**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **(Mark One)**                                                                              |
|---------------------------------------------------------------------------------------------|
| **ý**                                                                                  | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                        |   |   |
| **For the quarterly period ended June 30, 2005**                                       |
| ** **                                                                                  |
| **OR**                                                                                      |
| ** **                                                                                  |   |   |
| **o**                                                                                       |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                        |   |   |
| **For the transition period from     to     ** |
| ** **                                                                                  |
| **COMMISSION FILE NUMBER 000-29661**                                                        |

 

**UTSTARCOM, INC.**

(Exact name of registrant asspecified in its charter)

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

 

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

 

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

 

As of August 4, 2005there were 118,330,410 shares of the registrant’s common stock outstanding, parvalue $0.00125.

 

 

----

 

**TABLE OFCONTENTS**

 
| PART I—FINANCIAL INFORMATION | 3                                                                                                       |
|----------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                   |                                                                                                    |   |
|                                   | ITEM 1—CONDENSED  CONSOLIDATED FINANCIAL STATEMENTS                                                | 3 |
|                                   |                                                                                                    |   |
|                                   | ITEM 2—MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 31 |
|                                   |                                                                                                    |   |
|                                   | ITEM 3—QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISKS                                | 66 |
|                                   |                                                                                                    |   |
|                                   | ITEM 4—CONTROLS AND PROCEDURES                                                                     | 67 |
|                                   |                                                                                                    |   |
| PART II—OTHER  INFORMATION   | 75                                                                                                      |
|                                   |                                                                                                    |   |
|                                   | ITEM 1—LEGAL  PROCEEDINGS                                                                          | 75 |
|                                   |                                                                                                    |   |
|                                   | ITEM 2—UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS                                | 76 |
|                                   |                                                                                                    |   |
|                                   | ITEM 3—DEFAULTS UPON SENIOR SECURITIES                                                             | 77 |
|                                   |                                                                                                    |   |
|                                   | ITEM  4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                        | 77 |
|                                   |                                                                                                    |   |
|                                   | ITEM 5 —OTHER  INFORMATION                                                                         | 77 |
|                                   |                                                                                                    |   |
|                                   | ITEM 6—EXHIBITS                                                                                    | 77 |
|                                   |                                                                                                    |   |
|                                   | Signatures                                                                                              | 78 |
|                                   |                                                                                                    |   |
|                                   | Exhibit Index                                                                                      |   |

 

2

----

 

**PART I—FINANCIAL INFORMATION**

 

**ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 

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

 
| ** **                                                                                                                                                                             | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                             |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                        |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                              |       | $                       | 350,324    |                        | $          | 562,532 |   |
| Short-term investments                                                                                                                                                                 |       | 31,402                  |       | 136,283                     |       |
| Accounts receivable, net of allowances for  doubtful accounts of $82,221 and $49,438 at June 30, 2005 and  December 31, 2004, respectively                                   |       | 759,400                 |       | 719,625                     |       |
| Accounts receivable, related parties, net  of $94 and $1,769 at June 30, 2005 and December 31, 2004, respectively                                                            |       | 91,887                  |       | 86,988                      |       |
| Notes receivable                                                                                                                                                                       |       | 30,815                  |       | 26,982                      |       |
| Inventories                                                                                                                                                                            |       | 535,780                 |       | 590,832                     |       |
| Deferred costs/Inventories at customer  sites under contracts                                                                                                                          |       | 214,645                 |       | 198,155                     |       |
| Prepaids                                                                                                                                                                               |       | 66,394                  |       | 112,525                     |       |
| Current deferred taxes                                                                                                                                                                 |       | 42,868                  |       | 143,123                     |       |
| Short-term restricted cash and investments                                                                                                                                             |       | 32,607                  |       | 33,347                      |       |
| Other current assets                                                                                                                                                                   |       | 33,297                  |       | 42,058                      |       |
| Total current assets                                                                                                                                                                   |       | 2,189,419               |       | 2,652,450                   |       |
| Property, plant and equipment, net                                                                                                                                                     |       | 273,027                 |       | 268,759                     |       |
| Long-term investments                                                                                                                                                                  |       | 37,099                  |       | 35,590                      |       |
| Goodwill                                                                                                                                                                               |       | 196,037                 |       | 180,627                     |       |
| Intangible assets, net                                                                                                                                                                 |       | 89,100                  |       | 98,211                      |       |
| Other long-term assets                                                                                                                                                                 |       | 71,784                  |       | 80,368                      |       |
| Total assets                                                                                                                                                                           |       | $                       | 2,856,466  |                        | $          | 3,316,005 |   |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **LIABILITIES,  MINORITY INTEREST AND STOCKHOLDERS’ EQUITY**                                                                                                                      |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                   |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                       |       | $                       | 431,361    |                        | $          | 407,536 |   |
| Short-term debt                                                                                                                                                                        |       | 265,236                 |       | 351,183                     |       |
| Income taxes payable                                                                                                                                                                   |       | 1,814                   |       | 143,778                     |       |
| Customer advances                                                                                                                                                                      |       | 103,262                 |       | 323,938                     |       |
| Deferred revenue                                                                                                                                                                       |       | 88,784                  |       | 66,941                      |       |
| Other current liabilities                                                                                                                                                              |       | 250,988                 |       | 241,577                     |       |
| Total current liabilities                                                                                                                                                              |       | 1,141,445               |       | 1,534,953                   |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| Long-term debt                                                                                                                                                                         |       | 364,800                 |       | 410,655                     |       |
| Total liabilities                                                                                                                                                                      |       | 1,506,245               |       | 1,945,608                   |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| Commitments and contingencies (Note 15)                                                                                                                                                |       |                    |       |                        |       |
| Minority interest in consolidated  subsidiaries                                                                                                                                        |       | 5,290                   |       | 5,025                       |       |
| Stockholders’ equity:                                                                                                                                                             |       |                    |       |                        |       |
| Common stock: $0.00125 par value;  authorized: 750,000,000 shares; issued and outstanding: 116,480,951 and  114,486,632 at June 30, 2005 and December 31, 2004, respectively |       | 146                     |       | 144                         |       |
| Additional paid-in capital                                                                                                                                                             |       | 1,138,374               |       | 1,123,065                   |       |
| Deferred stock compensation                                                                                                                                                            |       | (4,584                  | )          | (6,102                      | )          |
| Retained earnings                                                                                                                                                                      |       | 206,745                 |       | 243,452                     |       |
| Accumulated other comprehensive income                                                                                                                                                 |       | 4,250                   |       | 4,813                       |       |
| Total stockholders’ equity                                                                                                                                                        |       | 1,344,931               |       | 1,365,372                   |       |
| Total liabilities, minority interest and  stockholders’ equity                                                                                                                    |       | $                       | 2,856,466  |                        | $          | 3,316,005 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

3

----

 

**UTSTARCOM, INC.**

 

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

 

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

 
| ** **                                                                                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Net sales                                                                                        |       |                                 |       |                               |       |   |   |   |   |
| Unrelated party                                                                                  |       | $                                    | 692,315    |                               | $          | 668,552 |   | $ | 1,298,475 |   | $ | 1,279,282 |   |
| Related party                                                                                    |       | 30,646                               |       | 21,076                             |       | 326,281 |   | 32,637 |   |
|                                                                                             |       | 722,961                              |       | 689,628                            |       | 1,624,756 |   | 1,311,919 |   |
| Cost of net sales                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Unrelated party                                                                                  |       | 596,785                              |       | 505,247                            |       | 1,134,423 |   | 946,772 |   |
| Related party                                                                                    |       | 16,729                               |       | 8,111                              |       | 142,697 |   | 12,842 |   |
| Gross profit                                                                                     |       | 109,447                              |       | 176,270                            |       | 347,636 |   | 352,305 |   |
| Operating expenses:                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Selling, general and administrative                                                              |       | 102,808                              |       | 67,830                             |       | 211,018 |   | 134,773 |   |
| Research and development                                                                         |       | 65,621                               |       | 52,592                             |       | 132,281 |   | 98,250 |   |
| In-process research and development                                                              |       | 660                                  |       | 1,400                              |       | 660 |   | 1,400 |   |
| Amortization of intangible assets                                                                |       | 6,776                                |       | 3,334                              |       | 13,748 |   | 6,307 |   |
| Restructuring costs                                                                              |       | 15,127                               |       | —                             |       | 15,127 |   | — |   |
| Total operating expenses                                                                         |       | 190,992                              |       | 125,156                            |       | 372,834 |   | 240,730 |   |
|                                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Operating income (loss)                                                                          |       | (81,545                              | )          | 51,114                             |       | (25,198 | ) | 111,575 |   |
|                                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Interest income                                                                                  |       | 1,452                                |       | 1,838                              |       | 2,801 |   | 3,191 |   |
| Interest expense                                                                                 |       | (4,711                               | )          | (1,139                             | )          | (8,989 | ) | (2,221 | ) |
| Other  income, net                                                                               |       | 8,867                                |       | 4,263                              |       | 2,020 |   | 13,048 |   |
| Income (loss) before income taxes, minority  interest and equity in loss of affiliated companies |       | (75,937                              | )          | 56,076                             |       | (29,366 | ) | 125,593 |   |
| Income tax expense (benefit)                                                                     |       | (1,485                               | )          | 10,975                             |       | 6,399 |   | 24,679 |   |
| Minority interest in (earnings) losses of  consolidated subsidiaries                             |       | 313                                  |       | (37                                | )          | 91 |   | (87 | ) |
| Equity in loss of affiliated companies                                                           |       | (574                                 | )          | (1,201                             | )          | (1,033 | ) | (2,198 | ) |
| Net income (loss)                                                                                |       | $                                    | (74,713    | )                                  | $          | 43,863 |   | $ | (36,707 | ) | $ | 98,629 |   |
|                                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Earnings (Loss) per share - Basic                                                                |       | $                                    | (0.65      | )                                  | $          | 0.39 |   | $ | (0.32 | ) | $ | 0.86 |   |
| Earnings (Loss) per share - Diluted                                                              |       | $                                    | (0.65      | )                                  | $          | 0.33 |   | $ | (0.32 | ) | $ | 0.73 |   |
|                                                                                             |       |                                 |       |                               |       |   |   |   |   |
| Weighted average shares used in per-share  calculation:                                          |       |                                 |       |                               |       |   |   |   |   |
| - Basic                                                                                          |       | 114,880                              |       | 113,773                            |       | 114,702 |   | 114,193 |   |
| - Diluted                                                                                        |       | 114,880                              |       | 136,095                            |       | 114,702 |   | 137,709 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

4

----

 

**UTSTARCOM, INC.**

 

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

**(In thousands)**

 
| ** **                                                                            | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |       |                               |       |   |   |
| Net income (loss)                                                                     |       | $                                  | (36,707    | ) | $ | 98,629 |   |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities: |       |                               |       |   |   |
| Depreciation and amortization                                                         |       | 51,411                             |       | 33,988 |   |
| Net loss on sale of assets                                                            |       | 3,684                              |       | 66 |   |
| Amortization of debt issuance costs                                                   |       | 1,166                              |       | 1,166 |   |
| Warrants adjustment to fair value                                                     |       | —                             |       | 32 |   |
| Loss on asset impairment                                                              |       | 6,739                              |       | — |   |
| In-process research and development                                                   |       | 660                                |       | 1,400 |   |
| Net loss on long-term investments                                                     |       | —                             |       | 469 |   |
| Stock compensation expense                                                            |       | 1,153                              |       | 245 |   |
| Provision for doubtful accounts                                                       |       | 33,609                             |       | 9,485 |   |
| Inventory provision                                                                   |       | 28,241                             |       | 15,853 |   |
| Equity in loss of affiliated companies                                                |       | 1,033                              |       | 2,198 |   |
| Deferred income taxes                                                                 |       | 97,466                             |       | (4,546 | ) |
| Minority interest in earnings (losses) of  consolidated subsidiary                    |       | (91                                | )          | 87 |   |
| Gain on extinguishment of debt                                                        |       | (11,094                            | )          | — |   |
| Changes in operating assets and  liabilities, net of effects of acquisition:          |       |                               |       |   |   |
| Accounts receivable                                                                   |       | (78,538                            | )          | (179,074 | ) |
| Inventories                                                                           |       | 41,929                             |       | (192,985 | ) |
| Deferred costs/Inventories at customer  sites under contracts                         |       | (26,927                            | )          | 223,337 |   |
| Other current and non-current assets                                                  |       | 58,531                             |       | 2,112 |   |
| Accounts payable                                                                      |       | 24,830                             |       | 136,856 |   |
| Income taxes payable                                                                  |       | (142,053                           | )          | 14,867 |   |
| Customer advances                                                                     |       | (226,307                           | )          | (309,772 | ) |
| Deferred revenue                                                                      |       | 21,871                             |       | 4,493 |   |
| Other current liabilities                                                             |       | 10,033                             |       | 22,549 |   |
| Net cash used in operating activities                                                 |       | (139,361                           | )          | (118,545 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |       |                               |       |   |   |
| Additions to property, plant and equipment                                            |       | (46,325                            | )          | (62,466 | ) |
| Investment in affiliates, net of cash  acquired                                       |       | (2,550                             | )          | (1,000 | ) |
| Purchase of business                                                                  |       | (23,806                            | )          | (44,711 | ) |
| Proceeds from disposal of property                                                    |       | 663                                |       | — |   |
| Purchase of technology licenses                                                       |       | (750                               | )          | (3,540 | ) |
| Change in restricted cash                                                             |       | 2,708                              |       | (8,677 | ) |
| Purchase of short-term investments                                                    |       | (123,768                           | )          | (132,654 | ) |
| Proceeds from sale of short-term  investments                                         |       | 228,649                            |       | 97,369 |   |
| Net cash provided by (used in) investing  activities                                  |       | 34,821                             |       | (155,679 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |       |                               |       |   |   |
| Issuance of stock, net of expenses                                                    |       | 4,223                              |       | 17,672 |   |
| Net proceeds from borrowing                                                           |       | 278,381                            |       | — |   |
| Repayments of borrowings                                                              |       | (373,081                           | )          | — |   |
| Repurchase of stock                                                                   |       | —                             |       | (107,567 | ) |
| Cash paid to extinguish debt                                                          |       | (15,781                            | )          | — |   |
| Capital contributions from minority  interests                                        |       | 356                                |       | — |   |
| Proceeds from equity offering                                                         |       | —                             |       | 474,554 |   |
| Net cash provided by (used in) financing  activities                                  |       | (105,902                           | )          | 384,659 |   |
| Effect of exchange rate changes on cash                                               |       | (1,766                             | )          | 358 |   |
| Net increase (decrease) in cash and cash  equivalents                                 |       | (212,208                           | )          | 110,793 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                     |       | 562,532                            |       | 377,747 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                            |       | $                                  | 350,324    |   | $ | 488,540 |   |
|                                                                                  |       |                               |       |   |   |
| Supplemental disclosure of cash flow  information:                                    |       |                               |       |   |   |
| Cash paid:                                                                            |       |                               |       |   |   |
| Interest                                                                              |       | $                                  | 8,179      |   | $ | 1,773 |   |
| Income taxes                                                                          |       | 11,387                             |       | 3,818 |   |
| Non-cash operating activity                                                           |       |                               |       |   |   |
| Accounts receivable transferred to notes  receivable                                  |       | 34,551                             |       | 55,876 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

5

----

 

**UTSTARCOM, INC.**

 

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

 

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

 

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

 

The accompanying financialstatements as of June 30, 2005 and for the three and six months ended June 30,2005 and 2004 have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission (the “SEC”). Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations. The December 31,2004 balance sheet was derived from audited financial statements, but does notinclude all disclosures required by generally accepted accounting principles.These condensed consolidated financial statements should be read in conjunctionwith the Company’s audited December 31, 2004 financial statements,including the notes thereto, and the other information set forth in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2004.

 

In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements reflect all adjustments (consisting of only normal recurringadjustments) considered necessary for a fair statement of the Company’sfinancial condition, the results of its operations and its cash flows for theperiods indicated. The results of operations for the three months and sixmonths ended June 30, 2005 are not necessarily indicative of the operatingresults for the full year.

 

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

 

Revenues from sales oftelecommunications equipment and handsets are recognized when persuasiveevidence of an arrangement exists, delivery of the product has occurred, customeracceptance has been obtained, the fee is fixed or determinable andcollectability is reasonably assured. If the payment due from the customer isnot fixed or determinable due to extended payment terms, revenue is recognizedas payments become due from the customer, assuming all other criteria forrevenue recognition are met. Any payments received prior to revenue recognitionare recorded as customer advances. Normal payment terms differ for variousreasons amongst different customer regions, depending upon common businesspractices for customers within a region. Shipping and handling costs arerecorded as revenues and costs of revenues. Any expected losses on contractsare recognized when identified.

 

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

 

Final acceptance isrequired for revenue recognition when installation services are not consideredperfunctory. Final acceptance indicates that the customer has fully accepteddelivery of equipment and the Company is entitled to the full payment. TheCompany will not recognize revenue before final acceptance is granted by thecustomer if acceptance is considered substantive to the transaction.Additionally, the Company does not recognize revenue when cash payments arereceived from customers for transactions

 

6

----

 

that do not have thecustomer’s final acceptance. The Company records these cash receipts ascustomer advances, and defers revenue recognition until final acceptance isreceived.

 

Where multiple elementsexist in an arrangement that includes software, and the software is consideredmore than incidental to the equipment or services in the arrangement, softwareand software related elements are recognized under the provisions of Statementof Position 97-2, as amended, and EITF No. 03-05. The Company allocatesrevenues to each element of software arrangements based on vendor specificobjective evidence (“VSOE”). VSOE of each element is based on the price chargedwhen the same element is sold separately. The Company uses the residual methodto recognize revenue when an arrangement includes one or more elements to bedelivered at a future date and VSOE of the fair value of all the undeliveredelements exists. Under the residual method, the fair value of the undeliveredelements is deferred and the remaining portion of the arrangement fee isrecognized as revenue. If evidence of fair value of one or more undeliveredelements does not exist, revenue is deferred and recognized when delivery ofthose elements occurs or when fair value can be established.

 

The Company recognizesrevenue for system integration, installation and training upon completion ofperformance and if all other revenue recognition criteria are met. Otherservice revenue, such as that related to maintenance and support contracts, isrecognized ratably over the contract term. Revenues from services were lessthan 10% of revenues for all periods.

 

The Company also sellsproducts through resellers. Revenue is generally recognized when the standardprice protection period, which ranges from 30 to 90 days, has lapsed. Ifcollectability cannot be reasonably assured in a reseller arrangement, revenueis recognized upon sell-through to the end customer and receipt of cash. Theremay be additional obligations in reseller arrangements such as inventoryrotation, or stock exchange rights on the product. As such, revenue isrecognized in accordance with Statement of Financial Accounting Standards No. 48,“Revenue Recognition When Right of Return Exists,” (“SFAS 48”). The Company hasdeveloped reasonable estimates for stock exchanges. Estimates are derived basedon historical experience with similar types of sales of similar products.

 

The Company has salesagreements with certain wireless customers that provide for a rebate of theselling price to such customers if the particular product is subsequently soldat a lower price to such customers or to a different customer. The rebateperiod extends for a relatively short period of time. Historically, the amountsof such rebates paid to customers have not been material. The Company estimatesthe amount of the rebate based upon the terms of each individual arrangement,historical experience and future expectations of price reductions, and theCompany records its estimate of the rebate amount at the time of the sale. TheCompany also enters into sales incentive programs, such as co-marketingarrangements, with certain wireless and handset customers. The Company recordsthe incurred incentive as a reduction of revenue when the sales revenue isrecognized.

 

The assessment ofcollectability is also a factor in determining whether revenue should berecognized. The Company assesses collectability based on a number of factors,including payment history and the credit worthiness of the customer. TheCompany does not request collateral from its customers. In international sales,the Company often requires letters of credit from its customers that can bedrawn on demand if the customer defaults on its payment. If the Companydetermines that collection of a payment is not reasonably assured, the Companyrecognizes revenue at the time collection becomes reasonably assured, which isgenerally upon receipt of cash. Occasionally, the Company enters into revenuesharing arrangements. Under these arrangements, the Company collects revenuesonly after its customer, the telecommunications service provider, collectsservice revenues. When the Company enters a revenue sharing arrangement, theCompany does not recognize revenue until collection is reasonably assured.

 

Because of the nature ofdoing business in China and other emerging markets, the Company’s billingsand/or customer payments may not correlate with the contractual payment termsand the Company generally does not enforce contractual payment terms prior tofinal acceptance. Accordingly, accounts receivable are not booked until theCompany recognizes the related customer revenue. Advances from customers arerecognized when the Company has collected cash from the customer, prior torecognizing revenue. Deferred revenue is recorded if there are undeliveredelements after final acceptance has been obtained.

 

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

 

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

 

 

7

----

 

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

 
| ** **                                                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands, except per share  data)**                         | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Numerator:                                                         |       |                                 |       |                               |       |   |   |   |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Net income (loss) for basic EPS computation                        |       | $                                    | (74,713    | )                                  | $          | 43,863 |   | $ | (36,707 | ) | $ | 98,629 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Effect of dilutive securities 7/8%  convertible subordinated notes |       | —                               |       | 884                                |       | — |   | 1,798 |   |
| Net income (loss) adjusted for dilutive  securities                |       | $                                    | (74,713    | )                                  | $          | 44,747 |   | $ | (36,707 | ) | $ | 100,427 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Denominator:                                                       |       |                                 |       |                               |       |   |   |   |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Shares used to compute basic EPS                                   |       | 114,880                              |       | 113,773                            |       | 114,702 |   | 114,193 |   |
| Dilutive common stock equivalent shares:                           |       |                                 |       |                               |       |   |   |   |   |
| Stock options                                                      |       | —                               |       | 5,010                              |       | — |   | 5,668 |   |
| Written call option                                                |       | —                               |       | —                             |       | — |   | 523 |   |
| Conversion of convertible subordinated  notes                      |       | —                               |       | 16,919                             |       | — |   | 16,919 |   |
| Warrants                                                           |       | —                               |       | 5                                  |       | — |   | 17 |   |
| Unvested acquisition-related stock                                 |       | —                               |       | 388                                |       | — |   | 389 |   |
| Shares used to compute diluted EPS                                 |       | 114,880                              |       | 136,095                            |       | 114,702 |   | 137,709 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Earnings (loss) per share - basic                                  |       | $                                    | (0.65      | )                                  | $          | 0.39 |   | $ | (0.32 | ) | $ | 0.86 |   |
| Earnings (loss) per share - diluted                                |       | $                                    | (0.65      | )                                  | $          | 0.33 |   | $ | (0.32 | ) | $ | 0.73 |   |

 

Potentially dilutive sharesare excluded from the computation of diluted net loss per share in which theireffect would be anti-dilutive for the three and six months ended June 30,2005.

 

Certain potential sharesrelated to employee stock options outstanding during the three and six monthsended June 30, 2004 were excluded in the diluted per share computations,since their exercise prices were greater than the average market price of theCompany’s common stock during the periods and, accordingly, their effect isanti-dilutive under the treasury stock method. For the three and six monthsended June 30, 2004, these shares totaled 2.0 million with a weightedaverage exercise price of $36.56 per share and 1.8 million shares with aweighted average exercise price of $37.49 per share, respectively.

 

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

 

The net income for thediluted EPS computation reflects the reduction in interest expense of $0.9million and $1.8 million, net of tax, for the three and six months ended June 30,2004, respectively, that would result from an assumed conversion of the 7/8%convertible subordinated notes.

 

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

 

For the six months ended June 30,2004, the dilutive and anti-dilutive effects of the call option and the bondhedge were derived by taking the weighted average effects of the first andsecond quarters, in accordance with SFAS 128. The average price of the Company’sstock exceeded both the specified strike prices of the convertible bond hedgeand call option transactions and, therefore, the dilutive effect of the 0.5million shares with respect to the call option transaction is included in thediluted earnings per share calculation. The convertible bond hedge, under SFAS 128, is always anti-dilutive.

 

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

 

The Company accounts foremployee stock option grants in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) andhas adopted the disclosure-only alternative of SFAS No. 123, as

 

8

----

 

amended by SFAS No. 148,“Accounting for Stock-Based Compensation” (“SFAS 123”). Under APB 25,compensation expense is based on the difference, if any, on the date of grantbetween the fair value of the common stock and the exercise price of theoption.

 

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

 

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

 
| ** **                                                                                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands, except per share  data)**                                                                               | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                    |       |                                 |       |                               |       |   |   |   |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Net income (loss):                                                                                                       |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | (74,713    | )                                  | $          | 43,863 |   | $ | (36,707 | ) | $ | 98,629 |   |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects       |       | 412                                  |       | 120                                |       | 822 |   | 175 |   |
| Deduct: Total compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | (5,739                               | )          | (9,092                             | )          | (12,017 | ) | (17,057 | ) |
| Pro forma net income (loss)                                                                                              |       | $                                    | (80,040    | )                                  | $          | 34,891 |   | $ | (47,902 | ) | $ | 81,747 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Basic income (loss) per share:                                                                                           |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | (0.65      | )                                  | $          | 0.39 |   | $ | (0.32 | ) | $ | 0.86 |   |
| Pro forma                                                                                                                |       | $                                    | (0.70      | )                                  | $          | 0.31 |   | $ | (0.42 | ) | $ | 0.72 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Diluted                                                                                                                  |       |                                 |       |                               |       |   |   |   |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Net income (loss):                                                                                                       |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | (74,713    | )                                  | $          | 43,863 |   | $ | (36,707 | ) | $ | 98,629 |   |
| Effect of dilutive securities 7/8%  Convertible subordinated notes                                                       |       | —                               |       | 884                                |       | — |   | 1,798 |   |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects       |       | 412                                  |       | 120                                |       | 822 |   | 175 |   |
| Deduct: Total compensation expense  determined under fair value method for all awards, net of related tax effects        |       | (5,739                               | )          | (9,092                             | )          | (12,017 | ) | (17,057 | ) |
| Pro forma net income (loss)                                                                                              |       | $                                    | (80,040    | )                                  | $          | 35,775 |   | $ | (47,902 | ) | $ | 83,545 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Diluted income (loss) per share:                                                                                         |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | (0.65      | )                                  | $          | 0.33 |   | $ | (0.32 | ) | $ | 0.73 |   |
| Pro forma                                                                                                                |       | $                                    | (0.70      | )                                  | $          | 0.27 |   | $ | (0.42 | ) | $ | 0.62 |   |

 

Thefollowing assumptions were used to calculate the fair values

 

| ** **                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                     |       |                                 |       |                               |       |   |   |   |   |
| Stock Options:                           |       |                                 |       |                               |       |   |   |   |   |
|                                     |       |                                 |       |                               |       |   |   |   |   |
| Expected remaining term in years         |       | 3                                    |       | 3                                  |       | 3 |   | 3 |   |
| Weighted average risk-free interest rate |       | 3.77                                 | %          | 2.90                               | %          | 3.71 | % | 2.75 | % |
| Expected dividend rate                   |       | 0.00                                 | %          | 0.00                               | %          | 0.00 | % | 0.00 | % |
| Volatility                               |       | 71.00                                | %          | 56.50                              | %          | 67.16 | % | 60.25 | % |

 

9

----

 

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

 

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

 

| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)**                    | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                  |       |                                 |       |                               |       |   |   |   |   |
| Net income (loss)                     |       | $                                    | (74,713    | )                                  | $          | 43,863 |   | $ | (36,707 | ) | $ | 98,629 |   |
| Unrealized gain (loss) on investments |       | (8                                   | )          | 712                                |       | (8 | ) | 479 |   |
| Foreign currency translation          |       | (81                                  | )          | (173                               | )          | (556 | ) | 501 |   |
| Total comprehensive income            |       | $                                    | (74,802    | )                                  | $          | 44,402 |   | $ | (37,271 | ) | $ | 99,609 |   |

 

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

 

Cash and cash equivalentsconsist of instruments with maturities of three months or less at the date ofpurchase. There were no available-for-sale securities included in cash and cashequivalents at June 30, 2005 or December 31, 2004. Short-terminvestments, consisting entirely of available-for-sale securities, were$31.4 million and $136.3 million at June 30, 2005 and December 31,2004, respectively. These available-for-sale securities consist ofgovernment-backed notes, commercial paper, floating rate corporate bonds andfixed income corporate bonds. These investments are recorded at fair value. Anyunrealized holding gains or losses are reported as a component of comprehensiveincome. Realized gains and losses are reported in earnings.

