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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)



|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly Period Ended September 30, 2004.



or



| ̈ | 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 000-30928



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PATH 1 NETWORK TECHNOLOGIES INC.

(Exact name of registrant as specified in
its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 13-3989885                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



6215 FERRIS SQUARE,
SUITE 140, SAN DIEGO, CALIFORNIA 92121

(858) 450-4220

(Address, including zip code, and telephone number, including area code, of principal executive offices)



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



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



As of October 31, 2004, 6,787,317 shares of the registrants common stock were outstanding.



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##### Table of Contents

PATH 1 NETWORK TECHNOLOGIES INC.



Quarterly Report on Form 10-Q

For the Quarterly Period Ended September 30, 2004



TABLE OF CONTENTS



|                                                     |  |                                                                                       |  |   
|---------------------------------------------------- |  | ------------------------------------------------------------------------------------- |  | --
|PART I  FINANCIAL INFORMATION                       |  | 3                                                                                    
|ITEM 1.                                              |  | FINANCIAL STATEMENTS (UNAUDITED)                                                      |  | 3 
|CONDENSED CONSOLIDATED BALANCE SHEETS                |  | 3                                                                                    
|CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS      |  | 4                                                                                    
|CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS      |  | 5                                                                                    
|NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS |  | 6                                                                                    
|ITEM 2.                                              |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 11
|ITEM 3.                                              |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 22
|ITEM 4.                                              |  | CONTROLS AND PROCEDURES.                                                              |  | 23
|PART II  OTHER INFORMATION                          |  | 23                                                                                   
|ITEM 1.                                              |  | LEGAL PROCEEDINGS                                                                     |  | 23
|ITEM 2.                                              |  | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                           |  | 23
|ITEM 3.                                              |  | DEFAULTS UPON SENIOR SECURITIES                                                       |  | 23
|ITEM 4.                                              |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   |  | 23
|ITEM 5.                                              |  | OTHER INFORMATION                                                                     |  | 23
|ITEM 6.                                              |  | EXHIBITS AND REPORTS ON FORM 8-K                                                      |  | 24
|SIGNATURES                                           |  | 25                                                                                   



2



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|PART | I  FINANCIAL INFORMATION
|---- | -------------------------

|ITEM | 1. FINANCIAL STATEMENTS
|---- | -----------------------



Path 1 Network Technologies Inc.

Condensed Consolidated Balance Sheets

(in thousands, except shares data)



