value added tax expense of $7.9 million resulting from an audit ofour 2003 through 2005 tax years by China tax authorities.

*RESEARCH AND DEVELOPMENT*

*Three months ended September 30, 2006 and 2005*

Research and development (“R&D”) expenses were$46.3 million, or 8% of net sales, in the three months ended September 30,2006, compared to $60.8 million, or 10% of net sales in the correspondingperiod of 2005.  The decrease of$14.5 million in absolute dollars of R&D expenses can be primarilyattributed to the decreased headcount of approximately 778 employees resultingfrom restructuring activities and the transfer of engineers as part of the saleof ACD.  Personnel related expensesdecreased by $3.9 million and equipment, facility and depreciation costdecreased by $8.2 million as a result of restructuring and write down ofR&D equipment.

78

----

*Nine months ended September 30, 2006, and 2005*

R&D expenses were $139.3 million and$192.3 million, or 8% and 8% of net sales, in the nine months endedSeptember 30, 2006 and 2005, respectively. In absolute dollars, R&D expenses decreased by $53.0 million,primarily due to a decrease in equipment, facility and depreciation costs of$25.0 million as a result of restructuring and write-down of R&Dequipment.  Also, there was a decrease inpersonnel expenses, including payroll, payroll taxes and benefits totaling$13.8 million resulting from the decreased headcount as describedabove.  In addition, the decrease inR&D expenses also can be attributed to a $7.1 million cost savingsresulting from a decreased use of consultants.

*AMORTIZATION OF INTANGIBLE ASSETS*

*Three and nine months ended September 30, 2006 and 2005*

Amortization of intangible assets expenses was$4.8 million and $6.6 million, or 1% and 1% of net sales, in thethree months ended September 30, 2006 and 2005, respectively.  Amortization of intangible assets expenseswere $14.6 million and $20.4 million, or 1% and 1% of net sales inthe nine months ended September 30, 2006 and 2005, as restated,respectively.  The decrease in the amortizationof intangible assets for the three and nine months ended September 30, 2006 wasdue to several intangible assets being fully amortized during the precedingtwelve months.

*GAIN ON SALE OF SEMICONDUCTOR DESIGN ASSETS*

*Three months and nine months ended September 30, 2006*

In February 2006, we sold substantially all of theassets and selected liabilities of our semiconductor design operations,including the assets related to the prior acquisition of AdvancedCommunications Devices Corporation to Marvell Technology Group Ltd.  We recognized a $12.3 million gain on sale ofthese assets in the third quarter of 2006 upon achieving the definedmilestones.

*ASSETIMPAIRMENT*

*Three and nine months ended September 30, 2006 and 2005*

In the third quarter of 2005, we determined that certaincircumstances had changed sufficiently to indicate that the fair value ofcertain of our reporting units may be below their book values. As a result, weconducted an evaluation of our long-lived assets including goodwill,intangible assets, and certain property plant and equipment for impairment andrecorded impairment charges.

Intangible assets classified as goodwill and those withindefinite lives are not amortized. Intangible assets with determinable livesare amortized over their estimated useful lives. We perform an annual impairmenttest of our goodwill as of November 1st of 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. When conducting the goodwill impairment analysis,we calculate impairment charges based on the two-step test prescribed inSFAS 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) and using theestimated fair value of the respective reporting units. We use 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. We also test long-lived assets in all of our asset groups forpotential impairment in accordance with SFAS 144, “Accounting for theImpairment or Disposal of Long- lived Assets.” Our long-livedassets are tested for recoverability based on undiscounted cash flows, and ifimpaired, written down to fair value based on either discounted cash flows orappraised values.

Management held a series of planning meetings inSeptember 2005 to assess the current business forecast for all reportingunits. This assessment analyzed various factors including a reduction in therate of growth of PAS subscribers in the third quarter, a delay of the expectedgranting of 3G licenses in China and Japan, challenges with product qualityprimarily in our Broadband reporting unit, a narrowing of our strategic focusrelated to our product offering and greater than expected revenue and margindecline due to continued pricing pressures for several of our key markets.Management concluded these factors combined represented a triggering event.

Due to the existence of the triggering event inSeptember 2005, we determined that there were significant adverse changesin the business outlook which could indicate the carrying value of certain ofour long lived assets groups may not be recoverable and could indicate the fairvalue of our reporting units may be below their fair value. As a result, weperformed interim impairment tests on goodwill and certain other long livedtangible and intangible assets.

79

----

Goodwill:

We performed an impairment analysis pursuant to SFAS 142as of September 30, 2005 for all of our reporting units. We compared thefair value of the reporting units to their carrying value. We determined thefair value of each reporting unit using both present value and comparablecompany techniques based, in part, upon an independent valuation. The fairvalues of the reporting units were reconciled to our overall marketcapitalization at September 30, 2005.

Based on the impairment assessment noted above, agoodwill impairment charge of $192.9 million was estimated and recordedduring the three months ended September 30, 2005 to write off thefull value of goodwill for the Wireless, Broadband, Handsets and PCD businessunits. The second step of the goodwill impairment test for Broadband andHandsets segments was completed in the third quarter and for the Wireless andPCD units was performed in the fourth quarter of 2005, which reaffirmed theestimate from the third quarter that the goodwill was fully impaired. As such,there was no adjustment from the amount previously recorded.

Long-lived Assets:

We also tested our long-lived assets in all of ourasset groups for potential impairment during the third quarter of 2005 inaccordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-livedAssets.” Based on this analysis, we determined that the undiscounted expectedfuture cash flows for the broadband and handset asset groups were less than thecarrying value of the net assets.

We determined the relative estimated fair value oftangible assets through a comparison of similar assets, and wherever practical,based on quoted market prices taking into consideration the asset type, age,condition, and physical location of the asset. As a result of this analysis, werecorded an impairment charge of $14.1 million for long-livedtangible assets related to the Broadband asset group and $9.4 million forlong-lived tangible assets related to the Handset asset group.

In addition, we determined that the fair value oftechnology-related intangible assets within the Handset asset group ascalculated using the discounted future cash flows was less than the carryingvalue of the net assets and as such, we recorded a net asset write-off of$1.7 million.

The following table summarizes the impairment chargesincurred during 2005:
| ** ** | ** ** | **Goodwill  Impairment** | ** ** | **Intangible  Impairment** | ** ** | **PP&E  Impairment** | ** ** | **Total** | ** ** |
|------------|------------|--------------------------|------------|----------------------------|------------|--------------------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)**  | ** ** |
| 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 |   |

 

There were noasset impairment charges recorded during the nine months ended September 30,2006.

*IN-PROCESS RESEARCH AND DEVELOPMENT*

*Nine months ended September 30, 2006 and 2005*

The $0.7 million charges to in-process research anddevelopment (“IPR&D”) for the nine months ended September 30, 2005,  were related to our acquisition of PedestalNetworks.  All charges to IPR&D werebased, in part, upon independent valuations. In assessing IPR&D projects, we considered key productcharacteristics including each product’s development stage at the acquisitiondate, each product’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. There have been no IPR&D costs in 2006.

80

----

*RESTRUCTURING*

*Three and nine months ended September 30, 2006 and 2005*

In the second quarter of the fiscal year 2005, weannounced and initiated a restructuring plan to rationalize our cost structurein response to the decline in demand for certain of our products.  In addition, the restructuring plan was designedto allow us to reduce break-even revenues for each product line, aligninvestments with key growth opportunities and facilitate the process ofglobalization.

During the threemonths ended September 30, 2005, the Company incurred approximately $3.4million in expenses in relation to the restructuring plan actions, consistingof $2.1 million related to severance payments and $1.2 million in assetimpairments primarily related to the write-off of equipment and licensesassociated with discontinued products.

During the ninemonths ended September 30, 2005, the Company incurred approximately $18.5million in operating expenses in relation to the restructuring plan actions,primarily consisting of $9.8 million related to severance payments and $8.7million in asset impairments primarily related to the impairment of equipmentand licenses associated with discontinued products.  Included in the restructuring costs of $18.5million were non-cash charges of $7.6 million in asset impairments.  We made cash payments of $10.5 million forseverance and other benefits, and $1.1 million of accrued expenses.  As part of the restructuring plan, during thenine months ended September 30, 2005 we recorded $5.5 million in inventorywrite-off which is associated with discontinued products.  Restructuring expense related to theinventory write-off is included in cost of sales in the consolidated statementsof operations.

During the fourth quarter of 2005, we incurred anadditional $11.2 million in operating expenses in relation to therestructuring plans.  As of December 31,2005, approximately $1.2 million remained unpaid in accrued expenses, andas of September 30, 2006, approximately $0.3 million remained unpaid,primarily relating to remaining lease termination expenses.There was no restructuring cost recorded duringthe nine months ended September 30, 2006.

*INTEREST INCOME*

*Three months ended September 30, 2006 and 2005*

Interest income was $3.2 million and $1.7 millionfor the three months ended September 30, 2006 and 2005, respectively.  Interest income was generated from cash andshort-term investment balances were higher in the three months ended September30, 2006 as compared to the corresponding period of 2005.  The average interest rate on investments was2.16% at September 30, 2006, an increase of 39% compared with the averageinterest rate of 1.55% at September 30, 2005.

*Nine months ended September 30, 2006 and 2005*

Interest income was $10.7 million and$4.5 million for the nine months ended September 30, 2006 and 2005,respectively.  Interest income was generatedfrom cash and short-term investment balances were higher in the nine monthsended September 30, 2006 as compared to the corresponding period of 2005.  The average interest rate on investments was2.16% at September 30, 2006, an increase of 39% compared with the averageinterest rate 1.55% at September 30, 2005.

*INTEREST EXPENSE*

*Three months ended September 30, 2006 and 2005*

Interest expense was $2.6 million and$3.9 million for the three months ended September 30, 2006 and 2005,respectively.  The decrease in interestexpense for the three months ended September 30, 2006 was attributable to thedecrease in short-term debt, which declined from approximately$226.4 million as of September 30, 2005 to approximately$105.0 million as of September 30, 2006.

*Nine months ended September 30, 2006 and 2005*

Interest expense was $9.3 million and$12.9 million for the nine months ended September 30, 2006 and 2005,respectively.  The decrease in interestexpense for the nine months ended September 30, 2006 was attributable to adecrease in short-term borrowings.

81

----

*GAIN ONEXTINGUISHMENT OF DEBT*

*Three and nine months endedSeptember 30, 2006 and 2005*

Gain onextinguishment of debt, net of write-off of unamortized issuance expenses, was$20.3 million and $31.4 million for the three and nine months ended September30, 2005, respectively.  In June 2005,1,482,000 shares of our common stock with a fair value of approximately $10.6million and approximately $15.8 million in cash were exchanged for $38.0million aggregate principal amount of our outstanding  convertible subordinated notes due 2008.  In the third quarter of 2005, we completedfour additional exchanges wherein we exchanged a total of 3,506,100 shares ofour 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.  There was noextinguishment of debt during the nine months ended September 30, 2006.

*OTHER INCOME (EXPENSES)*

*Three months ended September 30, 2006 and 2005*

Net other income was $1.8 million and $7.4 million for thethree months ended September 30, 2006 and 2005, respectively.  Net other income for the three months endedSeptember 30, 2006 primarily consisted of dividend income of$1.0 million.  Net otherincome for the three months ended September 30, 2005 primarily consisted offoreign exchange gains of $7.3 million. The foreign exchange gains were primarily the result of gains for thecompany’s China subsidiaries attributed to the appreciation of the ChineseRenminbi on US dollar denominated short-term debt and payables, offset by aloss attributed to the appreciation of the US dollar on Japanese Yendenominated cash and accounts receivable.

*Nine months ended September 30, 2006 and 2005*

Net other income was $12.3 million for the nine months endedSeptember 30, 2006 and net other expense was $1.7 million for the nine monthsended September 30, 2005.  Net otherincome for the nine months ended September 30, 2006 primarily consisted ofgains from foreign exchange of $6.1 million, a $2.5 million gain on saleof assets to Cellon and dividend income of $1.7 million.  Net other income for the nine months endedSeptember 30, 2005 primarily consisted of a $6.0 million consumption taxrefund in Japan offset by a foreign exchange loss of $7.3 million.

*INCOME TAX EXPENSE*

Income tax expense is based upon a blended effective taxrate based upon our expectation of the amount of income to be earned in eachtax jurisdiction and is accounted under the liability method.  Deferred income taxes are recognized for thedifferences between the tax bases of assets and liabilities and their financialstatement amounts based on enacted tax rates. Valuation allowances are established when necessary to reduce deferredtax assets to the amount expected to be realized.  We will maintain a full valuation allowanceon our net deferred tax assets in China, the United States, and other countriesuntil an appropriate level of profitability that generates taxable income issustained or until we are able to develop tax strategies that would enable usto conclude that it is more likely than not that a portion of our deferred taxassets will be realizable.  Any reversalof valuation allowances will favorably impact our results of operations in theperiod of the reversal.

We are subject to income taxes in both the UnitedStates and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions anddetermining our provision for income taxes. During the ordinary course of business, there are many transactions andcalculations for which the ultimate tax determination is uncertain.  We establish reserves for tax-relateduncertainties based on estimates of whether, and the extent to which,additional taxes and interest will be due. These reserves are established when, despite our belief that our taxreturn positions are fully supportable, we believe that certain positions arelikely to be challenged and may not be sustained on review by taxauthorities.  We adjust these reserves inlight of changing facts and circumstances, such as the closing of a taxaudit.  The provision for income taxesincludes the impact of reserve provisions and changes to reserves that areconsidered appropriate, as well as the related net interest.  In the fourth quarter of 2006, we recorded a$29.0 million income tax benefit related to the settlement of a tax audit inChina for the 2003 through 2005 tax years for UTStarcom Telecom Co., Ltd. (“HUTS”)and Hangzhou UTStarcom Telecom Co., Ltd (“HSTC”), two of our subsidiaries inChina and the acceptance of our tax holiday for HSTC.

Our  tax returnsfor the 2003, 2004 and 2005 tax years are currently under audit by the InternalRevenue Service.  We are also under auditby China tax authorities on a recurring basis. We provide tax reserves for federal, state and international exposuresrelating to audit results, tax planning initiatives and complianceresponsibilities.  The development ofthese reserves requires judgments about tax issues, potential outcomes andtiming, and is a subjective critical estimate. Although the outcome of these tax audits is uncertain, in management’sopinion, adequate provisions for income taxes have been made as a result ofthese reviews.  If actual outcomes differmaterially from these estimates, they could have a material impact on ourresults of operations.

82

----

*Three months ended September 30, 2006 and 2005*

Income tax expense was $1.5 million and $125.2 million for thethree months ended September 30, 2006 and 2005, respectively.  There are two primary reasons why the Companyhas tax expense while the Company has pretax losses.  First, we have not provided any tax benefiton the forecasted current year losses incurred and tax credits generated in theUnited States and other countries, because management believes that it is morelikely than not that the tax benefit associated with these losses will not berealized.  Second, we continue to accruetax expense in jurisdictions where we have been historically profitable.  Estimates of the annual effective tax rate atthe end of the interim periods are based on evaluations of possible futureevents and transactions and may be subject to subsequent refinement orrevision.  As of September 30,2005, we did not believe it was more likely than not that we would generate asufficient level and proper mix of taxable income within the appropriate periodto utilize all the deferred tax assets. As a result of the review undertaken at September 30, 2005, we concludedthat it was appropriate to establish a full valuation allowance for the netdeferred tax assets which the cumulative losses weigh heavily in the overallassessment.  Accordingly, we recorded a$116.6 million non-cash charge at September 30, 2005 in the United States andChina.

*Nine months ended September 30, 2006 and 2005*

Income tax expense was $9.0 million and $134.0 million for thenine months ended September 30, 2006 and 2005, respectively.  In the nine months ended September 30, 2005we recorded a $116.6 million non-cash charge to provide a full valuationallowance on our remaining net deferred tax assets at September 30, 2005 in theUnited States and China.

*EQUITY IN NET LOSS OF AFFILIATED COMPANIES*

*Three and nine months ended September 30, 2006 and 2005*

Equity in net loss of affiliated companies was$0.8 million and $1.8 million for the three and nine months endedSeptember 30, 2005, respectively.  Theloss in both periods was primarily attributable to the loss recognized from ourjoint venture investments with Matsushita Communication IndustrialCo., Ltd., and Matsushita Electronic Industrial Co., Ltd.  There was no equity net loss of affiliatedcompanies during the three and nine months ended September 30, 2006 as businessoperations have been terminated.

**SEGMENT REPORTING**

As of September 30, 2006, we managed our business on thebasis of four operating segments, namely Network Solutions, PCD, Handsets andService.  The Network Solutions operatingunit provides its products and services through two reporting segments;Broadband Infrastructure and Wireless Infrastructure.  Each reporting segment and operating unit isresponsible for managing its own performance.

We currently evaluate operating performance of andallocate resources to the reporting segments based on segment gross profit.  Cost of sales and direct expenses in relationto production are assigned to the reporting 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.

Summarized below are our segment sales revenue and grossprofit for the three and nine months ended September 30, 2006 and 2005,respectively.

***Network Solutions***

*Broadband Infrastructure*
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** | **(in thousands)**                                 | ** ** |
| Sales                                  |       | $                                                        | 50,754     |                                                    | $          | 31,018 |   | $ | 152,774 |   | $ | 414,148 |   |
| Gross profit                           |       | $                                                        | (837       | )                                                       | $          | (13,875 | ) | $ | 27,138 |   | $ | 166,958 |   |
| Gross profit as a  percentage of sales |       | (2                                                       | )%         | (45                                                     | )%         | 18 | % | 40 | % |

 

Our largest Broadband Infrastructure customer is Softbankin Japan, representing approximately 50% and 35% of total broadband salesduring the three months ended September 30, 2006 and 2005, respectively, and66% and 90% during the nine months ended September 30, 2006 and 2005,respectively.  Due to the customerconcentration in this segment, revenues fluctuate based upon the magnitude andtiming of revenue recognition on certain contracts.

83

----

Net sales from the Broadband Infrastructure segmentincreased $19.7 million for the three months ended September 30, 2006 ascompared to the same quarter in 2005. The increase is primarily due to an $8.5 million order cancellation feeincluded in revenue for the three months ended September 30, 2006, and expectedfluctuations resulting from customer concentration.

Gross profit during the three months ended September 30,2006 improved to negative 2% compared with a negative gross profit of 45%during the three months ended September 30, 2005.  The gross profit for the three months endedSeptember 30, 2006 of negative 2% was positively impacted by $8.5 million oforder cancellation fees, and negatively impacted by additional warrantyreserves of $4.7 million for the NetRing and GEPON equipment sold to Softbankduring 2003 and 2004.  OurBroadband Infrastructure operating segment reported a negative gross margin of45% during the three months ended September 30, 2005, primarily dueto recognizing $4.9 million of additional warranty expense relating to salesmade principally in Japan in prior quarters of three products where qualityissues were encountered.  We also had a$4.0 million increase in our overall estimated warranty liability for BroadbandInfrastructure products in this three month period based on the results of ananalysis of warranty costs incurred.

Broadband Infrastructure net sales during the nine monthsended September 30, 2005, included one large transaction with Softbank totaling$271.9 million of revenue on certain agreements entered into with JapanTelecom primarily for the iAN8000 product in 2005.  Included in Broadband Infrastructure salesfor the nine months ended September 30, 2006 are order cancellation fees of$31.2 million and included in cost of sales is a $4.4 millioninventory write-down.

*Wireless Infrastructure*
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** | **(in thousands)**                                 | ** ** |
| Sales                                  |       | $                                                        | 110,299    |                                                    | $          | 77,586 |   | $ | 331,997 |   | $ | 310,708 |   |
| Gross profit                           |       | $                                                        | 54,217     |                                                    | $          | 16,332 |   | $ | 158,835 |   | $ | 77,661 |   |
| Gross profit as a  percentage of sales |       | 49                                                       | %          | 21                                                      | %          | 48 | % | 25 | % |

 

During the three months ended September 30, 2006, salesof Wireless Infrastructure products increased by 42% compared to the sameperiod in 2005.  PAS systems salesincreased 26% during the three months ended September 30, 2006 and comprisedapproximately 85% of our Wireless Infrastructure sales for the three monthsended September 30, 2006 compared to 95% during the same period ended September30, 2005.  The increase in PAS systemssales was primarily due to the deferral and subsequent amortization of revenuesas noted in our China sales investigation. Certain contracts we signed with customers in prior years included termsrequiring us to defer such revenues and then recognize them ratably insubsequent years over the period we are obligated to provide the post contractsupport (For more information regarding the China sales investigation, see “Restatementof Consolidated Financial Statements” in Item 2 of this Form 10-Q).  The shift in timing of the revenuerecognition for these contracts offset decreases in sales due to maturity ofour PAS system product lines.  Sales ofproducts other than PAS systems, including our Moving Media 2000 and MovingMedia 6000 products, comprised the remaining 15% of sales during the threemonths ended September 30, 2006.

During the nine months ended September 30, 2006, WirelessInfrastructure sales increased by 7% compared to the same period in 2005. The increase is primarily due to the deferral and subsequent amortization ofrevenues as noted in our China sales investigation, and (i) the increase insales of other products including Moving Media 2000 and Moving Media 6000; and(ii) the deferral and subsequent amortization of certain long-term contracts asnoted above offsetting most of the decline of PAS system sales.  WorldwidePAS system sales decreased by 5% and comprised approximately 84% of ourWireless Infrastructure sales for the nine months ended September 30, 2006compared to 95% during the same period ended September 30, 2005.  Excluding amortization of long-termcontracts, new sales in China have declined continuously since late 2004 ascarriers have transitioned from new system installations to system expansionsas PAS/iPAS systems reach product maturity.

We anticipate moderate declines in PAS systemspending.  We plan to aggressively pursueopportunities for our other technology products in multiple markets, though wedo not anticipate that these sales will fully offset the decline in PAS salesover the next twelve months.

84

----

Gross profit as a percentage of sales increased by 28 percentagepoints in the three months ended September 30, 2006, as compared to thecorresponding quarter in 2005 due to a number of factors including:(i) the margins on PAS infrastructure improved due to a shift in productmix towards higher margin cell sites as well as a reduction in productdiscounts given; (ii) an improvement in inventory management and productquality resulting in a decrease in excess/slow moving inventory write-downs; and (iii) a decrease in component material costs.