 

The Company accepts banknotes receivable with maturity dates of between three and six months from itscustomers in China in the normal course of business.  Such bank notes are negotiable instrumentsand classified as short-term investments. The Company may discount these notes with banking institutions inChina.  A sale of these notes is reflectedas a reduction of short-term investments and the proceeds of the settlement ofthese notes are included in cash flows from investing activities in theconsolidated statement of cash flows. Bank notes totaling $16.2 million and$73.1 million were sold during the three and six months ended June 30,2005 and none for the three and six months ended June 30, 2004. Anynotes that have been sold are not included in the Company’s consolidatedbalance sheets as the criteria for sale treatment established by Statement ofFinancial Accounting Standards No. 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishment of Liabilities” (“SFAS 140”),have been met. Under SFAS 140, upon a transfer, the transferor or entitymust derecognize financial assets when control has been surrendered and thetransferee obtains control over the assets. In addition, the transferred assetshave been isolated from the transferor, beyond the reach of its creditors, andthe transferee has the right, without conditions or constraints, to pledge orexchange the assets it has received.  Thecost of settling these notes receivable was $0.1 million and $0.6 millionfor the three and six months ended June 30, 2005.

 

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

 

At June 30, 2005, theCompany had short-term restricted cash and investments of $32.6 millioncomprised of $29.4 million of restricted cash and $3.2 million of restrictedshort-term investments held for standby letters of credit and an escrowfund.  At December 31, 2004, the Company had restricted cash andshort-term investments of $33.3 million primarily comprised of $24.3 million ofrestricted cash and $8.6 million of restricted short-term investments forstandby letters of credit.

 

The Company issues standbyletters of credit primarily to support international sales activities outside ofChina. When the Company submits a bid for a sale, often the potential customerwill require that the Company issue a bid bond or a standby letter of credit todemonstrate its commitment through the bid process.  In addition, theCompany may be required to issue standby letters of credit as guarantees foradvance customer payments upon contract signing or performance guarantees. Thestandby letters of credit usually expire six to nine months from date ofissuance without being drawn by the beneficiary thereof. Finally, the Companymay issue commercial letters of credit in support of purchase commitments.

 

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

 

TheCompany accepts commercial notes receivable with maturity dates of betweenthree and six months from its customers in China in the normal course ofbusiness. Notes receivable available for sale was $30.8 million and $27.0million at June 30, 2005 and December 31, 2004, respectively. TheCompany may discount these notes with banking 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 receivablesold during the three and six months ended June 30, 2005 and 2004.

 

10

----

 

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

 

As of June 30, 2005 andDecember 31, 2004, total inventories consisted of the following:

 
| **(in thousands)**                               | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Inventories:                                     |       |                    |       |                        |       |
|                                             |       |                    |       |                        |       |
| Raw materials                                    |       | $                       | 100,918    |                        | $          | 154,977 |   |
| Work-in-process                                  |       | 57,929                  |       | 65,551                      |       |
| Finished goods                                   |       | 300,529                 |       | 271,357                     |       |
| Inventories at customer sites without  contracts |       | 76,404                  |       | 98,947                      |       |
| Total Inventories                                |       | $                       | 535,780    |                        | $          | 590,832 |   |

 

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

 

*Pedestal*

 

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

 

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

 

Atthe acquisition, Pedestal had one project under development related to thegigabit ethernet product that qualified for IPR&D.  The gigabit ethernet project is focused onsupporting a majority of Pedestal’s products and is considered 75% complete asof June 30, 2005.  In assessingPedestal’s IPR&D project, the Company considered key productcharacteristics including the product’s development stage at the acquisitiondate, the product’s life cycle and the product’s future prospects.  The Company also considered the rate at whichtechnology changes in the broadband equipment industry, the industry’scompetitive environment and the economic outlook for both local and globalmarkets.  The amount of the purchaseprice allocated to IPR&D of $0.7 million was charged to the Company’sresults of operations.

 

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

 

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

 

 

11

----

 

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

 

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

 

*Giga*

 

OnOctober 29, 2004, the Company entered into an asset purchase agreementwith Giga Telecom, Inc. (“Giga”), a Korean corporation that develops anddesigns wireless handsets. The acquisition is intended to facilitate theCompany’s expansion into the CDMA handset market. The Company completed theacquisition on January 4, 2005. At the closing, $13.0 million in cash waspaid, and an additional $2.0 million was paid into an escrow account for sixmonths.  The total consideration for theacquisition, funded from cash on hand, was approximately $18.4 million,including $2.0 million in acquisition-related transaction costs and a $1.5million payment made previously to be applied against the purchase price.  An earn-out of up to $2.0 million may becomepayable upon completion of certain product design milestones.  As of June 30, 2005, no milestones havebeen met and no contingent payment was accrued.

 

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

 

| **(in thousands)**                                                                              | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------|------------|
|                                                                                            |       |       |       |
| Fair value of tangible net assets                                                               |       | $          | 458        |   |
| Fair value of identified intangible assets:                                                     |       |       |       |
| Existing technology                                                                             |       | 1,200      |       |
| Pre-existing royalty agreement                                                                  |       | 1,920      |       |
| Excess of costs of acquiring Giga over fair  value of identified net assets acquired (goodwill) |       | 14,871     |       |
|                                                                                            |       |       |       |
| Total purchase price                                                                            |       | $          | 18,449     |   |

 

Theexcess of the purchase price over the fair value of the identified net assetsof approximately $14.9 million was allocated to goodwill and assigned to the Handsetssegment.  The goodwill created in thisacquisition results from the decreased time to market and design relatedsynergies.  This goodwill is taxdeductible.

 

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

 

Theresults of operations of Giga have been integrated with the “Handsets” segmentand included in the Company’s Consolidated Statement of Operations subsequentto the acquisition.  The pro formaeffects of this acquisition on the Company’s financial statements are notsignificant.

 

**11.****                                                                              ****GOODWILL AND INTANGIBLEASSETS:**

 

*Goodwill:*

 

As of June 30, 2005 andDecember 31, 2004, goodwill was $196.0 million and $180.6 million,respectively.

 

Effective in the firstquarter of 2005, the Company realigned its business into five operating unitsand, accordingly, goodwill has been reallocated to the reporting units, using arelative fair value allocation approach prescribed in Statement of FinancialAccounting

 

12

----

 

Standards No. 142, “Goodwilland Other Intangible Assets” (“SFAS 142”). The Company determined the relative fair value of each reporting unitbased, in part, upon an independent valuation analysis.  The goodwill reallocation is reflected asfollows:

 

| **(in thousands)**               | ** ** | **Goodwill** | ** ** |
|----------------------------------|------------|--------------|------------|
|                             |       |         |       |
| December 31, 2004:          |       |         |       |
|                             |       |         |       |
| China                            |       | $            | 118,787    |   |
| International                    |       | 37,132       |       |
| Personal Communications Division |       | 24,708       |       |
| Total                            |       | $            | 180,627    |   |
|                             |       |         |       |
| **(in  thousands)**              | ** ** | **Goodwill** | ** ** |
|                             |       |         |       |
| January 1, 2005:                 |       |         |       |
|                             |       |         |       |
| Handsets                         |       | $            | 74,003     |   |
| Wireless                         |       | 54,604       |       |
| PCD                              |       | 24,710       |       |
| Broadband                        |       | 23,210       |       |
| Service                          |       | 4,100        |       |
| Total                            |       | $            | 180,627    |   |
|                             |       |         |       |
| Giga acquisition                 |       | 14,871       |       |
| Effect of exchange rate changes  |       | 539          |       |
|                             |       |         |       |
| June 30, 2005               |       | $            | 196,037    |   |

 

 

13

----

 

*IntangibleAssets:*

 

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

 

| **(in thousands)**             | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Intangible assets:             |       |                    |       |                        |       |
|                           |       |                    |       |                        |       |
| Existing technology            |       | $                       | 42,052     |                        | $          | 39,530 |   |
| Less accumulated amortization  |       | (19,235                 | )          | (14,933                     | )          |
|                           |       | $                       | 22,817     |                        | $          | 24,597 |   |
|                           |       |                    |       |                        |       |
| Customer relationships         |       | $                       | 57,361     |                        | $          | 57,220 |   |
| Less accumulated amortization  |       | (8,751                  | )          | (5,455                      | )          |
|                           |       | $                       | 48,610     |                        | $          | 51,765 |   |
|                           |       |                    |       |                        |       |
| Supplier relationships         |       | $                       | 5,300      |                        | $          | 5,300 |   |
| Less accumulated amortization  |       | (1,767                  | )          | (442                        | )          |
|                           |       | $                       | 3,533      |                        | $          | 4,858 |   |
|                           |       |                    |       |                        |       |
| Trade names                    |       | $                       | 4,940      |                        | $          | 4,940 |   |
| Less accumulated amortization  |       | (1,829                  | )          | (966                        | )          |
|                           |       | $                       | 3,111      |                        | $          | 3,974 |   |
|                           |       |                    |       |                        |       |
| Backlog                        |       | $                       | 5,150      |                        | $          | 5,150 |   |
| Less accumulated amortization  |       | (4,083                  | )          | (2,483                      | )          |
|                           |       | $                       | 1,067      |                        | $          | 2,667 |   |
|                           |       |                    |       |                        |       |
| Non-compete agreement          |       | $                       | 10,800     |                        | $          | 10,800 |   |
| Less accumulated amortization  |       | (1,800                  | )          | $                           | (450       | ) |
|                           |       | $                       | 9,000      |                        | $          | 10,350 |   |
|                           |       |                    |       |                        |       |
| Pre-existing royalty agreement |       | $                       | 1,925      |                        | $          | — |   |
| Less accumulated amortization  |       | (963                    | )          | —                      |       |
|                           |       | $                       | 962        |                        | $          | — |   |
|                           |       |                    |       |                        |       |
| Total intangible assets        |       | $                       | 89,100     |                        | $          | 98,211 |   |

 

Amortization expense was$6.7 million and $3.5 million for the three months ended June 30, 2005 and2004, respectively, and was $13.7 million and $6.0 million for the sixmonths ended June 30, 2005 and 2004, respectively.  The estimated aggregate amortization expensefor intangibles for each of the five years from the year ended December 31,2006 through the year ended December 31, 2010 is $19.2 million,$16.3 million, $13.0 million, $7.1 million and $5.2 million, andis $15.7 million thereafter.

 

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

 

| **(in years)**                 | ** ** | **Weighted Average Life** | ** ** |
|--------------------------------|------------|---------------------------|------------|
| ** **                     | ** ** | ** **                | ** ** |
| Technology                     |       | 3.5                       |       |
| Customer relationships         |       | 8.1                       |       |
| Supplier relationships         |       | 1.3                       |       |
| Trade names                    |       | 2.3                       |       |
| Backlog                        |       | 0.3                       |       |
| Non-compete                    |       | 3.3                       |       |
| Pre-existing royalty agreement |       | 0.5                       |       |
| Total                          |       | 5.0                       |       |

 

14

----

 

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

 

The Company’s investmentsare as follows:

 

| **(in thousands)**            | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                          |       |                    |       |                        |       |
| Softbank China                |       | $                       | 5,294      |                        | $          | 5,294 |   |
| Cellon International          |       | 8,000                   |       | 8,000                       |       |
| Restructuring Fund No. 1 |       | 2,402                   |       | 1,836                       |       |
| Global Asia Partners L.P.     |       | 1,701                   |       | 1,150                       |       |
| Fiberxon Inc.                 |       | 3,000                   |       | 3,000                       |       |
| Immenstar                     |       | 2,000                   |       | 2,000                       |       |
| Matsushita Joint Venture      |       | 6,360                   |       | 7,959                       |       |
| GCT SemiConductor             |       | 3,000                   |       | 3,000                       |       |
| Xalted Networks               |       | 2,000                   |       | —                      |       |
| Infinera                      |       | 1,902                   |       | 1,902                       |       |
| Others                        |       | 1,440                   |       | 1,449                       |       |
|                          |       |                    |       |                        |       |
| Total                         |       | $                       | 37,099     |                        | $          | 35,590 |   |

 

*SoftbankChina*

 

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

 

*CellonInternational*

 

In September 2001, theCompany invested $2.0 million in Cellon International Holdings Corporation (“Cellon”). Cellon designs wireless terminals and related technology for handsetmanufacturers and private distributors. The Company invested an additional $3.0million in each of April and December 2002. As of June 30, 2005,the Company had a 9% ownership interest in Cellon. This investment is accountedfor under the cost method, and its carrying value is evaluated for possibleimpairment based on the achievement of business objectives and milestones, thefinancial condition and prospects of the company and other relevant factors. Asof June 30, 2005, the Company has not recorded any impairment of thisinvestment. The Company has outstanding purchase commitments with Cellon.  For additional information regardingtransactions with Cellon, refer to Note 18, Related Party Transactions.

 

*RestructuringFund No. 1*

 

During fiscal 2002, theCompany invested $2.0 million in Restructuring Fund No. 1, a venturecapital investment limited partnership established by SOFTBANK INVESTMENTCORP., an affiliate of SOFTBANK CORP. SOFTBANK America Inc., an entityaffiliated with SOFTBANK CORP., is a significant stockholder of the Company.The fund focuses on leveraged buyout investments in companies in Asiaundergoing restructuring or bankruptcy procedures. The total fund offering isexpected to be between approximately $150.0 million and $226.0 million,with each investor contributing a minimum of $0.8 million. The fund has aseparate management team, and none of the Company’s employees are employed bythe fund. The Company accounts for this investment under the equity method ofaccounting.  The Company hadinsignificant gain and loss for the three months ended June 30, 2005 and

 

15

----

 

recorded $0.6 million equitygain for the six months ended June 30, 2005.  No significant gains or losses were recordedduring the three and six months ended June 30, 2004.

 

*GlobalAsia Partners, L.P.*

 

In June 2002, theCompany invested $1.0 million in Global Asia Partners L.P.,$1.0 million in June 2003 and an additional capital contribution of$0.5 million in the second quarter of 2005, with a commitment to invest up to amaximum of $5.0 million. The remaining amount is due at such times and insuch amounts as shall be specified in one or more future capital calls to beissued by the general partner. The fund size is anticipated to be$10.1 million and the fund was formed to make private equity investmentsin private or pre-IPO technology and telecommunications companies. The fund’sgeographic focus is on technology investments in Asia, in particular in Indiaand China. The Company accounts for this investment under the equity method ofaccounting.   No significant gains orlosses were recorded during the three and six months ended June 30, 2005and 2004.

 

*FiberxonInc.*

 

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

 

*MatsushitaJoint Venture*

 

In July, 2002, the Companyentered into a joint venture agreement with Matsushita Communication IndustrialCo., Ltd., a stockholder of the Company, to jointly design and develop,manufacture and sell telecommunication products. The Company has a 49%ownership interest in the joint venture company, which has a registered sharecapital of $10.0 million. The cash consideration of $4.9 millionpayable by the Company was paid in October 2002. As the Company does nothave voting control over significant matters of the joint venture company, theinvestment in and results of operations of the joint venture company areaccounted for using the equity method of accounting.  The Company recorded equity losses of $0.6million and $1.6 million for the three and six months ended June 30, 2005,respectively and $1.2 million and $2.2 million for the three and six monthsended June 30, 2004, respectively.

 

*XaltedNetworks*

 

In May 2005, theCompany invested $2.0 million in Xalted Networks (“Xalted”). Xalted is adevelopment stage company providing telecommunication operator customers with acomprehensive set of network systems, software solutions and serviceofferings.  The Company has less than a10% ownership interest in Xalted and the investment is accounted for under thecost method.

 

 

16

----

 

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

 

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

 

| **(in thousands)**             | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                           |       |                    |       |                        |       |
| Notes payable                  |       | $                       | 2,081      |                        | $          | 1,183 |   |
| Bank loans                     |       | 263,455                 |       | 358,155                     |       |
| Convertible subordinated notes |       | 364,500                 |       | 402,500                     |       |
|                           |       |                    |       |                        |       |
| Total debt                     |       | $                       | 630,036    |                        | $          | 761,838 |   |
| Long-term debt                 |       | 364,800                 |       | 410,655                     |       |
| Short-term debt                |       | $                       | 265,236    |                        | $          | 351,183 |   |

 

Occasionally, the Companyissues short-term notes payable to its vendors in lieu of trade accountspayable.  The payment terms are normally three to nine months andtypically non-interest bearing.  The Company had $2.1 million of thesenotes at June 30, 2005 included in short-term debt.

 

At June 30, 2005, theCompany has loans with various banks totaling $255.0 million with interestrates ranging from 2.58% to 4.70% per annum. These bank loans mature within twelve months and are included inshort-term debt.

 

The Company has a bank loanin connection with an equipment purchase resulting from the consolidation ofMDC Holding Limited and its affiliated entities (“MDC”).  On January 10, 2003, a third partyestablished a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by the Company on January 23,2003, and subsequently transferred to MDC on December 31, 2003.  The bank loan of $8.2 million bears interestat a rate of 4.94% per annum, and expires on January 10, 2006.  The Company does not serve as legal obligorfor the loan.

 

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

 

The Company has availableborrowing facilities of $614.9 million as of June 30, 2005.$302.3 million of these facilities expire in 2005 and $312.6 million ofthese facilities expire in 2006 with interest rates ranging from 2.58% to 4.70%.The Company has not guaranteed any debt not included in the consolidatedbalance sheet.

 

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

 

OnJune 24, 2005, the Company entered into an agreement to exchange 1,482,000shares of Company’s common stock with a fair value of approximately $10.6million and approximately $15.8 million in cash for $38.0 million aggregateprincipal amount of its outstanding Notes with one of its note holders.  The exchange was settled on June 29,2005.  This exchange is considered anearly extinguishment of debt in which the aggregate fair value of the commonstock and cash is less than the carrying value of the Notes.  Accordingly, the Company recorded a gain of$11.1 million on such extinguishment included in Other Income in theConsolidated Statements of Operations, in accordance with provisions of SFAS145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASBStatement No. 13, and Technical Corrections.”

 

OnJune 30, 2005, the Company entered into a separate agreement to exchange1,560,000 shares of the Company’s common stock with a fair value ofapproximately $11.7 million and $17.0 million in cash for $40.0 millionaggregate principal amount of the Notes. The exchange agreement was settled on July 7, 2005. This exchangeis considered an early extinguishment of debt in which the aggregate fair valueof the common stock and cash is less than the carrying value of the Notes andthe resulting gain on the exchange of $10.8 million will be recorded in thethird quarter of 2005.

 

17

----

 

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

 

Theconvertible bond hedge and call option were amended as a result of theaforementioned early extinguishment of the Notes.  As part of the amendment, the Companyreceived proceeds of $0.9 million which were recorded against the additionalpaid-in capital. Theamended convertible bond hedge allows the Company to purchase 15.3 millionshares of its common stock at $23.79 per share from the other party to theagreement. The written call option allows the holder to purchase 15.3 millionshares of the Company’s common stock from the Company at $32.025 per share.

 

The Company recorded theseinstruments at cost, and their carrying value at June 30, 2005approximates their original cost. The convertible bond hedge and call optiontransactions are expected to reduce the potential dilution from conversion ofthe notes. The options have been included in stockholders’ equity in accordancewith the guidance in Emerging Issues Task Force Issue No. 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock.”

 

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

 

Warranty obligations are asfollows:

 
| ** **                                        | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)**                                | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                              |       |                                 |       |                               |       |   |   |   |   |
| Beginning of period                               |       | $                                    | 57,862     |                               | $          | 29,524 |   | $ | 46,596 |   | $ | 26,267 |   |
| Accruals for warranties issued during the  period |       | 9,479                                |       | 15,092                             |       | 32,568 |   | 25,100 |   |
| Settlements made during the period                |       | (8,755                               | )          | (10,380                            | )          | (20,578 | ) | (17,131 | ) |
| Balance at end of period                          |       | $                                    | 58,586     |                               | $          | 34,236 |   | $ | 58,586 |   | $ | 34,236 |   |

 

*Warranty obligations:*

 

During the first quarter2005, the Company incurred special warranty coverage for certain asynchronousdigital subscriber line (“ADSL”) equipment sold to SBBC, an affiliate ofSOFTBANK CORP and SOFTBANK America Inc., during 2003 and 2004.  Since the agreement to repair these partsexceed the Company’s normal warranty terms, the Company recorded a specialwarranty charge in the first quarter of $9.5 million. Completion of the repairof these units is expected to be completed by the end of 2005.

 

*Other:*

 

Certain of the Company’ssales contracts include provisions under which customers would be indemnifiedby the Company in the event of, among other things, a third-party claim againstthe customer for intellectual property rights infringement related to theCompany’s products. There are no limitations on the maximum potential futurepayments 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.

 

 

18

----

 

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

 

*Leases:*

 

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

 

| **(in thousands)**           | ** ** | **June 30, 2005** | ** ** |
|------------------------------|------------|------------------------|------------|
| ** **                   | ** ** | ** **             | ** ** |
| 1 year                       |       | $                      | 18,561     |   |
| 2 year                       |       | 12,172                 |       |
| 3 year                       |       | 6,771                  |       |
| 4 year                       |       | 5,014                  |       |
| 5 year and after             |       | 6,404                  |       |
|                         |       |                   |       |
| Total minimum lease payments |       | $                      | 48,922     |   |

 

Rent expense for the threeand six months ended June 30, 2005 were $5.4 million and $11.0 million,respectively.

 

Other contractualobligations and commitments were as follows:

 
| ** **                             | ** ** | **June 30, 2005  Payments Due by Period** | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands)**                     | ** ** | **Total**                                      | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** |
|                                   |       |                                           |       |   |   |   |   |   |   |
| Notes payable                          |       | $                                              | 2,081      |   | $ | 2,081 |   | $ | — |   | $ | — |   |
| Bank loans                             |       | $                                              | 263,455    |   | $ | 263,155 |   | $ | — |   | $ | 300 |   |
| Convertible subordinated notes         |       | $                                              | 364,500    |   | $ | — |   | $ | 364,500 |   | $ | — |   |
| Interest payable on subordinated notes |       | $                                              | 9,568      |   | $ | 3,189 |   | $ | 6,379 |   | $ | — |   |
| Standby letters of credit              |       | $                                              | 65,284     |   | $ | 64,475 |   | $ | 809 |   | $ | — |   |

 

*Notes payable*

 

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

 

*Bank loans*

 

At June 30, 2005, theCompany had loans with various banks totaling $255.0 million with interestrates ranging from 2.58% to 4.70% per annum. These bank loans mature within twelve months and are included inshort-term debt.

 

The Company has a bank loanin connection with an equipment purchase resulting from the consolidation ofMDC.  On January 10, 2003, a thirdparty established a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by the Company on January 23,2003, and subsequently transferred to MDC on December 31, 2003.  The bank loan of $8.2 million bears interestat 4.94% per annum, and expires on January 10, 2006.  The Company does not serve as legal obligorfor the loan.

 

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

 

*Convertible subordinated notes*

 

As of June 30, 2005,the Company had outstanding $364.5 million of convertible subordinated notes,due March 1, 2008, that bear interest at a rate of 7/8% per annum, payablesemiannually on May 1 and September 1, are convertible into theCompany’s common stock at a conversion price of $23.79 per share and aresubordinated to all present and future senior debt of the Company. Theprincipal is due only at maturity of the notes. Refer to Note 13, Debt.

 

19

----

 

*Standby letters of credit*

 

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

 

*Purchasecommitments*

 

The Company is obligated topurchase raw materials and work-in-process inventory under various orders fromvarious suppliers, all of which should be fulfilled without adverseconsequences material to the operations or financial condition of the Company.As of June 30, 2005, total open commitments under these purchase orderswere approximately $611.4 million.

 

*Investmentcommitments*

 

As of June 30, 2005,the Company had invested a total of $2.5 million in Global Asia PartnersL.P. The fund size is anticipated to be $10.1 million and the fund wasformed to make private equity investments in private or pre-IPO technology andtelecommunications companies in Asia. The Company has a commitment to invest upto a maximum of $5.0 million. The remaining amount is due at such timesand in such amounts as shall be specified in one or more future capital callsto be issued by the general partner.

 

*Intellectual property*

 

Certain sales contractsinclude provisions under which customers would be indemnified by us in theevent of, among other things, a third-party claim against the customer forintellectual property rights infringement related to our products. There are nolimitations on the maximum potential future payments under these guarantees.The Company has not accrued any amounts in relation to these provisions as nosuch claims have been made and the Company believes it has valid enforceablerights to the intellectual property embedded in its products.

 

*Litigation:*

 

*Securities Class Action Litigation*

 

Beginning in October 2004,several shareholder class actions alleging federal securities violations werefiled against the Company and various officers and directors.  The actions have been consolidated in UnitedStates District Court for the Northern District of California.  The actions are brought on behalf of aputative class of shareholders who purchased the Company’s stock between April 16, 2003and September 20, 2004.  Thelead plaintiffs in the case filed a First Amended Consolidated Complaint on July 26,2005.  The Complaint alleges violationsof the Securities Exchange Act of 1934. In addition to the Company defendants, the plaintiffs also sued Banc ofAmerica Securities LLC and Softbank. The Complaint seeks recovery of damages inan unspecified amount.  The Companyanticipates that it will move to dismiss the Complaint on October 10,2005.

 

Thislitigation is in its preliminary stages, and the Company cannot predict itsoutcome.  Management of the Companybelieves that the claims are not meritorious. Nevertheless, an adverse outcome in the litigation, if it occurred,could have a material adverse effect of the Company’s results ofoperations.  As of June 30, 2005, noloss amount has been accrued because a loss is not considered probable orestimable.

 

*Shareholder Derivative Litigation*

 

Beginning in August 2004,several shareholder derivative actions were filed in the Superior Court ofCalifornia for Alameda County.  Theactions allege claims for breach of fiduciary duty against certain of ourcurrent and former directors and officers and name the Company as a nominaldefendant. The Court has consolidated the various complaints into one action.

 

20

----

 

On June 9,2005, the Court entered an order sustaining defendants’ demurrer to theComplaint, with leave to amend.  On June 28,2005, plaintiffs filed their Second Amended Derivative Complaint.  On July 15, 2005, the defendants againdemurred to the Complaint.  Briefing onthat motion has not yet been completed.

 

Thislitigation is in its preliminary stages, and the Company cannot predict itsoutcome.  Management of the Companybelieves that plaintiffs have failed adequately to allege demand futility, andthat the action therefore should be dismissed. The Company cannot predict whether that position will prevail.  As of June 30, 2005, no loss amount hasbeen accrued because a loss is not considered probable or estimable.