|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                                                                                                                         |  | September 30,2004 |         |   | December 31,2003 |  
|                                                                                                                                                                                                                                                         |  | (unaudited)       |         |   | (audited)        |  
|ASSETS                                                                                                                                                                                                                                                   |  |                   |         |   |                  |   |         |  
|Current assets                                                                                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                                                                                |  | $                 | 2,448   |   |                  | $ | 7,807   |  
|Accounts receivable, net                                                                                                                                                                                                                                 |  |                   | 836     |   |                  |   | 510     |  
|Inventory                                                                                                                                                                                                                                                |  |                   | 380     |   |                  |   | 393     |  
|Other current assets                                                                                                                                                                                                                                     |  |                   | 214     |   |                  |   | 74      |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Total current assets                                                                                                                                                                                                                                     |  |                   | 3,878   |   |                  |   | 8,784   |  
|Property and equipment, net                                                                                                                                                                                                                              |  |                   | 407     |   |                  |   | 382     |  
|Debt issuance costs, net                                                                                                                                                                                                                                 |  |                   | 7       |   |                  |   | 62      |  
|Other assets                                                                                                                                                                                                                                             |  |                   | 49      |   |                  |   | 49      |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Total assets                                                                                                                                                                                                                                             |  | $                 | 4,341   |   |                  | $ | 9,277   |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                                     |  |                   |         |   |                  |   |         |  
|Current liabilities                                                                                                                                                                                                                                      |  |                   |         |   |                  |   |         |  
|Accounts payable and accrued liabilities                                                                                                                                                                                                                 |  | $                 | 597     |   |                  | $ | 699     |  
|Accrued compensation and benefits                                                                                                                                                                                                                        |  |                   | 224     |   |                  |   | 119     |  
|Deferred revenue                                                                                                                                                                                                                                         |  |                   | 214     |   |                  |   |        |  
|Current portion of leases payable                                                                                                                                                                                                                        |  |                   | 24      |   |                  |   | 15      |  
|Current portion of notes payable                                                                                                                                                                                                                         |  |                   | 171     |   |                  |   | 289     |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                                                                                                |  |                   | 1,230   |   |                  |   | 1,122   |  
|Long-term lease payable                                                                                                                                                                                                                                  |  |                   | 12      |   |                  |   | 14      |  
|Notes payable                                                                                                                                                                                                                                            |  |                   |        |   |                  |   | 113     |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                                                                                                                                                                                        |  |                   | 1,242   |   |                  |   | 1,249   |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Stockholders equity                                                                                                                                                                                                                                     |  |                   |         |   |                  |   |         |  
|Preferred stock, $0.001 par value; 10,000,000 shares authorized; no shares issued or outstanding                                                                                                                                                         |  |                   |        |   |                  |   |        |  
|Common stock, $0.001 par value; 40,000,000 shares authorized; 6,787,317 and 6,578,324 shares issued and outstanding at September 30, 2004, and
December 31, 2003 respectively; 2,777 shares held in treasury at September 30, 2004 and December 31, 2003 |  |                   | 7       |   |                  |   | 7       |  
|Additional paid in capital                                                                                                                                                                                                                               |  |                   | 48,614  |   |                  |   | 47,699  |  
|Deferred compensation                                                                                                                                                                                                                                    |  |                   | (1,357  | ) |                  |   | (1,300  | )
|Accumulated deficit                                                                                                                                                                                                                                      |  |                   | (44,165 | ) |                  |   | (38,378 | )
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                                                                                                                               |  |                   | 3,099   |   |                  |   | 8,028   |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                                                                               |  | $                 | 4,341   |   |                  | $ | 9,277   |  
|                                                                                                                                                                                                                                                         |  |                   |         |   |                  |   |         |  



See accompanying notes
to these condensed consolidated financial statements.



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Path 1 Network Technologies Inc.



Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)



|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|-------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ---------- | - |  | - | ------ | -
|                                                               |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                               |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003       |  
|                                                               |  |                                 |        |   | (restated)                     |   |        |      |  |   | (restated) |  
|Revenues                                                       |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Product revenue                                                |  | $                               | 734    |   |                                | $ | 587    |      |  | $ | 2,593      |   |  | $ | 1,595  |  
|                                                               |  |                                 |        |  
|License revenue                                                |  |                                 |       |   |                                |   |       |      |  |   | 21         |   |  |   | 53     |  
|Contract services revenue                                      |  |                                 | 20     |   |                                |   | 200    |      |  |   | 20         |   |  |   | 507    |  
|                                                               |  |                                 |        |  
|Other revenue                                                  |  |                                 | 2      |   |                                |   |       |      |  |   | 20         |   |  |   | 7      |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Total revenues                                                 |  |                                 | 756    |   |                                |   | 787    |      |  |   | 2,654      |   |  |   | 2,162  |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Cost of revenues                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Cost of product revenue                                        |  |                                 | 233    |   |                                |   | 379    |      |  |   | 1,828      |   |  |   | 871    |  
|                                                               |  |                                 |        |  
|Cost of contract services revenue                              |  |                                 | 7      |   |                                |   | 120    |      |  |   | 7          |   |  |   | 200    |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Total cost of revenues                                         |  |                                 | 240    |   |                                |   | 499    |      |  |   | 1,835      |   |  |   | 1,071  |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Gross profit                                                   |  |                                 | 516    |   |                                |   | 288    |      |  |   | 819        |   |  |   | 1,091  |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Operating expenses                                             |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Engineering, research and development                          |  |                                 | 466    |   |                                |   | 444    |      |  |   | 1,472      |   |  |   | 1,225  |  
|Sales and marketing                                            |  |                                 | 398    |   |                                |   | 480    |      |  |   | 2,242      |   |  |   | 1,091  |  
|General and administrative                                     |  |                                 | 636    |   |                                |   | 1,574  |      |  |   | 2,545      |   |  |   | 2,763  |  
|                                                               |  |                                 |        |  
|Stock-based compensation                                       |  |                                 |       |   |                                |   |       |      |  |   | 272        |   |  |   | 50     |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Total operating expense                                        |  |                                 | 1,500  |   |                                |   | 2,498  |      |  |   | 6,531      |   |  |   | 5,129  |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Operating loss                                                 |  |                                 | (984   | ) |                                |   | (2,210 | )    |  |   | (5,712     | ) |  |   | (4,038 | )
|                                                               |  |                                 |        |  
|Other expenses                                                 |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Interest expense, net                                          |  |                                 | (22    | ) |                                |   | (434   | )    |  |   | (72        | ) |  |   | (919   | )
|Other expense                                                  |  |                                 |       |   |                                |   | (262   | )    |  |   | (3         | ) |  |   | (262   | )
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Total other expenses                                           |  |                                 | (22    | ) |                                |   | (696   | )    |  |   | (75        | ) |  |   | (1,181 | )
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Net loss                                                       |  | $                               | (1,006 | ) |                                | $ | (2,906 | )    |  | $ | (5,787     | ) |  | $ | (5,219 | )
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Loss per common share - basic and diluted                      |  | $                               | (0.15  | ) |                                | $ | (0.64  | )    |  | $ | (0.86      | ) |  | $ | (2.01  | )
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  
|Weighted average common shares outstanding - basic and diluted |  |                                 | 6,764  |   |                                |   | 4,528  |      |  |   | 6,711      |   |  |   | 2,593  |  
|                                                               |  |                                 |        |   |                                |   |        |      |  |   |            |   |  |   |        |  