Gross profit as a percentage of sales increased by 23percentage points in the nine months ended September 30, 2006, as compared tothe corresponding nine months in 2005 due to a number of factors, including:(i) the margins on PAS infrastructure improved due to a shift in productmix towards higher margin cell sites as well as a reduction in productdiscounts given; (ii) an improvement in inventory management and productquality resulting in a decrease in excess inventory write-downs and scrapas compared with the comparable 2005 period; and (iii) sales of voice anddata networks software totaling $14.7 million in 2006 which typically havegross margins of approximately 90%.

***PCD***
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| Sales                                  |       | $                                                        | 328,701    |                                                    | $          | 363,637 |   | $ | 917,943 |   | $ | 1,021,452 |   |
| Gross profit                           |       | $                                                        | (7,057     | )                                                       | $          | 13,199 |   | $ | 19,653 |   | $ | 42,881 |   |
| Gross profit as a  percentage of sales |       | (2                                                       | )%         | 4                                                       | %          | 2 | % | 4 | % |

 

Revenue for thePCD segment decreased 10% during the three months ended September 30, 2006 ascompared to the same quarter in 2005. The decrease in revenue was the result of a 17% decrease in the numberof units sold, offset partially by an increase in the overall average sellingprice.  The number of units sold duringthe three months ended September 30, 2006 of 1.7 million reflected a decreaseof approximately 375,000 units from the comparable period in 2005.  Partially offsetting the effect of thedecrease in units sold was a 10% increase in the average sales price per unit.

Historically, PCD has relied upon a limited number ofmanufacturers to supply its handset products.**** During the three and nine months endedSeptember 30, 2006, sales of UTStarcom branded devices increased toapproximately 14% and 13%, respectively, from zero in the same periods lastyear.  In addition, three other vendorscombined to account for approximately 72% and 77% of handset products soldduring the three and nine months ended September 30, 2006, respectively.

Gross profit as a percentage of sales decreased to  negative 2% and positive 2% of net sales forthe three and nine months ended September 30, 2006, respectively compared with4% of net sales for the  same periods in2005.  The decreased gross profit in 2006was primarily due to inventory write-down to market for certain slow movingmodels purchased in Q3 2006 in connection with the Strategic Alliance Agreemententered into with Pantech & Curitel Communications, Inc. on September 25,2006.  Partially offsetting theseinventory charges were higher margins on UTStarcom branded devices sold during2006.

***Handsets***
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| Sales                                  |       | $                                                        | 93,163     |                                                    | $          | 106,294 |   | $ | 299,266 |   | $ | 378,256 |   |
| Gross profit                           |       | $                                                        | 24,012     |                                                    | $          | 13,633 |   | $ | 88,521 |   | $ | 48,972 |   |
| Gross profit as a  percentage of sales |       | 26                                                       | %          | 13                                                      | %          | 30 | % | 13 | % |

 

Handsets sales declined 12% for the three months endedSeptember 30, 2006 compared to the same period in 2005.  Nearly all our handset sales are in China,where we have experienced a decline in volume for our PAS handsets, partiallyoffset by an increase in the per-unit average price.  The units sold declined to 1.7 millioncompared to 2.1 million in the comparable period last year.  The 20% volume decline was primarilyattributed to lower demand for our PAS handsets resulting from slower subscribergrowth as service providers reduced marketing efforts for PAS handsets inanticipation of next generation technology networks.

85

----

The decline in revenue resulting from the decrease inunits sold was partially offset by an increase in the average selling price perunit.  The average selling price per unitimproved due to a shift in product mix to sales of higher-end models, includingour new PAS/GSM dual mode model.  Thisshift in product mix more than offset declining prices of other models due tocompetitive pricing pressures in the PAS market, which we have experienced inthe China telecommunications market since the latter part of 2003.  We expect to see cumulative PAS subscribergrowth at lower rates in future periods.

Handset sales declined 21% for the nine months endedSeptember 30, 2006 compared to the nine months ended September 30, 2005.  As noted above, the decrease in net sales wasprimarily attributable to declining volume in the China telecommunicationsmarket.  Unit sales declined to5.8 million for the nine months ended September 30, 2006 compared to8.1 million units in the prior year. The average selling price per unit remained relatively stable due to theoffset of competitive pricing pressures in the PAS market with a shift inproduct mix to sales of higher end models including our new dual mode model.

Gross profit as a percentage of sales for our handsetssegment increased by 13% in the three months ended September 30, 2006, ascompared to the corresponding quarter in 2005. A significant portion of the improvement in the gross profit percentagerelates to shifting most of our products to the use of chip-sets with greaterfunctionality in PAS handsets that reduce the overall component costs of eachunit.  Additionally, we have had a shiftin product mix towards higher margin products such as our PAS/GSM dual mode andultra-thin high-end PAS handsets. Additional factors leading to the improvement in gross profit is areduction in variances and overhead.

Gross profit as a percentage of sales for our handsetssegment increased by 17% in the nine months ended September 30, 2006, ascompared to the corresponding nine months in 2005.  A portion of the improvement in the grossprofit percentage relates to shifting most of our products to the use of chip-setswith greater functionality in PAS handsets that reduce the overall componentcosts of each unit.  Additionally, wehave had a shift in product mix towards higher margin products such as ourPAS/GSM dual mode and ultra-thin high-end PAS handsets.  Additional factors leading to the improvementin gross profit are a reduction in variances and warranty costs.

We believe our Handset segment is positioned to meetfuture market demand as we were awarded a license to sell both GSM and CDMAhandsets in China in July 2005. Additionally, we are focusing on expanding our handset product offeringoutside of China.  However, we do notexpect gross profit as a percentage of sales to continue at this level over theremainder of the year as the decline of the price per unit will likely exceedour ability to continue to reduce per-unit costs.

***Service***
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| Sales                                  |       | $                                                        | 17,982     |                                                    | $          | 18,900 |   | $ | 52,426 |   | $ | 65,454 |   |
| Gross profit                           |       | $                                                        | 4,466      |                                                    | $          | 8,598 |   | $ | 13,395 |   | $ | 36,709 |   |
| Gross profit as a  percentage of sales |       | 25                                                       | %          | 45                                                      | %          | 26 | % | 56 | % |

 

Our Service segment’s revenue decreased by $0.9 million for thethree months ended September 30, 2006 as compared to the corresponding quarterlast year.  Included in service revenueduring the three months ended September 30, 2006 is revenue of$4.1 million related to support and service performed for Softbankaffiliates compared to $2.1 million during the same period in 2005.

During the nine months ended September 30, 2006, wefocused on the revenue opportunities with respect to support in China.  Approximately 477 employees previouslyproviding sales and support services were shifted towards generating revenuefrom support arrangements, resulting in additional cost of goods sold for thethree and nine months ended September 30, 2006 of $4.1 million and$11.0 million, respectively, with a related decrease in the gross profitas a percentages of sales and a corresponding decrease to operatingexpenses.  Additionally, revenues of$2.1 million and $7.5 million from Wireless Infrastructure and$0.1 million and $0.5 million from Broadband Infrastructure segmentsales in China were allocated to the Service segment during the three and nine monthsended September 30, 2006, respectively. The allocation was made on certain completed contracts for which theservice element was not separately priced.

Our Service segment revenue declined by$13.0 million, or 20%, for the nine months ended September 30, 2006 ascompared to the corresponding period last year. The Service segments revenue for the nine months ended September 30,2006 included $10.7 million of revenue associated with services performedfor Softbank and affiliates compared to $21.1 million during the sameperiod in 2005.

86

----

**LIQUIDITY AND CAPITAL RESOURCES**

*Operating Activities*

*2006*

Net cash provided by operating activities for the ninemonths ended September 30, 2006 was $18.1 million.  Operating cash was affected by changes inaccounts receivable and customer advances, and offset by the net loss as wellas changes in inventories and other current liabilities.

The $105.5 million decrease in accounts receivablewas attributable to a decline in sales preceding the end of the September 30,2006 quarter as compared to sales preceding December 31, 2005.  Days sales outstanding, when calculated usingthe preceding quarterly sales, decreased to 69 days at September 30, 2006 ascompared to 95 days at September 30, 2005 as a result of improved cashcollections.

Customer advances increased by $61.8 million for the ninemonths ended September 30, 2006, primarily due to a longer construction andtesting period for the IPAS market. Customer advances represent cash deposits we have received from our customersfor orders that have not yet received final acceptance.  Upon subsequent receipt of final acceptancesand revenue recognition, customer advances are reduced and revenue and cost ofsales is recorded.

The decrease in other current liabilities is primarilythe result of a decrease in other taxes payable of approximately$13.5 million, a decrease in warranty liabilities of $11.8 million, adecrease in accrued contract costs, which relate to purchase of goods andservices for which invoices have not been received of approximately $9.1 millionand a decrease of approximately $24.7 million in other liabilities.

Non-cash charges for the nine months ended September 30, 2006 included$51.5 million of depreciation and amortization, and a $13.1 millionof stock-based compensation expense.  Inaddition, a $12.3 million gain was recognized from the sale of semiconductordesign assets to Marvell Technology Group, Ltd. during the nine monthsended September 30, 2006.

*2005*

Net cash providedby operating activities for the nine months ended September 30, 2005, was $83.6million.  Operating cash was primarilyaffected by changes in accounts receivable, inventory, and current andnon-current assets, offset by changes in customer advances, income tax payableand accounts payable.

The $202.7 millionreduction in accounts receivable was primarily attributable to the strongercollections in the third quarter of 2005, and offset by the incremental salesand related receivables from PCD.  Dayssales outstanding was 140 days, excluding PCD, at September 30, 2005 as comparedto 83 days at September 30, 2004.  Dayssales outstanding was 95 days including PCD at September 30, 2005.  The longer days sales outstanding is a directresult of longer collection cycles in China due to the slow-down in thetelecommunication industry which has necessitated a corresponding increase inthe provision for doubtful accounts.

The decreases ininventory balance of $116.0 million and other assets of $85.0 million havecontributed to our increase in operating cash.

Customer advancesdecreased by $164.8 million and income tax payable decreased by $118.6 millionfor the nine months ended September 30, 2005. In addition, accounts payable decreased by $120.5 million.  All of these factors contributed to adecrease in operating cash.  Customer advancesrepresent cash deposits we have received from our customers for orders thathave not yet received final acceptance. Upon subsequent receipt of final acceptances and revenue recognition,customer advances are reduced and revenue and cost of sales are recorded.

The reduction ofcustomer advances in the nine months ended September 30, 2005 was primarily dueto the completion of the revenue earning process for most of the agreementswith Japan 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 promotionalactivities was reflected as a customer advance in prior periods.  Revenue for certain of these agreements hasbeen recognized in the nine months ended 

87

----

September 30, 2005.  For additional information, refer to Note 18,“Related Party Transactions,” to our condensed consolidated financialstatements.

Non-cash charges forthe nine months ended September 30, 2005 included a change of $192.4 million 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 $14.6million provision for deferred costs, excluding $5.5 million write-off ofinventory associated with the Restructuring. In the nine months ended September 30, 2005, we recorded a $31.4 millionnon-cash gain on extinguishment of debt which offsets activities that increaseoperating cash.

*Investing Activities*

*2006*

 Net cash providedby investing activities for the nine months ended September 30, 2006totaled $32.6 million.  Cash inflows frominvesting activities included $20.0 million received from the sale of thesemiconductor design business division to Marvell Technology Group, Ltd.,$42.1 million of proceeds of the sale of short-term investments and $26.5million in changes to restricted cash. Cash outflows for investing activities, including $17.2 million ofadditions to property, plant and equipment, and $40.2 million of purchasesof short-term investments.

*2005*

Net cash provided by investing activities for the ninemonths ended September 30, 2005, totaling $32.5 million was primarily dueto $121.2 million of net proceeds from the purchase and sale of short-terminvestments.  The cash outflow wasprincipally attributable to $24.3 million related to our acquisitions ofGiga Telecom, Inc. in the first quarter of 2005, and Pedestal Networks inthe second quarter 2005, and $60.9 million in purchases of property, plantand equipment.

*Financing Activities*

*2006*

Net cash used in financing activities was$96.4 million, primarily consisting of a net repayment of short-termborrowings in excess of new borrowings of $96.0 million.

*2005*

Net cash used in financing activities was$182.8 million for the nine months ended September 30, 2005.  This was primarily due to the net repaymentof borrowing of $131.8 million and $57.1 million cash payment inconjunction with an early debt extinguishment.

*Liquidity*

We reported net losses in each quarter in the period beginning April 1,2005 and continuing through September 30, 2006, which have resulted in anaccumulated deficit of $452.2 million and total stockholders’ equity beingreduced to $789.3 million at September 30, 2006. Additionally, at September 30,2006, we had short-term debt in China under lines of credit to our Chinasubsidiaries of $105.0 million maturing in 2007 and long-term debt outside ofChina in the form of 7/8% convertible subordinated notes with a principalbalance of $274.6 million that matures in March 2008.

Our working capital was $815.6 million and $811.8 million atSeptember 30, 2006 and 2005, respectively, and included cash on hand of$604.4 million and $496.1 million and short term investments of$12.3 million in and $15.1 million, respectively in 2006 and 2005.  Planned capital expenditures include anincrease in the level of our capital expenditures in China in 2007 byapproximately $40 million to support wire line telephone carriers in China whoutilize our products and services to provide television service to theircustomers using the IPTV protocol.

Credit facilitiesin China at September 30, 2006 totaled $789.5 million, with $498.5 million ofthis amount available for working capital purposes, of which we had drawn$105.0 million in outstanding borrowings, with interest rates up to 5.02%, and$291.0 million was available for use in support of letters of credit andcorporate guarantees. These facilities expireprimarily in November and December of 2007.  We believe that based upon our recentfinancial performance and financial position our lenders may reduce the totalavailable credit when it negotiates renewals of these lines. Furthermore, 

88

----

each borrowing under thecredit facilities is subject to the bank’s current favorable opinion of thecredit worthiness of the Company’s China subsidiaries, as well as the bankhaving funds available for lending and other Chinese banking regulations.However, we believe the amounts of credit our lenders may make available andthe borrowings made under the renewed lines of credit will be sufficient tomeet planned uses of these credit facilities.

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

Of our total cashand short-term investments at September 30, 2006 of $616.7 million, a total of $455.4 million is held in China. Tomeet liquidity needs outside of China, our subsidiaries in China have theability to transfer cash to the Company in the United States under China’scurrent exchange control regulations. The amount of cash available for transferfrom the China subsidiaries is limited both by liquidity needs of thesubsidiaries in China and by Chinese government requirements that the Chinasubsidiaries retain adequate capital levels in China to protect creditors andto have funds available for mandated employee benefits. We believed the Chinasubsidiaries could freely transfer at least $200 million as of December 31,2006, and during the nine months ended September 30, 2007 our Chinasubsidiaries have made such transfers of funds out of China to the Companytotaling $150 million.

Althoughmanagement believes we now have a sufficient amount of cash resources tofinance our anticipated working capital and capital expenditure requirementsfor the next 12 months, we do not have enough cash outside of China to repaythe convertible notes due on March 1, 2008. Management’s liquidity plansinclude a partial or complete refinancing of the convertible notes, renewal ofthe lines of credit in China, transfers of more cash from its subsidiaries inChina to the extent necessary, and, if needed, liquidation of certaininvestments and/or seeking new financing arrangements. Our ability to maintainsufficient liquidity is also dependent on achieving projected sales andoperating margin forecasts.

The convertible notes were issued in March 2003 whenwe completed an offering of $402.5 million of 7/8% convertiblesubordinated notes due March 1, 2008 to qualified institutional buyers.The notes are convertible into our common stock at a conversion price of $23.79per share and are subordinated to all of our present and future senior debt.Concurrent with the issuance of the convertible notes, we entered into aconvertible bond hedge and a call option transaction with respect to our commonstock. Both the bond hedge and call option transactions may be settled at ouroption either in cash or net shares and expire on March 1, 2008. During2005, we completed exchanges of approximately 5.0 million shares of ourcommon stock and approximately $57.1 million in cash for$127.9 million aggregate principal amount of outstanding notes. As aresult of the early extinguishment, we also amended the convertible bond hedgeand call option transactions to reflect the change in principal amount of theunderlying notes.

If anevent of default were to occur and be continuing, the Trustee or the holders ofat least 25% in aggregate principal amount of the notes then outstanding coulddeclare all unpaid principal and accrued interest on the Notes then outstandingto be immediately due and payable. Therefore as a result of our inability totimely file our Quarterly Report on Form 10-Q for the period ended September30, 2006, because the independent review by the Governance Committee of theCompany’s historic stock option accounting was not completed, after receiving apurported notice of default from the trustee asserting that the delay in filingand a failure to comply with certain covenants had caused a default under theindenture, we solicited and received the requisite consents from the holders ofthe notes to a waiver of any defaults which may have occurred to and includingJanuary 9, 2007, caused by a delay in filing SEC Reports and entered into aFirst Supplemental Indenture with the trustee, dated January 9, 2007, whichprovided that any failure by us to comply with certain provisions of theoriginal agreement will not result in a default or an event of default through May31, 2007.  After receiving a notice ofdefault from the trustee asserting that our inability to timely file SECReports and comply with certain covenants as of May 31, 2007 had caused adefault under the indenture, we solicited and received the requisite consentsfrom the holders of the notes to a waiver of any defaults which may haveoccurred to and including July 26, 2007 and entered into a Second SupplementalIndenture with the trustee, after receiving consent from holders of more than50% of the outstanding aggregate principal amount of the convertiblesubordinated notes in connection with our consent solicitation announced July19, 2007. The Second Supplemental Indenture provides that (i) during the periodfrom and including July 26, 2007 to and including October 15, 2007 (“CovenantReversion Date”), any failure by us to comply with the covenants contained inthe original indenture agreement related to the required filing of reports withthe SEC, and the furnishing of copies of the SEC reports and certain compliancecertificates to the Trustee, will not constitute a default, and that (ii) if,but for the Second Supplemental Indenture, a default would be deemed to haveoccurred as a result of a failure to comply with such covenants and suchdefault remains uncured and is continuing as of the Covenant Reversion Date,such default will be deemed to have occurred on the Covenant Reversion Date.

89

----

Under the SecondSupplemental Indenture, the convertible subordinated notes accrue an additional6.75% per annum in special interest from and after January 9, 2007 to andincluding July 25, 2007, and an additional 10% per annum in special interestfrom and after July 26, 2007 to the date the notes are paid, prepaid, redeemed,converted or otherwise cease to be outstanding. The special interest rateaccruing on the notes after July 26, 2007 represents an increase of 3.25% perannum over the previous special interest rate of 6.75% per annum provided bythe First Supplemental Indenture. As a result of the Second SupplementalIndenture, the convertible subordinated notes now bear a stated interest rateof 10.875%. Accordingly, we will have $22.0million of additional annual interest expense in 2007 while the convertiblesubordinated notes are outstanding. Payments of special interest will bemade in addition to, and at the same time and in the same manner as, regularlyscheduled payments of interest to holders entitled to such regularly scheduledpayments of interest.

If additionalsources of liquidity were needed, the Company would consider new debt or equityofferings or obtaining cash from asset sales, but there is no assurance thatsuch transactions could be consummated on acceptable terms or at all. Failureto raise sufficient capital when needed could have a material adverse effect onthe business, results of operations and financial position of the Company.

Our China sales are generally denominated in localcurrency, and we accept commercial notes receivable with maturity dates ofbetween three and six months from our customers in China in the normalcourse of business. Notes receivable available for sale was $8.5 millionand $2.1 million at September 30, 2006 and December 31, 2005,respectively. We may discount these notes with banking institutions in China.Any notes that have been sold are not included in our consolidated balancesheets as the criteria for sale treatment established by Statement of FinancialAccounting Standards No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishment of Liabilities” (“SFAS 140”) have been met.

Due to the limitations on converting Renminbi, we arelimited in our ability to engage in foreign currency hedging activities inChina. We cannot guarantee that fluctuations in foreign currency exchange ratesin the future will not have a material adverse effect on revenues frominternational sales and, correspondingly, on our business, financial condition,results of operations and cash flows. We have contracts negotiated in JapaneseYen and we maintain bank accounts in Japanese Yen for purchasing portions ofour inventories and supplies. The balance of these Japanese Yen accounts atDecember 31, 2006 was approximately $13.1 million.

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

We have not guaranteed any debt that is not included in the consolidatedbalance sheet.

*Income Taxes*

Certain subsidiaries and joint ventures located in Chinaenjoy tax benefits in China which are generally available to foreign investmententerprises, including full exemption from national enterprise income tax fortwo years starting from the first profit-making year and/or a 50%reduction in national income tax rate for the following three years.  In addition, local enterprise income tax isoften waived or reduced during this tax holiday/incentive period.  Under current regulations in China, foreigninvestment enterprises that have been accredited as technologically advancedenterprises are entitled to additional tax incentives.  These tax incentives vary in differentlocales and could include preferential national enterprise income tax treatmentat 50% of the usual rates for different periods of time.  The tax holidays discussed above areapplicable or potentially applicable to CUTS, HUTS, Hangzhou UTStarcom TelecomCo., Ltd. (“HSTC”) and UTStarcom China Co., Ltd. (“UTSC”), our activesubsidiaries in China, as those entities may qualify as accreditedtechnologically advanced enterprises.

On March 16, 2007, China’s top legislature, theNational People’s Congress, passed the China Corporate Income Tax Law (“CIT Law”).  CIT Law will be effective on January 1,2008.  Under the CIT Law, China’s dualtax system for domestic enterprises and foreign investment enterprises (“FIEs”)would be effectively replaced by a unified system.  The new law establishes a tax rate of 25% formost enterprises and a reduced tax rate of 15% for certain qualified hightechnology enterprises.

Prior to this change in tax law, certain subsidiariesand joint ventures located in China enjoyed tax benefits in China which aregenerally available to FIEs.  The taxholidays/incentives for FIEs were applicable or potentially applicable to 

90

----

CUTS, HUTS, HSTC and UTSC, our active subsidiaries inChina, as those entities may qualify as accredited technologically advancedenterprises.