 

*IPOAllocation*

 

On October 31,2001, a complaint was filed in United States District Court for the SouthernDistrict of New York against the Company, some of the Company’s directors andofficers and various underwriters for the Company’s initial publicoffering.  Substantially similar actionswere filed concerning the initial public offerings for more than 300 differentissuers, and the cases were coordinated as *Inre Initial Public Offering Securities Litigation*, 21 MC 92 forpretrial purposes.  In April 2002, aconsolidated amended complaint was filed in the matter against the Company,captioned *In re UTStarcom, Initial PublicOffering Securities Litigation*, Civil Action No. 01-CV-9604.  Plaintiffs allege violations of theSecurities Act of 1933 and the Securities Exchange Act of 1934 throughundisclosed improper underwriting practices concerning the allocation of IPOshares in exchange for excessive brokerage commissions, agreements to purchaseshares at higher prices in the aftermarket and misleading analyst reports.  Plaintiffs seek unspecified damages on behalfof a purported class of purchasers of the Company’s common stock between March 2,2000 and December 6, 2000.  TheCompany’s directors and officers have been dismissed without prejudice pursuantto a stipulation.  On February 19,2003, the Court granted in part and denied in part a motion to dismissbrought by defendants including the Company. The order dismisses all claims against the Company except for a claimbrought under Section 11 of the Securities Act of 1933, which alleges thatthe registration statement filed in accordance with the IPO wasmisleading.  In June 2004, astipulation of settlement and release of claims against the issuer defendants,including the Company, was submitted to the court for approval.  The terms of the settlement, if approved,would dismiss and release all claims against the participating defendants(including the Company).  In exchange forthis dismissal, D&O insurance carriers would agree to guarantee a recoveryby the plaintiffs from the underwriter defendants of at least $1 billion, andthe issuer defendants would agree to an assignment or surrender to theplaintiffs of certain claims the issuer defendants may have against theunderwriters.  The settlement is subjectto a number of conditions, including court approval. If the settlement does notoccur, and litigation against the Company continues, the Company believes ithas valid defenses and intends to defend the case 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.

 

*StarentPatent Infringement Litigations*

 

The Company has sued StarentNetworks Corporation (“Starent”) for patent infringement in the U.S. DistrictCourt for the Northern District of California. On March 22, 2004, the Company filed its Complaint.  On June 3, 2004, the Company servedits Complaint on Starent.  On July 30, 2004,Starent filed and served its answer and counterclaims.  On August 30, 2004, the Companyserved and filed its Amended Complaint. In the Company’s Amended Complaint, the Company asserts that Starentinfringes a UTStarcom patent through the manufacture, use, offer for sale, andsale of Starent’s ST-16 Intelligent Mobile Gateway.  The Company seeks, inter alia, compensatorydamages and injunctive relief.  Starentfiled its answer to the Amended Complaint and counterclaims on September 17, 2004.  In its answer and counterclaims, Starentdenies the Company’s allegations and seeks a declaration that the patent-in-suitis not infringed, is invalid, and is unenforceable.  The Court held an initial case managementconference on November 2, 2004. On February 17, 2005, the Company filed a motion for apreliminary injunction against Starent’s use, sale, and offer for sale ofproducts having the infringing feature. The Court held a hearing on the Company’s motion on May 11, 2005and denied the Company’s motion on June 17, 2005.  On June 30, 2005, the Court held ahearing on the proper meaning or construction of the claims of the patent-in-suit.  The Court has not yet entered an orderconstruing these claims.

 

On February 16, 2005, theCompany filed a second suit against Starent for patent infringement in the U.S.District Court for the Northern District of California.  On May 6, 2005, the Company served theComplaint on Starent.  In the Complaint,the Company asserts that Starent infringes a UTStarcom patent through Starent’sdevelopment and testing of a software upgrade for its customer’s installed ST-16Intelligent Mobile Gateways.  The Companyseeks, inter alia, declaratory and injunctive relief.  The Court has set a case managementconference for August 19, 2005. Starent filed its answer and counterclaims on May 31, 2005, denyingthe Company’s allegations and seeking a declaration that the patent-in-suit isnot infringed, is invalid, and is unenforceable.  On June 16, 2005, the Company filed amotion to strike Starent’s affirmative defense and dismiss Starent’scounterclaim alleging inequitable

 

21

----

 

conduct.  On July 19, 2005, the parties stipulatedthat Starent would file an amended answer and counterclaim by July 27,2005 and that the Company would withdraw its motion to strike.

 

*FennerInvestments Patent Infringement Litigation*

 

On January 6, 2005,Fenner Investments, Ltd. (“Fenner”) filed suit against the Company and co-defendantsJuniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., LucentTechnologies, Inc., and Cisco Systems, Inc. in the U.S. DistrictCourt for the Eastern District of Texas. On May 17, 2005, Fenner amendedits complaint to add as defendants Ericsson Inc., Ericsson AB,Telefonaktiebolaget LM Ericsson, and Alcatel USA Inc.  The suit alleges that unspecified productsand services infringe two Fenner patents and seeks compensatory and injunctiverelief.  On March 1, 2005, theCompany filed a motion to dismiss the complaint due to improper venue.  On May 24, 2005, the Court denied theCompany’s motion.  On June 9, 2005,the Company filed a motion for reconsideration of the Court’s decision.  On July 14, 2005, the Court denied theCompany’s motion for reconsideration. The Court has scheduled a hearing to construe the claims of thepatents-in-suit for February 28, 2006. The Court has also scheduled trial for October 10, 2006.  This lawsuit is in its initial stage and itis not possible to reliably predict the outcome or any relief that could beawarded, as the litigation process is inherently uncertain.

 

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

 

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

 

For the three and six monthsended June 30, 2005, net proceeds from the exercise of stock options wereinsignificant and $0.7 million, respectively.  For the three and sixmonths ended June 30, 2004, the Company had $8.3 million and$17.6 million, respectively, of net proceeds from the exercise of stockoptions.  Total shares purchased through the Company’s Employee StockPurchase Plan were 439,000 and 211,750 for net proceeds of $3.6 million and$3.7 million for the three and six months ended June 30, 2005 and 2004,respectively.

 

In conjunction with the debtextinguishment agreement entered into on June 26, 2005, the Company issued 1,482,000 shares of commonstock.  Refer to Note 13, Debt.  Additional paid-in capital was increased by$10.6 million in connection with the share issuance and by $0.9 million relatedto proceeds received in connection with the amendment of the convertible bondhedge and call option.

 

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

 

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

 

The Company historicallymanaged its business as a single reportable segment. During 2004, the Companycontinued to expand its focus on markets and operations outside of China.Effective with the fourth quarter of 2004, it was determined that the Company’schief operating decision makers, in accordance with SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information,” were evaluatingperformance, making operating decisions and allocating resources based on twooperating segments, (i) China and (ii) all other regions referred toas International (“International”).

 

On November 1,2004, the Company acquired selected assets of the wireless handset division ofAudiovox Corporation. The acquired business has been integrated into theCompany as a separate and distinct operating division referred to as thePersonal Communications Division (“PCD”). As the Company determined to evaluateperformance and allocate resources to this division, it was considered a thirdoperating segment.

 

As a result, as of December 31,2004, the Company was organized, principally based on geographical marketlocations, in three operating segments, China, International and PCD, and eachsegment consisted of one reporting unit.

 

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

 

22

----

 

The Company currentlyevaluates operating performance of and allocates resources to the reportingsegments based on segment gross profit. Cost of sales and direct expenses in relation to production are assignedto the reporting segments.  Corporateheadquarters expenses and non-operating items are not allocated to thesegments.  The accounting policies usedin measuring segment assets and operating performance are the same as thoseused by corporate and are consistently applied across all segments.

 

Summarized below are theCompany’s segment sales revenue and gross profit for the three and six monthsended June 30, 2005 and 2004, respectively, based on the new reportingsegment structure.  The comparativesegment results for the six months ended June 30, 2004 incorporatesrevisions in classification of certain costs and gross profit between theWireless and Handset segments as reported in the first quarter 2005 Form 10-Q.  The impact of such revision in classificationis to decrease the previously reported prior period gross profit of the Wirelesssegment by $49.2 million and increase the Handset segment gross profit by thesame amount.

 
| ** **                      | ** ** | **Three months ended June 30, 2005**  | ** ** | ** **   | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|--------------|------------|
| **(in thousands)**              | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 64,737     |         | $          | 148,160 |   | $ | 146,039 |   | $ | 342,263 |   | $ | 21,762 |   | $ | 722,961 |   |
| Gross profit                    |       | 18,764                                     |       | 41,374       |       | 22,960 |   | 15,990 |   | 10,359 |   | 109,447 |   |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| ** **                      |       | **Three  months ended June 30, 2004** |       |         |       |
| ** **                      | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 60,266     |         | $          | 420,286 |   | $ | 194,330 |   | $ | — |   | $ | 14,746 |   | $ | 689,628 |   |
| Gross profit                    |       | 18,288                                     |       | 114,914      |       | 35,903 |   | — |   | 7,165 |   | 176,270 |   |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| ** **                      |       | **Six months  ended June 30, 2005**   |       |         |       |
| ** **                      | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 389,654    |         | $          | 258,111 |   | $ | 274,122 |   | $ | 657,815 |   | $ | 45,054 |   | $ | 1,624,756 |   |
| Gross profit                    |       | 182,280                                    |       | 71,564       |       | 37,498 |   | 29,682 |   | 26,612 |   | 347,636 |   |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| ** **                      |       | **Six  months ended June 30, 2004**   |       |         |       |
| ** **                      | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 96,967     |         | $          | 756,803 |   | $ | 430,772 |   | $ | — |   | $ | 27,377 |   | $ | 1,311,919 |   |
| Gross profit                    |       | 35,177                                     |       | 217,966      |       | 87,649 |   | — |   | 11,513 |   | 352,305 |   |

 

Assets by segment are asfollows:

 
| ** **              | ** ** | **As of June 30, 2005**      | ** ** | ** **   | ** ** |
|-------------------------|------------|-----------------------------------|------------|--------------|------------|
| **(in thousands)**      | ** ** | **Broadband**                     | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total long-lived assets |       | $                                 | 56,365     |         | $          | 87,356 |   | $ | 56,494 |   | $ | 1,210 |   | $ | 71,602 |   | $ | 273,027 |   |
| Total assets            |       | 614,175                           |       | 929,038      |       | 710,651 |   | 485,294 |   | 117,308 |   | 2,856,466 |   |
|                    |       |                              |       |         |       |   |   |   |   |   |   |   |   |
| ** **              |       | **As of  December 31, 2004** |       |         |       |
| ** **              | ** ** | **Broadband**                     | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** |   |
| Total long-lived assets |       | $                                 | 50,454     |         | $          | 106,003 |   | $ | 46,325 |   | $ | 1,330 |   | $ | 64,647 |   | $ | 268,759 |   |
| Total assets            |       | 1,018,608                         |       | 1,184,649    |       | 676,022 |   | 363,298 |   | 73,428 |   | 3,316,005 |   |

 

23

----

 

Sales data by geographicalareas are as follows:

 
| ** **         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)** | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|               |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| United States      |       | $                                    | 326,217    |                               | 45%        |   | $ | 14,387 |   | 2% |   | $ | 628,393 |   | 39% |   | $ | 31,759 |   | 2% |   |
| China              |       | 289,490                              |       | 40%                                |       | 618,323 |   | 90% |   | 516,699 |   | 32% |   | 1,188,889 |   | 91% |   |
| Japan              |       |                                 | 55,351     |                               | 8%         |   |   | 22,104 |   | 3% |   |   | 385,058 |   | 24% |   |   | 41,531 |   | 3% |   |
| Other              |       | 51,903                               |       | 7%                                 |       | 34,814 |   | 5% |   | 94,606 |   | 5% |   | 49,740 |   | 4% |   |
| Total net sales    |       | $                                    | 722,961    |                               | 100%       |   | $ | 689,628 |   | 100% |   | $ | 1,624,756 |   | 100% |   | $ | 1,311,919 |   | 100% |   |

 

Long-lived assets bygeographical areas are as follows:

 

| **(in thousands)**      | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **              | ** ** | ** **              | ** ** | ** **                  | ** ** |
| China                   |       | $                       | 237,761    |                        | $          | 229,469 |   |
| U.S.                    |       |                    | 21,416     |                        |       | 24,958 |   |
| Other                   |       | 13,850                  |       | 14,332                      |       |
| Total long-lived assets |       | $                       | 273,027    |                        | $          | 268,759 |   |

 

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

 

*Softbank*

 

The Company recognizedrevenue of $25.8 million and $50.1 million for the three and six months ended June 30,2005, respectively, and $21.1 million and $32.6 million for the three and sixmonths ended June 30, 2004, respectively, with respect to sales oftelecommunications equipment and services to SBBC, an affiliate of SOFTBANKCORP. and SOFTBANK America Inc., which, as of June 30, 2005, owned12.5% of the Company’s outstanding stock. SBBC offers asynchronous digitalsubscriber line (“ADSL”) coverage throughout Japan, which is marketed under thename “YAHOO! BB.” In addition, the Company supports SBBC’s newfiber-to-the-home service through sales of its carrier class Gigabit EthernetPassive Optical Network (“GEPON”) product as well as its multi-service opticaltransport product (“NetRingTM”).

 

Included in accountsreceivable at June 30, 2005 and December 31, 2004 were $48.3 millionand $86.8 million, respectively, related to these agreements. Customeradvances were $5.4 million and $5.5 million as of June 30, 2005 and December 31,2004, respectively.  Deferred revenue was$5.9 million and $0.5 million as of June 30, 2005 and December 31,2004, respectively.

 

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

 

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

 

The promotional servicesdiscussed above involved contracting with third party promotional vendors, whoin turn, facilitated the marketing and subscriber recruitment for the JTfiber-to-the-home program. During the fourth quarter of 2004, the Companydetermined that it would end its involvement with the JT promotional programafter completion of the contract discussed above. Accordingly, late in thefourth quarter of 2004 and during the first quarter of 2005, the Company eithercancelled or assigned to

 

24

----

 

another party all thirdparty contracts with promotional vendors related to the JT contract. Suchtermination or assignment of all third party promotional agreements, as well aseffective satisfaction of our obligations with JT under such agreements hassatisfied the revenue recognition criteria for these agreements and as such,the net value of the promotional services and the value of equipment delivered,which totaled $204.8 million, has been reported in the quarter ended March 31,2005.

 

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

 

The Company recognizedrevenue of $4.7 million and $276.0 million for the three and six months ended June 30,2005, respectively, with respect to sales of telecommunications equipment toJT.  At June 30, 2005, deferredrevenue from JT was $15.1 million and $43.0 million was included in accountsreceivable due from JT.

 

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

 

On July 17, 2003, theCompany entered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BBModem”), an affiliate of SOFTBANK CORP. Under the terms of the agreement, theCompany loaned BB Modem $10.1 million at an effective interest rate of 12.01%per annum, for the purpose of investing in a portfolio of ADSL modems andassociated modem rental agreements, from SBBC. SBBC will continue to servicesuch modems and modem rental agreements. The Company’s loan is subordinated tocertain senior lenders of BB Modem, and repayments are payable to the Companyover a 42-month period through January 31, 2007, with a substantialportion of the principal amount of the loan scheduled to be repaid duringthe last 16 months of this period. The Company’s recourse for nonpayment of theloan is limited to the assets of BB Modem, the account into which subscriberpayments are made and its rights under the securitization transactiondocuments. The value of BB Modem’s modems that serve as collateral for the loanmay decrease over time and may not be sufficient upon sale to pay theoutstanding amounts on the loans. The Company assesses the loan for impairmentwhenever events or changes in circumstances indicate that the carrying amountmay not be recoverable. The Company periodically reviews the underlying qualityof the asset pool securing the loan to assess whether impairment has incurredand needs to be recorded. During the three and six months ended June 30,2005, the Company recorded $0.3 million and $0.7 million, respectively, ininterest income in respect to this loan. During the three and six months ended June 30, 2004, the Companyrecorded $0.3 million and $0.7 million, respectively, in interest income inrespect to this loan.  The loanreceivable balances at June 30, 2005 and December 31, 2004 wereapproximately $10.9 million and $11.8 million, respectively, and were includedin other long-term assets.

 

On April 5, 2003, theCompany repurchased 8.0 million shares of common stock beneficially ownedby SOFTBANK America Inc., at a purchase price of $17.385 per share. Thetotal cost of the repurchase was $139.6 million including transactionfees. In connection with this repurchase transaction, SOFTBANK America Inc.entered into an agreement with the Company not to offer, sell or otherwisedispose of the Company’s common stock for a period of one year, subject to anumber of exceptions. As of June 30, 2005, SOFTBANK America Inc.beneficially owned approximately 12.5% of the Company’s outstanding stock.

 

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

 

*Cellon*

 

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

 

*Fiberxon*

 

The Company has an outstandingpurchase commitment with Fiberxon, in which the Company has an 11% ownershipinterest, to purchase component parts for optical networking products. TheCompany anticipates it will be able to fulfill this commitment without

 

25

----

 

material adverseconsequences to the operations or financial condition of the Company. Purchasesfrom Fiberxon totaled $3.1 million and $8.1 million during the three and sixmonths ended June 30, 2005. As of June 30, 2005 the Company had $2.6million in accounts payable and no open purchase commitments to Fiberxon.

 

*StarcomProducts, Inc.*

 

The Company obtainsengineering consulting and employee placement services from Starcom Products, Inc.(“Starcom”), which is 31% owned by an individual related to a member of theCompany’s Board of Directors. The Company paid $1.1 million to Starcom in2004.   In the three and six months endedJune 30, 2005, the Company obtained services from this entity in theamount of $0.5 million.

 

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

 

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

 

During the three monthsended June 30, 2005, the Company incurred approximately $20.7 million inexpenses in relation to the restructuring plan actions, primarily consisting of$7.6 million related to severance payments, $7.5 million in asset impairmentsprimarily related to the write-off of equipment and licenses associated withdiscontinued products and which are included in operating expenses and $5.5million in inventory write-off which is associated with discontinuedproducts.  Restructuring expense relatedto the inventory write-off is included in cost of sales in the Statements ofOperations.  As of June 30, 2005,approximately 870 employees had been terminated or placed in the workforcereduction programs.

 

 

26

----

 

The following table displaysa rollforward of the restructuring plan associated costs for the three monthsended June 30, 2005:

 

| ** **          | ** ** | **Three months ended June 30, 2005** | ** ** |
|---------------------|------------|-------------------------------------------|------------|
| **(in thousands)**  | ** ** | **Charges**                               | ** ** | **Cash  payment** | ** ** | **Non-cash  settlement** | ** ** | **Balance** | ** ** |
|                |       |                                      |       |   |   |   |   |   |   |
| **Wireless**        |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | $                                         | 894        |   | $ | (980 | ) | $ | 103 |   | $ | 17 |   |
| Asset impairment    |       | 6,024                                     |       | — |   | (5,914 | ) | 110 |   |
| Inventory write-off |       | 5,543                                     |       | — |   | (5,543 | ) | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| **Broadband**       |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | 1,361                                     |       | (484 | ) | 22 |   | 899 |   |
| Asset impairment    |       | 1,079                                     |       | — |   | (1,029 | ) | 50 |   |
| Inventory write-off |       | —                                    |       | — |   | — |   | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| **Handsets**        |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | 963                                       |       | (1,039 | ) | 97 |   | 21 |   |
| Asset impairment    |       | 350                                       |       | — |   | — |   | 350 |   |
| Inventory write-off |       | —                                    |       | — |   | — |   | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| **PCD**             |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | —                                    |       | — |   | — |   | — |   |
| Asset impairment    |       | —                                    |       | — |   | — |   | — |   |
| Inventory write-off |       | —                                    |       | — |   | — |   | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| **Service**         |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | 1,157                                     |       | (1,088 | ) | 52 |   | 121 |   |
| Asset impairment    |       | —                                    |       | — |   | — |   | — |   |
| Inventory write-off |       | —                                    |       | — |   | — |   | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| **Corporate**       |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | 3,267                                     |       | (2,693 | ) | 476 |   | 1,050 |   |
| Asset impairment    |       | 32                                        |       | — |   | — |   | 32 |   |
| Inventory write-off |       | —                                    |       | — |   | — |   | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| **Summary Totals**  |       |                                      |       |   |   |   |   |   |   |
| Severance payments  |       | $                                         | 7,642      |   | $ | (6,284 | ) | $ | 750 |   | $ | 2,108 |   |
| Asset impairment    |       | 7,485                                     |       | — |   | (6,943 | ) | 542 |   |
| Inventory write-off |       | 5,543                                     |       | — |   | (5,543 | ) | — |   |
|                |       |                                      |       |   |   |   |   |   |   |
| Total               |       | $                                         | 20,670     |   | $ | (6,284 | ) | $ | (11,736 | ) | $ | 2,650 |   |

 

 

27

----

 

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

 

The other income (expense) balancesin the three and six months ended June 30, 2005 and 2004 are comprised ofthe following items:

 

| ** **                           | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in millions)**                    | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Japan consumption tax refund         |       | $                                    | 4.8        |                               | $          | 1.0 |   | $ | 6.0 |   | $ | 2.4 |   |
| Foreign exchange gains (losses)      |       | (6.8                                 | )          | 0.9                                |       | (14.6 | ) | 0.5 |   |
| Chinese government financial subsidy |       | —                               |       | 2.1                                |       | 0.5 |   | 10.1 |   |
| Dividend income                      |       | —                               |       | 0.5                                |       | — |   | 0.5 |   |
| Gain on debt extinguishment          |       | 11.1                                 |       | —                             |       | 11.1 |   | — |   |
| Other                                |       | (0.2                                 | )          | (0.2                               | )          | (1.0 | ) | (0.5 | ) |
| Total                                |       | $                                    | 8.9        |                               | $          | 4.3 |   | $ | 2.0 |   | $ | 13.0 |   |

 

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

 

For the three and six monthsended June 30, 2005, approximately 40% and 32% of the Company’s sales,respectively, were derived from China. For the three and six months ended June 30, 2004, approximately 90%and 91% of the Company’s sales, respectively, were derived from China.

 

For the three and six monthsended June 30, 2005, sales recorded in Japan accounted for approximately8% and 24% of total sales, respectively, mainly resulting from the firstquarter recognition of deferred revenue recorded in prior year.  Refer to Note 18, Related Party Transactionsfor additional information.  For boththree and six months ended June 30, 2004, sales recorded in Japanaccounted for approximately 3% of total sales.

 

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

 

In establishing its deferredincome tax assets and liabilities, the Company makes judgments andinterpretations based on the enacted tax laws and published tax guidanceapplicable to its operations as well as the amount and jurisdiction of futuretaxable income.  The Company recordsdeferred tax assets and liabilities and evaluates the need for valuationallowances to reduce the deferred tax assets to realizable amounts.  The likelihood of a material change in theCompany’s expected realization of these assets is dependent on future taxableincome, its ability to use foreign tax credit carryforwards and carrybacks, andthe effectiveness of its tax planning strategies in the various relevantjurisdictions.  Changes to the Company’sincome tax provision or in the valuation of the deferred tax assets andliabilities may affect its annual effective income tax rate.

 

Income tax expense was abenefit of $1.5 million and an expense of $11.0 million for the three monthsended June 30, 2005 and 2004, respectively.  Income tax expense was $6.4 million and $24.7million for the six months ended June 30, 2005 and 2004,respectively.   The Company’s 2005 annualeffective tax benefit rate is estimated to be 8.8%, excepting discrete itemsprimarily relating to the valuation of deferred tax assets and the reversal ofinterest on certain tax reserves.  In thesix months ended June 30, 2005, the Company recorded an additional taxexpense of $9.0 million primarily relating to the valuation of its deferred taxassets in China offset by the reversal of interest on certain taxreserves.  During the quarter, UTStarcomTelecom Co., Ltd. (“HUTS”) received approval for a Knowledge Intensive,Technology Intensive Certificate (“Certificate”) which subjects the company toa reduced national tax rate of 15%.  Inthe previous quarter, the Company recorded a reduction in tax expense of $4.5million attributable to an increase in deferred tax assets arising from theassessment of a local income tax for HUTS and Hangzhou UTStarcom Telecom Co.,Ltd. (“HSTC”) in China.  The approval ofthe Certificate currently has no effect on the local taxation of HUTS.

 

The difference between thecurrent estimated annual effective tax benefit rate of 8.8% and the effectivetax provision rate of 27% projected in the first quarter of this year isprimarily due to changes in estimated annual income.  The Company has increased the estimatedannual losses in China which are benefited at lower tax rates offset byestimated income in the U.S. and Japan which are taxed at higher rates.  The difference between the U.S. statutoryprovision rate of 35% and the 2005 estimated benefit rate of 8.8% isattributable to expected utilization of operating losses, permanent taxdeductions related to the Company’s convertible debt offering in 2003 and lowertax rates in various jurisdictions the Company operates in, partially offset byapplication of state income taxes.

 

28

----

 

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

 

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

 

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

 

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

 

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

 

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

 

InDecember 2004, the FASB issued FSP No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004.”  TheAmerican Jobs Creation Act of 2004 provides a one-time 85% dividends receiveddeduction for certain foreign earnings that are repatriated under a plan forreinvestment in the United States, provided certain criteria are met.  FSP No. FAS 109-2 is effectiveimmediately and provides accounting and disclosure guidance for therepatriation provision.  FSP No. FAS109-2 allows companies additional time to evaluate the effects of the law onits unremitted earnings for the purpose of applying the “indefinite reversalcriteria” under APB Opinion No. 23, “Accounting for Income Taxes—SpecialAreas,” and requires explanatory disclosures from companies that have not yetcompleted the evaluation.  The Company iscurrently evaluating the effects of the repatriation provision and their impacton its consolidated financial statements. The Company does not expect to complete this evaluation before the endof 2006.  The range of possible amountsof unremitted earnings that is being considered for repatriation under thisprovision is between zero and $540 million and the related potential range ofincome tax is between zero and $28 million.

 

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

 

In June 2005, the FASB’sEmerging Issues Task Force (“EITF”) issued EITF Issue No. 05-02 “The Meaning of‘Conventional Convertible Debt Instrument’ in EITF Issue 00-19 ‘Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock’”, which retains the exception in paragraph 4 of EITF IssueNo. 00-19 for conventional convertible debt instruments. Those instruments inwhich the holder has an option to convert the instrument into a fixed number ofshares (or a corresponding amount of cash at the issuer’s discretion) and itsability to exercise the option is based on either (a) the passage of time or (b)a contingent event, should be considered “conventional” for purposes ofapplying that exception. The consensus should be applied on a prospective basisfor new or modified instruments starting from the third quarter of 2005. Theadoption of EITF No.** **05-02 isnot expected to have a material effect on the Company’s consolidated financialstatements or results of operations.

 

OnJune 1, 2005, the Financial Accounting Standards Board (“FASB”) issuedFASB Statement No. 154, Accounting Changes and Error Corrections (“SFAS154”), which will require entities that make a voluntary change in accountingprinciple to apply that change retrospectively to prior periods’ financialstatements, unless this would be impracticable. SFAS 154 supersedes AccountingPrinciples

 

29

----

 

BoardOpinion No. 20, Accounting Changes (“APB 20”), which previously requiredthat most voluntary changes in accounting principle be recognized by includingin the current period’s net income the cumulative effect of changing to the newaccounting principle.  SFAS 154 alsomakes a distinction between “retrospective application” of an accountingprinciple and the “restatement” of financial statements to reflect thecorrection of an error.