See accompanying notes
to these condensed consolidated financial statements.



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Path 1 Network Technologies Inc.



Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)



|                                                                                              |  |                                |        |   |            |   |        |  
|--------------------------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---------- | - | ------ | -
|                                                                                              |  | Nine Months EndedSeptember 30, |       
|                                                                                              |  | 2004                           |        |   | 2003       |  
|                                                                                              |  |                                |        |   | (restated) |  
|Cash flows from operating activities:                                                         |  |                                |        |   |            |   |        |  
|Net loss                                                                                      |  | $                              | (5,787 | ) |            | $ | (5,219 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                   |  |                                |        |   |            |   |        |  
|Depreciation and amortization                                                                 |  |                                | 233    |   |            |   | 419    |  
|Amortization of deferred compensation                                                         |  |                                | 272    |   |            |   | 72     |  
|Interest expense paid in stock                                                                |  |                                |       |   |            |   | 53     |  
|Accretion of debt discount & debt conversion expense                                          |  |                                | 100    |   |            |   | 1,397  |  
|Loss on extinguishment of debt                                                                |  |                                |       |   |            |   | 85     |  
|Changes in assets and liabilities                                                             |  |                                |        |   |            |   |        |  
|Accounts receivable                                                                           |  |                                | (326   | ) |            |   | (406   | )
|Inventory                                                                                     |  |                                | 13     |   |            |   | 17     |  
|Other current assets                                                                          |  |                                | (140   | ) |            |   | (78    | )
|Other assets                                                                                  |  |                                |       |   |            |   | (250   | )
|Accounts payable and accrued liabilities                                                      |  |                                | (87    | ) |            |   | 6      |  
|Accrued compensation and benefits                                                             |  |                                | 105    |   |            |   | 35     |  
|Deferred revenue                                                                              |  |                                | 214    |   |            |   | (60    | )
|                                                                                              |  |                                |        |   |            |   |        |  
|Cash used in operations                                                                       |  |                                | (5,403 | ) |            |   | (3,929 | )
|                                                                                              |  |                                |        |   |            |   |        |  
|Cash flows from investing activities:                                                         |  |                                |        |   |            |   |        |  
|Purchase of property and equipment                                                            |  |                                | (180   | ) |            |   | (121   | )
|                                                                                              |  |                                |        |   |            |   |        |  
|Cash used in investing activities                                                             |  |                                | (180   | ) |            |   | (121   | )
|                                                                                              |  |                                |        |   |            |   |        |  
|Cash flows from financing activities:                                                         |  |                                |        |   |            |   |        |  
|Issuance of common stock                                                                      |  |                                | 240    |   |            |   | 13,055 |  
|Repurchase of treasury shares                                                                 |  |                                |       |   |            |   | (93    | )
|Net borrowings under line of credit                                                           |  |                                |       |   |            |   | 473    |  
|Issuance of notes                                                                             |  |                                |       |   |            |   | 1,620  |  
|Repayments of notes                                                                           |  |                                | (16    | ) |            |   | (1,212 | )
|                                                                                              |  |                                |        |   |            |   |        |  
|Cash provided by financing activities                                                         |  |                                | 224    |   |            |   | 13,843 |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Increase (decrease) in cash                                                                   |  |                                | (5,359 | ) |            |   | 9,793  |  
|Cash and cash equivalents, beginning of period                                                |  |                                | 7,807  |   |            |   | 396    |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Cash and cash equivalents, end of period                                                      |  | $                              | 2,448  |   |            | $ | 10,189 |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Supplemental cash flow disclosures:                                                           |  |                                |        |   |            |   |        |  
|Capitalized debt issuance costs in connection with beneficial conversion charges and warrants |  | $                              |       |   |            | $ | 439    |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Conversion of notes and accrued interest to common stock                                      |  | $                              | 331    |   |            | $ | 1,122  |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Purchase of equipment for note payable                                                        |  | $                              | 23     |   |            | $ | 26     |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Retirement of 4% covertible notes by issuance of 7% convertible notes                         |  | $                              |       |   |            | $ | 228    |  
|                                                                                              |  |                                |        |   |            |   |        |  
|Executive restricted stock awards                                                             |  | $                              | 329    |   |            | $ |       |  
|                                                                                              |  |                                |        |   |            |   |        |  