CIT Law targets certain industries for the reduced 15%tax rate for certain qualified high technology enterprises.  For FIEs established before the promulgationof the new law who currently enjoy lower tax rates, any increase in their taxrates would be gradually phased in over five years.  Significant regulations regarding theinterpretation and implementation of the new tax law are still pending.  There is potential risk that our subsidiariesmay not qualify for the reduced 15% tax rate. Therefore, the new law may have an adverse impact on our future taxexpense in China.

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

*Off Balance Sheet Arrangements*

On August 1, 2005, we entered into a committedreceivables purchase facility with Citibank, N.A., which provides for the saleof up to $100.0 million of trade accounts receivable of our PCDsegment.  Sales of the accountsreceivables to Citibank, N.A. under this program will result in a reduction oftotal accounts receivable in our consolidated balance sheet.  The remaining accounts receivables not soldto Citibank, N.A. will be carried at their net realizable value, including anallowance for doubtful accounts.  We havenot sold any receivables pursuant to this facility during 2005 or the firstnine months of 2006.  We believe thatavailable funding under our accounts receivable financing program provides usincreased flexibility to manage working capital requirements, and that thereare sufficient trade accounts receivable to support the U.S. financingprograms.  Under the program, we willcontinue to service the accounts receivable.

At September 30, 2006, we have no other off balance sheetarrangements.

*Contractual Obligations and Other Commitments*

Our obligations under contractual obligations andcommercial commitments are as follows:
| ** **                        | ** ** | **Payments due by period** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | ** **                                | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Total**                                 | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **over 5 years** | ** ** |
| ** **                        | ** ** | **(in thousands)**                   | ** ** |
| **Contractual  Obligations**      | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |   |   |
| Bank loans                        |       | $                                         | 105,010    |   | $ | 105,010 |   | $ | — |   | $ | — |   | $ | — |   |
| Convertible subordinated notes    |       | $                                         | 274,600    |   | $ | — |   | $ | 274,600 |   | $ | — |   | $ | — |   |
| Interest payable on debt          |       | $                                         | 37,850     |   | $ | 23,940 |   | $ | 13,910 |   | $ | — |   | $ | — |   |
| Lease obligations                 |       | $                                         | 41,991     |   | $ | 16,467 |   | $ | 19,949 |   | $ | 3,609 |   | $ | 1,966 |   |
| **Other  Commercial Commitments** |       |                                      |       |   |   |   |   |   |   |   |   |
| Letters of credit                 |       | $                                         | 53,281     |   | $ | 49,640 |   | $ | 3,641 |   | $ | — |   | $ | — |   |
| Purchase commitments              |       | $                                         | 730,216    |   | $ | 663,560 |   | $ | 66,656 |   | $ | — |   | $ | — |   |

 

*Bank Loans*

At September 30, 2006, we had loans with various bankstotaling $105.0 million and each with interest rate to 5.02% perannum.  These bank loans mature withintwelve months and are included in short-term debt.  There are no significant covenants associatedwith these loans.

*Convertible Subordinated Notes*

Our convertible subordinated notes, due March 1,2008, are convertible into our common stock at a conversion price of $23.79 pershare and are subordinated to all our present and future senior debt. Theprincipal is due only at maturity of the notes.

Effective January 9, 2007, the Company and the holders ofthe remaining $274.6 million of convertible subordinated notes entered into aFirst Supplemental Indenture, providing that any failure by us to comply withcertain provisions of the original agreement will not result in a default or anevent of default through May 31, 2007. The convertible subordinated notes 

91

----

accrue an additional 6.75% per annum in special interest from and afterJanuary 9, 2007 to the March 1, 2008 maturity date of the notes, unless thenotes are earlier repurchased or converted. On July 26, 2007, we enteredinto a Second Supplemental Indenture providing that the convertiblesubordinated notes will accrue an additional 10% per annum in special interestfrom and after July 26, 2007 to the March 31, 2008 maturity date of the notesunless the notes are earlier repurchased or converted.  The special interest rate represents anincrease of 3.25% per annum over the previous special interest rate of 6.75%per annum in the First Supplemental Indenture. As a result of the Second Supplemental Indenture, the convertible subordinatednotes now bear a stated interest rate of 10.875%.  Interest is payable semiannuallyon March 1 and September 1, and payments of the special interest are made inaddition to and at the same time and in the same manner as regularly scheduledpayments of interest to holders entitled to such regularly scheduled paymentsof interest.  For more informationregarding the notice of default on May 31, 2007 and the Company’s SecondSupplemental Indenture see the “Liquidity” section of this Quarterly Report.

*Operating Leases*

We lease certain facilities under non-cancelableoperating leases that expire at various dates through 2013.

*Letters of credit*

We issue standby letters of credit primarily to supportinternational sales activities outside of China.  When we submit a bid for a sale, often thepotential customer will require that we issue a bid bond or a standby letter ofcredit to demonstrate our commitment through the bid process.  In addition, we may be required to issuestandby letters of credit as guarantees for advance customer payments uponcontract signing or performance guarantees. The standby letters of credit usually expire six to twelve months fromdate of issuance without being drawn by the beneficiary thereof.

*Purchase commitments*

We are obligated to purchase raw materials andwork-in-process inventory under various orders from various suppliers, all ofwhich should be fulfilled without adverse consequences material to ouroperations or financial condition.  As ofSeptember 30, 2006, total purchase commitments, including cancelable and non-cancelable purchase orders, approximated$730 million. Additionally, we have agreed to purchase from Marvell certainchip-sets that will be included in our PAS handsets through 2011.

*Investment commitments*

As of September 30, 2006, we had invested a total of$2.6 million in Global Asia Partners L.P. that is recorded as a long-terminvestment.  The fund size is anticipatedto be $10.0 million and the fund was formed to make private equityinvestments in private or pre-IPO technology and telecommunications companiesin Asia.  We had a commitment to investup to a maximum of $5.0 million.  Asthe result of a reorganization of capital contributions by the partners,reached in April 2005, our capital contribution of $0.5 million in April 2005was the final capital contribution to be made. In addition, the agreement allows the partnership to re-invest up to$2.5 million that otherwise would have been available to us as future distributions.  There were no cash distributions during thethree or nine months ended September 30, 2006 or 2005.

*Intellectual property*

Certain sales contracts include provisions under whichcustomers would be indemnified by us in the event of, among other things, athird-party claim against the customer for intellectual property rightsinfringement related to our products. There are no limitations on the maximum potential future payments underthese guarantees.  We have not accruedany amounts in relation to these provisions as no such claims have been madeand we believe we have valid enforceable rights to the intellectual propertyembedded in our products.

**RECENT ACCOUNTING PRONOUNCEMENTS**

See Note 24, “Recent Accounting Pronouncements”, of Notesto Condensed Consolidated Financial Statement in Item 1 of this QuarterlyReport for a full description of recent accounting pronouncements, includingthe expected dates of adoption and estimated effects on results of operationsand financial condition, which is incorporated herein by reference.

92

----

**ITEM 3—QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISKS**

We are exposed to the impact of interest rate changes,changes in foreign currency exchange rates and changes in the stock market.

*Interest Rate Risk*

Our exposure to market risk for changes in interest ratesrelates primarily to our investment portfolio. The fair value of our investment portfolio would not be significantlyaffected by either a 10% increase or decrease in interest rates due mainly tothe short-term nature of most of our investment portfolio.  However, our interest income can be sensitiveto changes in the general level of U.S. interest rates since the majority ofour funds are invested in instruments with maturities less than one year.  Our policy is to ensure the safety ofinvested funds by generally attempting to limit market risk.  Funds in excess of current operatingrequirements are mostly invested in government-backed notes, commercialpaper, floating rate corporate bonds, fixed income corporate bonds andtax-exempt instruments.  In accordancewith our investment policy, all short-term investments are invested in “investmentgrade” rated securities with minimum A or better ratings.  Currently, most of our short-term investmentshave AA or better ratings.

The table below represents carrying amounts and relatedweighted-average interest rates of our investment portfolio at September30, 2006:
|                                                         | ** ** | **(in thousands, except interest rates)** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Cash and cash  equivalents                              |       | $                                                             | 604,410    |   |
| Average interest  rate                                  |       | 2.04                                                          | %          |
|                                                    |       |                                                          |       |
| Restricted cash                                         |       | $                                                             | 23,835     |   |
| Average interest  rate                                  |       | 4.83                                                          | %          |
|                                                    |       |                                                          |       |
| Short-term  investments                                 |       | $                                                             | 12,330     |   |
| Average interest  rate                                  |       | 1.74                                                          | %          |
|                                                    |       |                                                          |       |
| Restricted cash  long-term                              |       | $                                                             | 3,640      |   |
| Average interest  rate                                  |       | 4.93                                                          | %          |
|                                                    |       |                                                          |       |
| Total cash, cash  equivalents and investment securities |       | $                                                             | 644,215    |   |
| Average interest rate                                   |       | 2.16                                                          | %          |

 

*Equity Investment Risk:*

Our investment portfolio includes equity investments inpublicly traded companies, the values of which are subject to market pricevolatility.  Economic events couldadversely affect the public equities market and general economic conditions mayworsen.  Should the fair value of ourpublicly traded equity investments decline below their cost basis in a mannerdeemed to be other-than-temporary, our earnings may be adversely affected.  We have also invested in several privatelyheld companies as well as investment funds which invest primarily in privatelyheld companies, many of which can still be considered in the start-up ordevelopment stages.  These investmentsare inherently risky, as the market for the technologies or products they haveunder development are typically in the early stages and may never materialize.

*Debt Investment Risk:*

Our debt investment portfolio consists of a$2.4 million note receivable from BB Modem, an affiliate of SOFTBANKCORP., pursuant to a Mezzanine Loan Agreement we entered into withBB Modem on July 17, 2003.  Ourloan is subordinated to certain senior lenders of BB Modem, and repaymentsare payable to us over a 42-month period, with a substantial portion of theprincipal amount of the loan repaid during the last 16 months of thisperiod.  Our recourse for nonpayment ofthe loan is limited to the assets of BB Modem, the account into whichsubscriber payments are made and its rights under the securitizationtransaction documents.  The value ofBB Modem’s modems that serve as collateral for the loan may decrease overtime and may not be sufficient upon sale to pay the outstanding amounts on theloan.  The note receivable was paid infull in January 2007.

*Foreign Exchange Rate Risk:*

We are exposed to foreign currency exchange rate riskbecause most of our sales in China are denominated in Renminbi and portions ofour accounts receivable and payable are denominated in Japanese Yen.  Due to the limitations on 

93

----

converting Renminbi, we are limited in our ability to engage in foreigncurrency hedging activities in China. Although the impact of currency fluctuations of Renminbi to date hasbeen slight, fluctuations in currency exchange rates in the future may have amaterial adverse effect on our results of operations.  The balance of cash and short-term investmentbalance held in China was $455.4 million at September 30, 2006.  In July 2005, China uncoupled theRenminbi from the U.S. dollar and let it float in a narrow band against abasket of foreign currencies.  The moverevalued the Renminbi by 2.1% against the U.S. dollar.  Additionally, during 2005 and the first ninemonths of 2006 we made significant sales in both Japanese Yen and inEuros.  We maintain Japanese Yen bankaccounts for purchasing portions of our inventories and supplies.

Our revenues, earnings and cash flows are subject tofluctuations due to changes in foreign currency exchange rates.  We may hedge currency exposures associatedwith certain assets and liabilities denominated in nonfunctional currencies andcertain anticipated nonfunctional currency transactions using forward foreigncurrency exchange rate contracts.  Wehave not hedged any such transactions, and due to the limitations on convertingRenminbi, we are limited in our ability to engage in currency hedgingactivities in China.  As a globalconcern, we face exposure to adverse movements in foreign currency exchangerates.

We have performed a sensitivity analysis as of September30, 2006, using a modeling technique that measures the change in the fairvalues arising from a hypothetical 10% positive or adverse movement in thelevels of foreign currency exchange rates relative to the U.S. Dollar, with allother variables held constant.  Theanalysis covers all of our foreign currency contracts offset by the underlyingexposures.  The foreign currency exchangerates used were based on market rates in effect at September 30, 2006.  The sensitivity analysis indicated that ahypothetical 10% movement in foreign currency exchange rates would result in again or loss in the fair values of our foreign exchange financial instrumentsof $4.3 million at September 30, 2006.

**ITEM 4—CONTROLS AND PROCEDURES**

**Governance Committee Review of Historical Stock Option Accounting**

In November 2006,UTStarcom, Inc. (“UTStarcom” or the “Company”) announced it was conducting avoluntary review of historical stock option practices under the leadership ofthe Nominating and Corporate Governance Committee of the Company’s Board ofDirectors (“Governance Committee”) following a preliminary review by managementwhich identified potential deficiencies and discrepancies in the documentationof stock option grants. The review considered all equity grant awards made inthe period from February 29, 2000, shortly before the initial public offeringof the Company’s Common Stock, through December 31, 2006 (“Review Period”) forcompliance with the various stock-based compensation accounting standardsapplicable during the Review Period. Referto Note 2, “Restatement of FinancialStatements” of Notes to Condensed Consolidated Financial Statements in Item 1of this Quarterly Report on Form 10-Q (“Form 10-Q”) for the effectof the restatement adjustments on stock-based compensation expense, additionalpaid-in capital accounts, related income tax accounts, retained earnings andrelated financial disclosures for each of the years ended December 31 inthe period 1998 through 2005. Furtherinformation concerning the Governance Committee’s review and the resultingrestatements of the Company’s historical financial statements can be found inthe Explanatory Note preceding Item 1, and in Item 2, Management’s Discussionand Analysis of Financial Condition and Results of Operations included in thisForm 10-Q, which should be read for a more complete description of thismatter.

Based on its findings, the Governance Committee madevarious recommendations to the Board of Directors. At the Board’s direction,management has implemented and will continue to implement remedial actions,including changes to its policies and procedures and enhancements to controls,over its equity-based compensation program. Management has also considered andtaken into account the impact of the findings of this review in its “Evaluationof Disclosure Controls and Procedures,”as presented below.

**Audit Committee Investigation of Historical Sales in China**

In July 2007, theCompany announced that the Audit Committee of its Board of Directors (“AuditCommittee”), with the assistance of independent counsel and forensicaccountants, was conducting an independent investigation of allegations ofimproprieties in certain sales offices in China. The investigation consideredsales contracts in each of the seven years in the period ended December 31,2006. The Investigating Team found instances where the customer contracts thatevidenced the arrangement contained obligations for the Company to deliversoftware upgrades when and if made available for the equipment sold for noadditional consideration and for an unspecified period that could extend overthe term of the contract. This additional contract obligation is an element of“post contract support”. In these cases, the Investigating Team found thatcontract documentation for the same transaction submitted by the sales officeto the Company’s China headquarters for accounting purposes and utilized by theCompany in determining the amount of revenue recognized did not includeevidence of such post contract support obligations.

94

----

Referto Note 2, “Restatement of FinancialStatements” of Notes to Condensed Consolidated Financial Statements in Item 1of this Quarterly Report on Form 10-Q (“Form 10-Q”) for the effectof the restatement adjustments on revenue and deferred revenue accounts,cost of sales and deferred cost accounts,related income tax accounts, retained earnings, and related financialdisclosures in the Company’s consolidated financial statements for the yearsended December 31, 2004 and 2005, each of the quarters in the year endedDecember 31, 2005, and for the first two quarters of the year ended December31, 2006. Further information concerning the Audit Committee’sinvestigation and the resulting restatements of the Company’s historicalfinancial statements can be found in the Explanatory Note preceding Item 1, andin Item 2, Management’s Discussion and Analysis of Financial Condition andResults of Operations included in this Form 10-Q, which should be read fora more complete description of this matter.

Based on the findings, the Audit Committee has made variousrecommendations to the Board of Directors. At the Board’s direction, managementhas implemented and will continue to implement remedial actions, includingchanges to its policies and procedures and enhancements to controls, over salesin China. Management has also considered and taken into account the impact ofthe findings of this investigation in “Management’s Annual Report on InternalControl over Financial Reporting,” as presented below.

**Evaluation of Disclosure Controls and Procedures**

UTStarcom maintains disclosure controls and proceduresthat are designed to ensure that information required to be disclosed in thereports the Company files or submits under the Securities Exchange Act of 1934,as amended (the “Exchange Act”), is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s (“SEC’s”) rules and forms, and that such information is accumulatedand communicated to the Company’s management, including its Chief ExecutiveOfficer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allowtimely decisions regarding required financial disclosure.

In connection with the preparation of thisForm 10-Q, the Company carried out an evaluation under the supervision andwith the participation of the Company’s management, including the CEO and CFO,as of September 30, 2006 of the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures, as such term is defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon thisevaluation, the CEO and CFO concluded that as of September 30, 2006 the Company’sdisclosure controls and procedures were not effective because of the materialweaknesses described in “Management’s Report on Internal Control Over FinancialReporting” in Item 9A of the Company’s Annual Report on Form 10-K forthe fiscal year ended December 31, 2005, as amended (the “2005Form 10-K”), which are still in the process of remediation as well as theadditional material weaknesses identified below as of September 30, 2006.Investors are directed to Item 9A of the 2005 Form 10-K for thedescription of previously identified weaknesses.

1.             *The Company did not maintaineffective controls over its accounting for and disclosure of stock-basedcompensation expense*.Specifically, the Company did not maintain effective controls, includingmonitoring, to ensure the completeness, existence, valuation and presentationof stock-based compensation transactions related to the granting, pricing andaccounting for certain of its stock-based compensation awards and the relatedfinancial reporting for these awards in accordance with GAAP. This control deficiencyresulted in the misstatement of the stock-based compensation expense,additional paid-in capital accounts, related income tax accounts, retainedearnings and related financial disclosures, and resulted in the restatement ofthe Company’s consolidated financial statements for the years ended December31, 2004 and 2005, each of the quarters in the year ended December 31, 2005,and the first two quarters of the year ended December 31, 2006.

2.             *The Company failed to prevent or detect instances of override relatedto controls in China over customer agreements.* Specifically, thiscontrol deficiency permitted the override of established controls in China’swestern sales region, by allowing for the existence of undisclosed agreementswith customers, which obligated the Company to provide products or performcertain services without the receipt of additional consideration. The existenceof these agreements was not communicated to either the Company’s financialreporting function or its independent registered public accounting firm. This control deficiency resulted in adjustments torestate revenue and deferred revenue accounts, cost of sales anddeferred cost accounts, related income taxaccounts, retained earnings, and related financial disclosures in the Company’sconsolidated financial statements for the years ended December 31, 2004 and2005, each of the quarters in the year ended December 31, 2005, and for thefirst two quarters of the year ended December 31, 2006.

3.             *The Company did not maintaineffective controls at its U.S. headquarters over its accounting for warrantyreserves and associated cost of sales.*  Specifically, the Company’scontrols failed to adequately identify, document and analyze requiredsupporting information to ensure the completeness, accuracy, valuation andadequacy of its warranty reserves and to ensure all related costs were recordedin the appropriate period. These processes were not always performed correctlyor timely, there was 

95

----

inadequate management review, and calculation and/or posting errorsoccurred. This control deficiency resulted in adjustments, including reviewadjustments, to the consolidated financial statements for the quarter endedSeptember 30, 2006 to correct warranty reserves, which are included in othercurrent liabilities, and the associated cost of sales.

A “material weakness” is a control deficiency in internalcontrol over financial reporting, or a combination of deficiencies in internalcontrol over financial reporting, that results in more than a remote likelihoodthat a material misstatement of the annual or interim consolidated financialstatements will not be prevented or detected. To address these materialweaknesses in internal control over financial reporting noted above, theCompany performed additional analyses and other procedures (as furtherdescribed below under “Management’s Further Remediation Initiatives and InterimMeasures”) to ensure that the Company’s consolidated financial statements areprepared in accordance with generally accepted accounting principles in theUnited States (“GAAP”). Accordingly, the Company’s management believes that theconsolidated financial statements included in this Form 10-Q fairly present inall material respects the Company’s financial condition, results of operationsand cash flows for the periods presented and that this 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 periodscovered by this report.

**Management’s Further Remediation Initiatives andInterim Measures**

The Company plans to make necessary changes andimprovements to the overall design of its control environment to address thematerial weaknesses in internal control over financial reporting describedabove, including changes to the overall design of its control environment andthe roles and responsibilities of each functional group within the organizationand the reporting structure, as well as developing policies and procedures toimprove overall internal control over financial reporting. In particular, theCompany has implemented during 2006, and plans to continue to implement during2007, the specific measures described below. In addition, in connection withthe September 30, 2006 quarter-end reporting process, the Company hasundertaken additional measures described under the subheadings “—InterimMeasures” below to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of the Company’s consolidated financialstatements included in this Form 10-Q and to ensure that material informationrelating to the Company and its consolidated subsidiaries was made known to managementin connection with the preparation of this Form 10-Q.

***Material weakness 1 described in “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2005Form 10-K***

*Remediation Initiatives.*The Company’s failure to have a sufficientcomplement of personnel with a level of accounting knowledge, experience andtraining in the application of GAAP commensurate with the Company’s financialreporting requirements contributed to the Company’s failure to maintaineffective controls over the financial reporting process. To remediate materialweakness 1 described in “Management’s Report on Internal Control Over FinancialReporting” in Item 9A of the 2005 Form 10-K, the Company hasimplemented the measures described below, and will continue to evaluate and mayin 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 havesufficient personnel with knowledge, experience and training in the applicationof GAAP commensurate with the Company’s financial reporting requirements. TheCFO, with assistance from his senior financial staff and outside consultants,has reviewed and will continue to review and adapt the overall design of theCompany’s financial reporting organizational structure, including the roles andresponsibilities of each functional group within the Company, to ensure thatthe Company has a sufficient compliment of personnel with knowledge, experienceand training in the application of GAAP commensurate with the Company’sfinancial reporting requirements. During 2006 and continuing in 2007, theCompany’s activities to address and remediate the material weakness in thisarea reported in 2005 have included:

(a)           Hiring or appointing personnel to fill open seniorfinancial positions necessary for an effective financial reportingorganizational structure including qualified and experienced personnel forcorporate, business unit, international and regional accounting; costaccounting; financial planning and analysis; revenue accounting; and taxcompliance. Personnel were hired primarily into open positions at its U.S.headquarters, in China, and in the Asia-Pacific and Europe, Middle East andAfrica (“EMEA”) regions. In addition, the Company hired or appointed personnelto fill open senior financial compliance and internal audit positions at itsU.S. headquarters and in China and India.