 

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

 

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

 

On August 1, 2005, theCompany entered into a Committed Receivables Purchase Agreement (“Agreement”)with a commercial bank, whereby the Company may sell up to $100.0 million ofits eligible accounts receivable, as defined in the Agreement.  The initial term of the Agreement will expireone year from execution but shall be extended automatically. The Agreementcontains provisions customary in transactions of this nature including certaincommitment fees.

 

30

----

 

**ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**FORWARD-LOOKINGSTATEMENTS**

 

This Report on Form 10-Q containsforward-looking statements within the meaning of the federal securities laws. Thesestatements are based on information that is currently available to management. Weintend such forward-looking statements to be covered by the safe harborprovisions of the Private Securities Litigation Reform Act of 1995, and we areincluding this statement for purposes of complying with those provisions. Theforward-looking statements include, without limitation, those concerning thefollowing: our expectations as to the nature of possible trends, including ourexpectations about continuing growth in the number of subscribers fortelecommunications products in the countries in which we do business; ourexpectations regarding competition in the markets in which we compete; ourexpectation that there will be fluctuations in our overall gross profit, grossprofit as a percentage of sales, net sales (including sales to specificcustomers), gross margin, product mix, quarter to quarter results, customerbase, selling prices and accounts receivable; our expectations concerning dayssales outstanding; our expectations regarding the evolution of our internalcontrols over financial reporting and the existence or discovery of futureadditional material weaknesses or significant deficiencies; our expectationsregarding our selling and marketing campaigns, the size of our salesorganization, and the amount of our sales and marketing expenditures; ourexpectations regarding the expenditure of significant resources to comply withSection 404 of the Sarbanes-Oxley Act and other related rules; ourexpectations regarding our annual effective tax rate and our activities tomanage our tax structure on a worldwide basis; our expectations regarding ourplans for expanding the direct sales organization and our selling and marketingcampaigns and activities; our expectation that we may use our cash, debt orsecurities to acquire or invest in complementary businesses, technologies orproduct offerings; our expectations regarding trends in customer acceptance ofour products; our expectations regarding trends in our industry; ourexpectations regarding future growth of our business and operations; ourexpectations regarding our ability to take advantage of strategic investmentopportunities; our expectations regarding the status of products under development;our expectations regarding our future levels of cash and cash equivalents, aswell as our expectation that existing credit facilities, short-terminvestments, cash and cash equivalents will be sufficient to finance ouroperations for the foreseeable future; our expectations regarding our currencyrisk management activities; our expectations regarding the potential impact onour results of operations, financial position and statement of cash flows fromchanges in legal and accounting regulations; our expectations regardinglicensing requirements and our ability to receive licenses in China for our PASsystem and other products; our expectations regarding the development of 3Gnetworks in China; our expectations regarding the development of a market forIPTV products and our ability to compete in such market; our expectationsregarding the impact of a reorganization of telecommunications companies inChina; our expectation that our business will continue to be significantlyinfluenced by the political, economic and legal environment in China, as wellas expectations about the nature of political, economic and legal reform in China;our expectations regarding the importance of sales in China to our operatingresults; our expectations regarding the future allocation of net sales byproduct group and geographic location; our expectations regarding efficiencieswe hope to achieve in supply chain management and inventory purchasing, as wellas trends in inventory growth; our expectations regarding our ability to reducemanufacturing costs; our expectations regarding our restructuringeffort to reduce costs, its timely completion and our ability to achieve theanticipated level of cost savings; ourexpectations regarding our ability to implement and enhance our administrativeinfrastructure; our expectations regarding our expansion into new marketsaround the world and the expansion of our operations to address potentialmarket opportunities; our expectations regarding the anticipated growth ofInternet-related businesses in China; our expectations regarding the long-termdemand for our PAS/iPAS products and the importance of the PAS technology andmarket in the future; our expectations regarding our ability to fulfilloutstanding purchase commitments; our expectations regarding our ability torepair certain units under special warranty coverage in a timely manner; andour expectations regarding our costs associated with our global transformation.Additional forward-looking statements may be identified by the words“anticipate,” “expect,” “believe,” “intend,” “will,” and similar expressions,as they relate to us or our management. Investors are cautioned that theseforward-looking statements are inherently uncertain. These statements aresubject to risks and uncertainties that may cause actual results and events todiffer materially. For a detailed discussion of these risks and uncertainties,see the “Factors Affecting Future Operating Results” section of thisForm 10-Q. We do not guarantee future results and undertake no obligationto update the forward-looking statements to reflect events or circumstancesoccurring after the date of this Form 10-Q.

 

**EXECUTIVESUMMARY**

 

We design, manufacture andsell telecommunications equipment and handset products and provide servicesassociated with their operation. Our telecommunication equipment products aredeployed and installed globally primarily by wireless and wirelinetelecommunications service providers. We provide an extensive range of productsfor transportation of voice, data and video traffic for these serviceproviders. We are currently operating in China, Japan, India, the Central andLatin American region, North America, the European, Middle Eastern and Africanregion and southeastern and northern Asia.

 

We differentiate ourselveswith products designed to reduce network complexity, integrate high performancecapabilities and allow a simple transition to next generation networks. Wedesign our products to facilitate cost-effective and efficient deployment,maintenance and upgrades.

 

Our key product familiesfall into three major categories:

 

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

 

31

----

 

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

 

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

 

We operate our businessin five segments (i) Broadband Infrastructure, (ii) WirelessInfrastructure, (iii) Handsets, (iv) Personal Communications Division(“PCD”), and (v) Services. For the three and six months ended June 30,2005, we recorded $723.0 million and $1,624.8 million of revenue, respectively,a 5% and 24% increase over the corresponding periods in 2004.  Historically, a substantial majority of oursales have been to telecommunication service providers in China.  Infiscal 2004, we continued to focus on the diversification of our globalcustomer base and market penetration internationally, and as a result, oursales derived from outside of China as a percentage of total sales haveincreased.  For the three and six monthsended June 30, 2005, 40% and 32% of our sales were derived from China ascompared to 90% and 91% for the three and six months ended June 30,2004.  The maturation of our PAS markettogether with customer delays in capital spending in anticipation of nextgeneration technology equipment have caused lower demand for our products inChina.  In addition, in the first quarterof 2005 we posted stronger sales revenue in Japan principally resulting fromthe recognition of revenue previously deferred in relation to certainagreements with Japan Telecom.

 

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

 

We use subscriber growthstatistics to gauge future inventory purchasing requirements as well as toforecast our anticipated revenue growth. We expect this subscriber growth tocontinue throughout 2005 because China’s teledensity rates, or the number oftelephones per person in a region, remain relatively low in comparison to thatof developed countries.

 

*The number of competitors for communications access andswitching systems and handsets in China has grown in line with China’stelecommunications market expansion. This growth has led to competitive pricingpressure, causing average selling prices to decrease during the three and sixmonths ended June 30, 2005 relative to those in the comparativeperiods in 2004.  In addition, grossprofit related to the handset sales from PCD which accounted for 47% and 40% ofour total sales for the three and six months ended June 30, 2005,respectively, is significantly lower than gross profit related to our PersonalAccess System (“PAS”) based handsets.*

* *

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

 

Over the past few years, wehave undertaken a significant globalization program and we intend to continueto expand our global sales outside of China in the current year. As we expand,we intend to continue to improve our internal supply chain and inventorymanagement processes to ensure timely deliveries. We also intend to continue toimplement and enhance our administrative infrastructure to assist our growthand globalization transformation.

 

**KEY TRANSACTIONS**

 

*Debtextinguishment*

 

OnJune 24, 2005 we entered into an agreement to exchange 1,482,000 shares ofour common stock with a fair value of approximately $10.6 million andapproximately $15.8 million in cash for $38.0 million aggregate principalamount of our outstanding 7/8% Convertible Subordinated Notes due 2008 (the “Notes”)as proposed to us by one of our Note holders. The exchange was settled on June 29, 2005.  This exchange is considered an earlyextinguishment of debt in which the aggregate fair value of the common stockand cash is less than the carrying value of the Notes.  Accordingly, we recorded a gain of $11.1million on the extinguishment and included the gain in other income in the ConsolidatedStatements of Operations.

 

OnJune 30, 2005 we entered into a separate agreement to exchange 1,560,000shares of our common stock and $17.0 million in cash for $40.0 millionaggregate principal amount of the Notes. The exchange agreement was settled on July 7, 2005.  This exchange is considered an earlyextinguishment of debt in which the aggregate fair value of the common stock ofapproximately $11.7 million and approximately $17.0 million in cash is lessthan the carrying value of the Notes, and the resulting gain on the exchange of$10.8 million is to be recorded in the third quarter of 2005.

 

32

----

 

*Acquisitions*

 

Pedestal

 

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

 

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

 

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

 

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

 

Giga

 

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

 

The acquisition wascompleted on January 4, 2005. At the closing, $13.0 million in cash waspaid, and an additional $2.0 million was paid into an escrow account held by usfor six months.  The total considerationfor the acquisition, funded from cash on hand, was approximately $18.4 million,including $2.0 million acquisition-related transaction costs and $1.5 millionpayment previously made to be applied against the purchase price.  An earn-out of up to $2.0 million may becomepayable upon completion of certain product design milestones which will beadjusted to be part of the purchase price in accordance with Statement ofFinancial Accounting Standards No. 141, “Business Combinations.”  As of June 30, 2005, no milestones havebeen met and no contingent payment was accrued.

 

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

 

*Restructuring costs*

 

In the second quarter offiscal 2005, we announced and initiated a restructuring plan to rationalize ourcost structure in response to the decline in demand for certain of our products.  In addition, the restructuring plan isdesigned to align investments with key growth opportunities and facilitate theprocess of globalization.  The primarygoal of these improvements is to optimize our cost structure and enable us todeliver consistent and sustainable profitability for our stockholders.

 

During the three monthsended June 30, 2005, we incurred approximately $20.7 million in expensesin relation to the restructuring

 

33

----

 

plan actions, primarilyconsisting of $7.6 million in severance payments, $7.5 million in assetimpairments primarily related to the write-off of equipment and licensesassociated with discontinued products and which are included in operatingexpenses and $5.5 million inventory write-off which is associated withdiscontinued products.  Restructuringexpense related to the inventory write-off is included in cost of sales in theStatements of Operations.  As of June 30,2005, approximately 870 employees had been terminated or placed in workforcereduction programs and we expect to complete the restructuring plan by the endof the third quarter.  We continue ourefforts in evaluating certain operations and may incur additional costsassociated with future actions to further align our business operations.

 

*Subsequent event*

 

On August 1, 2005, weentered into a Committed Receivables Purchase Agreement (“Agreement”) with acommercial bank, whereby we may sell up to $100.0 million of our eligibleaccounts receivable, as defined in the Agreement.  The initial term of the Agreement will expireone year from execution but shall be extended automatically. The Agreementcontains provisions customary in transactions of this nature including certaincommitment fees.

 

**RELATEDPARTY TRANSACTIONS:**

 

*Softbank*

 

We recognized revenue of$25.8 million and $50.1 million for the three and six months ended June 30,2005, respectively, and revenue of $21.1 million and $32.6 million for thethree and six months ended June 30, 2004, respectively, with respect tosales of telecommunications equipment and services to SBBC, an affiliate ofSOFTBANK CORP. and SOFTBANK America Inc., which is one of our significantstockholders. SBBC offers asynchronous digital subscriber line (“ADSL”)coverage throughout Japan, which is marketed under the name “YAHOO! BB.” Inaddition, we support SBBC’s new fiber-to-the-home service through sales of itscarrier class Gigabit Ethernet Passive Optical Network (“GEPON”) product as wellas its multi-service optical transport product (“NetRingTM”).

 

Included in accountsreceivable at June 30, 2005 and December 31, 2004 were $48.3 millionand $86.8 million, respectively, related to these agreements. Customeradvances were $5.4 million at June 30, 2005 and $5.5 million at December 31,2004, respectively.  Deferred revenue was$5.9 million and $0.5 million as of June 30, 2005 and December 31,2004, respectively.

 

During the first quarter of2005, we agreed to incur special warranty coverage for certain ADSL equipmentsold to SBBC during 2003 and 2004.  Sinceour agreement to repair these parts exceed our normal warranty terms, we haverecorded a special warranty charge in the first quarter of $9.5 million.Completion of the repair of these units is expected to be completed by the endof 2005.

 

During August 2004, weentered into several agreements with Japan Telecom Co., Ltd (“JT”), a whollyowned subsidiary of SOFTBANK Corp. These agreements relate to the sale of *i*AN-8000 equipment with specified valueand delivery dates, as well as an oral agreement which subsequently convertedinto specific service contracts to manage a sales promotional program for JT.The total gross value of this agreement is $534.1 million. We have determinedthat the service activities revenue should be recorded net of expectedpromotional spending.

 

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

 

The promotional servicesdiscussed above involved contracting with third party promotional vendors who,in turn, facilitated the marketing and subscriber recruitment for the JTfiber-to-the-home program. During the fourth quarter of 2004, we determinedthat we would end our involvement with the JT promotional program aftercompletion of the contract discussed above. Accordingly, late in the fourthquarter of 2004 and during the first quarter of 2005, we either cancelled orassigned to another party all third party contracts with promotional vendorsrelated to the JT contract. Such termination or assignment of all third party promotionalagreements, as well as effective satisfaction of obligations with JT under suchagreements has satisfied the revenue recognition criteria for these

 

34

----

 

agreements and as such, thenet value of the promotional services and the value of equipment delivered,which totaled $204.8 million, has been reported in the quarter ended March 31,2005.

 

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

 

We recognized revenue of$4.7 million and $276.0 million for the three and six months ended June 30,2005, respectively, with respect to sales of telecommunications equipment toJT.  At June 30, 2005, deferredrevenue from JT was $15.1 million and $43.0 million was included in accountsreceivable due from JT.

 

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

 

On July 17, 2003, weentered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”),an affiliate of SOFTBANK CORP. Under the terms of the agreement, we loaned BBModem $10.1 million at an effective interest rate of 12.01% per annum, for thepurpose of investing in a portfolio of ADSL modems and associated modem rentalagreements, from SBBC. SBBC will continue to service such modems and modemrental agreements. Our loan is subordinated to certain senior lenders of BBModem, and repayments are payable to us over a 42-month period through January 31,2007, with a substantial portion of the principal amount of the loanscheduled to be repaid during the last 16 months of this period. Our recoursefor nonpayment of the loan is limited to the assets of BB Modem, the accountinto which subscriber payments are made and its rights under the securitizationtransaction documents. The value of BB Modem’s modems that serve as collateralfor the loan may decrease over time and may not be sufficient upon sale to paythe outstanding amounts on the loans. We assess the loan for impairmentwhenever events or changes in circumstances indicate that the carrying amountmay not be recoverable. We periodically review the underlying quality of theasset pool securing the loan to assess whether impairment has incurred andneeds to be recorded. During the three and six months ended June 30, 2005,we recorded $0.3 million and $0.7 million, respectively, in interest income inrespect to this loan. The loans receivable at June 30, 2005 and December 31,2004 were approximately $10.9 million and $11.8 million, respectively, and wereincluded in other long-term assets.

 

On April 5, 2003, werepurchased 8.0 million shares of common stock beneficially owned bySOFTBANK America Inc., at a purchase price of $17.385 per share. The totalcost of the repurchase was $139.6 million including transaction fees. Inconnection with this repurchase transaction, SOFTBANK America Inc.entered into an agreement with us to not offer, sell or otherwise dispose ofthe Company’s common stock for a period of one year, subject to a number ofexceptions. As of June 30, 2005, SOFTBANK America Inc. beneficiallyowned approximately 12.5% of our outstanding stock.

 

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

 

*Cellon*

 

In October 2002, weentered into a license and a royalty agreement with Cellon International HoldingCorporation (“Cellon”), in which we have a 9% ownership interest. Per the termsof the royalty agreement, we are required to pay Cellon $3.00 per unit shippedfor a minimum of 0.1 million units. This agreement is not material to theoverall financial results of Cellon. We have evaluated our relationship withCellon under FIN 46, and determined that consolidation is not necessary.

 

*Fiberxon*

 

We have an outstandingpurchase commitment with Fiberxon, in which we have an 11% ownership interest,to purchase component parts for optical networking products. We anticipate thatwe will be able to fulfill this commitment without material adverseconsequences to our operations or financial condition. Purchases from Fiberxontotaled $3.1 million and $8.1 million during the three and six months ended June 30,2005. As of June 30, 2005, we had $2.6 million in accounts payable and noopen purchase commitments to Fiberxon.

 

35

----

 

*StarcomProducts, Inc.*

 

We obtain engineering consultingand employee placement services from Starcom Products, Inc. (“Starcom”),which is 31% owned by an individual related to a member of our Board ofDirectors. We paid $1.1 million to Starcom in 2004.  We obtained services amounted to $0.5 millionfrom this entity in the three and six months ended June 30, 2005.

 

**RESULTSOF OPERATIONS**

 

Our net sales consist ofproduct and service sales within three broad telecommunications productfamilies:  (i) wirelessinfrastructure, (ii) broadband infrastructure, and (iii) handsets andcustomer premise equipment. Wireless infrastructure is primarily comprised ofthe PAS and CDMA products. Broadband infrastructure is primarily comprised ofthe iAN-8000, IP-Based Digital Subscriber Line Access Multiplexer (“IP-DSLAM”)(“AN-2000”), GEPON, NetRingTM and other wireline products. The handsets andcustomer premise equipment products include PAS handsets, CPE and CDMA handsetsthat were introduced in the fourth quarter of 2004. With many of our productsales, we provide installation services. Additionally, we provide maintenanceservices for some of our products. We organize and operate our business in fiveoperating segments principally based upon these three product families, namely,Broadband, Wireless, Handsets, PCD and Services.  For each of the periods presented, totalservices sales accounted for less than 10% of net sales.  For the three and six months ended June 30,2005, our net sales were $723.0 million and $1,624.8 million,respectively,  in comparison to $689.6million and $1,311.9 million, respectively, in the corresponding periods lastyear.  Net sales may not grow at the samerate or may even decline in the future. Net sales increased in Broadband andService segments, and decreased in Wireless and Handsets segments in the threeand six months ended June 30, 2005 compared to the corresponding periodsof 2004.  PCD sales revenue wasincremental in comparison to the same periods in 2004 as a result of theselected assets acquisition from Audiovox in November 2004.

 

As a result of areduction in current and projected market demand for certain products, weannounced and initiated in the second quarter of 2005 a restructuring plan torationalize our cost structure and product offering.  This action has resulted in reduction ofpersonnel and impairment of certain assets which is expected to reduce ourongoing cost run rate.

 

Cost of sales consistsprimarily of material and labor costs associated with manufacturing, assemblyand testing of products, costs associated with installation and customertraining, warranty costs, fees to agents, inventory provision and overhead.  Cost of sales also includes import taxes andtariffs 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 party manufacturers to manufacture andassemble most of our handsets.

 

Our gross profit hasbeen affected by average selling prices, material costs and product mix.  In particular, the acquisition of PCD in November 2004has resulted in a higher percentage of revenue associated with a productoffering at lower margins.  Our grossprofit, as a percentage of net sales, varies among our product families. Weexpect that our overall gross profit, as a percentage of net sales, willfluctuate from period to period as a result of shifts in product mix,anticipated decreases in average selling prices and our ability to reduce costof sales.

 

Selling, general andadministrative expenses (“SG&A”) include compensation and benefits,professional fees, sales commissions, provision for doubtful accountsreceivable and travel and entertainment costs. A portion of our SG&A costsare fixed and are difficult to quickly reduce in periods of reduced sales. However,during the second quarter of 2005, we announced and initiated a restructuringplan which resulted in the reduction of certain SG&A costs to better alignour cost structure with current revenues.

 

Research and developmentexpenses consist primarily of salaries and related costs of employees engagedin research, design and development activities, costs of parts for prototypes,equipment depreciation and third party development expenses. A portion of ourcosts are fixed and are difficult to quickly reduce in periods of lower sales. However,during the second quarter of 2005, we announced and initiated a restructuringplan which resulted in the reduction of certain research and development costs.We believe that continued investment in research and development is critical toour long-term success.

 

Income tax expense isbased upon a blended effective tax rate based upon our expectation of theamount of income to be earned in each tax jurisdiction. We use credits andother tax incentives to minimize our income tax expense.

 

36

----

 

**NET SALES**

 
| ** **         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)** | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|               |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| United States      |       | $                                    | 326,217    |                               | 45%        |   | $ | 14,387 |   | 2% |   | $ | 628,393 |   | 39% |   | $ | 31,759 |   | 2% |   |
| China              |       | 289,490                              |       | 40%                                |       | 618,323 |   | 90% |   | 516,699 |   | 32% |   | 1,188,889 |   | 91% |   |
| Japan              |       |                                 | 55,351     |                               | 8%         |   |   | 22,104 |   | 3% |   |   | 385,058 |   | 24% |   |   | 41,531 |   | 3% |   |
| Other              |       | 51,903                               |       | 7%                                 |       | 34,814 |   | 5% |   | 94,606 |   | 5% |   | 49,740 |   | 4% |   |
| Total net sales    |       | $                                    | 722,961    |                               | 100%       |   | $ | 689,628 |   | 100% |   | $ | 1,624,756 |   | 100% |   | $ | 1,311,919 |   | 100% |   |

 

## ***Three months ended June 30, 2005 and 2004***

 

Net sales were $723.0million in the three months ended June 30, 2005, an increase of 5%compared to $689.6 million in the corresponding period of 2004. Although salesgenerated from China decreased, our overall net sales increased. This wasprimarily due to the incremental sales in the United States derived from PCD,resulting from the selected assets we acquired from Audiovox in November 2004.

 

Net sales revenue bygeography shifted significantly in comparison to the corresponding period of2004, attributable in part to our continuous efforts to grow our businessinternationally. Revenue derived from China accounted for approximately 40% ofour net sales revenue in the three months ended June 30, 2005, incomparison to approximately 90% in the corresponding period last year.

 

As we have experienced inrecent quarters, the demand for our PAS/iPAS products, including PAS/iPASsystem-based handsets, in the China market continued to mature, resulting inlower demand and average selling prices. We believe that demand for our PAS products has weakened as telecommunicationservice providers delay deploying new systems in anticipation of theintroduction of new technology for next generation telecommunication equipment.  However, we expect long-term demand for ourPAS/iPAS products will continue as we believe PAS will remain an importanttechnology and market in China for the foreseeable future.

 

Net sales increased in ourBroadband Infrastructure and Service segments. Net sales decreased in Wirelessand Handsets segments, offset by incremental sales derived from PCD, in thethree months ended June 30, 2005, compared to the corresponding period in2004.  For additional discussion of ourbusiness segments see “Segment Reporting” on page 42.

 

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

 

Jingsu province contributedapproximately 10% of our net sales for the three months ended June 30,2005.  Jiangsu and Hei Long Jiang provincescontributed approximately 15% and 10% respectively, of our net sales for thethree months ended June 30, 2004.

 

*Six months ended June 30,2005 and 2004*

 

Net sales were $1,624.8million in the six months ended June 30, 2005, an increase of 24% from$1,311.9 million in the corresponding period of 2004.  The overall increase in net sales wasprimarily due to the incremental revenue derived from PCD, resulting from theselected assets we acquired from Audiovox in November 2004, stronger firstquarter sales revenue in our Broadband Infrastructure segment primarily due torecognition of revenue for products delivered to Japan Telecom in the third andfourth quarters of 2004 which had been previously deferred, offset by thedecrease in Wireless and Handset sales in China.

 

Net sales increased in ourBroadband Infrastructure and Service segments. Net sales decreased in Wirelessand Handsets segments, offset by incremental sales derived from PCD, in the sixmonths ended June 30, 2005, compared to the corresponding period in2004.  For additional discussion of ourbusiness segments see “Segment Reporting” on page 42.

 

Net sales revenue bygeography shifted significantly in comparison to the corresponding period of2004, attributable in part to our continuous efforts to grow our businessinternationally. Revenue derived from China accounted for approximately 32% ofour net sales revenue in the six months ended June 30, 2005, in comparisonto approximately 91% in the corresponding period last year.

 

37

----

 

Sales to JT accounted for 17%of our sales for the six months ended June 30, 2005. Guangdong, Jiangsuand Hei Long Jiang province accounted for 16%, 11% and 10%, respectively of ournet sales for the six months ended June 30, 2004.

 

**GROSSPROFIT**

 

| ** **              | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)**      | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **              | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit            |       | $                                    | 109,447    |                               | $          | 176,270 |   | $ | 347,636 |   | $ | 352,305 |   |
| Gross profit percentage |       | 15                                   | %          | 26                                 | %          | 21 | % | 27 | % |
|                         |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

### *Three months endedJune 30, 2005 and 2004*

 

Gross profit was $109.4million, or 15% of net sales, in the three months ended June 30, 2005, comparedto $176.3 million, or 26% of net sales, in the corresponding quarter of2004.  The absolute decrease in grossprofit dollars is primarily the result of a 65% decline in Wireless revenuereflective of the maturing market in China. We attribute the decrease in gross profit, as a percentage of sales,principally to the impact of lower margins from our newly acquired PCDbusiness.  Handsets sales through PCDhave a gross profit margin of approximately 5%, which is lower than grossprofit margins realized on PAS/iPAS system based handsets.  PCD contributed $16.0 million in gross marginfor the three months ended June 30, 2005 and had no contribution in thecorresponding quarter in fiscal 2004 because we did not acquire PCD untilNovember 2004.  We have also included inCost of Sales for the three months ended June 30, 2005 a restructuring-related$5.5 million inventory write-off for discontinued products.  Overall gross profit for the three monthsended June 30, 2005 excluding PCD and the restructuring write-off was stable at26%.

 

The gross profitpercentage decreased in our Broadband, Handsets and Service segments, andimproved marginally in our Wireless segment in the three months ended June 30,2005.  We believe our gross profit as apercentage of net sales will fluctuate in the future.  For additional discussion of our businesssegments see “Segment Reporting” on page 42.

 

### *Six months ended June 30,2005 and 2004*

### * *

Gross profit was $347.6million, or 21% of net sales, in the six months ended June 30, 2005,compared to $352.3 million, or 27% of net sales, in the corresponding period of2004. Gross profit dollars declined slightly primarily attributable to theweakness of Wireless and Handset sales in China offset by an increase inBroadband sales in Japan, primarily in the first quarter.  The decline of the gross profit, as a percentageof sales, is primarily due to the inclusion of PCD with gross profit at 5% ofsales.  Gross profit for the six monthsended June 30, 2005 excluding PCD was 33%. For additional discussion ofour business segments see “Segment Reporting” on page 42.

 

**OPERATINGEXPENSES**

 

The following tablesummarizes our operating expenses:

 

| ** **                          | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)**                  | ** ** | **2005**                             | ** ** | **% of net  sales**                | ** ** | **2004** | ** ** | **% of net  sales** | ** ** | **2005** | ** ** | **% of net  sales** | ** ** | **2004** | ** ** | **% of net  sales** | ** ** |
|                                |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative |       | $                                    | 102,808    |                               | 14%        |   | $ | 67,830 |   | 10% |   | $ | 211,018 |   | 13% |   | $ | 134,773 |   | 10% |   |
| Research and development            |       |                                 | 65,621     |                               | 9%         |   |   | 52,592 |   | 8% |   |   | 132,281 |   | 8% |   |   | 98,250 |   | 7% |   |
| In-process research and development |       |                                 | 660        |                               | 0%         |   |   | 1,400 |   | 0% |   |   | 660 |   | 0% |   |   | 1,400 |   | 0% |   |
| Amortization of intangible assets   |       |                                 | 6,776      |                               | 1%         |   |   | 3,334 |   | 0% |   |   | 13,748 |   | 1% |   |   | 6,307 |   | 1% |   |
| Restructuring costs                 |       |                                 | 15,127     |                               | 2%         |   |   | — |   | 0% |   |   | 15,127 |   | 1% |   |   | — |   | 0% |   |
|                                |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses            |       | $                                    | 190,992    |                               | 26%        |   | $ | 125,156 |   | 18% |   | $ | 372,834 |   | 23% |   | $ | 240,730 |   | 18% |   |

 

38

----

 

*SELLING,GENERAL AND ADMINISTRATIVE*

 

Three months ended June 30,2005 and 2004

 

Selling, general andadministrative expenses were $102.8 million and $67.8 million in the threemonths ended June 30, 2005 and 2004, respectively. SG&A expenses as apercentage of net sales were 14% and 10% in the three months ended June 30,2005 and 2004, respectively.