See accompanying notes
to these condensed consolidated financial statements.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Condensed Consolidated Financial Statements



Note 1  Basis of Presentation



The accompanying condensed consolidated balance sheet at September 30, 2004, the condensed consolidated statements of operations for the three and
nine-month periods ended September 30, 2004 and 2003, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2004 and 2003, have been prepared by Path 1 Network Technologies Inc. (the
Company) and have not been audited. The condensed consolidated balance sheet at December 31, 2003 has been audited. These condensed consolidated quarterly financial statements, in the opinion of management, include all adjustments,
consisting only of normal and recurring adjustments, necessary to state fairly the financial information set forth therein, in accordance with accounting principles generally accepted in the United States. These condensed quarterly consolidated
financial statements should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2003 included in the Companys Form 10-K/A filed May 4, 2004. The interim consolidated financial information
contained in this filing is not necessarily indicative of the results to be expected for any other interim period or for the full year ending December 31, 2004.



The Annual Report on Form 10-K/A for the year ended December 31, 2003, includes restated consolidated financial information for the first three
quarters of 2003 from the Companys previously reported unaudited financial results. Financial statement information and related disclosures included in the Form 10-K/A reflect, as noted, changes as a result of the restatement.



This restatement related to the recording of the embedded beneficial
conversion feature related to convertible promissory notes the Company issued in 2002 and 2003. The related debt discount resulted from the conversion price of the notes being less than the fair value of the Companys common stock on the date
the notes were issued, which resulted in the embedded beneficial conversion feature. The Company had initially determined fair value based on a discount to the market price of the underlying common stock which was then trading on the
over-the-counter market. This discount was determined based on independent valuations of the Companys common stock. This accounting treatment was formulated in 2000 in connection with the filing of the Companys Form 10 and had been
consistently applied.



This restatement resulted from the
Companys revision of this accounting methodology in favor of determining fair value of the Companys common stock by reference primarily to the market trading price. This is in line with the terms of EITF 98-5, Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Rates. EITF 98-5 states generally that the trading price on an active market is the best evidence of fair value. The Companys previous
accounting methodology was based on the view that an active trading market for the Companys common stock did not exist at the time the promissory notes were issued and that reliance solely on the over-the-counter trading price would not yield
fair value. The financial restatement described in the Form 10-K/A results from a change in the Companys accounting methodology towards reliance on the market trading prices as quoted on the OTC Bulletin Board to determine fair value.