(b)           Implementing, in the first quarter of 2007, a new “managementby objectives” system which will be used globally to capture corporate andexecutive management goals and articulate them throughout the organization, andto cascade and align 

96

----

each employee’s goals to support corporate objectives.The goal setting, monitoring and evaluation process will incorporate capturingemployee’s training and development requirements, including training to staycurrent with the application of GAAP and the company’s code of business conductand ethics.

(c)           Retaining the services of outside consultants withrelevant accounting experience, skills and knowledge in the application ofGAAP, working under the supervision and direction of the Company’s management,to supplement the Company’s existing finance personnel.

(d)           Continuing to allocate the necessary resources tohire additional finance, internal audit and compliance personnel in the U.S.,China, India, and elsewhere, as necessary, with knowledge, experience andtraining in the application of GAAP commensurate with the Company’s financialreporting requirements.

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 that havethe potential of misstating revenue, deferred revenue and associated cost ofsales in future financial periods. These measures, at its U.S. headquarters andinternational (excluding China) locations, include the following:

(a)           Hiring and training additional experienced revenuemanagers and supporting staff to support the preparation and analysis ofrevenue recognition and deferred revenue accounts.

(b)           Enhancing the contract review process to includerequiring sales, operations, finance and legal staff to provide input duringthe contract negotiation process to ensure timely identification and accurateaccounting treatment for non-standard contracts.

(c)           Enhancing the policies, procedures and guidelinesaround recognizing and deferring revenue, and better defining the timing andextent of a second level of management review at its U.S. headquarters ofrevenue recognition for certain transactions.

(d)           Implementing additional procedures to enhancecontrols around recognized and deferred revenue to ensure the completeness,accuracy and validity of recognized and deferred revenue, including reviewingsales hold reports and fulfilled progress billing sales orders reports toensure that revenue is completely recorded and a secondary review ofmaintenance transactions to ensure the amounts are amortized accurately.

(e)           Implementing enhancements to its Oracle financialsystem which improved its automated processes and controls related to revenueand deferred revenue accounting.

(f)            Increasing the level and coverage of trainingconducted by revenue accounting personnel related to revenue recognition,including the impact of amendments and side agreements. During the firstquarter of 2006, several training seminars were conducted for various sales andservices teams in North and South America. In the second quarter, additionalrevenue recognition training was provided to personnel in North America andtraining was also conducted for the EMEA sales group. In the third quarter,training was conducted in the Philippines and in the US for Caribbean and LatinAmerican (“CALA”) based sales and services personnel. In October 2006, theCompany’s key management participated in a seminar on the critical factorsassociated with revenue recognition. In addition, certain revenue accountingpersonnel attended various revenue recognition seminars through-out the year aspart of their on-going training.

(g)           Expanding, in the third and fourth quarters of2006, the number of disclosures  includedin the certifications to senior management with respect to identification andcommunication of contract amendments, side agreements or other matters whichcould have a bearing on revenue recognition, as well as the number of personnelrequired to perform such certifications. The Company also implementedadditional steps to ensure appropriate members of management have reviewed andconfirmed critical information necessary to ensure proper revenue recognitionaccounting.

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. These measures includethe following:

(a)           In March 2006, the Company hired an internationalcost accounting director and, in October 2006, the Company in China hired adirector of finance, supply chain, both with relevant GAAP experience, skillsand knowledge. In November 2006, the Company hired an assistant controller anda shared services manager at its U.S. headquarters whose responsibilitiesinclude overseeing the international cost accounting function. These personnelhave considerable experience and training in cost accounting and utilization ofthe relevant Oracle financial system modules. The Company believes the additionof these personnel improves and strengthens the capabilities for the manualanalyses and management review required of this function.

97

----

(b)           During the second quarter of 2006, the Companyimplemented enhancements to its Oracle system which will improve its ability tomore effectively track inventory and evaluate deferred costs.

(c)           In the first quarter of 2007, the Company enhancedits processes and procedures related to properly tracking and confirminginventory movements to ensure the proper classification of inventory, includingfinished goods at customer sites, and deferred costs (and associated accountssuch as Purchase Price Variances), and to ensure the completeness and accuracyof the recording of the cost of sales when revenue is recognized. The revisedprocesses include involving and obtaining detailed and timely input frombusiness unit, operations and sales operations personnel to enhance theinformation available for finance to analyze these accounts. New reports havebeen developed and reports and procedures will continue to be enhanced asnecessary to facilitate the accuracy of accounting for these processes. Inaddition, finance management has placed increased attention on reviewing indetail the accounting in this area.

(d)           Throughout 2006 and continuing in 2007, theCompany enhanced and will continue to augment its processes and proceduresrelated to the evaluation of its inventory reserve accounts, including thedevelopment of detailed inventory reserve reports and additional review ofreserve accounts by management.

4.             Recording of Accrued Expenses—The Company’splanned remediation measures are intended to address a material weaknessrelated to the Company’s recording of accrued expenses that has the potentialof misstating accrued expenses and related income statement accounts in futurefinancial periods. The Company’s remediation measures include theimplementation in 2006 of control processes at its U.S. headquarters and inChina, which included:

(a)           Enhancing the process to review open purchaseorders, invoices and disbursements after the end of each quarter to ensureproper recording of accrued expenses and open purchase order commitments.

(b)           Hiring additional resources into the Company’saccounting and accounts payable functions at its U.S. headquarters and inChina. In addition, in November 2006, the Company hired an assistant controllerand a shared services manager at its U.S. headquarters whose responsibilitiesinclude overseeing the accounts payable and corporate accounting functions.These personnel add considerable experience and training in accounting andoversight for accounts payable and accrued expenses for the consolidatedfinancial statements and utilization of the relevant Oracle financial systemmodules. The Company believes the addition of these personnel improves andstrengthens the capabilities of this function.

(c)           Enhancing, in the first and second quarters of2006, the Company’s processes and procedures related to properly tracking andreviewing open purchase orders and reviewing of subsequent receipts, invoicesand disbursements after the end of each month to ensure proper recording ofopen purchase order commitments, accrued expenses and related income statementaccounts. The Company plans to continue enhancing reports and procedures, asnecessary, to facilitate the accuracy of accounting for these processes. Inaddition, finance management both in China and at its U.S. headquarters havecommitted to place increased attention on reviewing the accounting in thisarea.

5.             Accurate Preparation and Review of FinancialStatements and Segment Reporting—The Company’s planned remediation measures areintended to address material weaknesses related to the financial close andreporting process that have the potential for preventing the accuratepreparation and review of the Company’s consolidated financial statements infuture financial periods. These measures include the following:

(a)           During the first nine months of 2006, the Companyimplemented and plans to continue to improve procedures to ensure thatnon-routine transactions are identified and escalated to senior financialmanagement during the close process to help ensure proper accounting treatment;

(b)           During the first nine months of  2006, the Company implemented and plans tocontinue to augment month and quarter-end closing procedures to standardize itsprocesses for financial review to ensure that U.S. reviewers monitor financialinformation from decentralized locations in a consistent manner;

(c)           During the first nine months of 2006, the Company’scorporate finance department expanded and plans to continue to enhance therequired reporting package from various business units and subsidiaries inorder to ensure it has accumulated the necessary accounting, finance andoperational information to effectively analyze information required forfinancial statement preparation and footnote disclosures; and

98

----

(d)           In addition, in 2006 the Company’s externalreporting department expanded and plans to continue to improve thedocumentation and review of required information associated with thepreparation of its quarterly and annual filings under the Exchange Act.

(e)           In the fourth quarter of 2006, the Company’sfinance department commenced an initiative to “refresh” its finance andaccounting policies and procedures. Through this initiative, which the Companyexpects will be ongoing throughout 2007 and beyond, the Company’s financialpolicies and procedures will be reviewed for completeness, accuracy andadequacy, updated and brought current, and standardized globally as necessaryand appropriate. A communication plan will also be developed to ensure “refreshed”policies and procedures are publicized and understood, and appropriateemployees are trained in their application, as necessary. The Company expectsthis initiative will form the foundation for the process to maintain and keepcurrent its finance and accounting policies and procedures on a go-forwardbasis. In addition, starting in the fourth quarter of 2006, the Companycommenced internal audits of, and in 2007 plans to continue to expand andincrease the scope of its efforts to monitor, controls at the Company’sdecentralized and remote operations globally, through reviews and audits ofemployee compliance with applicable policies and procedures at business units,subsidiaries and other locations.

6.             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. These measures include the following:

(a)           The Company hired and trained additionalexperienced tax managers and supporting staff during the first nine months of 2006to support the preparation of the Company’s income tax provision and to assistin managing audits and to monitor tax compliance in China and other foreignlocations;

(b)           During the first nine months of 2006, the Companyutilized outside consultants, other than the Company’s independent registeredpublic accounting firm, to assist the Company’s management in the analysis andcalculation of its income tax provision and related balance sheet accounts. TheCompany plans to continue to utilize such outside consultants to assist in itsanalysis and calculation of such matters in future periods, as necessary; and

(c)           Throughout the first nine months of 2006, theCompany developed and continues to augment a more formalized and comprehensiveprocess to accumulate and organize financial and tax data used in connectionwith income tax calculation and reporting.

7.             Segregating duties and user access—The Company’sremediation measures are intended to address a material weakness related to thesegregation of duties and user access to certain J. D. Edwards business processapplications associated with the Company’s Personal Communications Divisionthat have the potential of misstating various accounts in future financialperiods. These measures include the following:

(a)           During the first quarter of 2006, the Company removedaccess rights from certain employees associated with inappropriate segregationof duties;

(b)           On a quarterly basis, management review andmodify, as necessary, access privileges to the J. D. Edwards business processapplications; and

(c)           The Company expanded its level of managementoversight related to areas associated with segregation of duties and useraccess issues including changes to the general ledger master file, invoiceterms and inventory.

*Interim Measures.*Management has not yet implemented and/or testedthe effectiveness of all the measures described in items 1 through 7 above.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 three quarters of 2006or subsequent to September 30, 2006 in connection with the September 30, 2006quarter-end reporting process, address material weakness 1 described in “Management’sReport on Internal Control Over Financial Reporting” in Item 9A of the2005 Form 10-K. These other measures include the following:

1.             The Company retained on an interim basis outsideconsultants, other than the Company’s independent registered public accountingfirm, with relevant GAAP experience, skills and knowledge, working under thesupervision and direction of Company management, to assist with the September30, 2006 quarter-end reporting process.

2.             The Company conducted an additional review of asubstantial majority of its revenue-generating contracts for compliancewith revenue recognition criteria. As part of this review, the Company gatheredand analyzed evidence of delivery and final acceptance.

99

----

3.             The Company performed the following reviews ofinventory-related matters: it reviewed consolidated revenue schedulesfrom the quarter to determine the proper recording of cost of goods sold; itconducted a reconciliation of inventories at customer sites to outstandingcontracts as of the quarter-end and analyzed inventory for recovery andpotential impairment; and it conducted an analysis of inventory relating topurchase orders to identify under-recorded inventory.

4.             The Company conducted a review of the processes torecord inventory reserves and a review of the manual procedures by which theCompany tracks the cost of its products.

5.             The Company conducted a variety of manual reviewprocedures, such as an extensive review of journal entry postings into theOracle system and an extensive review of account reconciliations.

6.             The Company conducted a detailed and extensivereview of the following: non-routine transactions and internal representations;financial statements, as well as certifications from decentralized locations,for accuracy; spreadsheets; and journal entries.

7.             The Company reviewed its reserves and relatedschedules and reported its findings to the Audit Committee.

***Material weakness 2 described in “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2005Form 10-K***

*Remediation Initiatives.*The Company’s failure to ensure that keymanagement fully understood the nature and potential significance of relatedparties and to ensure that a robust process for the identification of relatedparty transactions contributed to the Company’s failure to maintain effectivecontrols over the identification of and accounting for related partyrelationships and related party transactions with the Company. To remediatematerial weakness 2 described in “Management’s Report on Internal Control OverFinancial Reporting” in Item 9A of the 2005 Form 10-K, the Companyhas implemented or plans to implement the measures described below, and willcontinue to evaluate and may in the future implement additional measures.

1.             In the fourth quarter of 2005, the Company furtherexpanded the number of Company personnel required to certify to seniormanagement quarterly with respect to identification, recognition and disclosureof related party transactions for SEC reporting purposes, and revised theCompany’s internal certification process concerning identification, recognitionand disclosure of related party transactions. The listing of personnel requiredto so certify to senior management is reviewed and updated each quarter as partof the Company’s disclosure procedures.

2.             During 2006, the Company conducted periodictraining sessions with key managers and senior executives regarding the Code ofConduct, including the identification, recognition and disclosure of relatedparty transactions.

3.             The Company continued to evaluate the Company’sprocedures to ensure the identification, recognition and disclosure of relatedparty transactions.

4.             The Company provided key managers and seniorexecutives 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.

5.             During 2006, the legal department conductedtraining programs for executive management and personnel in various offices,which included training on related parties.

*Interim Measures.*Management has not yet implemented and / or testedthe effectiveness of all of the measures described. Nevertheless, managementbelieves those measures identified above as having been implemented, togetherwith the other measures undertaken by the Company described below, all of whichwere undertaken during the first three quarters of 2006 or subsequent toSeptember 30, 2006 in connection with the September 30, 2006 quarter-endreporting process are sufficient to address material weakness 2 described in “Management’sReport on Internal Control Over Financial Reporting” in Item 9A of the2005 Form 10-K. These other measures include senior executives providing newcertifications regarding related party transactions.

100

----

***Material weakness 3 described in “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2005Form 10-K***

*Remediation Initiatives.*Lack of clarity in roles and responsibilities in certainareas affecting the Company’s financial reporting structure contributed to amaterial weakness relating to the monitoring of its business unit accountingfunctions. To remediate material weakness 3 described in “Management’s Reporton Internal Control Over Financial Reporting” in Item 9A of the 2005Form 10-K, the Company has implemented or plans to implement the measuresdescribed under “—Material weaknesses described in item 1 of  “Management’s Report on Internal Control OverFinancial Reporting”—Remediation Initiatives—1. General plan for hiring andtraining of personnel” in Item 9A of the 2005 Form 10-K, as well asthose described below. The Company will continue to evaluate and may in thefuture implement additional measures.

1.             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.

2.             During the first nine months of 2006, the Companyimplemented and plans to continue to augment month and quarter-end closingprocedures to standardize its processes for financial review to ensure thatU.S. reviewers monitor financial information from decentralized locations in aconsistent manner.

3.             During the first nine months of 2006, the Company’scorporate finance department expanded and plans to continue to enhance therequired reporting package from various business units and subsidiaries inorder to ensure it has accumulated the necessary accounting, finance andoperational information to effectively analyze information required forfinancial statement preparation and footnote disclosures.

4.             In addition, in the first nine months of 2006 theCompany’s external reporting department expanded and plans to continue toimprove the documentation and review of required information associated withthe preparation of its quarterly and annual filings under the Exchange Act.

5.             In May 2006, the Company appointed a vicepresident of internal audit with relevant GAAP, audit and complianceexperience, skills and knowledge. Throughout the year, the Company expanded thesize of the internal audit group and the scope of the group’s responsibilitiesto monitor decentralized operations through reviews and audits of such businessunits, subsidiaries and locations.

6.             In the fourth quarter of 2006, the Company’sfinance department commenced an initiative to “refresh” its finance andaccounting policies and procedures. Through this initiative, which the Companyexpects will be ongoing throughout 2007 and beyond, the Company’s financialpolicies and procedures will be reviewed for completeness, accuracy andadequacy, updated and brought current, and standardized globally as necessaryand appropriate. A communication plan will also be developed to ensure “refreshed”policies and procedures are publicized and understood, and appropriateemployees are trained in their application, as necessary. The Company expectsthis initiative will form the foundation for the process to maintain and keepcurrent its finance and accounting policies and procedures on a go-forwardbasis. In addition, starting in the fourth quarter of 2006, the Companycommenced internal audits of, and in 2007 plans to continue to expand andincrease the scope of its efforts to monitor, controls at the Company’sdecentralized and remote operations globally, through reviews and audits ofemployee compliance with applicable policies and procedures at business units,subsidiaries and other locations.

*Interim Measures.*Management has not yet implemented and/or testedthe effectiveness of all the measures described above. Nevertheless, managementbelieves those measures identified above as having been implemented, togetherwith the other measures undertaken by the Company described below, all of whichwere undertaken during the first three quarters of 2006 or subsequent toSeptember 30, 2006 in connection with the September 30, 2006 quarter-endreporting process, address material weakness 3 described in “Management’sReport on Internal Control Over Financial Reporting” in Item 9A of the 2005Form 10-K. These other measures include the following:

1.             Senior financial staff in the Company’s U.S.headquarters did a thorough review of trial balances issued from decentralizedlocations.

2.             The Company utilized outside consultants, otherthan the Company’s independent registered public accounting firm, to assist theCompany’s management, working under its supervision and direction, with theSeptember 30, 2006 quarter-end review of decentralized operations.

3.             All non-routine material transactions fordecentralized locations were documented by staff in such decentralizedlocations and reviewed by senior financial staff in the Company’s U.S.headquarters.

101

----

***Material weakness 4 described in “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2005Form 10-K***

*Remediation Initiatives.*The Company’s failure to have sufficient personnelwith knowledge, experience and training in the application of GAAP commensuratewith the Company’s financial reporting requirements as well as failure toprevent or detect instances of non-compliance with established policies andprocedures or instances of non-compliance with laws and regulations contributedto a material weakness relating to the Company’s control environment. Toremediate material weakness 4 described in “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2005 Form 10-K,the Company has implemented or plans to implement the measures described under “—Materialweaknesses described in item 1 of “Management’s Report on Internal ControlOver Financial Reporting”—Remediation Initiatives—1. General plan for hiringand training of personnel” in Item 9A of the 2005 Form 10-K, as wellas those described below. The Company will continue to evaluate and may in thefuture implement additional measures.

1.             During thefirst nine months of 2006, the Company implemented and plans to continue toaugment month and quarter-end closing procedures to standardize its processesfor financial review to ensure that U.S. reviewers monitor financialinformation from decentralized locations in a consistent manner.

2.             Further,during the first nine months of 2006, the Company’s corporate financedepartment expanded and plans to continue to enhance the required reportingpackage from various business units and subsidiaries in order to ensure it hasaccumulated the necessary accounting, finance and operational information toeffectively analyze information required for financial statement preparationand footnote disclosures

3.             Inaddition, during the first nine months of 2006 the Company’s external reportingdepartment expanded and plans to continue to improve the documentation andreview of required information associated with the preparation of its quarterlyand annual filings under the Exchange Act.

4.             Duringthe second quarter of 2006, the Company launched a formal investigation at thedirection of the audit committee of the Company’s Board of Directors (“AuditCommittee”) to review alleged violations of the FCPA; refer to “*Governmental Investigations*” under Part II, Item 1, LegalProceedings,  for additional information. Throughoutthe course of this investigation, the Company has taken and plans to continueto take all appropriate actions including changes to its training, processesand procedures related to its code of business conduct and ethics, its paymentcontrols particularly in outlying regions, and its due diligence evaluation ofbusiness partnerships. Upon conclusion of this investigation, the Company willreview and, as necessary, further enhance its procedures to reduce the risk ofongoing control deficiencies in this area. In addition, in the third and fourthquarters of 2006, the Company provided training to personnel in offices invarious regions including North America, Europe, and China and, in 2007, plansto continue to provide training and expand its coverage of personnel employedin other regions and countries. In addition, the Company’s internal audit staffcommenced audits and plans to continue to expand and increase the scope of theCompany’s efforts to monitor controls at company operations globally, throughreviews and audits of employee compliance with applicable policies andprocedures at business units, subsidiaries and other locations.

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

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

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

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

102

----

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

v.             In thefirst quarter of 2007, the company implemented a new “management by objectives”system which will be used globally to capture corporate and executivemanagement goals and articulate them throughout the organization, and tocascade and align each employee’s goals to support corporate objectives. Thegoal setting, monitoring and evaluation process will incorporate capturingemployee’s training and development requirements, including training to staycurrent with the application of GAAP and the company’s code of business conductand ethics.

vi.            In thefirst quarter of 2007, the Company’s CFO, with assistance from senior financialstaff and outside consultants, reviewed and in the remainder of 2007 willcontinue to review and adapt the overall design of the Company’s financialreporting organization and structure, including the roles and responsibilitiesof each functional group within the Company.

5.             In May2006, the Company appointed a vice president of internal audit with relevantGAAP, audit and compliance experience, skills and knowledge. Throughout theyear, the Company expanded the size of the internal audit group and the scopeof the group’s responsibilities to monitor decentralized operations throughreviews and audits of such business units, subsidiaries and locations.

6.             In the fourth quarter of 2006, the Company’sfinance department commenced an initiative to “refresh” its finance andaccounting policies and procedures. Through this initiative, which the Companyexpects will be ongoing throughout 2007 and beyond, the Company’s financialpolicies and procedures will be reviewed for completeness, accuracy andadequacy, updated and brought current, and standardized globally as necessaryand appropriate. A communication plan will also be developed to ensure “refreshed”policies and procedures are publicized and understood, and appropriate employeesare trained in their application, as necessary. The Company expects thisinitiative will form the foundation for the process to maintain and keepcurrent its finance and accounting policies and procedures on a go-forwardbasis. In addition, starting in the fourth quarter of 2006, the Companycommenced internal audits of, and in 2007 plans to continue to expand andincrease the scope of its efforts to monitor, controls at the Company’sdecentralized and remote operations globally, through reviews and audits ofemployee compliance with applicable policies and procedures at business units,subsidiaries and other locations.