 

The increase in SG&Aexpenses in absolute dollars of $35.0 million was primarily due to several factorsincluding a $12.8 million increase in our provision for doubtful accountscompared to the same period of 2004. Days sales outstanding was 170 days,excluding PCD, at June 30, 2005 as compared to 70 days at June 30,2004. Days sales outstanding was 106 days including PCD at June 30,2005.   The longer days sales outstandingis a direct result of longer collection cycles in China due to the slow-down inthe telecommunication industry. In addition, headcount and overhead of $6.1million to support our PCD operations contributed to the increase as PCD didnot exist in the corresponding period in 2004, Increased professional fees of$4.4 million associated with the supply chain management, system integrationand Sarbanes-Oxley Act compliance projects also contributed to the increase inSG&A expenses.

 

Six months ended June 30,2005, and 2004

 

SG&A expenses were$211.0 million and $134.8 million in the six months ended June 30, 2005and 2004, respectively. SG&A expenses as a percentage of net sales were 13%and 10% in the six months ended June 30, 2005 and 2004, respectively.

 

The increase of $76.2million in absolute dollars in SG&A expenses was primarily due to i) anincrease in allowance for doubtful accounts expense of $24.1 million due to alonger collection cycle in China during the first six months of 2005 comparedto the corresponding period of 2004 as discussed above, ii) an increase inprofessional services fees of $15.1 million associated with supply chainmanagement, system integration and Sarbanes-Oxley Act compliance projects, andiii) increased headcount and overhead of $12.2 million to support our PCDoperations which did not exist in the corresponding period in 2004.

 

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

 

*RESEARCHAND DEVELOPMENT*

 

Three months ended June 30,2005 and 2004

 

Research and development (“R&D”)expenses were $65.6 million, or 9% of net sales, in the three months ended June 30,2005, compared to $52.6 million, or 8% of net sales, in the correspondingperiod of 2004.  The increase of $13.0 million in absolute dollars of R&D expensescan be primarily attributed to the increased headcount of approximately 120employees resulting from various acquisitions to support both productenhancements and new product development. The higher head count contributed to an increase of $5.6 million inpersonnel related expenses, and $2.2 million in depreciation and facilityexpenses.  In addition, the increase inR&D expenses is also attributed to the increased professional costs of $2.3million associated with outsourced projects in new designs and productdevelopment.

 

Six months ended June 30,2005, and 2004

 

R&D expenses were $132.3 million and $98.3million, or 8% and 7% of net sales, in the six months ended June 30, 2005and 2004, respectively. In absolute dollars, R&D expenses increased by$34.0 million, primarily due to the hiring of additional technical personnel tosupport product enhancements and development, as well as retention of employeesfrom various acquisitions.  Personnelexpenses, including payroll, payroll taxes and benefits, increased by $14.9million due to the increased head count. In addition, the increase in R&D expenses also can be attributed toincreased professional costs of $9.6 million associated with outsourcedprojects driven by numerous product development projects.

 

39

----

 

*IN-PROCESS RESEARCH ANDDEVELOPMENT*

 

Threeand six months ended June 30, 2005 and 2004

 

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

 

*AMORTIZATIONOF INTANGIBLE ASSETS*

 

Three months ended June 30,2005 and 2004

 

Amortization of intangibleassets expenses were $6.7 million and $3.3 million, or 1% and less than 1% ofnet sales in the three months ended June 30, 2005 and 2004,respectively.  The increase in theamortization of intangible assets for the three months ended June 30, 2005was due to a full three months of amortization expense associated with theintangible assets of TELOS acquired in May 2004, Audiovox in November 2004and Giga in January 2005, as compared to the one month expense relating toTELOS recorded in the same period last year. The increase in amortization ofintangible assets expense in the three months ended June 30, 2005 waspartially offset by the write-off of intangibles relating to HSI of $4.5million in the fourth quarter of 2004.

 

Six months ended June 30,2005 and 2004

 

Amortization of intangibleassets expenses were $13.7 million and $6.3 million, or 1% and 1% of net salesin the six months ended June 30, 2005 and 2004, respectively. In absolutedollars, amortization expense increased by $7.4 million.  The increase in the amortization ofintangible assets for the six months ended June 30, 2005 was due to a fullsix months of amortization expense associated with the intangibles recordedupon our acquisition of TELOS in May 2004, Audiovox in November 2004and Giga in January 2005, as compared to the one month expense related toTELOS recorded in the corresponding period of 2004.

 

*RESTRUCTURING COSTS*

 

Threeand six months ended June 30, 2005 and 2004

 

In the second quarter offiscal 2005, we announced and initiated a restructuring plan to rationalize ourcost structure in response to the decline in demand for certain of our products.  In addition, the restructuring plan isdesigned to allow us to reduce break-even revenues for each product line, aligninvestments with key growth opportunities and facilitate the process ofglobalization.  The primary goal of theseimprovements is to optimize our cost structure and enable us to deliverconsistent and sustainable profitability for our stockholders.

 

During the three and sixmonths ended June 30, 2005, we incurred approximately $15.1 million inoperating expenses relating to the restructuring plan actions, primarilyconsisting of $7.6 million in severance payments, $7.5 million in asset impairmentsprimarily related to the impairment of equipment and licenses associated withdiscontinued products.  Included in therestructuring costs of $15.1 million are non-cash charges of $6.9 million inasset impairments. We made cash payments of $6.3 million for severance andother benefits, and $2.7 million of accrued expenses will be settled in thethird quarter of 2005.  As part of therestructuring plan, during the three and six months ended June 30, 2005 werecorded $5.5 million in inventory write-off which is associated withdiscontinued products.  Restructuringexpense related to the inventory write-off is included in cost of sales in theConsolidated Statements of Operations.

 

As of June 30, 2005,approximately 870 employees had been terminated or placed in workforcereduction programs.  As of July 31,2005, employees terminated or placed in workforce reduction programs increasedto 960 employees.  We expect to completethese programs by the end of the third quarter of 2005.  We continue our efforts in evaluating certainoperations and may record additional costs associated with future actions tofurther align our business and operations.

 

40

----

 

*INTERESTINCOME*

 

Three months ended June 30,2005 and 2004

 

Interest income was $1.5million and $1.8 million for the three months ended June 30, 2005 and2004, respectively. Interest income was generated from cash and short-terminvestment balances which declined in the three months ended June 30, 2005as compared to the corresponding period of 2004.

 

Six months ended June 30,2005 and 2004

 

Interest income was $2.8million and $3.2 million for the six months ended June 30, 2005 and 2004,respectively. Interest income was generated from cash and short-term investmentbalances which declined in the six months ended June 30, 2005 as comparedto the corresponding period of 2004.

 

*INTERESTEXPENSE*

 

Three months ended June 30,2005 and 2004

 

Interest expense was $4.7million and $1.1 million for the three months ended June 30, 2005 and2004, respectively.  The increase ininterest expense for the three months ended June 30, 2005 was attributableto the increase in short-term borrowings in the form of bank loans.

 

Six months ended June 30,2005 and 2004

 

Interest expense was $9.0million and $2.2 million for the three months ended June 30, 2005 and2004, respectively.  The increase ininterest expense for the six months ended June 30, 2005 was attributableto an increase in short-term borrowings in the form of bank loans.

 

*OTHERINCOME (EXPENSES)*

 

Three months ended June 30,2005 and 2004

 

Net other income was $8.9million and $4.3 million for the three months ended June 30, 2005 and2004, respectively. Net other income for the three months ended June 30,2005 primarily consisted of an $11.1 million gain recognized on early debtextinguishment and $4.8 million Japan consumption tax refund offset by foreignexchange losses of $6.8 million.  For the three months ended June 30,2004, net other income of $4.3 million include (i) a $2.1 millionfinancial subsidy from the local Chinese government relating to our investmentin local research and development and manufacturing; (ii) Japaneseconsumption tax refund of $1.0 million, and (iii) a foreign exchange gainof $0.9 million.

 

Six months ended June 30,2005 and 2004

 

Net other income was $2.0million and $13.0 million for the six months ended June 30, 2005 and 2004,respectively. Net other income for the six months ended June 30, 2005primarily consisted of an $11.1 million gain recognized on early debtextinguishment and a $6.0 million consumption tax refund in Japan offset by aforeign exchange loss of $14.6 million.  Yen-denominated sales andaccounts receivable were significantly higher during the six months ended June 30,2005 as compared to the same period last year. As such, we incurred a $14.6million unrealized loss in foreign exchange due to the weakened Japanese Yenagainst the US dollar for the six months ended June 30, 2005.

 

For the six months ended June 30,2004, net other income of $13.0 million can be attributed primarily to a $10.1million financial subsidy from the local Chinese government relating to ourinvestment in local research and development and manufacturing and a Japaneseconsumption tax refund of $2.4 million.

 

41

----

 

*INCOME TAXEXPENSE (BENEFIT)*

 

Threemonths ended June 30, 2005 and 2004

 

Income tax expense was abenefit of $1.5 million and an expense of $11.0 million for the three monthsended June 30, 2005 and 2004, respectively.  The decrease in income tax expense was theresult of a decrease in our pre-tax income offset, in part, by an increase intax expense of $13.5 million primarily relating to the valuation of our deferredtax assets in China.  During the quarter,UTStarcom Telecom Co., Ltd. (“HUTS”) received approval for a KnowledgeIntensive, Technology Intensive Certificate (“Certificate”) which subjects thecompany to a reduced national tax rate of 15%. The approval of the Certificate currently has no effect on the localtaxation of HUTS.

 

Sixmonths ended June 30, 2005 and 2004

 

Income tax expense was$6.4 million and $24.7 million for the six months ended June 30, 2005 and2004, respectively.  The decrease inincome tax expense was the result of the tax benefit due to operating losses,offset in part by an increase in tax expense primarily relating to thevaluation of our deferred tax assets in China.  In the six months ended June 30, 2005, we recorded an additionaltax expense of $9.0 million primarily relating to the valuation of our deferredtax assets in China.  During the sixmonths ended June 30, 2005, HUTS received approval for a Certificate whichsubjects the company to a reduced national tax rate of 15%.  In the previous quarter, the Company recordeda reduction in tax expense attributable to an increase in deferred tax assetsarising from the assessment of a local income tax for HUTS and HangzhouUTStarcom Telecom Co., Ltd. (“HSTC”) in China.  The approval of theCertificate currently has no effect on the local taxation of HUTS.

 

*EQUITY INNET LOSS OF AFFILIATED COMPANIES*

 

Three months ended June 30,2005 and 2004

 

Equity in net loss ofaffiliated companies was $0.5 million and $1.2 million for the three monthsended June 30, 2005 and 2004, respectively. The loss in both periods wasprimarily attributable to the loss recognized from our joint ventureinvestments with Matsushita Communication Industrial Co., Ltd., and MatsushitaElectronic Industrial Co., Ltd.

 

Six months ended June 30,2005 and 2004

 

Equity in net loss ofaffiliated companies was $1.0 million and $2.2 million for the six months endedJune 30, 2005 and 2004, respectively. The loss in both periods wasprimarily attributable to the loss recognized from our joint ventureinvestments with Matsushita Communication Industrial Co., Ltd., and MatsushitaElectronic Industrial Co., Ltd.

 

**SEGMENTREPORTING**

 

We historically managedour business as a single reportable segment. During 2004, we continued toexpand our focus on markets and operations outside of China. Effective with thefourth quarter of 2004, it was determined that our chief operating decisionmakers, in accordance with SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” were evaluating performance, makingoperating decisions and allocating resources based on two operating segments, (i) Chinaand (ii) all other regions referred to as International (“International”).

 

On November 1,2004, we acquired selected assets of the wireless handset division of AudiovoxCorporation. The acquired business has been integrated into our operation as aseparate and distinct operating division referred to as the PersonalCommunications Division, (“PCD”). As we determined to evaluate performance andallocate resources to this division, it was considered a third operatingsegment.

 

As a result, as of December 31,2004, we were organized, principally based on geographical market locations, inthree operating segments, China, International and PCD, and each segment consistedof one reporting unit.

 

Effective in the firstquarter of 2005, we decided to reorganize our business based principally uponproduct lines and realigned our business into five operating units, (i) BroadbandInfrastructure, (ii) Wireless Infrastructure, (iii) Handsets, (iv) PCDand (v) Service.

 

42

----

 

Each operating unitrepresents its own reporting segment and each operating unit is responsible forits own production and sales management.

 

We currently evaluatethe operating performance of and allocate resources to the reporting segmentsbased on segment gross profit.  Cost ofsales and direct expenses in relation to production are assigned to thereporting segments.  Corporateheadquarters expenses and non-operating items are not allocated to thesegments.  The accounting policies usedin measuring segment assets and operating performance are the same as thecorporate and among segments.

 

Summarized below are oursegment sales revenue and gross profit for the three and six months ended June 30,2005 and 2004, respectively, based on the new reporting segment structure.  The comparative segment results for the sixmonths ended June 30, 2004 incorporates revisions in classification ofcertain costs and gross profit between the Wireless and Handset segments asreported in the first quarter 2005 Form 10-Q.  The impact of such revision in classificationis to decrease the previously reported prior period gross profit of theWireless segment by $49.2 million and increase the Handset segment gross profitby the same amount.

 

| ** **                      | ** ** | **Three months ended June 30, 2005**  | ** ** | ** **   | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|--------------|------------|
| **(in thousands)**              | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 64,737     |         | $          | 148,160 |   | $ | 146,039 |   | $ | 342,263 |   | $ | 21,762 |   | $ | 722,961 |   |
| Gross profit                    |       | 18,764                                     |       | 41,374       |       | 22,960 |   | 15,990 |   | 10,359 |   | 109,447 |   |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| ** **                      |       | **Three  months ended June 30, 2004** |       |         |       |
| ** **                      | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 60,266     |         | $          | 420,286 |   | $ | 194,330 |   | $ | — |   | $ | 14,746 |   | $ | 689,628 |   |
| Gross profit                    |       | 18,288                                     |       | 114,914      |       | 35,903 |   | — |   | 7,165 |   | 176,270 |   |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| ** **                      |       | **Six  months ended June 30, 2005**   |       |         |       |
| ** **                      | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 389,654    |         | $          | 258,111 |   | $ | 274,122 |   | $ | 657,815 |   | $ | 45,054 |   | $ | 1,624,756 |   |
| Gross profit                    |       | 182,280                                    |       | 71,564       |       | 37,498 |   | 29,682 |   | 26,612 |   | 347,636 |   |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| ** **                      |       | **Six  months ended June 30, 2004**   |       |         |       |
| ** **                      | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                            |       |                                       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from external customers |       | $                                          | 96,967     |         | $          | 756,803 |   | $ | 430,772 |   | $ | — |   | $ | 27,377 |   | $ | 1,311,919 |   |
| Gross profit                    |       | 35,177                                     |       | 217,966      |       | 87,649 |   | — |   | 11,513 |   | 352,305 |   |

 

| ** **              | ** ** | **As of June 30, 2005**      | ** ** | ** **   | ** ** |
|-------------------------|------------|-----------------------------------|------------|--------------|------------|
| **(in thousands)**      | ** ** | **Broadband**                     | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total long-lived assets |       | $                                 | 56,365     |         | $          | 87,356 |   | $ | 56,494 |   | $ | 1,210 |   | $ | 71,602 |   | $ | 273,027 |   |
| Total assets            |       | 614,175                           |       | 929,038      |       | 710,651 |   | 485,294 |   | 117,308 |   | 2,856,466 |   |
|                    |       |                              |       |         |       |   |   |   |   |   |   |   |   |
| ** **              |       | **As of  December 31, 2004** |       |         |       |
| ** **              | ** ** | **Broadband**                     | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** |   |
| Total long-lived assets |       | $                                 | 50,454     |         | $          | 106,003 |   | $ | 46,325 |   | $ | 1,330 |   | $ | 64,647 |   | $ | 268,759 |   |
| Total assets            |       | 1,018,608                         |       | 1,184,649    |       | 676,022 |   | 363,298 |   | 73,428 |   | 3,316,005 |   |

 

*Broadband Infrastructure*

 

Revenue from externalcustomers for this operating segment was $64.7 million in the three monthsended June 30, 2005, as compared to $60.3 million in the correspondingquarter in 2004.  Although revenue growthwas minimal, there was a shift in product mix towards newer products such atGEPON and NetRingTM product lines.  Thesetwo product lines made up 48% of the total Broadband segment compared to 7% forthe corresponding period in 2004.

 

43

----

 

Gross profit contributionfrom external customers for the segment was $18.7 million in the three monthsended June 30, 2005, as compared to $18.3 million in the correspondingquarter in 2004.  Gross profit as a percentageof sales remained relatively flat however we do expect to see increased marginsin the third quarter 2005 as we expand our Broadband deployment in Japan andChina.

 

Revenue from externalcustomers for this operating segment was $389.7 million in the six months endedJune 30, 2005, as compared to $97.0 million in the corresponding period in2004.  The strong increase in net saleswas due to the completion of revenue recognition of certain agreements enteredinto with Japan Telecom for the iAN8000 product that had been recorded asdeferred revenue in prior quarters. We do not expect our sales to Japan Telecomto maintain this pace in the future.

 

Gross profit from externalcustomers for the segment was $182.3 million in the six months ended June 30,2005, as compared to $35.2 million in the corresponding period in 2004.  The gross margin improvement, both inabsolute dollars and as a percentage of net sales, in the six months ended June 30,2005 was largely due to the margins achieved on our iAN8000 products relatingto the Japan Telecom agreements in the first quarter. 

 

Our ability to continue to growthe Broadband segment is dependent on the expansion of our current product baseand further successful introduction and acceptance of new and innovative Broadbandproduct offerings such as mVision and IPTV in China, Japan and other geographicregions.

 

*Wireless Infrastructure*

 

Revenue from externalcustomers for this operating segment was $148.2 million in the three monthsended June 30, 2005, as compared to $420.3 million in the correspondingquarter in 2004. The decrease in net sales was primarily a result of ourcustomers in China continuing the transition from new system installations tosystem expansions as PAS/iPAS systems reach product maturation and customers delaying capital spending inanticipation of next generation technology.

 

Gross profit contributionfrom external customers for this operating segment totaled $41.4 million in thethree months ended June 30, 2005, as compared to $114.9 million in thecorresponding quarter in 2004.  The grossprofit as a percentage of net sales for the three months ended June 30,2005 improved slightly compared to the corresponding quarter in 2004.

 

Revenue from externalcustomers for this operating segment was $258.1 million in the six months endedJune 30, 2005, as compared to $756.8 million in the corresponding periodin 2004.  The decrease in net salesprimarily was a result of our customers in China transitioning from new systeminstallations to system expansions as PAS/iPAS systems reach product maturationand customers delaying capitalspending in anticipation of next generation technology.

 

Gross profit from externalcustomers for this operating segment totaled $71.6 million in the six monthsended June 30, 2005, as compared to $218.0 million in the correspondingperiod in 2004.  The gross profit inabsolute dollars declined proportionally to the revenue decrease in the sixmonths ended June 30, 2005. The gross profit as a percentage of net salesfor the six months ended June 30, 2005 remained relatively constantcompared to the six months ended June 30, 2004.

 

We willcontinue to support our customers in China as they manage subscriber demand fortheir PAS networks over the next several years. In addition, we believe we are positioned to grow the Wireless segmentwith products supporting the emerging 3G market in China.

 

*Handsets*

 

Revenue from externalcustomers in the PAS/iPAS systems Handsets operating segment totaled $146.0million in the three months ended June 30, 2005 as compared to $194.3million in the corresponding quarter of 2004. The decrease in net sales wasprimarily attributable to pricing pressure in the China telecommunicationsmarket since the later part of 2004. Decreasing unit volume along with price erosion contributed to thedownward gross profit for the handset segment in the three months ended June 30,2005.  The number of PAS handsets soldthis quarter was 3.4 million units compared to 3.7 million units for thecorresponding quarter in 2004.

 

Revenue from externalcustomers in the PAS/iPAS systems Handsets operating segment totaled $274.1million in the six months ended June 30, 2005 as compared to $430.8million in the corresponding period of 2004. As noted above, the decrease innet sales was primarily attributable to pricing pressure in the Chinatelecommunications market since the later part of 2004.  Decreasing unit volume along with priceerosion contributed to the downward gross profit for the handset segment in thesix months ended June 30, 2005. In the second half of 2005, we believe weexpect to see a continued improvement of gross profit, as a percentage ofsales, due to cost reduction efforts in manufacturing.

 

We believe our Handsetsegment is positioned to meet future market demand as we were awarded a licenseto sell both GSM and CDMA handsets in China. In addition, our global product offering continues to expand through ourdevelopment activities.

 

*PCD*

 

Revenue from externalcustomers for the segment was $342.3 million in the three months ended June 30,2005. No revenue was recorded in the corresponding quarter last year due to thefact that the acquisition of ACC and the creation of PCD did not occur until November 2004.

 

44

----

 

Gross profit from externalcustomers for the segment was $16.0 million in the three months ended June 30,2005. The gross profit as a percentage of net sales recognized on handset salesthrough PCD was 5% and is typically lower than that realized on PAS/iPASsystems based handsets.

 

Revenue from externalcustomers for the segment was $657.8 million in the six months ended June 30,2005. No revenue was recorded in the corresponding period last year due to thefact that the acquisition of ACC and the creation of PCD did not occur until November 2004.

 

Gross profit from externalcustomers for the segment was $29.7 million in the six months ended June 30,2005. The gross profit as a percentage of net sales was 5% and is expected toremain stable for the second half of 2005.

 

*Service*

 

Service Revenue fromexternal customers for this operating segment was $21.8 million in the threemonths ended June 30, 2005 as compared to $14.7 million in thecorresponding quarter last year.  Theincrease was due to the continuing development of our service productofferings.

 

The gross profitcontribution in absolute dollars increased proportionally to the revenue growthin the three months ended June 30, 2005. The gross profit as a percentageof net sales for the three months ended June 30, 2005 remained relativelyconstant compared to the three months ended June 30, 2004.

 

Service Revenue fromexternal customers for this operating segment was $45.1 million in the sixmonths ended June 30, 2005 as compared to $27.4 million in the correspondingquarter last year.  The Service segmentfor the six months ended June 30, 2005 included $12.6 million of revenueand gross profit associated with promotional services for Japan Telecom recognizedin the first quarter of 2005.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

*OPERATING ACTIVITIES*

 

*2005*

 

Net cash used in operatingactivities for the six months ended June 30, 2005 was $139.4 million.Operating cash was primarily affected by changes in accounts receivable, incometax payable and customer advances, offset by changes in payables, inventory,and current and non-current assets.

 

The $78.5 million increasein accounts receivable was primarily attributable to two factors: (i) incrementalsales derived from PCD sales and (ii) longer collection cycles in Chinawhich we have been experiencing since late 2004.  Days sales outstandingwas 170 days, excluding PCD, at June 30, 2005 as compared to 70 days at June 30,2004. Days sales outstanding was 106 days including PCD at June 30,2005.   The longer days sales outstandingis a direct result of longer collection cycles in China due to the slow-down inthe telecommunication industry which has necessitated in a correspondingincrease in the provision for doubtful accounts.  We do not expect a significant improvement toshorten days sales outstanding in the near future.

 

Income tax payable decreasedby $142.0 million and customer advances decreased by $226.3 million for the sixmonths ended June 30, 2005.  Customer advances represent cashdeposits we have received from our customers for orders that have not yetreceived final acceptance.  Uponsubsequent receipt of final acceptances and revenue recognition, customeradvances are reduced and revenue and cost of sales are recorded.

 

The reduction of customeradvances in the six months ended June 30, 2005 was primarily due to thecompletion of the revenue earning process for most of the agreements with JapanTelecom, 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

 

45

----

 

and in advance of spendingfor promotional activities was reflected as a customer advance in priorperiods.  Revenue for certain of these agreements has been recognized inthe six months ended June 30, 2005.  For additional information,refer to Note 18, “Related Party Transactions,” to our condensed consolidatedfinancial statements.

 

The decreases in inventorybalance of $41.9 million and other current and non-current assets of $58.5million have contributed to our increase in operating cash.  In addition, accounts payable increased by$24.8 million, and deferred revenue increased by $21.9 million, both contributingto the increase in operating cash.

 

Non-cash charges for the sixmonths ended June 30, 2005 included $51.4 million of depreciation andamortization, a $6.7 million loss on asset impairment, a $33.6 millionprovision for doubtful accounts and a $28.2 million inventory provisionexcluding $5.5 million write-off of inventory associated with theRestructuring.  In the six months ended June 30,2005, we recorded an $11.1 million non-cash gain on extinguishment of debtwhich offsets activities that increase operating cash.

 

2004

 

Net cash used inoperating activities for the six months ended June 30, 2004 was $118.5million. Operating cash was affected by changes in customer advances, inventoryand accounts receivable, offset by net income and non-cash charges includingdepreciation and amortization and changes in deferred costs and accountspayable.

 

The $179.1 millionincrease in accounts receivable was attributable to a larger volume of sales.Longer collection periods during the six months ended June 30, 2004 ascompared to the same period in the prior year also contributed to the largeraccounts receivable balance; our days sales outstanding was 70 days at June 30,2004 as compared to 58 days at June 30, 2003.

 

Inventory, net ofinventory provision, increased by $193.0 million, contributing to the decreasein operating cash.

 

The $309.8 milliondecrease in customer advances also decreased operating cash for the period.Customer advances, which represent cash deposits we have received from ourcustomers for orders that have not yet received final acceptance, decreased dueto an increased amount of customer acceptances.

 

Offsetting the activitythat decreased operating cash for the period were net income and non-cashcharges including depreciation and amortization and changes in deferred costsand accounts payable. Net income was $98.6 million, and included non-cashcharges of $34.0 million of depreciation and amortization. Deferred costs, orinventory at customer sites awaiting final acceptance, decreased by $223.3million. The decrease in deferred costs was also a result of increased revenuesand a greater number of customer acceptances, corresponding to the decrease incustomer advances. Accounts payable increased by $136.9 million, consistentwith increased inventory purchasing.

 

*INVESTINGACTIVITIES*

 

*2005*

 

Net cash provided byinvesting activities for the six months ended June 30, 2005 totaling $34.8million was primarily due to $104.9 million of net proceeds from the purchaseand sale of short-term investments.  Thecash outflow was principally attributable to $23.8 million related to ouracquisitions of Giga Telecom, Inc. in the first quarter of 2005 andPedestal Networks in the second quarter 2005 and $46.3 million in purchases ofproperty, plant and equipment.

 

*2004*

 

Netcash used in investing activities for the six months ended June 30, 2004of $155.7 million was primarily due to purchases of property, plant andequipment to support our expansion. Of the total $62.5 million invested inproperty, plant and equipment, construction costs incurred on our Hangzhoumanufacturing facility were $35.1 million during the period. Also contributingto net cash used in investing activities was our purchases of TELOS and HSI,which resulted in a cash outflow of $44.7 million. Finally, net purchases ofshort-term investments of $35.3 million contributed to cash used in investmentactivities.