The effects of this restatement were non-cash and
non-operating, and only required adjustments to interest expense, notes payable and stockholders equity. The significant relevant effects of the restatement on the quarter ended September 30, 2003, were as follows (in thousands):



|                                               |  |                      |        |   |                             |   |        |  
|---------------------------------------------- |  | -------------------- | ------ | - | --------------------------- | - | ------ | -
|                                               |  | AsPreviouslyReported |        |   | AsRestatedin theForm 10-K/A |  
|At September 30, 2003:                         |  |                      |        |   |                             |   |        |  
|Current portion of notes payable               |  | $                    | 853    |   |                             | $ | 731    |  
|Total liabilities                              |  | $                    | 2,147  |   |                             | $ | 1,886  |  
|Additional paid-in capital                     |  | $                    | 45,254 |   |                             | $ | 46,140 |  
|Total stockholders equity                     |  | $                    | 9,734  |   |                             | $ | 9,995  |  
|For the three months ended September 30, 2003: |  |                      |        |   |                             |   |        |  
|Interest expense, net                          |  | $                    | (194   | ) |                             | $ | (434   | )
|Net loss                                       |  | $                    | (2,666 | ) |                             | $ | (2,906 | )
|Net loss per share                             |  | $                    | (0.59  | ) |                             | $ | (0.64  | )
|For the nine months ended September 30, 2003:  |  |                      |        |   |                             |   |        |  
|Interest expense, net                          |  | $                    | (589   | ) |                             | $ | (919   | )
|Net loss                                       |  | $                    | (4,889 | ) |                             | $ | (5,219 | )
|Net loss per share                             |  | $                    | (1.89  | ) |                             | $ | (2.01  | )



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On July 23, 2003, the Company effected a one-for-six reverse stock split in anticipation of its public
offering and listing on the American Stock Exchange. All per share figures herein reflect such reverse stock split.



Reclassifications



Certain reclassifications have been made to prior periods financial statements to conform to current year presentation.



Recently Issued Accounting Standards



In April 2002, the FASB issued SFAS No. 145 (SFAS No. 145)
Rescission of SFAS No. 4, 44 and 64, Amendment of SFAS No. 13, and Technical Corrections. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of
Motor Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 requires, among other things, (i) that the modification of a lease that results in a change of the classification of the
lease from capital to operating under the provisions of SFAS No. 13 be accounted for as a sale-leaseback transaction, and (ii) the reporting of gains or losses from the early extinguishment of debt as extraordinary items only if they met the
criteria of Accounting Principles Board Opinion No. 30, Reporting the Results of Operations. The amendment of SFAS No. 13 is effective for transactions occurring on or after May 15, 2002. Although the rescission of SFAS No. 4 is effective
January 1, 2003, the FASB has encouraged early application of the provisions of SFAS No. 145. On August 6, 2003, the Company repurchased $1,180,000 principal amount, plus accrued unpaid interest totaling $25,427, of its 7% convertible notes payable
for an aggregate amount of $1,382,427. The Company recognized a $262,000 ordinary loss on the early extinguishment of these notes. See Note 10.



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. This statement amends SFAS
No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.



The following table summarizes the impact on the Companys net loss had
compensation cost been determined based upon the fair value at the grant date for awards under the stock option plans consistent with the methodology prescribed under SFAS No. 123 (in thousands, except per share data):



|                                                                                                   |  |                                 |        |   |            |   |        |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---------- | - | ------ | -
|                                                                                                   |  | Nine Months Ended September 30, |       
|                                                                                                   |  | 2004                            |        |   | 2003       |  
|                                                                                                   |  |                                 |        |   | (restated) |  
|Net loss, as reported                                                                              |  | $                               | (5,787 | ) |            | $ | (5,219 | )
|Less: Unrecorded stock-based employee compensation resulting from options vested during the period |  |                                 | 14     |   |            |   | 18     |  
|                                                                                                   |  |                                 |        |   |            |   |        |  
|Pro forma net loss                                                                                 |  | $                               | (5,801 | ) |            | $ | (5,237 | )
|                                                                                                   |  |                                 |        |   |            |   |        |  
|Basic and diluted loss per share:                                                                  |  |                                 |        |   |            |   |        |  
|As reported                                                                                        |  | $                               | (0.86  | ) |            | $ | (2.01  | )
|                                                                                                   |  |                                 |        |   |            |   |        |  
|Pro forma                                                                                          |  | $                               | (0.86  | ) |            | $ | (2.02  | )
|                                                                                                   |  |                                 |        |   |            |   |        |  