8.             In the first quarter of 2007, the companyimplemented a new “management by objectives” system which will be used globallyto capture corporate and executive management goals and articulate themthroughout the organization, and to cascade and align each employee’s goals tosupport corporate objectives. The goal setting, monitoring and evaluationprocess will incorporate capturing employee’s training and developmentrequirements, including training to stay current with the application of GAAPand the company’s code of business conduct and ethics.

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

*Interim Measures.*Management has not yet implemented and/or testedthe effectiveness of all the measures described above. Nevertheless, managementbelieves those measures identified above as having been implemented, togetherwith the other measures undertaken by the Company described below, all of whichwere undertaken during the first three quarters of 2006 or subsequent toSeptember 30, 2006 in connection with the September 30, 2006 quarter-endreporting process, address material weakness 4 described in “Management’sReport on Internal Control Over Financial Reporting.” These other measuresinclude the following:

1.             Senior financial staff in the Company’s U.S.headquarters performed a thorough review of trial balances issued fromdecentralized locations.

2.             The Company utilized outside consultants, otherthan the Company’s independent registered public accounting firm, to assist theCompany’s management, working under its supervision and direction, with theSeptember 30, 2006 quarter-end review of decentralized operations.

3.             Non-routine material transactions fordecentralized locations were documented by staff in such decentralizedlocations and reviewed by senior financial staff in the Company’s U.S.headquarters.

103

----

***Material weakness 5identified as of September 30, 2006, resulting from the Company’s review of itshistorical stock option practices, as described above under “Governance Committee Review of Historical StockOption Accounting”***

*Remediation Initiatives.* The Company’s planned remediation measures are intended to addressmaterial weaknesses in internal control over its accounting for and disclosureof stock-based compensation expense that have the potential of misstating thesebalances in the financial statements in future financial periods. Thesemeasures include the following:

1.             In November 2006, the Company migrated to a new vendor’s systemfor stock options and equity awards administration, selected in part for its improved processes, systems and controls.

2.             In April 2007, the Company’s compensation committee of the board ofdirectors approved an equity award grant policy and procedures (“Awards Policy”).Under this Awards Policy, the Company has adopted the following equity awardsgrant processes:

a)              Equity awards willbe made only on grant dates pre-determined in accordance with the AwardsPolicy.

b)             The awardscommittee (a committee as defined in the Awards Policy consisting of humanresources, legal and finance personnel, duly formed and authorized by thecompensation committee, with specific, limited authority to approve certaingrants of equity awards) will ensure completeness and accuracy of the finalequity awards grant list.

c)              All equity awardswill be approved monthly, at a meeting of the awards committee, thecompensation committee or the board of directors, as applicable.

d)             Internal audit willconduct periodic review of the accounting records and equity awards grantprocess.

3.             Relevant personnel atthe Company will be provided training in the equity awards granting andaccounting process.

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

5.             During 2007, the Company will update its recordretention policy to specify retention of equity award records.

*Interim Measures. *Managementhas not yet implemented and/or tested the effectiveness of all the measuresdescribed above. 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 firstthree quarters of 2006 or subsequent to September 30, 2006 in connection withthe September 30, 2006 quarter-end reporting process, address material weakness5, as described above under *“Governance CommitteeReview of Historical Stock Option Accounting.”* These other measuresinclude, as part of the voluntary review of historical stock option practices,the Governance Committee retaining independent outside counsel and forensicaccountants to review substantially all equity grant awards made in the ReviewPeriod for compliance with the various stock-based compensation accountingstandards applicable during the Review Period and, as necessary to establishalternative measurement dates for those grants where the original measurementdate was found to be in error. In addition, the accounting and reportingprocess for the consolidated financial statements for the quarter endedSeptember 30, 2006 was extended significantly, thereby allowing the Companytime to conduct additional procedures and analyses, to assess the adequacy and accuracyof reserves and actual expense results, and to make additional adjustments anddisclosures as necessary to ensure the accuracy of financial reporting.

***Material weakness 6 identified as of September 30,2006, resulting from the Company’s review of historical sales in China,as described above under “*AuditCommittee Investigation of Historical Sales in China*”***

*Remediation Initiatives.* The Company’s planned remediation measures are intended to addressmaterial weaknesses in internal control over its customer agreements and therelated revenue recognition in China that have the potential of misstating itsrevenue, deferred revenue, cost of sales and deferred cost accounts, relatedincome tax accounts, retained earnings and related financial disclosures in thefinancial statements in future financial periods. These measures include thefollowing:

1.             In the period fromJanuary to May, 2007, the Company effected personnel changes in the sales forcein China’s western sales region, as well as certain associated sales offices.The Company believes that these changes will enable effective management of theChina western sales region’s sales operations and enhance compliance with theCompany’s policies and procedures, including the Company’s Code of BusinessConduct and Ethics.

104

----

2.             The Company plans torevise its  policies and proceduresrelated to entering into sales contracts, document retention, as well the Codeof Business Conduct and Ethics to provide for details around the standards forentering into sales agreements and breaches to the Code of Business Conduct andEthics.

3.             The Company plans toimplement mandatory training to employees in China’s sales organization aroundcontrol consciousness and ongoing training to Sales, Contract Management andFinance in China around the Company’s policies and procedures, includingrevenue recognition.

4.             The Company plans toreview and make improvements to the sales databases to capture relevantcontract information and current status information.

5.             The Company plans to establisha process around organizing visits by business operations and the regionalsales managers to the various sales offices in China to enhance the awarenessand compliance with the Company’s polices and procedures.

*Interim Measures.*Management has notyet implemented and/or tested the effectiveness of all the measures describedabove. Nevertheless, management believes those measures identified above ashaving been implemented, together with the other measures undertaken by theCompany described below, all of which were undertaken during the first threequarters of 2006 or subsequent to September 30, 2006 in connection with theSeptember 30, 2006 quarter-end reporting process, address material weakness 6, asdescribed above under***“**Audit Committee Investigation of Historical Salesin China.**”*** These other measures include, as part ofthe investigation of historical sales in China**,**the Audit Committee retaining independentoutside counsel and forensic accountants to conduct an investigation of salesin China. The investigation was expanded to consider sales contractsentered into in the period 2000 to 2006 in China, beyond the western region inorder to provide adequate coverage percentage of the value of sales contractsentered into during the period. The investigation encompassed different reviewprocedures depending on the contract type, date and region in which thecontracts were executed. In addition, the accounting and reporting process forthe consolidated financial statements for the quarter ended September 30, 2006was extended significantly, thereby allowing the Company time to conductadditional procedures and analyses, to assess the adequacy and accuracy of therelated balances, and to make additional adjustments and disclosures asnecessary to ensure the accuracy of financial reporting

***Material Weakness 7 identified as ofSeptember 30, 2006 related to the Company’s accounting for warranty reservesand associated cost of sales at its U.S. Headquarters***

*Remediation Initiatives.* The Company’s planned remediation measures are intended to addressmaterial weaknesses in internal control over its accounting for warrantyreserves and related cost of sales that have the potential of misstating thesebalances in the financial statements in future financial periods. Thesemeasures include the following:

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

2.             Thecompany plans in 2007 to enhance its processes and procedures related toinvolving and obtaining detailed and timely input from business unit,operations and sales operations personnel to enhance the information availablefor finance to analyze these accounts. New reports have been developed and reports and procedures will continueto be enhanced as necessary to facilitate the accuracy of accounting for theseprocesses. In addition, finance management has placed increased attention onreviewing in detail the accounting in this area.

*Interim Measures. *Management has not yet implemented and/or testedthe effectiveness of all the measures described above. Nevertheless, managementbelieves those measures identified above as having been implemented, togetherwith the other measures undertaken by the Company described below, all of whichwere undertaken during the first three quarters of 2006 or subsequent toSeptember 30, 2006 in connection with the September 30, 2006 quarter-endreporting process, address material weakness 7 related to the Company’saccounting for its warranty reserves and associated cost of sales.  These other measures include analysisof actual cost reports associated with specific warranty reserves, anddiscussions with business unit, operations and sales and services personnel toenhance the information available for finance to analyze, to determine theliability reserves for warranty and associated cost of sales.

105

----

***Management’s Conclusions***

Management believes the remediation measures describedunder “Management’s Further Remediation Initiatives and Interim Measures” abovewill strengthen the Company’s internal control over financial reporting andremediate the material weaknesses 1 through 7 listed above. However, managementhas not yet implemented all of these measures and/or tested them. Management believesthat the interim measures described under “Management’s Further RemediationInitiatives and Interim Measures” above provide reasonable assurance regardingthe reliability of financial reporting and the preparation of the Company’sfinancial statements included in this Form 10-Q and has discussed this with theCompany’s Audit Committee.

The Company is committed to continuing to improve itsinternal control processes and will continue to diligently and vigorouslyreview its disclosure controls and procedures and its internal control overfinancial reporting in order to ensure compliance with the requirements ofSection 404 of the Sarbanes-Oxley Act. However, any control system,regardless of how well designed, operated and evaluated, can provide onlyreasonable, not absolute, assurance that its objectives will be met. Asmanagement continues to evaluate and work to improve the Company’s internalcontrol over financial reporting, it may determine to take additional measuresto address control deficiencies, and it may determine not to complete certainof the measures described under “Management’s Further Remediation Initiativesand Interim Measures” above.

**Changes in Internal Control over Financial Reporting**

The discussion above under “Management’s FurtherRemediation Initiatives and Interim Measures” describes the material plannedand actual changes to the Company’s internal control over financial reportingduring the first three quarters of 2006 and subsequent to September 30, 2006that materially affect, or are reasonably likely to materially affect, theCompany’s internal control over financial reporting.

**PART II—OTHERINFORMATION**

**ITEM 1—LEGAL PROCEEDINGS**

*Securities Class Action Litigation*

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

OnJune 2, 2006, we and the individual defendants filed a motion to dismiss theSecond Amended Complaint.  On March 21,2007, the Court granted defendants’ motion and dismissed plaintiffs’ SecondAmended Complaint.  The Court grantedplaintiffs leave to file a Third Amended Complaint, which plaintiffs filed onMay 25, 2007. On July 13, 2007, we and the individual defendants filed a motionto dismiss and a motion to strike the Third Amended Complaint.

On September 4, 2007, asecond shareholder class action complaint captioned *Peter Rudolph v. UTStarcom, et al.*, Case No. C-07-4578 SI,was filed in the United States District Court for the Northern District ofCalifornia against us and some of our current and former directors andofficers. The complaint alleges violations of the Securities Exchange Act of1934 through undisclosed improper accounting practices concerning ourhistorical equity award grants. Plaintiff seeks unspecified damages on behalf of a purported class ofpurchasers of our common stock between July 24, 2002 and September 4, 2007.

106

----

Due to the preliminary status of these lawsuits and uncertaintiesrelated to litigation, we are unable to evaluate the likelihood of either afavorable or unfavorable outcome. Accordingly, we areunableat this time to estimate the effects of these complaints on ourfinancial position, results of operations, or cashflows.

*GovernmentalInvestigations*

In September 2005, we have received notice of a formalinquiry by the staff of the Securities & Exchange Commission (“SEC”) intocertain aspects of our financialdisclosures during prior reporting periods and certain other issues.  In addition, in December 2005, the U.S.Embassy in Mongolia informed us that it had forwarded to the Department ofJustice (“DOJ”) allegations that an agent of our Mongolia joint venture hadoffered payments to a Mongolian government official in possible violation ofthe Foreign Corrupt Practices Act (the “FCPA”). We, through our Audit Committee, authorized an independent investigationinto possible violations of the FCPA, and we have been in contact with the DOJand SEC regarding the investigation.  Theinvestigation has identified possible FCPA violations in Mongolia, SoutheastAsia, India, and China, as well as possible violations of U.S. immigrationlaws.  DOJ has requested that we voluntarily produce documents related to theinvestigation and the SEC has subpoenaed us for documents.  We haveexecuted tolling agreements extending the statute of limitations for the FCPAissues under investigation by the SEC and DOJ and the immigrationissues under investigation by DOJ.  At this time, we cannot predict when anyinquiry will be completed or what the outcome of any inquiry will be.

*Shareholder Litigation*

On November 17, 2006, ashareholder derivative complaint captioned *ErnestoEspinoza v. Ying Wu et al.*, Case No. RG06298775, was filed againstcertain of our current and former officers and directors in the Superior Courtof the County of Alameda, California. The complaint alleges that the individual defendants, among otherthings, breached their duties, were unjustly enriched, and violated the CaliforniaCorporations Code in connection with the timing of stock option grants.  The complaint names us as a nominal defendantand seeks unspecified monetary damages against the individual defendants andvarious forms of injunctive relief.  OnFebruary 2, 2007, we and the individual defendants filed demurrers against thecomplaint.  On April 11, 2007, theCourt sustained the individual defendants’ demurrer, overruled our demurrer,ordered the plaintiff to file an amended complaint, and ordered us to answerthe original complaint.  The plaintifffiled an amended complaint and we have filed an answer to the amended complaint.  On August 21, 2007, the individual defendantsfiled demurrers against the amended complaint. The Court sustained the individual defendants’ demurrers and ordered theplaintiff to file a second amended complaint.

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

*IPOAllocation*

On October 31, 2001, a complaint was filed in United StatesDistrict Court for the Southern District of New York against us, some of ourdirectors and officers and various underwritersfor our initial public offering. Substantially similar actions were filed concerning the initial publicofferings for more than 300 different issuers, and the cases were coordinatedas *In re Initial Public Offering SecuritiesLitigation*, 21 MC 92 for pretrial purposes.  In April 2002, a consolidated amendedcomplaint was filed in the matter against us, captioned *In re UTStarcom, Initial Public Offering SecuritiesLitigation*, Civil Action No. 01-CV-9604.  Plaintiffs allege violations of 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 February 19, 2003,the Court granted in part and denied in part a motion to dismiss broughtby defendants including us.  The orderdismissed all claims against us except for a claim brought underSection 11 of the Securities Act of 1933, which alleges that theregistration statement filed in accordance with the IPO was misleading.  In June 2004, a stipulation ofsettlement and release of claims against the issuer defendants, including us, wassubmitted to the court for approval.  Theterms of the settlement, if approved, would have dismissed and released allclaims against the participating defendants (including us).  In August 2005, the Court preliminarilyapproved the settlement.  In December2006, the Court of Appeals for the Second Circuit reversed the Court’s October2004 order certifying a class in six test cases that were selected by theunderwriter defendants and plaintiffs in the coordinated proceedings.  Our case isnot one of the test cases. Because class certification was a condition of thesettlement, it was unlikely that the settlement would receive final Courtapproval.  On June 25, 2007, the Courtentered an order terminating the proposed settlement based on a stipulationamong the parties to the settlement. Plaintiffs have filed amended master allegations and amended complaintsin the six test cases.  It is unclearwhether there will be any revised or future settlement.  If the litigation proceeds, we believe thatwe have meritorious defenses and intend to defend the action vigorously.  

107

----

Thetotal 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 the litigation.

*Passave Litigation*

In November 2005, we filed suit in the Superior Courtof California, County of Santa Clara, against Passave, Inc. (“Passave”) forbreaches of contract and warranties in connection with a semiconductor devicesold by Passave, Ltd. (Passave’s wholly-­owned subsidiary) to us. Our Complaint alleges that the Passave device, known as the PAS5001M3chip, has exhibited certain operational malfunctions within some of ourFiber-to-the-Home product line, and has thereby caused damage to us.  The parties entered into a settlementagreement, dated August 7, 2007, and have since dismissed all claims withprejudice.

*UTStarcom, Inc. v. Starent Patent InfringementLitigations*

We brought suit against Starent Networks Corporation (“Starent”)for patent infringement in the U.S. District Court for the Northern District ofCalifornia.  The Complaint was filed onMarch 22, 2004, and later amended.  Inthis action, we asserted that Starent infringed our patent U. S. Reg. No.6,628,671 through the manufacture, use, offer, for sale, and sale of Starent’sST-16 Intelligent Mobile Gateway.  Wesought damages and injunctive relief. Starent filed its answer to the Amended Complaint and counterclaims,denying our allegations and seeking a declaration that the patent-in-suit isnot infringed, is invalid, and is unenforceable.  A motion for a preliminary injunction againstthe making, using or selling of infringing products and methods was brought,but the Court denied it on June 17, 2005. After a claims construction hearing and order, on September 20, 2005,Starent filed a motion for summary judgment of non-infringement and we filed amotion for summary judgment that Starent is estopped from asserting invalidityand unenforceability.  On December 6,2005, the Court granted Starent’s motion for summary judgment.  On February 2, 2006, the Court enteredjudgment in favor of Starent and dismissed the case.  On March 2, 2006 we filed an appeal to theFederal Circuit.  On April 6, 2007, afterreviewing the parties’ briefs and hearing oral argument on April 2, 2007, theFederal Circuit, without a written opinion, affirmed the District Court’sjudgment and dismissal of the case. Althoughthe Federal Circuit ruled against the Company, this decision will not have amaterial adverse effect on the business, financial condition, or results of itsoperations.

On February 16, 2005, we filed a second suit againstStarent for patent infringement in the U.S. District Court for the NorthernDistrict of California.  In theComplaint, we assert that Starent infringes UTStarcom patent U.S. Reg. No.  6,829,473 (“the ‘473 patent”) through Starent’sdevelopment and testing of a software upgrade for its customer’s installedST-16 Intelligent Mobile Gateways.  Weseek declaratory and injunctive relief. Starent subsequently filed its answer and counterclaims, denying ourallegations and seeking a declaration that the patent-in-suit is not infringed,is invalid, and is unenforceable.  OnJune 16, 2005, we filed a motion to strike Starent’s affirmative defense anddismiss Starent’s counterclaim alleging inequitable conduct.  On July 19, 2005, the parties stipulated thatStarent would file an amended answer and counterclaim by July 27, 2005 and thatwe would withdraw our motion to strike. On August 10, 2005, we responded to Starent’s amended counterclaim filedon July 27, 2005.  In early December 2006, we filed a reissueapplication for the ‘473 patent with the United States Patent and TrademarkOffice.  Starent has also filed forreexamination of the ‘473 patent.  Thereexamination and reissue are currently copending.  The litigation is still in a preliminarystage and its outcome cannot be predicted, although we believe the litigationhas merit.  Nonetheless, we believe thatany adverse judgment on Starent’s counterclaims will not have a materialadverse effect on our business, financial condition, or results of operations.

On May 8, 2007, wefiled an third suit against Starent and sixteen individual defendants (who wereall former employees of 3Com’s CommWorks division which we acquired certainassets of in May of 2003) in the Northern District of Illinois.  The causes of action include claims forpatent infringement, misappropriation of trade secrets, intentionalinterference with business relations and prospective economic advantage anddeclarations of ownership of certain patent rights.  In its Complaint, we assert that Starentinfringes UTStarcom patents U. S. Reg. Nos. 7,173,905; 6,978,128; 6,963,582;6,975,900; and 6,684,256 through the manufacture, use, offer, for sale, andsale of Starent’s ST16 Intelligent Mobile Gateway and ST40 multimedia codeplatform, that the individual Defendants and Starent have misappropriatedvaluable Company trade secrets by improperly taking and using  our confidential and proprietary informationfor the benefit of Starent, that the individual defendants and Starent haveinterfered with our business relations and prospective economic advantage byusing the misappropriated information to obtain and enhance sales of Starent’sproducts, and that several of Starent’s patent applications and one issuedpatent are based on information obtained by the former employees while at theCompany (CommWorks) and on that basis belong to UTStarcom.  We seek compensatory damages, punitivedamages and injunctive relief.  After thecourt denied the defendants motion to dismiss the misappropriation of tradesecrets claims, on August 30, 2007, Starentanswered our complaint, denying our allegations and asserting a number ofaffirmative defenses and counterclaims, including non-infringement of thesubject patents and alleged tortious interference with prospective economicadvantage.  We have filed a motion todismiss most of the counterclaims and the court has ordered appointment of aspecial 

108

----

master to handlediscovery, which is just beginning.  Webelieve that any adverse judgment on Starent’s counterclaims will not have amaterial adverse effect on our business, financial condition or results ofoperations.

*Telemetrix, Inc. Arbitration*

On October 19, 2006, Telemetrix,Inc. (“Telemetrix”) filed a formal Request for Arbitration against us to theWorld Intellectual Property Organization (“WIPO”) in Geneva, Switzerland.  The Request for Arbitration sought unspecified damages arising from a contractbetween Telemetrix and Telos Technology, Inc., dated October 22, 2003.  We assumed Telos’ rights and obligationsunder this contract pursuant to ourpurchaseof Telos’ assets on May 19, 2004. Telemetrix alleged nine causes of action, including breach of contract,fraud, negligent misrepresentation, interference with contractual relations,and interference with prospective economic advantage.  In December 2006, we filed a formal responseto the Request for Arbitration, denying all material factual allegationsasserted by Telemetrix.  An arbitrator was selected by the parties, and, on August 2, 2007, the arbitrator granted a pleading motion in favor of usdue to Telemetrix’s failure to allege sufficient facts in support of a majorityof its causes of action.  On August 17,2007, Telemetrix filed an Amended Statement of Claim, alleging six causes ofaction, including breach of contract, fraud, interference with contractualrelations and interference with prospective economic advantage.  The previous hearing date of December 11-13has been vacated.  No hearing date hasbeen rescheduled.  Discovery has begun.

**Telos Technology, Inc. Litigation**

OnNovember 22, 2005, plaintiffs Telos Technology, Inc., TelosTechnology (Canada), Inc., Telos Technology (Bermuda) Ltd., and TelosEngineering Limited (collectively, the “Telos Plaintiffs”) filed a Complaintagainst the Company in the Superior Court of California, County of SantaClara.  The Complaint alleges five causesof action, including breach of contract, breach of the implied covenant of goodfaith and fair dealing, fraudulent inducement, intentional misrepresentationand negligent misrepresentation, all of which arise from the Asset PurchaseAgreement between the parties dated April 21, 2004.  The Telos Plaintiffs assert that the Companybreached the express and implied terms of the Asset Purchase Agreement and maderepresentations to the Telos Plaintiffs during negotiations that it neverintended to fulfill.  The Telos Plaintiffssought at least $19 million in damages, unspecified punitive damages andattorneys’ fees.  The parties executed asettlement agreement in the amount of $4.5 million on August 20, 2007 and thecase was dismissed on September 26, 2007 with prejudice.