 

46

----

 

*FINANCINGACTIVITIES*

 

*2005*

 

Net cash used in financingactivities was $105.9 million for the six months ended June 30, 2005.  This was primarily due to the repayment ofshort-term borrowing of $94.7 million and $15.8 million cash payment inconjunction with an early debt extinguishment. We received $3.6 million for the issuance of common stock through theemployee stock purchase plan.  We received $0.7 million from the issuanceof common stock through the exercise of stock options for the six months ended June 30,2005.

 

*2004*

 

Netcash provided by financing activities was $384.7 million for the six monthsended June 30, 2004. This was primarily due to proceeds raised from ourselling 12.1 million shares of common stock at $39.25 per share to Banc ofAmerica Securities, LLC, for net proceeds of approximately $474.6 million. Inaddition to the sale of stock, we received $17.7 million for the issuance ofcommon stock through stock option and warrant exercises. Offsetting cashprovided by financing activities, we used a portion of the capital raised torepurchase a total of 3.6 million shares of our common stock at an averageprice of $30.25 per share for a total cost of $107.6 million, includingtransaction fees.

 

*LIQUIDITY*

 

Our working capital was $1.0billion and $1.3 billion at June 30, 2005, and 2004, respectively.  This decrease in working capital mainlyconsists of (i) a decrease in cash on hand, to $350.3 million in cash andcash equivalents and $31.4 million of short term investments at June 30,2005 from $488.5 million of cash and cash equivalents and $77.0 million ofshort-term investments at June 30, 2004 and (ii) an increase inshort-term debt of $265.2 million at June 30, 2005 compared to thecorresponding period in the prior year. The decrease in working capital isprimarily attributable to the funding of our globalization efforts and a seriesof acquisitions completed in 2004.   Thedecease in working capital was also due to higher balances in accounts payableand short term debt to fund our operations, as well as the early extinguishmenta portion of our Convertible Notes, offset by higher accounts receivablebalances.

 

Our China sales aregenerally denominated in local currency. Due to the limitations on convertingRenminbi, we are limited in our ability to engage in foreign currency hedgingactivities in China. We cannot guarantee that fluctuations in foreign currencyexchange rates in the future will not have a material adverse effect onrevenues from international sales and, correspondingly, on our business,financial condition and results of operations. We have contracts negotiated inJapanese Yen and we maintain a bank account in Japanese Yen for purchasingportions of our inventories and supplies. The balance of this Japanese Yenaccount at June 30, 2005 was approximately $79.5 million.  We may hedge certain Japanese Yen-denominatedbalance sheet exposures against future movements in foreign currency exchangerates by using foreign currency forward contracts. Gains and losses on thesefair value hedges are intended to offset gains and losses from the revaluationof our Japanese Yen-denominated recognized assets and liabilities. Inaccordance with Statement of Financial Accounting Standards No. 133 (“SFAS133”), “Accounting for Derivative Instruments and Hedging Activities,” werecognize derivative instruments and hedging activities as either assets orliabilities on the balance sheet and measure them at fair value. Our foreigncurrency forward contracts generally mature within three months. We do notintend to utilize derivative financial instruments for speculative tradingpurposes.

 

We accept bank notesreceivable and commercial notes receivable with maturity dates of between threeand six months from our customers in China in the normal course of business.Notes receivable available for sale was $30.8 million and $27.0 million atJune 30, 2005 and December 31, 2004, respectively. We may discountthese notes with banking institutions in China. Any notes that have been soldare not included in our consolidated balance sheets as the criteria for saletreatment established by Statement of Financial Accounting Standards No. 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentof Liabilities” (“SFAS 140”), have been met.

 

In March 2003, wecompleted an offering of $402.5 million of convertible subordinated notesdue March 1, 2008 to qualified institutional buyers pursuant to Rule 144Aunder the Securities Act of 1933, as amended. The notes bear interest at a rateof 7/8% per annum, are convertible into our common stockat a conversion price of $23.79 per share and are subordinated to all of ourpresent 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.

 

47

----

 

In June, 2005, we entered into an agreement toexchange approximately 1.5 million shares of our common stock and approximately$15.8 million in cash for $38.0 million aggregate principal amount of itsoutstanding Notes. As a result of the early extinguishment, we alsoamended the above convertible bond hedge and call option transactions in June 2005to reflect the change in principal amount of the underlying Notes.

 

OnJune 30, 2005, we entered into a separate agreement to exchange 1.6million shares of our common stock and $17.0 million in cash for $40.0 millionaggregate principal amount of the Notes. The exchange agreement was settled on July 7, 2005, and theaggregate fair value of the common stock and cash was less than the carryingvalue of the Notes, and the resulted gain on the exchange of $10.8 million willbe recorded in the third quarter 2005.

 

We believe that our existingcredit facilities and cash and cash equivalents, short-term investments andcash from operations will be sufficient to finance our operations and any cashused for planned restructuring activities through at least the next12 months. As of June 30, 2005, we had cash, restricted cash,short-term investments and restricted short-term investments of $414.3 millionand lines of credit totaling $614.9 million available for future borrowings.$302.3 million of these facilities expire in 2005 and $312.6 million of thesefacilities expire in 2006.  We are proceeding with the extension orrenewal of these credit facilities, however, such renewal is not certain.   Of our total cash and short-term investmentbalance, $165.9 million is held in China where currency exchange controlsexist.  As a result, our ability to make payments in other jurisdictionscould be limited by our ability to move money from China to the otherjurisdictions**.**

 

In the event that ourcurrent cash balances, future cash flows from operations and current lines ofcredit are not sufficient to meet our obligations or strategic needs or in theevent that market conditions are favorable, we would consider raisingadditional funds in the capital or equity markets. If additional financing isneeded, there can be no assurance that such financing will be available to uson commercially reasonable terms, or at all.

 

On August 1, 2005, weentered into a Committed Receivables Purchase Agreement (“Agreement”) with a commercialbank, whereby we may sell up to $100.0 million of our eligible accountsreceivable, as defined in the Agreement. The initial term of the Agreement will expire one year from executionbut shall be extended automatically. The Agreement contains provisionscustomary in transactions of this nature including certain commitment fees.

 

*INCOMETAXES*

 

Certain subsidiaries andjoint ventures located in China enjoy tax benefits in China which are generallyavailable to foreign investment enterprises, including full exemption fromnational enterprise income tax for two years starting from the firstprofit-making year and/or a 50% reduction in national income tax rate for thefollowing three years. In addition, local enterprise income tax is often waivedor reduced during this tax holiday/incentive period. Under current regulationsin China, foreign investment enterprises that have been accredited astechnologically advanced enterprises are entitled to additional tax incentives.These tax incentives vary in different locales and could include preferentialnational enterprise income tax treatment at 50% of the usual rates fordifferent periods of time. The tax holidays/incentives discussed above areapplicable or potentially applicable to UTStarcom (Chongging) 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, asthose entities may qualify as accredited technologically advanced enterprises.

 

Income tax expense was abenefit of $1.5 million and an expense of $11.0 million for the three monthsended June 30, 2005 and 2004, respectively.  Income tax expense was $6.4 million and $24.7million for the six months ended June 30, 2005 and 2004, respectively. Our 2005 annual effective tax rate is estimated to be 8.8% which would haveresulted in a $2.6 million tax benefit for the six months ended June 30,2005.   The difference of $9.0 million between the expected taxbenefit of $2.6 million and actual tax expense of $6.4 million is primarilyattributable to the revaluation of our deferred tax assets in China relating tothe reduced national tax rate.  Duringthe quarter, HUTS received approval for a Knowledge Intensive, TechnologyIntensive Certificate (the “Certificate”) which subjects the company to areduced national tax rate of 15%.  In theprevious quarter, the Company recorded a reduction in tax expense attributableto an increase in deferred tax assets arising from the assessment of a local incometax for HUTS and HSTC in China.  The approval of the Certificate currentlyhas no effect on the local taxation of HUTS.

 

We are working toimplement a research and development cost sharing arrangement among our keyworldwide entities. The purpose of cost sharing is to enable its participantsto jointly develop and own intangibles. Under research and development costsharing, the total research and development expense is paid by cost-sharingparticipants in proportion to each participant’s future sales. The benefit

 

48

----

 

is that there is greatercertainty with respect to transfer pricing and defined ownership ofintellectual property. Cost sharing in China is a new concept and we arecontinually working with the Tax and Regulatory Authorities in China to gainapproval for cost sharing.

 

*CONTRACTUALOBLIGATIONS AND OTHER COMMITMENTS*

 

Our obligations undercontractual obligations and commercial commitments are as follows:

 

| ** **                             | ** ** | **June 30, 2005  Payments Due by Period** | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands)**                     | ** ** | **Total**                                      | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **over 5 years** | ** ** |
|                                   |       |                                           |       |   |   |   |   |   |   |   |   |
| Notes Payable                          |       | $                                              | 2,081      |   | $ | 2,081 |   | $ | — |   | $ | — |   | $ | — |   |
| Bank Loans                             |       | $                                              | 263,455    |   | $ | 263,155 |   | $ | — |   | $ | — |   | $ | 300 |   |
| Convertible Subordinated Notes         |       | $                                              | 364,500    |   | $ | — |   | $ | 364,500 |   | $ | — |   | $ | — |   |
| Interest payable on Subordinated Notes |       | $                                              | 9,568      |   | $ | 3,189 |   | $ | 6,379 |   | $ | — |   | $ | — |   |
| Operating leases                       |       | $                                              | 48,922     |   | $ | 18,561 |   | $ | 18,943 |   | $ | 8,834 |   | $ | 2,584 |   |
| Standby letters of credit              |       | $                                              | 65,284     |   | $ | 64,475 |   | $ | 809 |   | $ | — |   | $ | — |   |

 

*Notes Payable*

 

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

 

*Bank Loans*

 

At June 30, 2005, wehad loans with various banks totaling $255.0 million with interest ratesranging from 2.58% to 4.70% per annum. These bank loans mature within twelve months and are included inshort-term debt.

 

We have a bank loan inconnection with an equipment purchase resulting from the consolidation of MDCHolding Limited and its affiliated entities (“MDC”).  On January 10, 2003, a third partyestablished a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by us on January 23, 2003,and subsequently transferred to MDC on December 31, 2003.  The bank loan of $8.2 million bears interestat a rate of 4.94% per annum, and expires on January 10, 2006.  We do not serve as legal obligor for theloan.

 

We have a bank loan inconnection with a joint venture which we consolidate.  As of June 30, 2005, the joint venturehad an outstanding loan to its other investor, and we bore the loan resultingfrom the consolidation.   The bank loanamounts to $0.3 million, at an interest rate of 9.00% per annum, and expires onJune 15, 2008.  We do not serve aslegal obligor for the loan.

 

*Convertible Subordinated Notes*

 

As of June 30, 2005, wehave $364.5 million of convertible subordinated notes, due March 1,2008, that bear interest at a rate of 7/8% per annum, payable semiannually on May 1and September 1, which are convertible into our common stock at aconversion price of $23.79 per share and are subordinated to all our presentand future senior debt. The principal is due only at maturity of the notes.

 

*Operating Leases*

 

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

 

49

----

 

*Standby Letters Of Credit*

 

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

 

*Purchase commitments*

 

We are obligated to purchaseraw materials and work-in-process inventory under various orders from varioussuppliers, all of which should be fulfilled without adverse consequencesmaterial to our operations or financial condition. As of June 30, 2005total open commitments under these purchase orders were approximately $611.4million.

 

*Investment commitments*

 

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

 

*Intellectual property*

 

Certain sales contractsinclude provisions under which customers would be indemnified by us in theevent of, among other things, a third-party claim against the customer forintellectual property rights infringement related to our products. There are nolimitations on the maximum potential future payments under these guarantees. Wehave not accrued any amounts in relation to these provisions as no such claimshave been made and we believe we have valid enforceable rights to theintellectual property embedded in our products.

 

*Offbalance sheet arrangements*

 

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

 

***RECENTACCOUNTING PRONOUNCEMENTS***

 

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

 

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

 

50

----

 

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

 

InDecember 2004, the FASB issued FSP No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004.”  TheAmerican Jobs Creation Act of 2004 provides a one-time 85% dividends receiveddeduction for certain foreign earnings that are repatriated under a plan forreinvestment in the United States, provided certain criteria are met.  FSP No. FAS 109-2 is effectiveimmediately and provides accounting and disclosure guidance for therepatriation provision.  FSP No. FAS109-2 allows companies additional time to evaluate the effects of the law onits unremitted earnings for the purpose of applying the “indefinite reversalcriteria” under APB Opinion No. 23, “Accounting for Income Taxes—SpecialAreas,” and requires explanatory disclosures from companies that have not yetcompleted the evaluation.  The Company iscurrently evaluating the effects of the repatriation provision and their impacton its consolidated financial statements. The Company does not expect to complete this evaluation before the endof 2006.  The range of possible amountsof unremitted earnings that is being considered for repatriation under thisprovision is between zero and $540 million and the related potential range ofincome tax is between zero and $28 million.

 

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

 

In June 2005, the FASB’sEmerging Issues Task Force (“EITF”) issued EITF Issue No. 05-02 “The Meaning of‘Conventional Convertible Debt Instrument’ in EITF Issue 00-19 ‘Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock’”, which retains the exception in paragraph 4 of EITF IssueNo. 00-19 for conventional convertible debt instruments. Those instruments inwhich the holder has an option to convert the instrument into a fixed number ofshares (or a corresponding amount of cash at the issuer’s discretion) and itsability to exercise the option is based on either (a) the passage of time or(b) a contingent event, should be considered “conventional” for purposes ofapplying that exception. The consensus should be applied on a prospective basisfor new or modified instruments starting from the third quarter of 2005. Theadoption of EITF No.** **05-02 isnot expected to have a material effect on the Company’s consolidated financial statementsor results of operations.

 

OnJune 1, 2005, the Financial Accounting Standards Board (“FASB”) issuedFASB Statement No. 154, Accounting Changes and Error Corrections (“SFAS154”), which will require entities that voluntarily make a change in accountingprinciples to apply that change retrospectively to prior periods’ financialstatements, unless this would be impracticable. SFAS 154 supersedes AccountingPrinciples Board Opinion No. 20, Accounting Changes (“APB 20”), whichpreviously required that most voluntary changes in accounting principle berecognized by including in the current period’s net income the cumulativeeffect of changing to the new accounting principle. SFAS 154 also makes adistinction between “retrospective application” of an accounting principle andthe “restatement” of financial statements to reflect the correction of anerror.

 

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

 

51

----

 

**FACTORS AFFECTING FUTURE OPERATING RESULTS**

 

**RISKS RELATED TO OUR COMPANY**

 

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

* *

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

 

•                  the timing and size of the orders for ourproducts;

 

•                  changes in our customers’ subscriber growthrate;

 

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

 

•                  cancellation, deferment or delay inimplementation of large contracts;

 

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

 

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

 

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

 

•                  shift in our product mix or market focus; and

 

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

 

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

 

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

* *

Wehave experienced intense competition in the past years, and we believe that wewill continue to face intense competition from both domestic and internationalcompanies in our target markets, many of which may operate under lower coststructures or may be given preferential treatment by applicable governmentalregulators and policies and have much larger sales forces than we do.Additionally, other companies not presently offering competing products mayalso enter our target markets. Many of our competitors have significantlygreater financial, technical, product development, sales, marketing and otherresources than we do. As a result, our competitors may be able to respond morequickly to new or emerging technologies and changes in service providerrequirements. Our competitors may also be able to devote greater resources thanwe can to the development, promotion and sale of new products. Thesecompetitors may be able to offer significant financing arrangements to serviceproviders, which may give them a competitive advantage in selling systems toservice providers with limited financial and currency resources. In many of thedeveloping markets in which we operate or intend to operate, relationships withlocal governmental telecommunications agencies are important to establish andmaintain. In many such markets, our competitors may have or be able toestablish better relationships with local governmental telecommunicationsagencies than we have, which could result in their ability to influencegovernmental policy formation and interpretation to their advantage.Additionally, our competitors might have better relationships with their thirdparty suppliers and obtain component parts at a reduced rate, allowing them tooffer their end products at reduced prices. Moreover, the telecommunicationsand cable industries have experienced significant consolidation, and we expectthis trend to continue. If we have fewer significant customers, we may be morereliant on such large customers and our bargaining position and profit marginsmay suffer. Increased competition is likely to result in price reductions,reduced gross profit as a percentage of net sales and loss of market

 

52

----

 

share,any one of which could materially harm our business, cash flows, financialcondition including, potential impairment in value of our tangible, intangibleassets and goodwill if extended losses were incurred.

 

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

* *

Wecurrently anticipate that our available cash resources, which include existingcash and cash equivalents, short-term investments and cash from operations,will be sufficient to meet our anticipated needs for working capital andcapital expenditures for the foreseeable future. If we are unable to generatesufficient cash flows from operations, we may need to raise additional funds todevelop new or enhanced products, respond to competitive pressures, takeadvantage of acquisition opportunities or raise capital for strategic purposes.If we raise additional funds through the issuance of equity securities, ourstockholders will experience dilution of their ownership interest, and thenewly issued securities may have rights superior to those of common stock. Ifwe raise additional funds by issuing debt, we may be subject to limitations onour operations and increase our leverage. For example, in connection with thesale of convertible debt securities in March 2003, we incurred $402.5million of indebtedness, ($38.0 million of this amount was exchanged andextinguished during the three months ended June 30, 2005). As a result ofthis indebtedness, our principal and interest payment obligations haveincreased substantially. The degree to which we are leveraged could materiallyand adversely affect our ability to obtain financing for working capital,acquisitions or other purposes and could make us more vulnerable to industrydownturns and competitive pressures. 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. Finally, we are not certain that we canmaintain our existing unsecured credit line available to our China operationsor additional sources of financing may not be available on reasonable terms orat all if and when we require it, which could harm our business.

 

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

* *

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

 

•                  increased competition;

 

•                  aggressive price reductions by competitors;

 

•                  rapid technological change; and

 

•                  constant change in customer buying behaviorand market trends.

 

Theaverage selling prices of our products may continue to decrease in the futurein response to product introductions by us or our competitors or other factors,including price pressures from customers. Certain of our products, includingwireless handsets, have historically had low gross profit margins, and anyfurther deterioration of our profit margins on such products could result inlosses with respect to such products. Therefore, we must continue to developand introduce new products and enhancements to existing products thatincorporate features that can be sold at higher average selling prices. Failureto do so could cause our revenues and gross profit to decline.

 

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

 

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

* *

Approximately$289.5 million, or 40%, and $516.7 million, or 32%, of our net sales for thethree and six months ended June 30, 2005, respectively, occurred in China. Approximately $618.3 million, or 90%,and $1,188.9 million, or 91%, of our net sales for the three and six monthsended June 30, 2004, respectively, occurred in China. While we anticipateexpansion into other markets, a significant

 

53

----

 

portionof our net sales will be derived from China for the foreseeable future. Inaddition, we have made substantial investments in China and our business,financial condition and results of operations are to a significant degreesubject to economic, political, legal and social developments and other eventsin China. Please read the risks detailed below under the heading “Risks Relatedto Conducting Business in China” for additional information about the risks weface in connection with our China operations.

 

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

* *

Themarket for communications equipment is characterized by rapid technologicaldevelopments, frequent new product introductions and evolving industry andregulatory standards. Our success will depend in large part on our ability toenhance our network and broadband access and switching technologies and developand introduce new products and product enhancements that anticipate changingservice provider requirements and technological developments. We may need tomake substantial capital expenditures and incur significant research anddevelopment costs to develop and introduce new products and enhancements. If wefail to develop and introduce new products or enhancements to existing productsthat effectively respond to technological change on a timely basis, ourbusiness, financial condition and results of operations could be materiallyadversely affected. Certain of our products, including wireless handsets, havea short product life. Moreover, from time to time, our competitors or we mayannounce new products or product enhancements, technologies or services thathave the potential to replace or shorten the life cycles of our products andthat may cause customers to defer purchasing our existing products, resultingin inventory reserve due to obsolescence. Future technological advances in thecommunications industry may diminish or inhibit market acceptance of ourexisting or future products or render our products obsolete.

 

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

 

•                  our ability to obtain necessary approvalsfrom regulatory organizations within the countries in which we operate and forany new technologies that we introduce;

 

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

 

•                  our products being compatible with legacytechnologies and standards existing in previously deployed network equipment;

 

•                  our ability to attract customers who may havepreexisting relationships with our competitors;

 

•                  product pricing relative to performance;

 

•                  the level of customer service available tosupport new products; and

 

•                  the timing of new product introductionsmeeting demand patterns.

 

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

 

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

* *

Wehave contracts with a single supplier or with a limited group of suppliers topurchase some components and materials used in our products. If any supplier isunwilling or unable to provide us with high-quality components and materials inthe quantities required and at the costs specified by us, we may not be able tofind alternative sources on favorable terms, in a timely manner, or at all.Further, a supplier could market its products directly to our customers. Inparticular, our PCD segment is highly dependent on a single supplier for ourhandset devices. The possibility of a supplier marketing its own products wouldcreate direct competition and may affect our ability to obtain adequatesupplies. Our inability to obtain or to develop alternative sources if and asrequired could result in delays or reductions in manufacturing or productshipments. From time to time, there could be shortages of different products orcomponents. Moreover, our suppliers may supply us with inferior quality products.If an inferior product supplied by a third party is embedded in our end productand causes a problem, it might be difficult to identify the source of theproblem as being due to the component parts. If any of these events occur, ourcompetitive position, reputation and business could suffer.

 

54

----

 

Ourability to source a sufficient quantity of high-quality, cost-effectivecomponents used in our products may also be limited by import restrictions andduties in the foreign countries in which we manufacture our products. Werequire a significant number of imported components to manufacture ourproducts, and imported electronic components and other imported goods used inthe operation of our business may be limited by a variety of permitrequirements, approval procedures, import duties and registration requirements.Moreover, import duties on such components increase the cost of our productsand may make them less competitive.

 

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

* *

Manyof our products are highly complex and may have quality issues resulting fromthe design or manufacture of such product, or from the software used in theproduct. Often these issues are identified prior to the shipment of theproducts and may cause delays in market acceptance of our products, delays inshipping products to customers, or the cancellation of orders. In other cases,we may identify the quality issues after the shipment of products. In suchcases, we may incur unexpected expenses and diversion of resources to replacedefective products or correct problems. Such pre-shipment and post-shipmentquality issues could result in delays in the recognition of revenue, loss ofrevenue or future orders, and damage to our reputation and customerrelationships. In addition, we may be required to pay damages for failedperformance under certain customer contracts.

 

*Our recent growth has strained our resources, and ifwe are unable to manage and sustain our growth, our operating results will benegatively affected.*

* *

Wehave experienced a period of rapid growth and anticipate that we must continueto transform our operations to address market demands and potential marketopportunities. Our transformation will place a significant strain on ourmanagement, operational, financial and other resources. To manage our growtheffectively, 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;

 

•                  maintainingclose coordination among our engineering, accounting, finance, marketing, salesand operations organizations;

 

•                  expanding, training and managing our employeebase;

 

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

 

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

 

•                  improving and sustaining our supply chaincapability;

 

•                  managingthe expansion of both our direct and indirect sales channels in acost-efficient and competitive manner; and

 

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

 

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

 

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

* *

Thesuccess of our business depends in significant part upon the continued contributionsof key technical and senior management personnel, many of whom would bedifficult to replace. In particular, our success depends in large part on theknowledge, expertise and services of Hong Liang Lu, our Chairman of the Board,President and Chief Executive Officer, Ying Wu, our Chairman and ChiefExecutive Officer of China Operations, and Philip Christopher, President andChief Executive Officer of our Personal Communications Division. The loss ofany key employee, the failure of any key employee to perform satisfactorily inhis or her

 

55

----

 

currentposition or our failure to attract and retain other key technical and seniormanagement employees could have a significant negative impact on our operations.

 

Toeffectively manage our recent and anticipate future growth, we will need torecruit, train, assimilate, motivate and retain qualified employees bothlocally and internationally. Competition for qualified employees is intense,and the process of recruiting personnel in all fields, including technology,research and development, sales and marketing, administration and managerialpersonnel with the combination of skills and attributes required to execute ourbusiness strategy can be difficult, time-consuming and expensive. As we growglobally, we must implement hiring and training processes that are capable ofquickly deploying qualified local residents to knowledgeably support ourproducts and services. Alternatively, if there is an insufficient number ofqualified local residents available, we might incur substantial costs importingexpatriates to service new global markets. For example, we have historicallyexperienced difficulty finding qualified accounting personnel knowledgeable inboth U.S. and Chinese accounting standards who are Chinese residents. If wefail to attract, hire, assimilate or retain qualified personnel, our businesswould be harmed.

 

Competitorsand others have in the past, and may in the future, attempt to recruit ouremployees. In addition, companies in the telecommunications industry whoseemployees accept positions with competitors frequently claim that thecompetitors have engaged in unfair hiring practices. We may be the subject ofthese types of claims in the future as we seek to hire qualified personnel.Some of these claims may result in material litigation and disruption to ouroperations. We could incur substantial costs in defending ourselves againstthese claims, regardless of their merit.

 

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

* *

Wehave acquired other businesses, products and technologies. For example, duringthe second quarter of 2004, we completed our acquisitions of TELOS and HSI for$30.0 million and $14.1 million, respectively. On November 1, 2004, wecompleted our selected asset acquisition of ACC for $165.1 million.Additionally, in January and May 2005, we completed the acquisitions ofselected assets, including research and development of various products, fromGiga Telecom, Inc. and Pedestal Networks. Anticipated benefits of these acquisitions may not be realized. We havein the past and will continue to evaluate acquisition prospects that wouldcomplement our existing product offerings, augment our market coverage, enhanceour technological capabilities, or that may otherwise offer growthopportunities. Acquisitions may result in dilutive issuances of equitysecurities, use of our cash resources, the incurrence of debt and theamortization of expenses related to intangible assets. In addition,acquisitions involve numerous risks, including difficulties in the assimilationof operations, technologies, products and personnel of the acquired company,diversion of management’s attention from other business concerns, risks ofentering markets in which we have no direct or limited prior experience, thepotential loss of key employees of the acquired company, unanticipated costsand, in the case of the acquisition of financially troubled businesses,challenges as to the validity of such acquisitions from third party creditorsof such businesses. For example, in the fourth quarter 2004, we encountereddifficulties in integrating HSI’s legacy operations into our operations anddetermined to abandon a substantial amount of HSI’s legacy operations. As aresult, in the fourth quarter 2004, we wrote off the entire goodwill andintangibles associated with HSI. In addition, the acquisitions of businessesinvolved in the manufacturing or sales of handset products could introducespecific litigation risk from the potential harmful effects of electric andmagnetic fields (“EMF”).

 

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

* *

Werely on a combination of patents, copyrights, trademarks, trade secret laws andcontractual obligations to protect our technology. We have applied for patentsin the United States and internationally. Additional patents may not be issuedfrom our pending patent applications, and our issued patents may not be upheld.In addition, we have, from time to time, chosen to abandon previously filedapplications. Moreover, we may face difficulties in registering our existingtrademarks in new jurisdictions in which we operate. We cannot guarantee thatthe intellectual property protection measures that we have taken will besufficient to prevent misappropriation of our technology or trademarks or thatour competitors will not independently develop technologies that aresubstantially equivalent or superior to ours. In addition, the legal systems ofmany foreign countries do not protect or honor intellectual property rights tothe same extent as the legal system of the United States. For example, inChina, the legal system in general, and the intellectual property regime inparticular, are still in the development stage. It may be very difficult,time-consuming and costly for us to attempt to enforce our intellectualproperty rights in these jurisdictions.