In January 2003, the
FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities. This interpretation clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in
which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. It
further clarifies whether an entity shall be subject to consolidation according to the provisions of this interpretation, if by design, certain conditions exist. Management is assessing the impact of this interpretation.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equities.This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. Management
has assessed the impact of this statement and believes that it has no material impact.



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Note 2  Public Offering



On July 30, 2003, the Company raised $13.5 million in a public offering of
1,250,000 units consisting of three shares of the Companys common stock and two publicly traded redeemable warrants. The Companys common stock, units and public warrants commenced trading on the American Stock Exchange on July 31, 2003.
On August 29, 2003, the Company raised approximately $2.0 million from the issuance of an additional 187,500 units, each consisting of three shares of the Companys common stock and two publicly traded redeemable warrants. In total, the Company
raised approximately $15.5 million and issued 1,437,500 units representing 4,312,500 common shares and 2,875,000 warrants to purchase common stock of the Company. On August 30, 2003, in accordance with the units terms, the units separated and
the 4,312,500 common shares and 2,875,000 warrants became outstanding as such rather than as components of units.



Net proceeds, after expenses, from the public offering was approximately $13.1 million. Expenses included $1,164,375 of underwriting discounts, a managing
underwriters non-accountable expense allowance of $349,313, other expenses paid for underwriters of $45,500, and approximately $911,000 of legal, accounting, printing and other expenses. None of these payments went directly or indirectly to
our directors, officers, general partners, affiliates, 10% owners, or any of their associates.



Note 3  Management Estimates And Assumptions



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



Note 4  Inventory



The Company records inventory, which consists primarily of
raw materials used in the production of video gateways and related products, at the lower of cost or market. Cost is determined principally on the average cost method. Provisions for potentially obsolete or slow-moving inventory are made based on an
analysis of inventory levels and future sales forecasts.



Note 5  Revenue Recognition



The Company generates revenue primarily from the sale of the Companys video gateway products. The Company sells its products through direct sales channels and through distributors or resellers. The Company also derives revenue from
engineering contract services, license fees, extended warranty contract fees and other sources of revenue such as billable product repairs and billable engineering support for products in the field.



The Company recognizes revenue from the sales of our products and services in
conformance with AICPA Statement of Position 97-2,Software Revenue Recognition, AICPA Statement of Position 98-9,Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions and EITF 03-5,
Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software. SOP 97-2 provides guidance on the proper timing and methodology for revenue recognition related to the
sale of software and multiple-element arrangements containing software. SOP 98-9 amends SOP 97-2 to require revenue recognition under the residual method when certain conditions exist. EITF 03-5 requires non-software deliverables
included in an arrangement that includes software that is not incidental to the whole be treated as software-related and therefore subject to revenue recognition under SOP 97-2.



It is managements position that the software contained within our products is in fact, while critical to our product
performance, incidental to the hardware of our products. Management arrives at this conclusion because the software element cost, as determined by application of SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or
Otherwise Marketed, bears an insignificant relation to the total cost of the Companys products, the Companys customers are not entitled to upgrades or enhancements upon development, the Companys customers are not entitled
without the purchase of an extended warranty product to post-contract customer support beyond what would be deemed a standard product warranty, and the Company neither markets its software separately nor do the Companys customers perceive
their purchase of the Companys products as purchases of software.



Product Revenue



The Company recognizes
product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured. Significant management judgments and estimates must be made in connection with the
measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors including specific



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contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness
of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition until evidence of sell-through occurs
and cash is received. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized. The Companys products generally carry a one-year warranty from the date of purchase.