*Other Litigation*

We are a party to other litigation matters and claimsthat are normal in the course of operations, and while the results of suchlitigation matters and claims cannot be predicted with certainty, we believethat the final outcome of such matters will not have a material adverse impacton our financial position or results of operations.

**ITEM 1A—RISK FACTORS**

**FACTORSAFFECTING FUTURE OPERATING RESULTS**

**FACTORS AFFECTING FUTURE OPERATING RESULTS**

**RISKS RELATED TO OUR COMPANY**

*The restatement of our consolidated financial statementsfollowing the**Nominating and CorporateGovernance Committee’s and management’s review of our past stock optiongranting practices and the Audit Committee’s and management’s review of certainsales in China has resulted in expanded litigation and regulatory proceedingsand may result in future litigation which could harm our financial results*

Our review of ourhistoric option granting practices and certain sales in China has required usto incur substantial expenses for legal, accounting, tax and other professionalservices, has diverted our management’s attention from our business, and couldin the future harm our business, financial condition, results of operations andcash flows.

The Audit Committee of our Board of Directors(“Audit Committee”) engaged independent counsel to conduct an investigation ofsales in China. The independent counsel engaged forensic accountants.The China sales investigation, which commenced in February 2007 and wascompleted in September 2007, covered each of the seven years in the periodended December 31, 2006.  As a result ofthe review, management concluded and recommended to the Audit Committee thatour previously issued financial statements should be restated to defer the systemsales contract revenue and the related cost of net sales for certain salesarrangements in one region of China found to contain post-contract supportobligations and recognize such amounts in our consolidated statements ofoperations over the estimated period of post-contract support. The AuditCommittee concurred with management’s recommendation.

109

----

In November 2006we announced that the Nominating and Corporate Governance Committee of ourBoard of Directors (“Governance Committee”), comprised of independentdirectors, was conducting a voluntary review, with the assistance ofindependent legal counsel and forensic accounting experts (the “Option GrantReview Team”), of our historic option granting practices, the timing of optiongrants and related accounting matters. The review considered all optiongrant awards made in the period from February 29, 2000, shortly before theinitial public offering of our Common Stock, through August 2006 for compliancewith the various stock-based compensation accounting standards applicable aswell as the rules of our stock option plans. Upon completion of the review,management concluded the adjustments to correct errors in stock optionaccounting in our previously issued financial statements for the years endedDecember 31, 1998 and 2000 through 2005, and the quarterly periods of 2005, aswell as in the quarterly periods ended March 31 and June 30, 2006 that arereflected in our consolidated financial statements included in Exhibit 99.1 inour Annual Report on Form 10-K for the year ended December 31, 2006 should bemade.

In determining therestatement adjustments in connection with the review of our historical optiongranting practices, management used all reasonably available relevantinformation to form conclusions it believes are reasonable as to the most likelyoption granting actions that occurred, the dates when such actions occurred,and the determination of grant dates for financial accounting purposes based onwhen the requirements of the accounting standards were met. The Option GrantReview Team and management considered various alternatives throughout thecourse of the review and restatement; management believes the  adjustments to measurement dates used in ourrestatement of our financial statements are reasonable and appropriate in ourcircumstances.

Our restatement ofpreviously issued financial statements to correct revenue recognition forcertain sales in China and for the effects of past stock options grantingpractices has exposed us to greater risks associated with litigation andregulatory proceedings. We have voluntarily provided information about theconduct of our independent investigation and review, the findings of thereviews, and our conclusions to the staff of the Securities and ExchangeCommission (“SEC”), and are cooperating, and will continue to cooperate fullywith the SEC. In addition, as described in Part II, Item 1, “LegalProceedings,” of this Form 10-Q, several derivative complaints have been filedagainst certain of our current and formerofficers and directors pertaining to allegations relating to stockoption grants. However, our judgments may be challenged in legal proceedings orregulatory reviews, and we could be subject to adverse findings that couldrequire us to again restate our financial statements, to pay damages or penalties,or have other remedies imposed upon us that could harm our business, financialcondition, results of operations and cash flows.  We may also be exposed to legal proceedingsin connection with the results of our investigation of certain sales in China.  We cannot guarantee that new lawsuits relatedto the matters resulting in the restatements will not be filed, and we cannotpredict the outcome of any current or potential future litigation or regulatoryproceeding against the Company or our current and former directors or officers.

*The matters relating to the Audit Committee’s investigationof revenue recognition in China, the Governance Committee’s review of our paststock option granting practice, and the restatement of our consolidatedfinancial statements may otherwise adversely impact our business.*

As a result of ourdelayed filing of our Quarterly Reports on Form 10-Q for the quarters endedSeptember 30, 2006, March 31, 2007 and June 30, 2007, as well as our Form 10-Kfor the fiscal year ended December 31, 2006, we will be ineligible to registerour securities on Form S-3 for sale by us or resale by others until we havebeen current in our SEC filings for 12 calendar months.  We may use Form S-1 to raise capital, butdoing so could increase transaction costs and the time required to completesuch transactions.

Employees who wereawarded options at a discount from fair market value and were totally orpartially unvested as of December 31, 2004, may be subject to a penaltytax under Internal Revenue Code Section 409A (“Section 409A”) andcorresponding states taxes upon exercise of these stock options. We areconsidering certain actions, which we believe would be in the best interests ofour stockholders and employees that might substantially reduce or eliminate thefederal and state penalty taxes. However, there is no guarantee that we will besuccessful in developing effective measures to address employees’ adverse taxconsequences, and any such measures may cause us to incur additional cash ornoncash compensation expense. Furthermore, such measures, or the failure ofsuch measures, may require the Company to incur substantial expenses for legal,accounting, tax and other professional services and may divert management’sattention from our business, which could in the future harm our business,financial condition, results of operations and cash flows.

110

----

*Our future product sales are unpredictable and, as aresult, our operating results are likely to fluctuate from quarter to quarter.*

Our quarterly and annual operating results havefluctuated in the past and are likely to fluctuate in the future due to avariety of factors, some of which are outside of our control.  Factors that may affect our future operatingresults include:

·             the timing and size of the orders for ourproducts;

·             consumer acceptance of new products we mayintroduce to market;

·             changes in the growth rate of customer purchasesof communications services;

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

·             revenue recognition, which is based primarily oncustomer acceptance of delivered products, is unpredictable;

·             cancellation, deferment or delay in implementationof large contracts;

·             quality issues resulting from the design ormanufacture of the products, or from the software used in the product;

·             cash collection cycles in China and other emergingmarkets;

·             reliance on product, software and componentsuppliers who may constitute a sole source of supply or may have going concernissues;

·             the decline in business activity we typicallyexperience during the Chinese Lunar New Year, which leads to decreased salesand collections during our first fiscal quarter;

·             issues that might arise from the integration ofacquired entities or the inability to achieve expected results from suchacquisitions; and

·             shifts in our product mix or market focus.

As a result of these and other factors, period-to-periodcomparisons of our operating results are not necessarily meaningful orindicative of future performance.  In addition,the factors noted above may make it difficult for us to forecast and provide ina timely manner public guidance (including updates to prior guidance) relatedto our projected financial performance. Furthermore, it is possible that in some future quarters our operatingresults will fall below the expectations of securities analysts orinvestors.  If this occurs, the tradingprice of our common stock could decline.

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

We have experienced intense competition in the pastyears, and we believe that we will continue to face intense competition fromboth domestic and international companies in our target markets, many of whichmay operate under lower cost structures or may be given preferential treatmentby applicable governmental regulators and policies and have much larger salesforces than we do.  Additionally, othercompanies not presently offering competing products may also enter our targetmarkets.  Many of our competitors havesignificantly greater financial, technical, product development, sales,marketing and other resources than we do. As a result, our competitors may be able to respond more quickly to newor emerging technologies and changes in service provider requirements.  Our competitors may also be able to devotegreater resources than we can to the development, promotion and sale of newproducts.  These competitors may be ableto offer significant financing arrangements to service providers, which maygive them a competitive advantage in selling systems to service providers withlimited financial resources.  In many ofthe developing markets in which we operate or intend to operate, relationshipswith local governmental telecommunications agencies are important to establishand maintain.  In many such markets, ourcompetitors may have or be able to establish better relationships with localgovernmental telecommunications agencies than we have, which could result intheir ability to influence governmental policy formation and interpretation totheir advantage.  Additionally, ourcompetitors might have better relationships with their third party suppliersand obtain component parts at a reduced rate, allowing them to offer their endproducts at reduced prices.  Moreover,the telecommunications and data transmission industries have experiencedsignificant consolidation, and we expect this trend to continue.  If we have fewer significant customers, wemay be more reliant on such large customers and our bargaining position andprofit margins may suffer.  Increasedcompetition is likely to result in price reductions, reduced gross profit as apercentage of net sales and loss of market share, any one of which couldmaterially harm our business, cash flows and financial condition, includingpotential impairment in value of our tangible and intangible assets andgoodwill if extended losses were incurred.

111

----

*We have**incurred net losses in the past and will need to renew our lines ofcredit in China, refinance our convertible subordinated notes, and transfercash from our subsidiaries in China to have sufficient cash resources andliquidity. Our ability to accomplish these actions is not assured, and ourability to raise funds for other purposes is uncertain.*

At September 30, 2006, we had cash and short-term investments of $616.7million to meet our liquidity requirements of which $455.4 million was held byour subsidiaries in China. China imposes currency exchange controls ontransfers of funds outside of China; such controls limit transfers ofapproximately $200 million of our net assets outside of China without firstobtaining the consent of the Chinese government. While we believed the Chinasubsidiaries could freely transfer at least $200 million as of September 30,2006, the amount of cash available for transfer from the China subsidiaries islimited both by the liquidity needs of the subsidiaries in China and by theChinese government requirements that the China subsidiaries retain adequatecapital levels in China to protect creditors and to have funds available formandated employee benefits. Additionally, available credit facilities in China at September 30, 2006totaled $789.5 million, of which $498.5 million was available for workingcapital purposes and $291.0 million was available for use in support of lettersof credit and corporate guarantees. These credit facilities expire principallyin November and December 2007, and we had borrowed $105.0 million at September30, 2006 under the working capital portion of the available credit lines andsuch borrowings increased to $140.1 million at September 30, 2007. We also haveoutstanding long-term debt outside of China in the form of our convertiblesubordinated notes with a principal balance of $274.6 million that mature in March2008 (the “Notes”).

During the ninemonths ended September 30, 2007 our China subsidiaries have made transfers offunds out of China to the Company totaling $150 million.  Although we believe the Company now hassufficient amount of cash resources to finance the Company’s anticipatedworking capital and capital expenditure requirements for the next 12 months,  we do not have enough cash outside of Chinato repay the convertible notes maturing in March 2008, and we expect our recentfinancial performance and financial positionwill cause the lenders to reduce the total available credit facilities when wenegotiate renewals of the lines of credit in China in late 2007.  Management’s liquidity plans include apartial or complete refinancing of the convertible notes, renewal of the linesof credit in China, transfers of additional cash from its subsidiaries in Chinato the extent necessary, and, if needed, liquidation of certain investmentsand/or seeking new financing arrangements. In addition, it may be necessary for us to make significant changes toour business plan to maintain adequate liquidity for at least the next 12months in the event of various matters, such as:

·                  changes in financial market conditions or ourbusiness condition that could limit our access to existing credit facilities ormake planned re-financings more costly or even unfeasible;

·                  changes in China’s currency exchange controlregulations that could limit our ability to access cash in China to meetliquidity requirements outside of China; and

·                  inability to achieve planned operating resultsthat could increase liquidity requirements beyond those considered in ourfinancial plans.

We may desire to raise additional funds for purposes notpresently included in our financial plans such as to develop new or enhancedproducts, respond to competitive pressures, take advantage of acquisitionopportunities or raise capital for strategic purposes. There is no assurancethat additional financing for these or other purposes would be available onacceptable terms or at all. If we raise additional funds through the issuanceof equity securities, our stockholders will experience dilution of theirownership interest, and the newly issued securities may have rights superior tothose of common stock.  If we raiseadditional funds by issuing debt, our ability to meet our debt serviceobligations will be dependent upon our future performance, which will besubject to financial, business and other factors affecting our operations, manyof which are beyond our control, we may be subject to limitations on ouroperations, and our leverage may increase. The degree to which we are leveraged could materially and adverselyaffect our ability to obtain financing for working capital, acquisitions orother purposes and could make us more vulnerable to industry downturns andcompetitive pressures.

*Our ability to meet our obligations under the terms ofour outstanding convertible notes and to continue operations may be compromisedif we are unable to transfer funds from our China operations as needed.*

Duringthe nine months ended September 30, 2007 our China subsidiaries have madetransfers of funds out of China to the Company totaling $150 million.  Although we believe the Company now hassufficient amount of cash resources to finance the Company’s anticipatedworking capital and capital expenditure requirements for the next 12 monthswe do not have enough cash outside ofChina to also repay the convertible notes, aggregating $274.6 million and maturing onMarch 1, 2008

112

----

Because we are limited by the Chinesegovernment’s imposition of currency controls on transfer of funds outside ofChina, it may be time-consuming, difficult and /or expensive for us to transferfunds from China to repay the Notes.  Asa result, if an Event of Default on the Notes were to occur, we may not havesufficient cash resources to repay the Note and to continue operations without seeking new financing arrangements.  We cannot be certain that additionalfinancing for these purposes would be available on acceptable terms or at all,and if such financing is not available, our business could be seriouslyharmed.  See the risk factorentitled “*We face a variety of risks relatedto our convertible subordinated notes”*for a further description ofour obligations under the Notes, our recent consent solicitation of thenoteholders and our compliance with certain covenants under the Indenture.

*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, politicaland social events, and the performance of our senior management team  in China.*

Approximately $785.5 million, or 32%,$870.6 million, or 30%, and $2,028.2 million, or 79%, of our netsales for fiscal years 2006, 2005 and 2004, respectively, occurred in China.  While we have expanded into other markets, wehave made substantial investments in China and, therefore, our business,financial condition and results of operations are to a significant degreesubject to economic, political, legal and social developments and other eventsin China.  In addition, we have hadsignificant changes within our senior management team in China recently, andour current senior management team as a whole does not have the same degree ofexperience in China as our senior management team had in the past. (See therisk factor entitled “*Our success isdependent on continuing to hire and retain qualified personnel, including forsenior management positions, and if we are not successful in attracting andretaining these personnel and in managing key employee turnover, our businesswill suffer”)*.  If our currentsenior management in China cannot maintain and /or establish key relationshipswith customers, governmental entities and others in China, our business inChina may decline significantly. If our business in China declines, ourfinancial condition and results of operations may be significantly harmed.

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

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

·             increased competition;

·             aggressive price reductions by competitors;

·             rapid technological change; and

·             constant change in customer buying behavior andmarket trends.

The average selling prices of our products may continueto decrease in the future in response to product introductions by us or ourcompetitors or other factors, including price pressures from customers.  Certain of our products, including wirelesshandsets, have historically had low gross profit margins, and any furtherdeterioration of our profit margins on such products could result in losseswith respect to such products. Therefore, we must continue to develop, source and introduce newproducts and enhancements to existing products that incorporate features thatcan be sold at higher average selling prices. Failure to do so or the failure of consumers or our direct customers toaccept such new products could cause our revenues and gross profit to decline.

Our cost reduction efforts initiated in 2005 and oursubsequent efforts in the second half of 2007 and early 2008 may not allow usto keep pace with competitive pricing pressures or lead to improved grossprofit, 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 successful in these efforts orin delivering our products to market in a timely manner.  In addition, any redesign may not result insufficient cost reductions to allow us to reduce the prices of our products toremain competitive or to improve or maintain our gross profit, as a percentageof net sales, which would cause our financial results to suffer.

113

----

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

The market for communications equipment is characterizedby rapid technological developments, frequent new product introductions,changes in consumer preferences and evolving industry and regulatorystandards.  Our success will depend inlarge part on our ability to enhance our technologies and develop and introducenew products and product enhancements that anticipate changing service providerrequirements, technological developments and evolving consumerpreferences.  We may need to makesubstantial capital expenditures and incur significant research and developmentcosts to develop and introduce new products and enhancements.  If we fail to develop and introduce newproducts or enhancements to existing products that effectively respond totechnological change on a timely basis, our business, financial condition andresults of operations could be materially adversely affected.  Certain of our products, including wirelesshandsets, have a short product life. Moreover, from time to time, our competitors or we may announce newproducts or product enhancements, technologies or services that have thepotential to replace or shorten the life cycles of our products and that maycause customers to defer purchasing our existing products, resulting in chargesfor inventory obsolescence reserves. Future technological advances in the communications industry maydiminish or inhibit market acceptance of our existing or future products orrender our products obsolete.  Even if weare able to develop and introduce new products, they may not gain marketacceptance.  Market acceptance of ourproducts will depend on various factors, including:

·             our ability to obtain necessary approvals fromregulatory organizations within the countries in which we operate and for anynew technologies that we introduce;

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

·             the compatibility of our products with legacytechnologies and standards existing in previously deployed network equipment;

·             our ability to attract customers who may havepre-existing relationships with our competitors;

·             product pricing relative to performance;

·             the level of customer service available to supportnew products; and

·             the timing of new product introductions meetingdemand patterns.

If our products fail to obtain market acceptance in atimely manner, our business and results of operations could suffer.

*We depend on some sole source and key suppliers forhandsets, base stations, components and materials 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.*

We have contracts with a limited group of suppliers topurchase some components and materials used in our products.  If any supplier is unwilling or unable toprovide us with high-quality components and materials in the quantitiesrequired and at the costs specified by us, we may not be able to findalternative sources on favorable terms, in a timely manner, or at all.  Further, a supplier could market its productsdirectly to our customers.  Thepossibility of a supplier marketing its own products would create directcompetition and may affect our ability to obtain adequate supplies.  Our inability to obtain or to develop alternativesources if and as required could result in delays or reductions inmanufacturing or product shipments.  Fromtime to time, there could be shortages of certain products or components.  Moreover, our suppliers may supply us withinferior quality products.  If aninferior product supplied by a third party is embedded in our end product andcauses a problem, it might be difficult to identify the source of the problemas being due to the component parts.  Ifany of these events occur, our competitive position, reputation and businesscould suffer.

Our ability to source a sufficient quantity ofhigh-quality, cost-effective components used in our products may also belimited by import restrictions and duties in the foreign countries in which wemanufacture our products.  We require asignificant number of imported components to manufacture our products, andimported electronic components and other imported goods used in the operationof our business may be limited by a variety of permit requirements, approvalprocedures, patent infringement claims, import duties and licensingrequirements.  As an example, a recentcourt case between a third party and one of our suppliers involved a patentdispute potentially restricting the importation of handsets into the U.S.  While this case has been resolved in thesupplier’s favor at the trial court level, our supply of products could beaffected by similar cases in the future. Moreover, import duties on such components increase the cost of ourproducts and may make them less competitive.

114

----

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

Many of our products are highly complex and may have qualitydeficiencies resulting from the design or manufacture of such product, or fromthe software or components used in the product. For example, during 2005 we recorded warranty charges of$70.6 million, including special warranty charges of $11.7 million forcertain asynchronous digital subscriber line (“ADSL”) products,$4.0 million for NetRingTM equipment and $14.9 million for GEPONequipment sold to SBBC, an affiliate of SOFTBANK CORP and SOFTBANKAmerica 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 may identify the qualityissues after the shipment of products. In such cases, we may incur unexpected expenses and diversion ofresources to replace defective products 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.  In addition, we may be required to paydamages for failed performance under certain customer contracts, and mayreceive claims from customers related to the performance of our products.  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.  In addition, we may be required to paydamages for failed performance under certain customer contracts and may receiveclaims from customers related to the performance of our products.

*Our global diversification strategy and growth hasstrained our resources, adversely affected our reported gross margins, and ifwe are unable to manage this growth, our future operating results will befurther negatively affected.*

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

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

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

·             enhancing management information systems,including forecasting procedures;

·             further developing our operating, administrative,financial 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 and improvingemployee hiring and training programs;

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

·             improving and sustaining our supply chaincapability; and

·             managing both our direct and indirect saleschannels in a cost-efficient and competitive manner.

115

----

If we fail to implement or improve systems or controls orto manage any future growth and transformation effectively, our business couldsuffer.

*Any failure by us to execute planned cost reductionssuccessfully could result in total costs and expenses that are greater thanexpected.*

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

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

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

Notwithstanding our workforce restructurings, to effectivelymanage our operations, we will need to recruit, train, assimilate, motivate andretain qualified employees both locally and internationally.  Competition for qualified employees isintense, and the process of recruiting personnel in all fields, includingtechnology, research and development, sales and marketing, administration andmanagement with the combination of skills and attributes required to executeour business strategy can be difficult, time-consuming and expensive.  As we grow globally, we must implement hiringand training processes that are capable of quickly deploying qualified localresidents to knowledgeably support our products and services.  Alternatively, if there is an insufficientnumber of qualified local residents available, we might incur substantial costsimporting expatriates to service new global markets.  For example, we have historically experienceddifficulty finding qualified accounting personnel knowledgeable in both U.S.and Chinese accounting standards who are Chinese residents.  If we fail to attract, hire, assimilate orretain qualified personnel, our business would be harmed.  Competitors and others have in the past, andmay in the future, attempt to recruit our employees.  In addition, companies in the telecommunicationsindustry whose employees accept positions with competitors frequently claimthat the competitors have engaged in unfair hiring practices.  We may be the subject of these types ofclaims in the future as we seek to hire qualified personnel.  Some of these claims may result in materiallitigation and disruption to our operations. We could incur substantial costs in defending ourselves against theseclaims, regardless of their merit.

*Any acquisitions and divestitures that we undertakecould be difficult to integrate, disrupt our business, dilute our stockholdersand harm our operating results.*

We have acquired and divested certain businesses,products and technologies.  Anticipatedbenefits of these acquisitions and divestitures may not be realized.  We have in the past and will continue toevaluate acquisition prospects that would complement our existing productofferings, augment our market coverage, enhance our technological capabilities,or that may otherwise offer growth opportunities.  Acquisitions may result in dilutive issuancesof equity securities, use of our cash resources, the incurrence of debt and theamortization of expenses related to intangible assets.  In addition, acquisitions involve 

116

----

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 Hyundai Syscomm, Inc. (“HSI”) legacyoperations into our operations and determined to abandon a substantial amountof HSI’s legacy operations.  As a result,in the fourth quarter 2004, we wrote off the entire goodwill and intangiblesassociated with HSI.