 

56

----

 

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

 

Theindustry in which we compete is moving towards aggressive assertion, licensing,and litigation of patents and other intellectual property rights. From time totime, we have become aware of the possibility or have been notified that we maybe infringing certain patents or other intellectual property rights of others.Regardless of their merit, responding to such claims could be time consuming,divert management’s attention and resources and cause us to incur significantexpenses. In addition, although some of our supplier contracts provide forindemnification from the supplier with respect to losses or expenses incurredin connection with any infringement claim, certain contracts with our keysuppliers do not provide for such protection. Moreover, certain of our salescontracts provide that we must indemnify our customers against claims by thirdparties for intellectual property rights infringement related to our products.There are no limitations on the maximum potential future payments under theseguarantees. Therefore, we may incur substantial costs related to anyinfringement claim, which may substantially harm our results of operations andfinancial condition.

 

Wemay, in the future, become subject to litigation to defend against claimedinfringements of the rights of others or to determine the scope and validity ofthe proprietary rights of others. Future litigation may also be necessary toenforce and protect our trade secrets and other intellectual property rights.Any intellectual property litigation or threatened intellectual property litigationcould be costly, and adverse determinations or settlements could result in theloss of our proprietary rights, subject us to significant liabilities, requireus to seek licenses from or pay royalties to third parties which may not beavailable on commercially reasonable terms, if at all, and/or prevent us frommanufacturing or selling our products, which could cause disruptions to ouroperations.

 

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

 

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

* *

Wemarket and sell our products globally, with significant portion of our salesmade in China historically. The expansion of our existing multinationaloperations and entry into new markets will require significant managementattention and financial resources. Multinational operations are subject to avariety of risks, such as:

 

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

 

•                  theburden of complying with United States laws and regulations for foreignoperations, including the Foreign Corrupt Practices Act;

 

•                  difficultycomplying with continually evolving and changing global product andcommunications standards and regulations for both our end products and theircomponent technology;

 

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

 

•                  relianceon local original equipment manufacturers (“OEMs”), third party distributorsand agents to effectively market and sell our products;

 

•                  unusual contract terms required by customersin developing markets;

 

•                  changes in local governmental control orinfluence over our customers;

 

•                  changesto import and export regulations, including quotas, tariffs, licensingrestrictions and other trade barriers;

 

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

 

•                  reduced protection for intellectual propertyrights in some countries;

 

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

 

•                  longer accounts receivable collectionperiods; and

 

•                  difficultiesand costs of staffing and managing multinational operations, including but notlimited to internal controls and compliance.

 

 

57

----

 

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

* *

Lessdeveloped markets present additional risks, such as the following:

 

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

 

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

 

•                  inconsistent infrastructure support;

 

•                  lack of a large, highly trained workforce;

 

•                  difficulty in controlling local operationsfrom our headquarters;

 

•                  variable ethical standards and an increasedpotential for fraud;

 

•                  unstable political and economic environments;and

 

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

 

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

 

*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.*

* *

Ourhandset products are subject to a wide range of environmental, health andsafety laws, including laws relating to the use, disposal and clean up of, andhuman exposure to hazardous substances. In the United States, these laws oftenrequire parties to fund remedial action regardless of fault. Factors such asthe discovery of additional contaminants, the extent of remediation andcompliance expenses, and the imposition of additional cleanup obligations couldcause us to incur substantial costs relating to remediation activities.Compliance with existing or future environmental, health and safety laws couldalso cause us to incur substantial costs relating to such compliance, includingthe expense of modifying product designs and manufacturing processes. Inaddition, restrictions on the use of certain materials in our facilities orproducts in the future could have a negative impact on our operations.

 

Additionally,there have been claims made alleging a link between the use of wirelesshandsets and the development or aggravation of certain cancers, including braincancer. The scientific community is divided on whether there is a risk fromwireless handset use, and if so, the magnitude of the risk. Even if there is nolink established between wireless handset use and cancer, the negativepublicity and possible litigation could have a material adverse effect on ourbusiness.  In the past, severalplaintiffs’ groups have brought class actions against wireless handsetmanufacturers and distributors, alleging that wireless handsets have causedcancer. To date, we have not been named in any of these actions and none ofthese actions has been successful. In the future we could incur substantialcosts in defending ourselves against similar claims, regardless of their merit.Also, claims may be successful in the future and have a material adverse effecton our business

 

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

* *

Becausemost of our sales are made in foreign countries, we are exposed to market riskfor changes in foreign exchange rates on our foreign currency denominatedaccounts and notes receivable balances. Historically, the majority of our saleshave been made in China and denominated in Renminbi; as such, the impact ofcurrency fluctuations of Renminbi thus far has been insignificant as it wasfixed to the U.S. dollar.  In July 2005,China uncoupled Renminbi from the dollar and will let it float in a narrow bandagainst a basket of

 

58

----

 

foreigncurrencies.  The move revalues Renminbiby 2.1% against the U.S. dollar; however, it is uncertain what furtheradjustments would follow.  TheRenminbi-U.S. dollar exchange rate could float, and the Renminbi could appreciaterelative to the U.S. dollar. For example, if the Renminbi had been revaluatedat the beginning of the second quarter at 8.11 Renminbi to the US Dollarinstead of the actual rate of 8.28, the impact on the company’s reportedresults would have been to increase net income by approximately $5.0 million.If the revaluation had been applied at the period end, the impact on the Company’sfinancial position would have been to increase total assets by $29.5 million,increase total liabilities by $15.7 million and total equity by $13.7 million.Any significant revaluation of the Renminbi may materially and adversely affectour cash flows, revenues, operating results and financial position.

 

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

 

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

 

Moreover,some of the foreign countries in which we do business might impose currencyrestriction that may limit the ability of our subsidiaries and joint venturesin such countries to obtain and remit foreign currency necessary for the purchaseof imported components and may limit our ability to obtain and remit foreigncurrency in exchange for foreign earnings. For example, China employs currencycontrols restricting Renminbi conversion, limiting our ability to engage incurrency hedging activities in China. Various foreign exchange controls mayalso make it difficult for us to repatriate earnings, which could have amaterial adverse effect on our ability to conduct business globally.

 

*Business interruptions could adversely affect our business.*

* *

Ouroperations are vulnerable to interruption by fire, earthquake, power loss,telecommunications failure, external interference with our informationtechnology systems, incidents of terrorism and other events beyond our control.For example, our Hangzhou manufacturing facility’s ability to producesufficient products is dependent upon a continuous power supply. However, theHangzhou facility has in the past been subject to power shortages, which hasaffected our ability to produce and ship sufficient products. We do not have adetailed disaster recovery plan, and the occurrence of any events like thesethat disrupt our business could harm our business and operating results.

 

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

* *

Weface the risk of loss relating to our equipment held at customer sites. In somecases, our equipment held at customer sites is under contract, pending finalacceptance by the customer. We generally do not hold title or risk of loss onsuch equipment, as title and risk of loss are typically transferred to thecustomer upon delivery of our equipment. However, we do not recognize revenueand accounts receivable with respect to the sale of such equipment until weobtain acceptance from the customer. If we do not obtain final acceptance, wemay not be able to collect the contract price and recover this equipment or itsassociated costs. In other cases, particularly in China, where governmentalapproval is required to finalize certain contracts, inventory not undercontract may be held at customer sites. We hold title and risk of loss on thisinventory until the contracts are finalized and, as such, are subject to anylosses incurred resulting from any damage to or loss of this inventory. If ourcontract negotiations fail or if the government of China otherwise delaysapproving contracts, we may not recover or receive payment for this inventory.Moreover, our insurance may not cover all losses incurred if our inventory atcustomer sites not under contracts is damaged prior to contract finalization.If we incur a loss relating to inventory for any of the above reasons, ourfinancial condition, cash flows, and operating results could be harmed.

 

*We have been named as a defendant in securitieslitigation and other lawsuits, as well as lawsuits in the ordinary course ofbusiness.*

* *

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

 

59

----

 

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

 

Severalforeign governments and U.S. state and local governments have adopted or areconsidering adopting legislation that would restrict or prohibit the use ofwireless handsets while driving. Widespread legislation that restricts orprohibits the use of wireless handsets while driving could negatively affectour future growth.

 

*F**ailureto achieve and maintain effective internal controls in accordance with Section 404of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on ourbusiness and stock price.*

 

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

 

Wehave identified material weaknesses in our internal controls over financialreporting. See “Item 9A—Controls and Procedures—Management’s Report on InternalControl Over Financial Reporting” in our Annual report on Form 10-K forthe year ended December 31, 2004 for a discussion of these materialweaknesses. As of the date of the filing of this quarterly report on Form 10-Q,we are still in the process of implementing remedial measures related to thematerial weaknesses identified. If our efforts to remedy the weaknesses weidentified are not successful, our business and operating results could beharmed and the reliability of our financial statements could be impaired, whichcould adversely affect our stock price. The requirements of Section 404 ofthe Sarbanes-Oxley Act are ongoing and also apply to future years. In addition,during 2005, we will apply the requirements of the Sarbanes-Oxley Act to our November 2004acquisition of ACC, which was exempted from our 2004 assessment as permittedunder the Sarbanes-Oxley Act. We expect that our internal controls overfinancial reporting will continue to evolve as we continue in our efforts togrow and transform our business in the future. Although we are committed tocontinue to improve our internal control processes and we will continue todiligently and vigorously review our internal controls over financial reportingin order to ensure compliance with the Section 404 requirements, anycontrol system, regardless of how well designed, operated and evaluated, canprovide only reasonable, not absolute, assurance that its objectives will bemet. Therefore, we cannot assure you that in the future additional materialweaknesses or significant deficiencies will not exist or otherwise bediscovered.

 

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

* *

TheSarbanes-Oxley Act has required and will continue to require changes in some ofour corporate governance and securities disclosure or compliance practices. TheSarbanes-Oxley Act also requires the SEC to promulgate new rules on avariety of subjects, in addition to rule proposals already made, andNASDAQ has revised its requirements for companies that are quoted on it. Thesedevelopments (i) have required and may continue to require us to devoteadditional resources to our operational, financial and management informationsystems procedures and controls to ensure our continued compliance with currentand future laws and regulations, (ii) will make it more difficult and moreexpensive for us to obtain director and officer liability insurance, and we maybe required to accept reduced coverage, increase our level of self-insurance,or incur substantially higher costs to obtain coverage, and (iii) couldmake it more difficult for us to attract and retain qualified members on ourboard of directors, or qualified executive officers. To implement plans andmeasures to comply with Section 404 of the Sarbanes-Oxley Act and otherrelated rules, we expect to expend significant resources and incur additionalexpenses.  We continue to evaluate andmonitor regulatory developments and cannot estimate the timing or magnitude ofadditional costs that we may incur as a result of such developments.

 

*Changes in accounting rules.*

* *

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

 

60

----

* *

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

 

During the second quarter of 2005, we announced ourplans to undertake certain restructuring efforts to reduce costs and simplifyour product portfolios in all of our business units.  As a result, we consolidated certainoperations in research and development and manufacturing and reduced ouremployee population.  The impact of theseactions on our sales and profitability may be influenced by a variety of factors,including but not limited to our ability to successfully execute our plans, ourability to achieve the anticipated level of cost savings, and our ability toretain key employees. We may face additional costs associated with futureactions in streamlining of our operations, including but not limited to,outsourcing of certain operations to other parties.

 

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

 

# **RISKSRELATED TO CONDUCTING BUSINESS IN CHINA**

# ** **

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

* *

Since1978, the Chinese government has been in a state of evolution and reform. Thereforms have resulted in and are expected to continue to result in significanteconomic and social development in China. Many of the reforms are unprecedentedor experimental and may be subject to change or readjustment due to a varietyof political, economic and social factors. Multiple government bodies areinvolved in regulating and administrating affairs in the telecommunicationsindustry, among which the Ministry of Information Industry (“MII”), theNational Development and Reform Commission (“NDRC”) and the State AssetSupervisory Administrative Commission play the leading roles. These governmentagencies have broad discretion and authority over all aspects of thetelecommunications and information technology industry in China, including butnot limited to, setting the telecommunications tariff structure, granting carrierlicenses and frequencies, approving equipment and products, granting productlicenses, specifying technological standards as well as appointing carrierexecutives, all of which may impact our ability to do business in China.

 

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

 

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

 

•                  inconsistentenforcement and application of the telecommunications industry’s rules andregulations by the Chinese government between foreign and domestic companies;

 

•                  the restructuring of telecommunicationscarriers in China;

 

•                  the introduction of measures to controlinflation or stimulate growth;

 

•                  theintroduction of new guidelines for tariffs and service rates, which affect ourability to competitively price our products and services;

 

•                  changes in the rate or method of taxation;

 

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

 

•                  anyactions that limit our ability to develop, manufacture, import or sell ourproducts in China, or to finance and operate our business in China.

 

Forexample, on November 1, 2004, as a continuation of the restructuring oftelecom carriers relating to the initial public offering of China Netcom in2004, SASAC decided to swap the senior executives of China Mobile, ChinaUnicom, China Telecom and China Netcom in an effort to ease competition amongcarriers. This led to business interruption between China Telecom and ChinaNetcom, which had an adverse impact of delaying revenue recognition in thefourth quarter of 2004. Moreover, we are not certain whether there may beadditional government interference, including government imposed mergers orspin-offs of the existing carriers.

 

61

----

 

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

 

Under China’scurrent regulatory structure, the communications products that we offer inChina must meet government and industry standards. In addition, a networkaccess license for the equipment must be obtained. Without a license,telecommunications equipment is not allowed to be connected to publictelecommunications networks or sold in China. Moreover, we must ensure that thequality of the telecommunications equipment for which we have obtained anetwork access license is stable and reliable, and will not negatively affectthe quality or performance of other installed licensed products.

 

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

 

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

* *

Since1978, the Chinese government has been reforming the economic system in China toincrease the emphasis placed on decentralization and the utilization of marketforces in the development of China’s economy. These reforms have resulted insignificant economic growth. However, any economic reform policies or measuresin China may from time to time be modified or revised by the Chinesegovernment. While we may be able to benefit from the effects of some of thesepolicies, these policies and other measures taken by the Chinese government toregulate the economy could also have a significant negative impact on economicconditions in China, which would result in a negative impact on our business.China’s economic environment has been changing as a result of China’s entry, inDecember of 2001, into the World Trade Organization (the “WTO”). Entryinto the WTO requires that China reduce tariffs and eliminate non-tariffbarriers, including quotas, licenses and other restrictions in 2005 and it isstill too early to evaluate the impact of these changes on China’s economy.Moreover, although China’s entry into the WTO and the related relaxation oftrade restrictions may lead to increased foreign investment, it may also leadto increased competition in China’s markets from other foreign companies. IfChina’s entry into the WTO results in increased competition or has a negativeimpact on China’s economy, our business could suffer. In addition, althoughChina is increasingly according foreign companies and foreign investmententerprises established in China the same rights and privileges as Chinesedomestic companies as a result of its admission into the WTO, special laws,administrative rules and regulations governing foreign companies andforeign investment enterprises in China may still place foreign companies at adisadvantage in relation to Chinese domestic companies and may adversely affectour competitive position.

 

*Uncertainties with respect to the Chinese legalsystem may adversely affect us.*

* *

Weconduct our business in China primarily through our wholly owned subsidiariesincorporated in China. Our subsidiaries are generally subject to laws andregulations applicable to foreign investment in China. Accordingly, ourbusiness might be affected by China’s developing legal system. Since 1978, manynew laws and regulations covering general economic matters have beenpromulgated in China, and government policies and internal rules promulgatedby 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 policies withouthaving any knowledge of their existence. In addition, there are uncertaintiesregarding the interpretation and enforcement of laws, rules and policiesin China. The Chinese legal system is based on written statutes, and priorcourt decisions have limited precedential value. Because many laws andregulations are relatively new and the Chinese legal system is still evolving,the interpretations of many laws, regulations and rules are not alwaysuniform. Moreover, the relative inexperience of China’s judiciary in many casescreates additional uncertainty as to the outcome of any litigation, and theinterpretation of statutes and regulations may be subject to governmentpolicies reflecting domestic political changes. Finally, enforcement ofexisting laws or contracts based on existing law may be uncertain and sporadic,and it may be difficult to obtain swift and equitable enforcement, or to obtainenforcement of a judgment by a court of another jurisdiction. Any litigation inChina may be protracted and result in substantial costs and diversion ofresources and management’s attention.

 

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

* *

The Chinesegovernment is considering the imposition of a “unified” corporate income tax thatwould phase out, over time, the preferential tax treatment to which foreigninvestment enterprises, such as our Company, are currently entitled. While itis not certain whether the government will implement such a unified taxstructure or whether we will be grandfathered under into any new tax

 

62

----

 

structure, if anew tax structure is implemented, a new tax structure may adversely affect ourfinancial condition. Moreover, certain of our subsidiaries and joint ventureslocated in China enjoy tax benefits in China that are generally available toforeign investment enterprises. If these tax benefits are reduced or repealeddue to changes in tax laws, our business could suffer.

 

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

* *

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

* *

Themarket for PAS exceeded 77 million users as of the end of May 2005 and is availablein most of the provinces throughout China. We believe the PAS market hasmatured. For example, during the first half of 2005, net sales of the PAS/IPASsystem and the wireless infrastructure market significantly declined.  In addition, the increase in handsetcompetitors entering the market during 2004 has resulted in decreased averageselling prices and margins. * *If additional handset competitorsenter the market or if competitors decide to further reduce pricing, our salesof PAS handsets may be adversely impacted.

 

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

 

*Our PAS system and handsets sales may experience asharp decline if China Telecom or China Netcom obtain licenses allowing them todeliver mobile services.*

* *

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

 

*We only have trial licenses for the PAS system andhandsets in China.*

* *

Weonly have trial licenses for our PAS systems and handsets. We have applied for,but have not yet received, a final official network access license for our PASsystems and handsets. Based upon communication with the MII, we understand thatour PAS systems and handsets are considered to still be in the trial period andsales of our PAS systems and handsets may continue to be made by us during thistrial period, but that licenses will ultimately be required. If we fail toobtain the required licenses, we could be prohibited from making further salesof the unlicensed products, including our PAS systems and handsets, in China,which would substantially harm our business, financial condition and results ofoperations. The regulations implementing these requirements are not very detailed,have not been applied by a court and may be interpreted and enforced byregulatory authorities in a number of different ways. Our legal counsel inChina has advised us that China’s governmental authorities may interpret orapply the regulations with respect to which licenses are required and theability to sell a product while a product is in the trial period in a mannerthat is inconsistent with the information received by our legal counsel inChina, and either of these conditions could have a material adverse effect onour business, financial condition and results of operations.

 

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

* *

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

 

Inthe case of PAS systems, all China Netcom contracts are negotiated and enteredinto between the provincial operators and the Company. However, the centralheadquarters of China Telecom had, in the past, exerted their influence, andmay, in the future, choose

 

63

----

 

toexert their influence in the purchasing decision-making process by negotiatingcontractual terms, such as purchase price, payment terms, and acceptanceclauses at the central level. The provincial operator then further negotiatesthe contract based on the guidelines provided by the headquarters. Finalcontracts are entered into between the provincial operator and the Company.However, if this trend of centralized decision-making expands to unifiedpurchasing, resulting in the negotiation and execution of contracts at thecentral headquarter level, there may be a concentration of customers whichcould have a significant impact on our business.

 

**RISKS RELATED TO OUR STOCK PERFORMANCE ANDCONVERTIBLE DEBT SECURITIES**

 

*Our stock price is highly volatile.*

* *

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

 

•                  actualor anticipated fluctuations in operating results, actual or anticipated grossprofit as a percentage of net sales, levels of inventory, our actual oranticipated rate of growth and our actual or anticipated earnings per share;

 

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

 

•                  changesin governmental regulations or policies in China;

 

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

 

•                  theoperating and stock price performance of other comparable companies; and

 

•                  newsand commentary emanating from the media, securities analysts or governmentbodies in China relating to us and to the industry in general.

 

Generalmarket conditions and domestic or international macroeconomic factors unrelatedto our performance may also affect our stock price. For these reasons,investors should not rely on recent trends to predict future stock prices orfinancial results. In addition, following periods of volatility in a company’ssecurities, securities class action litigation against a company is sometimesinstituted. This type of litigation could result in substantial costs and thediversion of management’s time and resources.

 

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

 

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

* *

SOFTBANKCORP. and its related entities, including SOFTBANK America Inc. (collectively, “SOFTBANK”),beneficially owned approximately 12.5% of our outstanding stock as of June 30,2005. As a result, SOFTBANK has the ability to influence all matters submittedto our stockholders for approval, as well as our management and affairs.Matters that could require stockholder approval include:

 

•                  electionand removal of directors;

 

•                  mergeror consolidation of our Company; and

 

•                  saleof all or substantially all of our assets.

 

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

 

64

----

 

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

* *

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

 

•                  authorizingthe board of directors to issue additional preferred stock;

 

•                  prohibitingcumulative voting in the election of directors;

 

•                  limitingthe persons who may call special meetings of stockholders;

 

•                  prohibitingstockholder action by written consent;

 

•                  creatinga classified board of directors pursuant to which our directors are elected forstaggered three year terms; and

 

•                  establishingadvance notice requirements for nominations for election to the board ofdirectors and for proposing matters that can be acted on by stockholders atstockholder meetings.

 

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

* *

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

 

•                  wemay be limited in our ability to purchase the Notes in the event of a change incontrol, either for cash or stock, which could result in our defaulting on theNotes at the time of the change in control and purchases for stock would besubject to market risk;

 

•                  anevent of default under our senior debt, including one of our subsidiaries,could restrict our ability to purchase or pay any or all amounts due on Notes,and after paying our senior debt in full, we may not have sufficient assetsremaining to pay any or all amounts due on the Notes;

 

•                  thereis no listed trading market for the Notes, which could have a negative impacton the market price of the Notes;

 

•                  wehave significantly increased our leverage as a result of the sale of the Noteswhich could have an adverse impact on our ability to obtain additionalfinancing for working capital;

 

•                  hedgingtransactions related to the Notes and our common stock and other transactions,as well as changes in interest rates and our creditworthiness, may affect thevalue of the Notes and of our common stock; and

 

•                  theNotes might not be rated or may receive a lower rating than anticipated byinvestors, ultimately having a negative affect on the price of the Notes and ofour common stock.

 

In addition, weare subject to various covenants and obligations pursuant to the terms of theindenture governing the Notes (the “Indenture”). Should we default on certainof these obligations, then all unpaid principal and accrued interest on theNotes then outstanding could become immediately due and payable. For example, fromApril 1, 2005 to April 15, 2005, we were in technical noncomplianceunder the Indenture due to the untimely filing of our Annual Report on Form 10-Kfor the year ended December 31, 2004 (the “Annual Report”). If in thefuture we fail to file all reports and other information and documents which weare required to file with the SEC pursuant to Section 13 or 15(d) andwe fail to cure such technical non compliance within 60 days of written noticebeing provided to us by either the trustee under the Indenture or the holdersof at least 25% in aggregate principal amount of the Notes then outstanding, anevent of default under the Indenture will be deemed to occur. If an event ofdefault under the Indenture occurs and if payment of principal and accruedinterest on the Notes is accelerated, our business could be seriously harmed.

 

65

----

 

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

 

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

 

*InterestRate Risk.*  Ourexposure to market risk for changes in interest rates relates primarily to ourinvestment portfolio. The fair value of our investment portfolio would not besignificantly affected by either a 10% increase or decrease in interest ratesdue mainly to the short-term nature of most of our investment portfolio.However, our interest income can be sensitive to changes in the general levelof U.S. interest rates since the majority of our funds are invested ininstruments with maturities less than one year. Our policy is to ensure thesafety of invested funds by generally attempting to limit market risk. Funds inexcess of current operating requirements are mostly invested ingovernment-backed notes, commercial paper, floating rate corporate bonds, fixedincome corporate bonds and tax-exempt instruments. In accordance with ourinvestment policy, all short-term investments are invested in “investment grade”rated securities with minimum A or better ratings. Currently, most of ourshort-term investments have AA or better ratings.

 

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

 

| **(in thousands, except interest  rates)**              | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|
| Cash and cash equivalents                               |       | $          | 350,324    |   |
| Average interest rate                                   |       | 0.70       | %          |
|                                                    |       |       |       |
| Restricted cash                                         |       | 31,445     |       |
| Average interest rate                                   |       | 2.40       | %          |
|                                                    |       |       |       |
| Restricted short-term investments                       |       | 1,162      |       |
| Average interest rate                                   |       | 3.06       | %          |
|                                                    |       |       |       |
| Short-term investments                                  |       | 31,402     |       |
| Average interest rate                                   |       | 2.24       | %          |
|                                                    |       |       |       |
| Long-term securities                                    |       | 809        |       |
| Average interest rate                                   |       | 2.58       | %          |
|                                                    |       |       |       |
| Total cash, cash equivalents and investment  securities |       | $          | 415,142    |   |
| Average interest rate                                   |       | 0.96       | %          |

 

*Foreign ExchangeRate Risk.*  Weare exposed to foreign currency exchange rate risk because our sales generatedfrom China, which accounts for a significant portion of our total sales, aredenominated in Renminbi. Due to the limitations on converting Renminbi, we arelimited in our ability to engage in foreign currency hedging activities inChina. Although the impact of currency fluctuations of Renminbi to datehas been insignificant, fluctuations in foreign currency exchange rates in thefuture may have a material adverse effect on our results of operations.  In July 2005, China uncoupled the Renminbifrom the dollar and will let it float in a narrow band against a basket offoreign currencies.  The move revalues theRenminbi by 2.1% against the U.S. dollar. The extent of further adjustments theChinese government will take in governing its foreign currency exchange isstill uncertain.

 

Beginning in the firstquarter of 2004, we hedged certain Japanese Yen-denominated balance sheetexposures against future movements in foreign currency exchange rates by usingforeign currency forward contracts. Gains and losses on these fair value hedgesare intended to offset gains and losses from the revaluation of our JapaneseYen-denominated recognized liabilities. In accordance with Statement of FinancialAccounting Standards No. 133 (“SFAS 133”), “Accounting for DerivativeInstruments and Hedging Activities,” we recognize derivative instruments andhedging activities as either assets or liabilities on the balance sheet andmeasure them at fair value. There were no hedging activities in the three andsix months ended June 30, 2005.  Thenet result of gains and losses on contracts and revaluation included ininterest and other income (expense) was insignificant for the three and six monthsended June 30, 2004. Our foreign currency forward contracts generallymature within three months. We do not intend to utilize

 

66

----

 

derivative financialinstruments for speculative trading purposes. There were no foreign currency forward contracts held at June 30,2005. Movements in currency exchange rates could cause variability in our otherincome (expense).

 

We maintain a bank accountin Japanese Yen for purchasing portions of our inventories and supplies.  The balance of this Japanese Yen account as ofJune 30, 2005 was approximately $79.5 million.   Accounts receivable balance andinter-company accounts receivable balance denominated in Japanese Yen as of June 30,2005 was $108.7 million and $49.2 million, respectively.  Primarily due to the weakened Japanese Yenagainst the US dollar, for the three months ended June 30, 2005, weincurred unrealized foreign exchange losses of $3.0 million, of which $1.0million is due to Yen account balance, $2.0 million is due to accounts receivablesin Japanese Yen denomination. For the six months ended June 30, 2005, weincurred unrealized foreign exchange losses of $13.3 million, of which $4.4million is due to Yen account balance, $8.2 million is due to accounts receivablesin Japanese Yen denomination and $1.2 million is due to inter-company accounts receivables.