Contract Service Revenue



Revenue from support or maintenance contracts, including extended warranty
programs, is recognized ratably over the contractual period. Amounts invoiced to customers in excess of revenue recognized on support or maintenance contracts are recorded as deferred revenue until the revenue recognition criteria are met. Revenue
on engineering design contracts, including technology development agreements, is recognized on a percentage-of-completion method, based on costs incurred to date compared to total estimated costs, subject to acceptance criteria. Billings on
uncompleted contracts in excess of incurred costs and accrued profits are classified as deferred revenue.



License Revenue



Revenues from license fees are recognized when persuasive evidence of a sales arrangement exists, delivery and acceptance have occurred, the price is fixed or determinable, and collectability is reasonably assured.



Allowances for Doubtful Accounts, Returns and Discounts



The Company has established allowances for doubtful accounts, returns and
discounts based on credit profiles of the Companys customers, current economic trends, contractual terms and conditions and historical payment, return and discount experience, as well as for known or expected events. If there were to be a
deterioration of a major customers creditworthiness, or if actual defaults, returns or discounts were higher than the Companys historical experience, the Companys operating results and financial position could be adversely
affected.



Note 6  Warranty Reserves,
Indemnification Arrangements and Guarantees



In connection
with the Companys adoption of FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others,the following disclosures are made with respect
to the Companys product warranties.



The Company provides
a limited warranty for the Companys products. A provision for the estimated warranty cost is recorded at the time revenue is recognized. Liabilities for the estimated future costs of repair or replacement are established and charged to cost of
sales at the time the related revenue is recognized. The amount of liability to be recorded is based on managements best estimates of future warranty costs after considering historical and projected product failure rates and product repair
costs. The Companys standard product warranties are for one year, although in some agreements, it may warrant products for periods in excess of one year. The Company had approximately $115,000 in warranty reserves at September 30, 2003. The
following table summarizes the activity in the liability accrual related to product warranty during the nine months ended September 30, 2004:



|                                                   |  |                |     |  
|-------------------------------------------------- |  | -------------- | --- | -
|                                                   |  | (in thousands) |    
|Balance at December 31, 2003                       |  | $              | 78  |  
|Decrease in expense related to change in estimates |  |                | (14 | )
|Actual warranty costs incurred in the period       |  |                | (31 | )
|                                                   |  |                |     |  
|Balance at September 30, 2004                      |  | $              | 33  |  
|                                                   |  |                |     |  



The Company also
undertakes indemnification obligations in the ordinary course of business related to its products, the licensing of its software, and the issuance of securities. Under these arrangements, the Company may indemnify other parties such as business
partners, customers, and underwriters, for certain losses suffered, claims of intellectual property infringement, negligence and intentional acts in the performance of services, and violations of laws including certain violations of securities laws.
The Companys obligation to provide such indemnification in such circumstances would arise if, for example, a third party sued a customer for intellectual property infringement and the Company agreed to indemnify the customer against such
claims. The Company is unable to estimate with any reasonable accuracy the liability that may be incurred pursuant to its indemnification obligations. Some of the factors that would affect this assessment include, but are not limited to, the nature
of the claim asserted, the relative merits of the claim, the financial ability of the parties, the nature and amount of damages claimed, insurance coverage that the Company may have to cover such claims, and the willingness of the parties to reach
settlement, if any. Because of the uncertainty surrounding these



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circumstances, the Companys indemnification obligations could range from immaterial to having a material adverse impact on its financial position and
its ability to continue in the ordinary course of business.



Note 7  Off Balance Sheet Arrangements



The Company does not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as special purpose entities (SPEs).



Note 8  Reportable Operating Segments



The Company is a network communications technology company enabling
simultaneous delivery of broadcast quality and interactive video transmissions and other real-time data streams over Internet Protocol (IP) networks. For the purpose of applying SFAS No. 131, management determined that, subsequent to the
discontinuance of the Silicon Systems business unit (Sistolic) in April 2002, it has one operating segment.



Note 9  Stock-based Compensation



The Company accounts for stock-based compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles
Board Opinion (APB) 25, Accounting for Stock Issued to Employees,Statement of Financial Accounting Standards (SFAS) Interpretation No. 28,Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award
Plans, and SFAS Interpretation No. 38, Determining the Measurement Date for Stock Option, Purchase, and Award Plans involving Junior Stock. The Company also complies with the disclosure provisions of SFAS No. 123, Accounting for
Stock-Based Compensation.