*We may be unable to adequately protect the loss ormisappropriation of our intellectual property, which could substantially harmour business.*

We rely on a combination of patents, copyrights, trademarks,trade secret laws and contractual obligations to protect our technology.  We have applied for patents in the UnitedStates and internationally.  Additionalpatents may not be issued from our pending patent applications, and our issuedpatents may not be upheld.  In addition,we have, from time to time, chosen to abandon previously filed patent andtrademark applications.  Moreover, we mayface difficulties in registering our existing trademarks in new jurisdictionsin which we operate, and we may be forced to abandon or change product orservice trademarks because of the unavailability of our existing trademarks orbecause of oppositions filed or legal challenges to our trademark filings.  We cannot guarantee that the intellectualproperty protection 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 legalsystems of many foreign countries do not protect or honor intellectual propertyrights to the same extent as the legal system of the United States.  For example, in China, the legal system ingeneral, and the intellectual property regime in particular, are still in thedevelopment stage.  It may be verydifficult, time-consuming and costly for us to attempt to enforce ourintellectual property rights in these jurisdictions.

*We may be subject to claims that we infringe theintellectual property rights of others, which could substantially harm ourbusiness.*

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

We have been and may in the future become subject tolitigation to defend against claimed infringements of the rights of others orto determine the scope and validity of the proprietary rights of others.  Future litigation may also be necessary toenforce and protect our patents, trade secrets and other intellectual propertyrights.  Any intellectual propertylitigation or threatened intellectual property litigation could be costly, andadverse determinations or settlements could result in the loss of our proprietaryrights, subject us to significant liabilities, require us to seek licenses fromor pay royalties to third parties which may not be available on commerciallyreasonable terms, if at all, and/or prevent us from manufacturing or sellingour products, which could cause disruptions to our operations.

In the event that there is a successful claim ofinfringement against us and we fail to develop non-infringing technology orlicense the proprietary rights on commercially reasonable terms and conditions,our business, results of operations and financial condition could be materiallyand adversely impacted.

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

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

·             the burden of complying with a variety of foreignlaws and regulations;

117

----

·             the burden of complying with United States lawsand regulations for foreign operations, including the Foreign Corrupt PracticesAct;

·             difficulty complying with continually evolving andchanging global product and communications standards and regulations for bothour end products and their component technology;

·             market acceptance of our new products, includinglonger product acceptance periods in new markets into which we enter;

·             reliance on local original equipment manufacturers(“OEMs”), third party distributors and agents to effectively market and sellour products;

·             unusual contract terms required by customers indeveloping markets;

·             changes in local governmental control or influenceover our customers;

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

·             the burden of compliance with complex and varyingtaxation requirements of multiple jurisdictions;

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

·             reduced protection for intellectual propertyrights in some countries;

·             unproven business operation models developed oroperated in specific countries or regions;

·             longer accounts receivable collection periods; and

·             difficulties and costs of staffing, monitoring 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.*

Less developed markets present additional risks, such asthe following:

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

·             new and unproven markets for our products and thetelecommunications services that our products enable;

·             lack of a large, highly trained workforce;

·             difficulty in controlling local operations fromour headquarters;

·             variable ethical standards and an increasedpotential for fraud;

·             unstable political and economic environments; and

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

In particular, these factors create the potential forphysical loss of inventory and misappropriation of operating assets.  We have in the past experienced cases ofvandalism and armed theft of our equipment that had been or was being installedin the field.  If disruptions for any ofthese reasons become too severe in any particular market, it may become necessaryfor us to terminate contracts and withdraw from that market and suffer theassociated costs and lost revenue.

118

----

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

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

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

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

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

*Currency rate fluctuations and exchange controls mayadversely affect our cash flow and operating results.*

Because a significant percentage of our sales are made inforeign countries and denominated in local currency, we are exposed to marketrisk for changes in foreign exchange rates on our foreign currency denominatedaccounts and notes receivable balances. Historically, the majority of our sales have been made in China anddenominated in Renminbi.  Prior toJuly 2005, the impact of currency fluctuations of Renminbi wereinsignificant as it was fixed to the U.S. dollar.  However, in July 2005, China uncoupledthe Renminbi from the U.S. dollar and let it float in a narrow band against abasket of foreign currencies.  The moverevalued the Renminbi by 2.1% against the U.S. dollar; however, it is uncertainwhat further adjustments may be made in the future.  The Renminbi-U.S. dollar exchange rate couldfloat, and the Renminbi could appreciate relative to the U.S. dollar.  For example, the Renminbi-U.S. dollarexchange rate was 8.28 to the U.S. dollar prior to the float of the Renminbi inJuly 2005 and 7.80 Renminbi to the U.S. dollar at December 31, 2006.  Any significant revaluation of the Renminbimay materially and adversely affect our cash flows, revenues, operating resultsand financial position.

Outside of China, our primary foreign currency exposureshave related to non-dollar denominated sales and purchases in Japan, Europe andCanada.  Additionally, we have exposuresto emerging market currencies, which can have extreme currency volatility.  We have experienced material adverse impactson our results of operations from fluctuations in currency exchange rates andmay continue to do so in the future.

We may, from time to time, enter into foreign exchangeforward contracts to minimize the short-term impact of foreign currencyfluctuations on certain foreign currency receivables and payables.  Our attempts to hedge against these risks maynot be successful, resulting in an adverse impact on our results ofoperations.  Moreover, some of theforeign countries in which we do business might impose currency restrictionsthat may limit the ability of our subsidiaries and joint ventures in suchcountries to obtain and remit foreign currency necessary for the purchase ofimported components and may limit our ability to obtain and 

119

----

remit foreign currency in exchange for foreign earnings.  For example, China employs currency controlsrestricting Renminbi conversion, limiting our ability to engage in currencyhedging activities in China.  Variousforeign exchange controls may also make it difficult for us to repatriateearnings, which could have a material adverse effect on our ability to conductbusiness globally.

*Business interruptions could adversely affect ourbusiness.*

Our operations are vulnerable to interruption by fire,earthquake, power loss, telecommunications failure, external interference withour information technology systems, incidents of terrorism and other eventsbeyond our control.  For example, ourHangzhou manufacturing facility’s ability to produce sufficient products isdependent upon a continuous power supply. However, the Hangzhou facility has in the past been subject to powershortages, which has affected our ability to produce and ship sufficientproducts.  Also, our operations inAlameda, California are located in an area prone to earthquakes.  We do not have a detailed disaster recoveryplan, and the occurrence of any events like these that disrupt our businesscould harm our business and operating results.

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

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

If our contract negotiations fail or if the government ofChina otherwise delays approving contracts, we may not recover or receivepayment for this inventory.  Moreover,our insurance may not cover all losses incurred if our inventory at customersites not under contract is damaged prior to contract finalization.  If we incur a loss relating to inventory forany of the above reasons, our financial condition, cash flows, and operatingresults could be harmed.

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

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

*We have been named as a defendant in securitieslitigation and other lawsuits, as well as lawsuits in the ordinary course ofbusiness.*

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

*We face risks related to pending governmentalinquiries.*

In September 2005, we received notice of a formal inquiryby the staff of the Securities & Exchange Commission (“SEC”) intocertain aspects of our financial disclosures during prior reporting periods andcertain other issues.  In addition, inDecember 2005, the U.S. Embassy in Mongolia informed us that it hadforwarded to the Department of Justice (“DOJ”) allegations that an agent of ourMongolia joint venture had offered payments to a Mongolian government officialin possible violation of the Foreign Corrupt Practices Act (the “FCPA”).  We, through our Audit Committee, authorizedan independent investigation into possible violations of the FCPA, and we havebeen in contact with the DOJ and SEC regarding the investigation.  The investigation has identified possibleFCPA violations in Mongolia, Southeast Asia, India and China, as well aspossible violations of U.S. immigration laws. The DOJ has requested that the Company voluntarily produce documentsrelated to the investigation and the SEC has subpoenaed the Company fordocuments.  The Company has executed tolling agreements extending thestatute of limitations for the FCPA issues under investigation by the SEC andthe DOJ and the immigration issues under investigation by the DOJ.  At this time, we cannot predict when anyinquiry will be completed or what

120

----

the outcome of any inquiry will be. These inquiries could harm relationships with existing customers and ourability to obtain new customers and partners. If the SEC or the DOJ makes a determination that we have violatedfederal laws, we may face sanctions including, but not limited to, fines,disgorgement and an injunction. Additionally, such a determination by the SEC or the DOJ could adverselyaffect our business, results of operations, financial position and cash flow,and ultimately our stock price.

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

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

*Failure to achieve and maintain effective internalcontrols in accordance with Section 404 of the Sarbanes-Oxley Act of2002 could have a material adverse effect on our business and stock price.*

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

We have identified material weaknesses in our internalcontrol over financial reporting.  See “PartI Item 4 — Controls and Procedures—Management’s Report on Internal Control OverFinancial Reporting.”  As of the date ofthis quarterly report on Form 10-Q, we are still in the process ofimplementing remedial measures related to the material weaknesses identified in2004 through 2006.  If our efforts toremediate the weaknesses we identified are not successful, our business andoperating results could be harmed and the reliability of our financialstatements could be impaired, which could adversely affect our stockprice.  The requirements ofSection 404 of the Sarbanes-Oxley Act are ongoing and also apply tofuture years.  We expect that ourinternal control over financial reporting will continue to evolve as wecontinue in our efforts to transform our business.  Although we are committed to continue toimprove our internal control processes and we will continue to diligently andvigorously review our internal control over financial reporting in order toensure compliance with the Section 404 requirements, any control system,regardless of how well designed, operated and evaluated, can provide onlyreasonable, not absolute, assurance that its objectives will be met.  In addition, successful remediation of thenoted control deficiencies is dependent on the Company’s ability to hire andretain qualified personnel.  Therefore,we cannot be certain that in the future additional material weaknesses orsignificant deficiencies will not exist or otherwise be discovered.

**RISKS RELATED TO CONDUCTING BUSINESS IN CHINA**

*China’s governmental and regulatory reforms may impactour ability to do business in China.*

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

Any of the following changes in China’s political andeconomic conditions and governmental policies could have a substantial impacton our business:

·             the promulgation of new laws and regulations andthe interpretation of those laws and regulations;

121

----

·             inconsistent enforcement and application of thetelecommunications industry’s rules and regulations by the Chinese governmentbetween foreign and domestic companies;

·             the restructuring of telecommunications carriersin China, including policy making governing 3G network infrastructure andlicensing;

·             restrictions on IPTV license grants, which couldlimit the potential market for our products;

·             the introduction of measures to control inflationor stimulate growth;

·             the introduction of new guidelines for tariffs andservice rates, which affect our ability to competitively price our products andservices;

·             changes in the rate or method of taxation;

·             the imposition of laws, rules or regulationsaffecting the direct or indirect nationalization of assets controlled bynon-governmental persons or entities;

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

·             any actions that limit our ability to develop,manufacture, import or sell our products in China, or to finance and operateour business in China.

In addition to modifying the existing telecommunicationsregulatory framework, the Chinese government is currently preparing a draft ofa standard, national telecommunications law (“Telecommunications Law”) toprovide a uniform regulatory framework for the telecommunicationsindustry.  Currently a draft of the lawhas been finished and delivered to the National People’s Congress fordiscussion.  We do not yet know the finalnature or scope of the regulations that would be created if theTelecommunications Law is passed. Accordingly, we cannot predict whether it will have a positive ornegative effect on us or on some or all aspects of our business.

Under China’s current regulatory structure, thecommunications products that we offer in China must meet government andindustry standards.  In addition, anetwork access license for the equipment must be obtained.  Without a license, telecommunicationsequipment is not allowed to be connected to public telecommunications networksor sold in China.  Moreover, we mustensure that the quality of the telecommunications equipment for which we haveobtained a network access license is stable and reliable, and will notnegatively affect the quality or performance of other installed licensedproducts.

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

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

*China’s entry into the World Trade Organization andrelaxation of trade restrictions have led to increased foreign investment inChina’s telecommunications industry and may lead to increased competition inour markets which may have an adverse impact on our business.*

China’s economic environment has been changing as aresult of China’s entry, in December of 2001, into the World Trade Organization(“WTO”).  Foreign investment in thetelecommunications sector is regulated by the “Provisions on Administration ofForeign Invested Telecommunications Enterprises” promulgated by the StateCouncil in December 2001 and effective as of January 1, 2002.  The provisions brought foreign equity limitsinto conformity with China’s WTO commitments, allowing foreign investors to ownequity generally up to 49% for basic telecom services enterprises and up to 50%for value-added telecom services enterprises. Furthermore, China is gradually introducing a market oriented pricingmechanism for telecommunication services. On July 13, 2005, China’s Ministry of Information Industry (“MII”)and National Development and Reform Commission (“NDRC”) approved the launch ofplan-based pricing for fixed-line telephone service by China’s two 

122

----

fixed-line operators, China Telecom and China Netcom.  In August 2005, MII and NDRC endorsed a “Circularon the Changes in Administration of Telecom Service Pricing,” which becameeffective on October 1, 2005 and further relaxed the pricingadministration on certain telecom services.  As China gradually relaxes such legal provisions, internationaltelecommunication service vendors may seize this opportunity to adjust theirChina strategy, increasing their investment in China and converting some oftheir joint-ventures into fully-owned enterprises.

As the existing international vendors increase theirinvestment in China, and more vendors enter the China market, the competitionin the telecommunication equipment market may increase, and as a result, ourbusiness may suffer. If China’s entry into the WTO results in increasedcompetition or has a negative impact on China’s economy, our business couldsuffer. In addition, although China is increasingly according foreign companiesand foreign investment enterprises established in China the same rights andprivileges as Chinese domestic companies as a result of its admission into theWTO, special laws, administrative rules and regulations governing foreigncompanies and foreign investment enterprises in China may still place foreigncompanies at a disadvantage in relation to Chinese domestic companies and mayadversely affect our competitive position.

*Uncertainties with respect to the Chinese legal systemmay adversely affect us.*

We conduct our business in China primarily through ourwholly owned subsidiaries incorporated in China. Our subsidiaries are generallysubject to laws and regulations applicable to foreign investment in China.Accordingly, our business might be affected by China’s developing legal system.Since 1978, many new laws and regulations covering general economic mattershave been promulgated in China, and government policies and internal rulespromulgated by governmental agencies may not be published in time, or at all.As a result, we may operate our business in violation of new rules and policieswithout having any knowledge of their existence. In addition, there areuncertainties regarding the interpretation and enforcement of laws, rules andpolicies in China. Governmental authorities have broad discretion in theinterpretation and enforcement of the laws, regulations and rules. The Chineselegal system is based on written statutes, and prior court decisions havelimited precedential value. Because many laws and regulations are relativelynew and the Chinese legal system is still evolving, the interpretations of manylaws, 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 subsidiaries locatedin China are reduced or repealed, our business could suffer.*

On March 16, 2007, China’s top legislature, theNational People’s Congress, passed the China Corporate Income Tax Law (“CIT Law”).  CIT Law will be effective on January 1,2008.  Under the CIT Law, China’s dualtax system for domestic enterprises and foreign investment enterprises (“FIEs”)would be effectively replaced by a unified system.  The new law establishes a tax rate of 25% formost enterprises and a reduced tax rate of 15% for certain qualified hightechnology enterprises.

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

CIT Law targets certain industries for the reduced 15%tax rate for certain qualified high technology enterprises.    For FIEs established before thepromulgation of the new law who currently enjoy lower tax rates, any increasein their tax rates would be gradually phased in over five years.  Significant regulations regarding theinterpretation and implementation of the new tax law are still pending.  There is potential risk that our subsidiariesmay not qualify for the reduced 15% tax rate. Therefore, the new law may have an adverse impact on our future taxexpense in China.

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

123

----

*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.*

The market for PAS exceeded 96 million users as ofthe end of fiscal year 2006 and is available in most of the provincesthroughout China. We believe the PAS market has matured. For example, duringfiscal year 2005, net sales of the PAS/iPAS system and the wirelessinfrastructure market declined significantly as compared to fiscal year2004.  This decline continued throughfiscal year 2006, and the first quarter of 2007. If additional handsetcompetitors enter the market, or if competitors decide to further reducepricing, our sales of PAS handsets may be adversely impacted.

Furthermore, competition from mobile operators, such asChina Mobile and China Unicom, has increased in cities where PAS is deployed.Mobile operators offering special promotional pricing or incentives tocustomers, such as free incoming calls or free mobile-to-mobile calls, haveharmed the ability of our customers, China Telecom and China Netcom, to competeeffectively. The continued use of such incentive programs by mobile operatorsmay adversely impact China Telecom and China Netcom’s ability to increase PASsubscriptions. Due to our relationships with China Telecom and China Netcom,reduced subscription growth at these carriers may have a material adverseeffect on our pricing and harm our business 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’s media sources have widely reported that the MIImay grant 3G mobile licenses to China Telecom or China Netcom, or to both in2007. If China Telecom or China Netcom obtains 3G mobile licenses, they mayre-allocate capital expenditures to construct 3G networks, and as aconsequence, may significantly reduce capital expenditures relating to PASnetworks that utilize our existing products. In addition, it is possible thatcurrent PAS frequency bands utilized by PAS networks may be reallocated for useby 3G networks, resulting in the restriction of or shutting down of PASnetworks. If this were to occur, we could lose current and potential futurecustomers of our products, and our financial condition and results ofoperations could be significantly harmed.

*We only have trial licenses for the PAS system andhandsets in China.*

We only have trial licenses for our PAS systems andhandsets. We have applied for, but have not yet received, a final officialnetwork access license for our PAS systems and handsets. Based uponcommunication with the MII, we understand that our PAS systems and handsets areconsidered to still be in the trial period and sales of our PAS systems andhandsets may continue to be made by us during this trial period, but thatlicenses will ultimately be required. If we fail to obtain the requiredlicenses, we could be prohibited from making further sales of the unlicensedproducts, including our PAS systems and handsets, in China, which wouldsubstantially harm our business, financial condition and results of operations.The regulations implementing these requirements are not very detailed, have notbeen applied by a court and may be interpreted and enforced by regulatoryauthorities in a number of different ways. Our external legal counsel in Chinahas advised us that China’s governmental authorities may interpret or apply theregulations with respect to which licenses are required and the ability to sella product while a product is in the trial period in a manner that isinconsistent with the information received by our legal counsel in China, andeither of these conditions could have a material adverse effect on ourbusiness, financial condition and results of operations.

*Increasing centralization of purchasing decision-makingby carriers may lead to customer concentration and affect the results of ourbusiness.*

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

124

----

*Television over the internet is a new business inChina and laws regulating the business have not been fully developed and may beunpredictable. Unfavorable regulation of the industry may adversely affect ourIPTV operations in China and negatively impact our business.*

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

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

Under the measures issued by SARFT in July 2004,entities intending to engage in the IPTV operator service business shouldobtain a license from SARFT and foreign investment enterprises are prohibitedfrom engaging in the IPTV operator service business. In practice, SARFT onlygrants such licenses to state-owned companies. Since we are the technicalservice and equipment provider in this field, our business development willdepend on the cooperation of license holders and network operators. Ourbusiness may suffer if we fail to cooperate with license holders or networkoperators, or if the license holder(s) we’re cooperating with lose their licenses.

**RISKS RELATED TO OUR STOCK PERFORMANCE AND CONVERTIBLEDEBT SECURITIES**

*Our stock price is highly volatile.*

The trading price of our common stock has fluctuatedsignificantly since our initial public offering in March of 2000. Our stockprice could be subject to wide fluctuations in the future in response to manyevents or factors, including those discussed in the preceding risk factorsrelating to our operations, as well as:

·             actual or anticipated fluctuations in operatingresults, actual or anticipated gross profit as a percentage of net sales,levels of inventory, our actual or anticipated rate of growth and our actual oranticipated earnings per share;

·             changes in expectations as to future financialperformance or changes in financial estimates or buy/sell recommendations ofsecurities analysts;

·             changes in governmental regulations or policies inChina;

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

·             the operating and stock price performance of othercomparable companies; and

·             news and commentary emanating from the media,securities analysts or government bodies in China relating to us and to theindustry in general.

125

----

General market conditions and domestic or internationalmacroeconomic factors unrelated to our performance may also affect our stockprice. For these reasons, investors should not rely on recent trends to predictfuture stock prices or financial results. In addition, following periods ofvolatility in a company’s securities, securities class action litigationagainst a company is sometimes instituted. We have experienced substantialcosts and the diversion of management’s time and resources on this type oflitigation and may do so in the future.

In addition, public announcements by China Telecom, ChinaNetcom, China Mobile, and China Unicom each of which exert significantinfluence over many of our major customers in China, may contribute tovolatility in the price of our stock. The price of our stock may react to suchannouncements.

*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 ourstockholders.*

SOFTBANK CORP. and its related entities, including SOFTBANKAmerica Inc. (collectively, “SOFTBANK”), beneficially owned approximately12% of our outstanding stock as of December 31, 2006.  As a result, SOFTBANK has the ability toinfluence all matters submitted to our stockholders for approval, as well as ourmanagement and affairs. Matters that could require stockholder approvalinclude:

·             election and removal of directors;

·             our merger or consolidation with or into anotherentity; and

·             sale of all or substantially all of our assets.

This concentration of ownership may delay or prevent achange of control or discourage a potential acquirer from making a tender offeror otherwise attempting to obtain control of us, which could decrease themarket price of our common stock.

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

Other companies may seek to acquire or merge with us. Ouracquisition or merger could result in benefits to our stockholders, includingan increase in the value of our common stock. Some provisions of ourCertificate of Incorporation and Bylaws, as well as provisions of Delaware law,may discourage, 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 election ofdirectors;

·             limiting the persons who may call special meetingsof stockholders;

·             prohibiting stockholder action by written consent;

·             creating a classified board of directors pursuantto 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.