 

#### **ITEM4—CONTROLS AND PROCEDURES**

 

# **Evaluationof Disclosure Controls and Procedures**

 

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

 

Inconnection with the preparation of this Quarterly Report on Form 10-Q, theCompany carried out an evaluation under the supervision and with theparticipation of the Company’s management, including the CEO and CFO, as of June 30,2005 of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures, as such term is defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act. Based upon this evaluation, the CEO andCFO concluded that as of June 30, 2005 the Company’s disclosure controlsand procedures were not effective because of the material weaknesses describedunder “Management’s Report on Internal Control Over Financial Reporting” inItem 9A of the Company’s Annual Report on Form 10-K for the year ended December 31,2004 (the “2004 Form 10-K”), which the Company is still in the process ofremediating. Investors are directed to Item 9A of the 2004 Form 10-K forthe description of these weaknesses.

 

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

 

Management excluded AudiovoxCommunication Corporation (“Audiovox”) from its assessment of the Company’sinternal control over financial reporting as of December 31, 2004 becauseAudiovox was acquired by the Company through a purchase business combination inNovember 2004. Audiovox’s total assets and total revenue representapproximately 7% and approximately 47%, respectively, of the Company’s relatedconsolidated financial statement amounts as of and for the three months ended June 302005.

 

**Management’s Remediation Initiatives and Interim Measures**

** **

Inresponse to the matters discussed in “Management’s Report on Internal ControlOver Financial Reporting” in Item 9A of the 2004 Form 10-K, the Companyplans to continue to review and make necessary changes to the overall design ofits control environment, including the roles and responsibilities of eachfunctional group within the organization and reporting structure, as well aspolicies and procedures to improve the overall internal control over financialreporting. In particular, the Company has implemented and/or plans to implementduring 2005 the specific measures described below to remediate the materialweaknesses described in “Management’s Report on Internal Control Over FinancialReporting” in Item 9A of the 2004 Form 10-K.  In addition, in the absence of full

 

67

----

 

implementationof these remediation measures in the first two quarters of 2005 and subsequentto June 30, 2005 in connection with the June 30, 2005 quarter-endreporting process, the Company has undertaken the additional measures describedunder the subheadings “—Interim Measures” below to provide reasonable assuranceregarding the reliability of financial reporting and the preparation of theCompany’s financial statements included in this Quarterly Report on Form 10-Qand to ensure that material information relating to the Company and itsconsolidated subsidiaries was made known to management in connection with thepreparation of this Quarterly Report on Form 10-Q.

 

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

*** ***

*Remediation Initiatives*.   TheCompany’s failure to have a sufficient complement of personnel with a level ofaccounting knowledge, experience and training in the application of generallyaccepted accounting principles commensurate with the Company’s financial reportingrequirements contributed to the Company’s failure to maintain effectivecontrols over the financial reporting process. To remediate the materialweaknesses described in item 1 of “Management’s Report on Internal Control OverFinancial Reporting” in Item 9A of the 2004 Form 10-K, the Company hasimplemented or plans to implement the measures described below, and willcontinue to evaluate and may in the future implement additional measures.

 

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

 

(a)          TheCompany promoted the chief financial officer to executive vice president andchief operating officer on June 1, 2005; while the company conducted asearch for a replacement chief financial officer, the chief operating officer continuedto serve as acting chief financial officer for the Company.  The Company’s acting chief financial officer,with assistance from senior financial staff and outside consultants, other thanthe Company’s independent registered public accounting firm, has reviewed andwill continue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of each functionalgroup within the Company;

 

(b)         TheCompany hired regional controllers with relevant accounting experience, skillsand knowledge for each of the Asia-Pacific region, the Central America andLatin America region, the Europe, Middle East and Africa region and Japan inlate 2004 and early 2005;

 

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

 

(d)         TheCompany hired a senior manager for SEC reporting with relevant accountingexperience, skills and knowledge in February 2005;

 

(e)          TheCompany hired a senior manager of international tax with relevant accounting andtax experience, skills and knowledge in May, 2005;

 

(f)            TheCompany retained and intends to continue to retain the services of outsideconsultants, other than the Company’s independent registered public accountingfirm, with relevant accounting experience, skills and knowledge, working underthe supervision and direction of the Company’s management, to supplement theCompany’s existing accounting personnel;

 

(g)         TheCompany hired a vice president of finance for the Company’s China operationswith relevant accounting experience, skills and knowledge in April 2005;

 

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

 

68

----

 

(i)             The Company in February 2005 implementedan enhanced formal training process for the training of financial staff andplans to continue this process to ensure that personnel have the necessarycompetency, training and supervision for their assigned level of responsibilityand the nature and complexity of the Company’s business.

 

2.               Revenue Recognition—The Company’s plannedremediation measures are intended to address material weaknesses related torevenue and deferred revenue accounts and associated cost of sales. Thesematerial weaknesses were evidenced by the identification of six separatetransactions aggregating approximately $5 million in which revenue was initiallyincluded in the Company’s fourth quarter 2004 financial statements before allcriteria for revenue recognition were met. In addition, there were othertransactions for which there was insufficient initial documentation for revenuerecognition purposes, but which did not result in any adjustments to theCompany’s fourth quarter 2004 financial statements. If unremediated, thesematerial weaknesses have the potential of misstating revenue in futurefinancial periods. The Company’s planned remediation measures include thefollowing:

 

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

 

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

 

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

 

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

 

(a)             The Company is in the process of continuingto upgrade and implement additional Oracle modules to more effectively trackinventory and evaluate deferred costs;

 

(b)            The Company implemented in late 2004 itsprocess to confirm the existence of off-site inventory by systematicallyobtaining customer confirmations, investigating discrepancies in the confirmedresults, and properly recording and reporting the results of the investigation;

 

(c)             During the fourth quarter of 2004, theCompany initiated a process to accumulate information necessary to evaluateinventory and deferred cost contracts for impairment. The Company plans tocontinue to enhance this process in 2005 by better coordinating theaccumulation of such information from non-U.S. locations;

 

(d)            The Company plans to implement in 2005 morerobust controls over the release of costs to the income statement by betterutilizing the Oracle system;

 

(e)             The Company is in the process of selecting aservice provider with expertise and systems to more effectively manage and trackthe Company’s inventory in Japan, to whom the Company plans to outsource thisfunction in 2005; and

 

(f)               The Company plans to deploy the Oracle systemin Japan by the third quarter of 2005.

 

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

 

(a)              In the first quarter of 2005, the Companyimplemented a process of reallocating goodwill to the Company’s five reportingunits in a manner reflective of the Company’s new organization; and

 

69

----

 

(b)             As part of the process described in (a) above,the Company retained an outside consultant, working under the supervision anddirection of the Company’s management, to assist in a valuation analysis thatwas used in the allocation process. The Company plans to use the consultant onat least an annual basis to assist in a valuation and impairment analysis withrespect to goodwill.

 

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

 

6.               Recording of Accrued Expenses and OpenPurchase Orders—The Company’s planned remediation measures are intended toaddress a material weakness related to the Company’s recording of accruedexpenses, primarily in China and Japan, that has the potential of misstatingaccrued expenses and related income statement accounts in future financialperiods. The Company’s planned remediation measures include the implementation during2005 of a process of enhanced review of open purchase orders and review ofinvoices and receipts after the end of each quarter to ensure proper recordingof accrued expenses and open purchase order commitments.

 

7.               Accurate Preparation and Review of FinancialStatements, Reconciliations, Journal Entries and Segment Reporting—The Company’splanned remediation measures are intended to address material weaknessesrelated to the financial close and reporting process that have the potential ofpreventing the accurate preparation and review of the Company’s consolidatedfinancial statements in future financial periods. The Company’s plannedremediation measures include the following:

 

(a)              During the first and second quarters of 2005,the Company began to implement, and plans to continue to improve, new andenhanced procedures to ensure that non-routine transactions are identified andescalated to senior financial management during the close process to helpensure proper accounting treatment. Specific steps include training and ongoingmonitoring of financial staff, expansion of the officer sub-certifications andactive review of contracts by knowledgeable financial and legal staff, from thecontract negotiation process through recognition of revenue for such contracts;

 

(b)             During the fourth quarter of 2004, theCompany implemented, and plans to continue to enhance, its month-end closingprocedures, including reconciliations and controls over spreadsheets, andstandardized checklists to ensure such procedures are consistently andeffectively applied throughout the organization; and

 

(c)              The Company plans to enhance in 2005 thecommunication and distribution of its accounting policies and procedures anddevelopment of a process to more effectively accumulate and analyze informationrequired for financial statement footnote disclosures.

 

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

 

(a)             During the second quarter of 2005, theCompany hired an additional experienced tax manager and intends to hire andtrain additional supporting staff in 2005 to closely monitor reporting fromChina and Japan, to assist in managing audits and to monitor tax compliance inChina and Japan;

 

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

 

(c)          The Company plans to develop a comprehensive process to accumulate andorganize financial and tax data used in connection with income tax calculationand reporting.

 

70

----

 

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

 

(a)              During the first half of 2005, the Companyoutsourced to a third-party expert the position of chief security officer to,among other duties, monitor access rights with respect to the Oracle system andmanage ongoing provisioning and changes;

 

(b)             The Company plans to improve utilization ofcurrent functionality and continue to upgrade and expand functionality of theOracle financial reporting system through utilization of additional modules toreduce manual procedures and the utilization of spreadsheets;

 

(c)              The Company plans to deploy the Oracle systemin Japan by the third quarter of 2005;

 

(d)             The Company is in the process of continuingto upgrade and implement additional Oracle modules to more effectively trackinventory and evaluate deferred costs; and

 

(e)              The Company plans to implement in 2005 morerobust controls over the release of costs to the income statement by betterutilizing the Oracle system.

 

*Interim Measures*. Management has not yet implemented all of the measures described initems 1 through 9 above and/or tested them. Nevertheless, management believesthose measures identified above as having been implemented, together with theother measures undertaken by the Company described below, all of which wereundertaken during the first and second quarters of 2005 or subsequent to June 30,2005 in connection with the June 30, 2005 quarter-end reporting process,address the material weaknesses described in item 1 of “Management’s Report onInternal Control Over Financial Reporting” in Item 9A of the 2004 Form 10-K.  These other measures include the following:

 

•                  The Company retained on an interim basisoutside consultants, other than the Company’s independent registered publicaccounting firm, with relevant accounting experience, skills and knowledge,working under the supervision and direction of the Company’s management, toassist with the June 30, 2005 quarter-end reporting process.

•                  In connection with the 2004 year-endreporting process, the Company conducted an additional review of a substantialmajority of its revenue-generating contracts for compliance with revenuerecognition criteria and continued this review during the second quarter of2005. As part of this review, the Company gathered and analyzed evidence ofdelivery and final acceptance.

•                  The Company performed the following reviewsof inventory-related matters: it reviewed consolidated revenue schedules fromthe second quarter of 2005 to determine the proper recording of cost of goodssold; it performed a roll forward analysis of inventory balances from March 31,2005 to June 30, 2005 and reviewed various supporting documentation; and itconducted physical inventory counts at selected locations.

•                  The Company conducted a review of theprocesses to record inventory reserves and a review of the manual procedures bywhich the Company tracks the cost of its products.

•                  The Company conducted a variety of manualreview procedures, such as an extensive review of journal entry postings intothe Oracle system and an extensive review of account reconciliations.

•                  The Company conducted a detailed andextensive review of the following matters: all non-routine transactions andinternal representations; financial statements, as well as certifications fromdecentralized locations, for accuracy and journal entries.

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

 

***Material weakness described in item 2 of “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

*** ***

*Remediation Initiatives*.   TheCompany’s failure to ensure that key management fully understood the nature andpotential significance of related parties and to ensure that a robust processfor the identification of related party transactions contributed to the Company’sfailure to maintain effective controls over the identification of andaccounting for related party relationships and related party transactions withthe Company. To remediate the material weakness described in item 2 of “Management’sReport on Internal Control

 

71

----

 

OverFinancial Reporting” in Item 9A of the 2004 Form 10-K, the Company hasimplemented or plans to implement the measures described below, and willcontinue to evaluate and may in the future implement additional measures.

 

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

 

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

 

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

 

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

 

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

 

*Interim Measures*.   Management has not yetimplemented all of the measures described above and/or tested them.Nevertheless, management believes those measures identified above as havingbeen implemented, together with the other measures undertaken by the Companydescribed below, all of which were undertaken during the first and secondquarters of 2005 or subsequent to June 30, 2005 in connection with the June 30,2005 quarter-end reporting process are sufficient to address the materialweakness described in item 2 of “Management’s Report on Internal Control OverFinancial Reporting”  in Item 9A of the2004 Form 10-K.  These othermeasures include the following:

 

•                  Management directly interviewed seniorexecutives regarding related party transactions.

 

•                  After receiving additional training onrelated party transactions, key managers and senior executives provided newcertifications regarding related party transactions.

 

***Material weakness described in item 3 of “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

*** ***

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

 

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

 

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

 

3.               The Company’s acting chief financial officer,with assistance from senior financial staff and outside consultants, other thanthe Company’s independent registered public accounting firm, has reviewed andwill continue to review and adapt the overall

 

72

----

 

design of the Company’sfinancial reporting structure, including the roles and responsibilities of eachfunctional group within the Company.

 

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

 

*Interim Measures*.   Management has not yetimplemented all of the measures described above and/or tested them.Nevertheless, management believes those measures identified above as havingbeen implemented, together with the other measures undertaken by the Companydescribed below, all of which were undertaken during the first and second quartersof 2005 or subsequent to June 30, 2005 in connection with the June 30,2005 quarter-end reporting process, address the material weakness described initem 3 of “Management’s Report on Internal Control Over Financial Reporting” inItem 9A of the 2004 Form 10-K. These other measures include the following:

 

•                  The Company utilized outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,with the review of invoices and cash disbursements in Japan**.**

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

•                  The Company utilized outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,with the quarter-end review of China operations.

•                  All non-routine transactions in non-U.S.locations were documented by staff in such non-U.S. locations and reviewed bysenior financial staff in the Company’s U.S. headquarters.

 

***Material weakness described in item 4 of “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

*** ***

*Remediation Initiatives*.   TheCompany’s failure to have sufficient personnel with knowledge, experience andtraining in the application of generally accepted accounting principlescommensurate with the Company’s financial reporting requirements contributed toa material weakness relating to the Company’s control environment. To remediatethis material weakness, described in item 4 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K, theCompany has implemented or plans to implement the measures described under “—Materialweaknesses described in item 1 of ‘Management’s Report on Internal Control OverFinancial Reporting’—Remediation Measures—1. General plan for hiring andtraining of personnel” in Item 9A of the 2004 Form 10-K, as well as thosedescribed below. The Company will continue to evaluate and may in the futureimplement additional measures.

 

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

 

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

 

3.               The Company’s acting chief financial officer,with assistance from senior financial staff and outside consultants, other thanthe Company’s independent registered public accounting firm, has reviewed andwill continue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of eachfunctional group within the Company.

 

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

 

*Interim Measures*.   Management has not yetimplemented all of the measures described above and/or tested them.Nevertheless, management believes those measures identified above as havingbeen implemented, together with the other measures undertaken by the Companydescribed below, all of which were undertaken during the first and secondquarters of 2005 or subsequent to June 30,

 

73

----

 

2005in connection with the June 30, 2005 quarter-end reporting process, addressthe material weaknesses described in item 4 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K.  These other measures include the following:

 

•                  The Company utilized outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,with the review of invoices and cash disbursements in Japan**.**

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

•                  The Company utilized outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,with the quarter-end review of China operations.

•                  All non-routine transactions in non-U.S.locations were documented by staff in such non-U.S. locations and reviewed bysenior financial staff in the Company’s U.S. headquarters.

 

***Control deficiencies not constitutingmaterial weaknesses***

*** ***

Inaddition to the material weaknesses described in “Management’s Report onInternal Control Over Financial Reporting” in Item 9A of the 2004 Form 10-K,management has identified other deficiencies in internal control over financialreporting that did not constitute material weaknesses as of December 31,2004. The Company has implemented and/or plans to implement during 2005 variousmeasures to remediate these control deficiencies and has undertaken other interimmeasures to address these control deficiencies.

 

***Management’s Conclusions***

*** ***

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

 

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

 

**Changes in Internal Control over Financial Reporting**

** **

Thediscussion above under “Management’s Remediation Initiatives and InterimMeasures” describes the material planned and actual changes to the Company’sinternal control over financial reporting during the second quarter of 2005 andsubsequent to June 30, 2005 that materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

74

----

 

**PART II—OTHERINFORMATION**

 

**ITEM 1—LEGAL PROCEEDINGS**

 

*Securities Class Action Litigation*

* *

Beginning in October 2004,several shareholder class actions alleging federal securities violations werefiled against us and various officers and directors.  The actions have been consolidated in UnitedStates District Court for the Northern District of California.  The actions are brought on behalf of aputative class of shareholders who purchased our stock between April 16, 2003and September 20, 2004.  Thelead plaintiffs in the case filed a First Amended Consolidated Complaint on July 26,2005.  The Complaint alleges violationsof the Securities Exchange Act of 1934. In addition to our defendants, the plaintiffs also sued Banc of AmericaSecurities LLC and Softbank. The Complaint seeks recovery of damages in anunspecified amount.  We anticipate thatwe will move to dismiss the Complaint on October 10, 2005.

 

Thislitigation is in its preliminary stages, and we cannot predict itsoutcome.  Our management believes thatthe claims are not meritorious. Nevertheless, an adverse outcome in the litigation, if it occurred,could have a material adverse effect on our results of operations.  As of June 30, 2005, no loss amount hasbeen accrued because a loss is not considered probable or estimable.

 

*Shareholder Derivative Litigation*

* *

Beginning in August 2004,several shareholder derivative actions were filed in the Superior Court ofCalifornia for Alameda County.  Theactions allege claims for breach of fiduciary duty against certain of ourcurrent and former directors and officers and name us as a nominal defendant.The Court has consolidated the various complaints into one action.

 

On June 9,2005, the Court entered an order sustaining defendants’ demurrer to theComplaint, with leave to amend.  On June 28,2005, plaintiffs filed their Second Amended Derivative Complaint.  On July 15, 2005, the defendants againdemurred to the Complaint.  Briefing onthat motion has not yet been completed.

 

Thislitigation is in its preliminary stages, and we cannot predict itsoutcome.  Our management believes thatplaintiffs have failed adequately to allege demand futility, and that theaction therefore should be dismissed.  Wecannot predict whether that position will prevail.  As of June 30, 2005, no loss amount hasbeen accrued because a loss is not considered probable or estimable.

 

*IPOAllocation*

* *

On October 31,2001, a complaint was filed in United States District Court for the SouthernDistrict of New York against us, some of our directors and officers and variousunderwriters for 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 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 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 orderdismisses all claims against us except for a claim brought under Section 11of the Securities Act of 1933, which alleges that the registration statementfiled in accordance with the IPO was misleading.  In June 2004, a stipulation ofsettlement and release of claims against the issuer defendants, including us,was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release allclaims against the participating defendants (including us).  In exchange for this dismissal, D&Oinsurance carriers would agree to guarantee a recovery by the plaintiffs fromthe underwriter defendants of at least $1 billion, and the issuer defendantswould agree to an assignment or surrender to the plaintiffs of certain claimsthe issuer defendants may have against the underwriters.  The settlement is subject to a number of conditions,including court approval. If the settlement does not occur, and litigationagainst us continues, we believe it has valid defenses and intends to defendthe case vigorously.  The total amount ofthe loss associated with the above litigation is not determinable at thistime.  Therefore, we are unable tocurrently estimate the loss, if any, associated with the litigation.

 

75

----

 

*StarentPatent Infringement Litigations*

* *

We have sued StarentNetworks Corporation (“Starent”) for patent infringement in the U.S. DistrictCourt for the Northern District of California. On March 22, 2004, we filed our Complaint.  On June 3, 2004, we served ourComplaint on Starent.  On July 30, 2004,Starent filed and served its answer and counterclaims.  On August 30, 2004, we served andfiled our Amended Complaint.  In ourAmended Complaint, we assert that Starent infringes a UTStarcom patent throughthe manufacture, use, offer for sale, and sale of Starent’s ST-16 IntelligentMobile Gateway.  We seek, inter alia, compensatorydamages and injunctive relief.  Starentfiled its answer to the Amended Complaint and counterclaims on September 17, 2004.  In its answer and counterclaims, Starentdenies our allegations and seeks a declaration that the patent-in-suit is not infringed,is invalid, and is unenforceable.  TheCourt held an initial case management conference on November 2, 2004.  On February 17, 2005, we filed amotion for a preliminary injunction against Starent’s use, sale, and offer forsale of products having the infringing feature. The Court held a hearing on our motion on May 11, 2005 anddenied our motion on June 17, 2005. On June 30, 2005, the Court held a hearing on the proper meaning orconstruction of the claims of the patent-in-suit.  The Court has not yet entered an orderconstruing these claims.  Although wecannot reliably predict the outcome of this litigation, we believe that anyadverse judgment on Starent’s counterclaims will not have a material adverseeffect on the business, financial condition, or results of our operations.

 

On February 16, 2005,we filed a second suit against Starent for patent infringement in the U.S.District Court for the Northern District of California.  On May 6, 2005, we served the Complainton Starent.  In the Complaint, we assertthat Starent infringes a UTStarcom patent through Starent’s development andtesting of a software upgrade for its customer’s installed ST-16 IntelligentMobile Gateways.  We seek, inter alia,declaratory and injunctive relief.  TheCourt has set a case management conference for August 19, 2005.  Starent filed its answer and counterclaims onMay 31, 2005, denying our allegations and seeking a declaration that thepatent-in-suit is not infringed, is invalid, and is unenforceable.  On June 16, 2005, we filed a motion tostrike Starent’s affirmative defense and dismiss Starent’s counterclaimalleging inequitable conduct.  On July 19,2005, the parties stipulated that Starent would file an amended answer andcounterclaim by July 27, 2005 and that we would withdraw our motion tostrike.  Although we cannot reliablypredict the outcome of this litigation, we believe that any adverse judgment onStarent’s counterclaims will not have a material adverse effect on thebusiness, financial condition, or results of our operations.

 

*FennerInvestments Patent Infringement Litigation*

* *

On January 6, 2005,Fenner Investments, Ltd. (“Fenner”) filed suit against us and co-defendantsJuniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., LucentTechnologies, Inc., and Cisco Systems, Inc. in the U.S. DistrictCourt for the Eastern District of Texas. On May 17, 2005, Fenner amendedits complaint to add as defendants Ericsson Inc., Ericsson AB,Telefonaktiebolaget LM Ericsson, and Alcatel USA Inc.  The suit alleges that unspecified productsand services infringe two Fenner patents and seeks compensatory and injunctiverelief.  On March 1, 2005, wefiled a motion to dismiss the complaint due to improper venue.  On May 24, 2005, the Court denied ourmotion.  On June 9, 2005, we filed amotion for reconsideration of the Court’s decision.  On July 14, 2005, the Court denied ourmotion for reconsideration.  The Courthas scheduled a hearing to construe the claims of the patents-in-suit for February 28,2006.  The Court has also scheduled trialfor October 10, 2006.  This lawsuitis in its initial stage and it is not possible to reliably predict the outcomeor any relief that could be awarded, as the litigation process is inherentlyuncertain.  We intend to contest theallegations and claims and defend ourselves vigorously. If the outcome of thelitigation is adverse to us and if, in addition, we are enjoined or required topay significant monetary damages, our business may be harmed.  At a minimum, this litigation could result insubstantial costs and divert our management’s attention and resources, whichcould harm our business.

 

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

 

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

 

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

** **

None

 

76

----

 

**ITEM 3—DEFAULTS UPON SENIOR SECURITIES**

 

None

 

**ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

** **

On May 13, 2005, the Company held its annual meeting ofstockholders. As of March 14, 2005, the record date for the annual meeting,there were 114,809,960 shares of common stock of the Company issued andoutstanding and entitled to vote at the annual meeting. The following proposalswere submitted to a vote of the stockholders:

 

(i)          Toelect the following two Class II directors to serve for a term expiring onthe date on which the annual meeting of stockholders is held in the year 2008.

 

| **Election of Directors** | ** ** | **Votes for** | ** ** | **Votes Withheld** | ** **            |
|-------------------------------------|------------|--------------------|------------|-------------------------|-----------------------|
| Larry D. Horner                     |       | 99,694,004         |       |                    |   1,907,797 |   |
| Allen Lenzmeier                     |       | 100,173,667        |       |                    |   1,428,134 |   |

 

There were no broker non-votes on this matter. As a result, Messrs. Hornerand Lenzmeier were elected as Directors of the Company.  Other directors whose terms of officecontinued after the meeting were as follows:

 

| **Class I (Term Expiring 2007)** | ** ** | **Class III (Term Expiring 2006)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                           | ** ** | ** **                                             | ** ** |
| Thomas Toy                                           |       | Jeff Clarke                                            |       |
|                                                 |       |                                                   |       |
| Ying Wu                                              |       | Hong Liang  Lu                                         |       |

 

(ii)       Toratify and approve the appointment of PricewaterhouseCoopers LLP as theIndependent Registered Public Accounting Firm of the Company for the fiscalyear ending December 31, 2005.

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 99,871,583 |       | 1,399,584   |       | 330,634     |       |

 

There were no broker non-votes on this matter. As a result, theappointment of PricewaterhouseCoopers LLP as the Independent Registered PublicAccounting Firm of the Company was ratified.

 

**ITEM 5 —OTHER INFORMATION**

** **

None

 

**ITEM 6—EXHIBITS**

 
| **Exhibit  Number** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                       |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                         |
| 10.106*             |       | Committed Receivables  Purchase Agreement dated August 1, 2005 between UTStarcom Personal  Communications LLC and Citibank, N.A.                                              |
| 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.                                        |

 

----

* Registrant has omittedportions of the referenced exhibit and filed such exhibit separately with theSecurities and Exchange Commission pursuant to a request for confidential treatmentunder Rule 24b-2 promulgated under the Securities Exchange Act of 1934, asamended.

 

77

----

 

**SIGNATURES**

 

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

 

 
|                            | UTSTARCOM, INC. |
|---------------------------------|-----------------|
| Date: August 8, 2005       | By:             | /s/ Hong Liang Lu |   |
|                            |            | Hong Liang Lu |
| * *                        | * *        | *President,  Chief Executive Officer and Director* |
| * *                        | * *        | *(Principal  Executive Officer)* |
| * *                        | * *        | * * |
|  Date: August 8, 2005 | By:             | /s/ Michael J. Sophie |   |
|                            |            | Michael J. Sophie |
| * *                        | * *        | *Executive  Vice President, and Chief Operating Officer, acting Chief  Financial Officer* |
| * *                        | * *        | *(Principal  Financial Officer)* |
|                                 |                 |  |  |  |

 

----

 

**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                       |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                         |
| 10.106*             |       | Committed Receivables  Purchase Agreement dated August 1, 2005 between UTStarcom Personal  Communications LLC and Citibank, N.A.                                              |
| 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.                                        |

 

----

* Registrant has omittedportions of the referenced exhibit and filed such exhibit separately with theSecurities and Exchange Commission pursuant to a request for confidentialtreatment under Rule 24b-2 promulgated under the Securities Exchange Act of1934, as amended.

 

----