W*e**face avariety of risks related to ourconvertible subordinated notes.*

We face a variety of risks with respect to ourconvertible subordinated notes due in 2008 (“Notes”), including the following:

·             we have significantly increased our leverage as aresult of the sale of the Notes which could have an adverse impact on ourability to obtain additional financing for working capital;

126

----

·             we may be limited in our ability to purchase theNotes 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; and

·             hedging transactions related to the Notes and ourcommon stock and other transactions, as well as changes in interest rates andour creditworthiness, may affect the value of our common stock.

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

In July 2007, we sought and obtained the requisite consents from holdersof the Notes to certain amendments to the Indenture, which provide that (i) anyfailure by us to file SEC Reports with the SEC and provide copies of suchreports and certain certificates to the Trustee prior to 5:30 p.m. New YorkCity time on October 15, 2007 (the “Expiration Date”) will not cause a defaultunder the Indenture, (ii) any such failure continuing after the Expiration Datewould cause a default under the Indenture, which would be deemed to haveoccurred as of the Expiration Date, and (iii) we will pay additional intereston the Notes of (a) 6.75% annually from January 9, 2007 to and including July25, 2007, and (b) 10.0% annually from and including July 26, 2007 to the datethe Notes are paid, prepaid, converted, redeemed or otherwise cease to beoutstanding (in each case, in addition to interest of 7/8% annually, asprovided by the Indenture, without regard to any amendments). Thus, if we failto file the SEC Reports and deliver copies of such reports and certaincertificates to the Trustee on or prior to October 15, 2007, the Trustee or the25% Holders may give notice to us asserting that such failure caused a defaultunder the Indenture, which, if not cured within 60 days after the date thenotice is effective, would cause an event of default under the Indenture.  If an event of default were to occur, theTrustee or the 25% Holders would have the right to accelerate the maturity ofthe Notes and declare all unpaid principal and accrued interest on the Notesthen outstanding to be immediately due and payable, as described above. Noassurance can be given that we would be able to obtain the requisite consentsof the Holders to a further amendment to the Indenture, providing for a waiverof compliance with covenants in the Indenture relating to the filing of SECReports, on acceptable terms or at all. If an event of default under the Indenture were to occur, and thematurity of the Notes were accelerated, and all unpaid principal and accruedinterest is declared immediately due and payable, our business would beseriously harmed.  If we have notfiled the SEC Reports, our ability to raise additional capital may be limited,and specifically, we would not be able to refinance indebtedness under theNotes from the proceeds of an issuance of new convertible notes.  Inaddition, if we are able to raise capital to refinance indebtedness under theNotes by issuing new convertible notes, the terms of such notes may besignificantly less favorable than the terms of the Notes, and may cause greaterdilution to holders of our common stock.

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

As a result of our failure to timely file ourQuarterly Report on Form 10-Q for the period ended September 30, 2006 (“Q3 2006Form 10-Q”), our Annual Report on Form 10-K for the year ended December 31,2006, our Quarterly Report on Form 10-Q for the period ended March 31, 2007 (“Q12007 Form 10-Q”) and our Quarterly Report on Form 10-Q for the period endedJune 30, 2007 (“Q2 2007 Form 10-Q”), we have not been in full compliance withNASDAQ Marketplace Rule 4310(c)(14), which requires us to make, on a timelybasis, all filings with the Securities and Exchange Commission required by theSecurities Exchange Act of 1934. Although we have now filed this Q3 2006 10-Q and our Form 10-K, we havenot yet filed our Q1 2007 Form 10-Q and Q2 2007 Form 10-Q and thus continue notto be in full compliance with this rule. We are required to comply with NASDAQMarketplace Rule 4310(c)(14) as a condition for our common stock to continue tobe listed on the NASDAQ Stock Market.

127

----

In connection with our failure to timely file ourperiodic reports, we received four NASDAQ Staff Determination letters, datedNovember 15, 2006, March 7, 2007, May 16, 2007 and August 13, 2007,respectively, stating that, as a result of each of these non-timely filings, wewere not in compliance with the requirements of Marketplace Rule 4310(c)(14)and, therefore, that our stock was subject to delisting from the NASDAQ StockMarket. We appealed the November 15, 2006 determination to the Nasdaq ListingQualifications Panels (the “Panel”) and were granted a conditional extension toour request for continued listing until April 16, 2007. On April 17, 2007 thePanel extended the deadline for filing our Q3 2006 Form 10-Q  to May 14, 2007.  The Panel alsoextended the deadline for filing our 2006 Form 10-K until July 16, 2007. On May 2, 2007, we asked the NASDAQ Listing and Hearing Review Council (“ListingCouncil”) to review the April 17, 2007 decision of the Panel.  On May 14,2007, the Listing Council called the Panel’s decision for review and requestedthat we provide an update on our efforts to file our delinquent filings. We have continued and continue to comply with that request.  In addition,the Listing Council stayed the Panel’s decision that required us to file our Q32006 Form 10-Q by May 14, 2007, and to file our 2006 Form 10-K by July 16,2007.  On August 23, 2007, the Listing Council granted the Company anextension until October 22, 2007 to file our delinquent periodic reports andrestatements.

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

**ITEM 2—UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

None

**ITEM 3—DEFAULTSUPON SENIOR SECURITIES**

None

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

OnJuly 21, 2006, the Company held its annual meeting of stockholders. As of May25, 2006, the record date for the annual meeting, there were 121,089,996 sharesof common stock of the Company issued and outstanding and entitled to vote atthe annual meeting. The following proposals were submitted to a vote of thestockholders:

(i)                                     Toelect the following two Class III directors to serve for a term expiringon the date on which the annual meeting of stockholders is held in the year2009.
| Election of Directors | ** ** | **Votes for** | ** ** | **Votes Withheld** | ** ** |
|---------------------------------|------------|--------------------|------------|-------------------------|------------|
| Jeff Clarke                     |       | 103,480,609        |       | 1,809,464               |       |
| Hong Liang Lu                   |       | 101,449,620        |       | 3,840,453               |       |

 

Therewere no broker non-votes on this matter. As a result, Messrs. Clarke and Luwere elected as Directors of the Company. Other directors whose terms of office continued after the meeting wereas follows:

| Class I (Term Expiring 2007) | ** ** | **Class II (Term Expiring 2008)** |
|--------------------------------------------------|------------|-------------------------------------------------------|
| ** **                                       | ** ** | ** **                                            |
| Thomas Toy                                       |       | Larry D. Horner                                       |
|                                             |       |                                                  |
| Ying Wu                                          |       | Allen Lenzmeier                                       |

 

(ii)        Toadopt and approve the 2006 Equity Incentive Plan, which would govern the grantof incentive awards to the Company’s service providers, including (a) stockoptions, (b) stock appreciation rights, (c) restricted stock, (d) restrictedstock units, (e) performance shares and performance units, and (f) other stockor cash awards.

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 46,952,724 |       | 7,245,445   |       | 667,710     |       |

 

128

----

Therewere 50,424,194 broker non-votes on this matter. As described in the Company’sdefinitive proxy statement as filed with the SEC on June 21, 2006, brokernon-votes are counted for purposes of establishing quorum but do not effect theoutcome of the proposal being voted on because they are not consideredvotes cast. As a result, the 2006 Equity Incentive Plan was approved andadopted.

 (iii)        Toratify and approve the appointment of PricewaterhouseCoopers LLP as theIndependent Registered Public Accounting Firm of the Company for the fiscalyear ending December 31, 2006.

| For         | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|-------------|------------|-------------|------------|-------------|------------|
| 102,151,544 |       | 2,620,700   |       | 517,829     |       |

 

Therewere no broker non-votes on this matter. As a result, the appointment ofPricewaterhouseCoopers LLP as the Independent Registered Public Accounting Firmof the Company was ratified.

**ITEM 5—OTHER INFORMATION**

Amended and RestatedChange of Control Severance Agreement with Francis Barton

We entered into anAmended and Restated Change of Control Severance/Involuntary TerminationAgreement dated August 23, 2006 with Mr. Barton (“Barton SeveranceAgreement”).  The Barton SeveranceAgreement provides that if Mr. Barton’s employment with us terminates as aresult of an involuntary termination at any time within 18 months after achange of control, or any other regular involuntary termination during theperiod of employment, (i) Mr. Barton will be entitled to 24 months of basesalary as in effect as of the date of such termination, payable in a lump sumwithin 30 days of termination, and 100% of the bonus for the year in whichtermination occurs, (ii) all equity awards, including without limitationoption grants, restricted stock and stock purchase rights, granted to Mr.Barton prior to the change of control will become fully vested and/orexercisable to the extent such equity awards are outstanding and/orunexercisable at the time of such termination, (iii) Mr. Barton would bepermitted to exercise such vested equity awards for the shorter period of(a) 12 months from the date of termination and (b) the remaining term ofthe respective equity awards, and (iv) we will continue to provide Mr.Barton the same level of health coverage as in effect on the day immediatelypreceding the termination date until the earlier of the date he is no longereligible to receive continuation coverage pursuant to the COBRA, or 12 monthsfrom the termination date.

The Barton SeveranceAgreement also provides that if Mr. Barton’s employment with us terminates as aresult of a regular involuntary termination during the period of employmentapart from a change of control, (i) Mr. Barton will be entitled to 24months of base salary as in effect as of the date of such termination, payablein a lump sum within 30 days of termination, and 100% of the bonus for the yearin which termination occurs, (ii) all equity awards, including withoutlimitation option grants, restricted stock and stock purchase rights, grantedto Mr. Barton will become fully vested and/or exercisable to the extent suchequity awards are outstanding and/or unexercisable at the time of suchtermination, (iii) Mr. Barton would be permitted to exercise such vested equityawards for the shorter period of (a) 12 months from the date of termination and(b) the remaining term of the respective equity awards, and (iv) we willcontinue to provide Mr. Barton the same level of health coverage as in effecton the day immediately preceding the termination date until the earlier of thedate he is no longer eligible to receive continuation coverage pursuant to theCOBRA or 12 months from the termination date. The Barton Severance Agreement isfiled as Exhibit 10.15 to this Form 10-Q for the quarter ended September 30,2006.

If Mr. Barton’semployment with us terminates other than as a result of a change of control orother involuntary termination, Mr. Barton shall not be entitled to receiveseverance or other benefits under the Barton Severance Agreement.

Amended and RestatedChange of Control/Involuntary Severance Agreement with Ying Wu

OnNovember 14, 2006, we entered into an Amended and Restated Change ofControl/Involuntary Termination Severance Agreement with Mr. Ying Wu, our thenExecutive Vice President, Vice Chairman of the Board and Chairman and ChiefExecutive Officer of our subsidiary, UTStarcom China Co., Ltd. (“Wu SeveranceAgreement”).  The Wu Severance Agreementprovided that if Mr. Wu’s employment with us terminated as a result of aninvoluntary termination at any time within 18 months after a change of control,(i) Mr. Wu would be entitled to 24 months of base salary as in effect asof the 

129

----

date of suchtermination payable in a lump sum within 30 days of termination, and 100% ofthe bonus for the year in which termination occurred, (ii) all equityawards, including without limitation option grants, restricted stock and stockpurchase rights, granted to Mr. Wu prior to the change of control would becomefully vested and/or exercisable, to the extent such equity awards wereoutstanding and/or unexercisable at the time of such termination, (iii) Mr. Wuwould be permitted to exercise such vested equity awards for the shorter periodof (a) 12 months from the date of termination and (b) the remaining term of therespective equity awards, and (iv) we would continue to provide Mr. Wu thesame level of health coverage as in effect on the day immediately preceding thetermination date until the earlier of the date he is no longer eligible toreceive continuation coverage pursuant to COBRA, or 12 months from thetermination date.

The Wu SeveranceAgreement also provided that if Mr. Wu’s employment with us terminated as aresult of a regular involuntary termination during the period of employmentapart from a change of control, (i) Mr. Wu would be entitled to 12 monthsof base salary as in effect as of the date of such termination, payable in alump sum within 30 days of termination, and 100% of the bonus for the year inwhich termination occurred, (ii) all equity awards, including withoutlimitation option grants, restricted stock and stock purchase rights, grantedto Mr. Wu would become fully vested and/or exercisable to the extent suchequity awards were outstanding and/or unexercisable at the time of suchtermination, (iii) Mr. Wu would be permitted to exercise such vested equityawards for the shorter period of (a) 12 months from the date of termination and(b) the remaining term of the respective equity awards, and (iv) we wouldcontinue to provide Mr. Wu the same level of health coverage as in effect onthe day immediately preceding the termination date until the earlier of thedate he is no longer eligible to receive continuation coverage pursuant toCOBRA or 12 months from the termination date.

If Mr. Wu’s employmentwith us terminated other than as a result of a change of control or otherinvoluntary termination, Mr. Wu would not be entitled to receive severance orother benefits under the Wu Severance Agreement.  The Wu Severance Agreement is filed asExhibit 10.28 to our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2006.

Mr. Wu’semployment with the Company and its subsidiaries terminated on June 1,2007.  Mr. Wu is eligible to receiveseverance benefits for involuntary termination without a change in control inaccordance with the terms of the Wu Severance Agreement as described above,such payments to total $998,768.83 (comprised of $550,000 in base salary,$440,000 in bonus, subject to applicable withholding, and $8,768.83 for healthcare premiums).

Amended and RestatedChange of Control/Involuntary Severance Agreement with William Huang

We entered into anAmended and Restated Change of Control/Involuntary Termination SeveranceAgreement dated August 21, 2006 with Mr. Huang (“Huang Severance Agreement”).  The Huang Severance Agreement had the sameterms and conditions as the Wu Severance Agreement described above.  The Huang Severance Agreement is filed asExhibit 10.14 to this Form 10-Q for the quarter ended September 30, 2006.  Mr. Huang voluntarily resigned as our SeniorVice President and Chief Technology Officer effective on December 31,2006.  In connection with his departure, Mr.Huang did not receive any severance payments or benefits under the Huang SeveranceAgreement.  However, Mr. Huang receivedpayments for his accrued but unpaid time off and floating holiday benefits inan amount of $67,305.

**ITEM 6—EXHIBITS**
| Exhibit  Number | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                                                                                                                                                                                        |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Thirteenth Amended and Restated Certificate of  Incorporation of UTStarcom, Inc., as amended. (incorporated by reference  to Exhibit 3.1 of Current Report on Form 8-K filed with the SEC on December  12, 2003)                                                                                                                          |
|            |       |                                                                                                                                                                                                                                                                                                                                           |
| 3.2             |       | First Amended and Restated Bylaws of  UTStarcom, Inc., as amended (incorporated by reference to Exhibit 3.1 of  Current Report on Form 8-K filed with the SEC on November 11, 2006)                                                                                                                                                       |
|            |       |                                                                                                                                                                                                                                                                                                                                           |
| 4.1             |       | See exhibits 3.1 and 3.2 for provisions of  the Certificate of Incorporation and Bylaws defining the rights of holders of  Common Stock.                                                                                                                                                                                             |
|            |       |                                                                                                                                                                                                                                                                                                                                           |
| 4.2             |       | Specimen Common Stock Certificate. (incorporated by  reference to Exhibit 4.1 of Form S-1/A filed with the SEC on February 7,  2000)                                                                                                                                                                                                           |
|            |       |                                                                                                                                                                                                                                                                                                                                           |
| 4.3             |       | Third Amended and Restated Registration Rights  Agreement dated December 14, 1999. (incorporated by reference to  Exhibit 4.2 of Form S-1 filed with the SEC on December 20, 1999)                                                                                                                                                   |
| 4.4             |       | Convertible Subordinated Notes Indenture dated as of  March 12, 2003 between UTStarcom, Inc. and U.S. Bank National  Association, including the form of the 7¤8% Convertible Subordinated  Notes due 2008. (incorporated by reference to Exhibit 4.4 of Quarterly Report  on Form 10-Q filed with the SEC on May 12, 2003) |
|            |       |                                                                                                                                                                                                                                                                                                                                           |

 

130

----

 
| 4.5      |   | First Supplemental Indenture, dated January 9, 2007,  by and between the Company and U.S. Bank National Association. (incorporated by reference to Exhibit 99.2 of  Current Report on Form 8-K filed with the SEC on January 10, 2007)                          |
|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                            |
| 4.6      |   | Underwriting Agreement, dated January 8, 2004  between the Company and Bank of America Securities LLC, as amended on  January 14, 2004. (incorporated by reference to Exhibit 4.7 of Form 10-K  filed with the SEC on April 15, 2005)            |
|     |   |                                                                                                                                                                                                                                                            |
| 4.7      |   | Consent Solicitation Statement dated December 22,  2006 related to the Company’s 7/8% Convertible Subordinated Notes due 2008  (incorporated by reference to Exhibit 99.2 of Current Report on Form 8-K  filed with the SEC on December 22, 2006)          |
|     |   |                                                                                                                                                                                                                                                            |
| 4.8      |   | Amended Letter of Consent related to the Company’s  7/8% Convertible Subordinated Notes due 2008 (incorporated by reference to  Exhibit 99.3 of Current Report on Form 8-K filed with the SEC on January 8,  2007)                                         |
|     |   |                                                                                                                                                                                                                                                            |
| 4.9      |   | Supplemental Consent Solicitation Statement dated  January 8, 2007 related to the Company’s 7/8% Convertible Subordinated Notes  due 2008 (incorporated by reference to Exhibit 99.2 of Current Report on Form  8-K filed with the SEC on January 8, 2007) |
|     |   |                                                                                                                                                                                                                                                            |
| 4.10     |   | Second Consent Solicitation Statement dated July 19,  2007 relating to the Company’s Convertible Subordinated Notes due 2008  (incorporated by reference to Exhibit 99.2 to the Form 8-K filed with the SEC  on July 19, 2007)                             |
|     |   |                                                                                                                                                                                                                                                            |
| 4.11     |   | Letter of Consent relating to the Company’s  Convertible Subordinated Notes due 2008 (incorporated by reference to Exhibit  99.3 to the Form 8-K filed with the SEC on July 19, 2007)                                                                      |
|     |   |                                                                                                                                                                                                                                                            |
| 4.12     |   | Second Supplemental Indenture, dated July 26, 2007,  by and between the Company and U.S. Bank National Association (incorporated  by reference to Exhibit 99.1 to the Form 8-K filed with the SEC on July 30,  2007)                                            |
|     |   |                                                                                                                                                                                                                                                            |
| 10.1*(1) |   | UTStarcom, Inc. 2006 Equity Incentive Plan (2006  EIP)                                                                                                                                                                                                          |
|     |   |                                                                                                                                                                                                                                                            |
| 10.2*(1) |   | Form of Stock Option Award Agreement to be used with  2006 EIP                                                                                                                                                                                                  |
|     |   |                                                                                                                                                                                                                                                            |
| 10.3*(1) |   | Form of Stock Option Award Agreement for Directors  and Officers to be used with 2006 EIP                                                                                                                                                                       |
|     |   |                                                                                                                                                                                                                                                            |
| 10.4*(1) |   | Form of Restricted Stock Agreement to be used with  2006 EIP                                                                                                                                                                                                    |
|     |   |                                                                                                                                                                                                                                                            |
| 10.5*(1) |   | Form of Restricted Stock Unit Agreement to be used  with 2006 EIP                                                                                                                                                                                               |
|     |   |                                                                                                                                                                                                                                                            |
| 10.6*    |   | Offer Letter to Viraj Patel dated November 2, 2005.                                                                                                                                                                                                             |
|     |   |                                                                                                                                                                                                                                                            |
| 10.7*    |   | Offer Letter to Mark Green dated December 19, 2005.                                                                                                                                                                                                             |
|     |   |                                                                                                                                                                                                                                                            |
| 10.8*    |   | Offer Letter to David King dated April 3, 2006.                                                                                                                                                                                                                 |
|     |   |                                                                                                                                                                                                                                                            |
| 10.9*    |   | Employment Agreement by and between Philip  Christopher and UTStarcom, Inc. dated June 11, 2004.                                                                                                                                                                |
|     |   |                                                                                                                                                                                                                                                            |
| 10.10*   |   | Severance Agreement and Release by and between  Michael J. Sophie and UTStarcom, Inc. dated April 13, 2006.                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                            |
| 10.11++  |   | Strategic Alliance Agreement by and between Pantech  & Curitel Communications and UTStarcom, Inc., dated September 25, 2006.                                                                                                                                |
|     |   |                                                                                                                                                                                                                                                            |
| 10.12*   |   | UTStarcom, Inc. Vice President Change in Control and  Involuntary Termination Severance Pay Plan                                                                                                                                                                |
|     |   |                                                                                                                                                                                                                                                            |
| 10.13*   |   | UTStarcom, Inc. Executive Involuntary Termination  Severance Pay Plan                                                                                                                                                                                           |
|     |   |                                                                                                                                                                                                                                                            |
| 10.14*   |   | Amended and Restated Change of Control/Involuntary  Termination Severance Agreement by and between William X. Huang and  UTStarcom, Inc. dated August 21, 2006.                                                                                            |
|     |   |                                                                                                                                                                                                                                                            |
| 10.15*   |   | Amended and Restated Change of Control/Involuntary  Termination Severance Agreement by and between Francis P. Barton and  UTStarcom, Inc. dated August 23, 2006.                                                                                           |
|     |   |                                                                                                                                                                                                                                                            |
| 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.                                                                                                                          |

 

----

|        | *   |   | Management contract, plan or arrangement                                                                                                                                   |
|--------|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | ++  |   | Portions of the exhibit have been omitted pursuant  to a request for confidential treatment filed with the Securities and  Exchange Commission for confidential treatment. |
|   | (1) |   | Incorporated by reference to the registrant’s  Current Report on Form 8-K, which was filed with the Securities and  Exchange Commission on July 27, 2006.   |

 

131

----

**SIGNATURES**

Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.
|                        |   | UTSTARCOM, INC. |
|------------------------|--------|----------------------|
|                   |   |                 |   |
|                   |   |                 |   |
| Date: October 10, 2007 |   | By:                  | /s/ Francis  P. Barton | * * |
|                   |   |                 | Francis P. Barton |
|                   |   |                 | *Executive Vice President and Chief Financial  Officer* |
|                   |   |                 | *(Principal Financial Officer)* |

 

132

----