The Company accounts for equity
instruments issued to non-employees using the fair value method in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services. In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. This statement amends SFAS No. 123 to provide alternative methods
of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual
and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has made the required disclosure under SFAS No. 148. See Note 1.



Equity instruments issued to non-employees that are fully vested and
non-forfeitable are measured at fair value at the issuance date and expensed in the period over which the benefit is expected to be received. Equity instruments issued to non-employees which are either unvested or forfeitable, for which
counter-party performance is required for the equity instrument to be earned, are measured initially at the fair value and subsequently adjusted for changes in fair value until the earlier of: 1) the date at which a commitment for performance by the
counter-party to earn the equity instrument is reached; or, 2) the date on which the counter-partys performance is complete.



During the nine-month period ended September 30, 2004, the Company recorded $272,000 of stock-based compensation expense related to the amortization of
deferred compensation for shares of restricted stock awarded in November 2003 to Patrick Bohana, the Companys former vice president of sales and general manager, that vested during the quarter ended June 30, 2004. The shares became vested upon
Mr. Bohanas early retirement from the Company on April 26, 2004. Additionally, 135,000 of the remaining 270,000 unvested shares of restricted stock awarded to Mr. Cary, Mr. Zavoli and Mr. Carnevale were scheduled to vest during September 2004;
however, due to the planned vesting dates occurring within a quiet period, as defined in the agreements under which the stock was awarded, no such vesting took place. The 135,000 shares will now vest two weeks following the lifting of
trading restrictions as per the amended restricted stock grant agreements. Had the 135,000 shares vested as planned the Company would have recorded approximately $559,000 of additional stock-based compensation expense during the 2004 period. For the
same nine-month period in 2003, the Company recognized expense of $50,000 related to the amortization of stock-based deferred compensation.



Note 10  Notes Payable



In 2002 and 2003, the Company closed private placements of aggregate $4.4 million in face value of convertible notes payable and warrants and received
cash proceeds, net of issuance costs, of approximately $3.7 million from accredited investors.



The carrying value of the Companys remaining convertible notes payable, excluding its line of credit, at September 30, 2004, is as follows:



|                                                              |  |                |     |  
|------------------------------------------------------------- |  | -------------- | --- | -
|                                                              |  | (in thousands) |    
|Face value of convertible notes payable                       |  | $              | 228 |  
|Unamortized discount related to warrants                      |  |                | (9  | )
|Unamortized discount related to beneficial conversion feature |  |                | (48 | )
|                                                              |  |                |     |  
|Carrying value of convertible notes payable                   |  | $              | 171 |  
|                                                              |  |                |     |  



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| |  | Interest expense for the three months ended September 30, 2004, includes coupon interest of approximately $4,000; non-cash interest expense of approximately $4,000 pertaining to the
discount related to the warrants; and non-cash interest expense of approximately $19,000 pertaining to the discount related to the beneficial conversion feature.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Amortization of debt issuance costs for the three months ended September 30, 2004, was $3,000.
| | - | ----------------------------------------------------------------------------------------------



On February 14, 2003, the Company entered into a $1 million revolving line of credit with Laurus. This revolving line of
credit (the LOC) is secured by the Companys accounts receivables and other assets, and the Company has the ability to draw down advances under the LOC subject to limits. Under the terms of the LOC, Laurus can convert advances made
to the Company into common stock at a fixed conversion price of $6.78 per share. In connection with the LOC, the Company issued warrants to purchase 12,500 shares of the Companys Common Stock at $6.78 per share. On February 14, 2003, the
Company borrowed a $300,000 advance under the LOC. The Company recorded a non-cash debt discount of $23,000 in its quarter ended March 31, 2003. The carrying value of the LOC at September 30, 2004, is zero.



The maturities of the Companys notes payable at September 30, 2004, are
as follows (in thousands):



Short-term notes payable consist of
the following at September 30, 2004:



|                                                                                                                              |  |   |    
|----------------------------------------------------------------------------------------------------------------------------- |  | - | ---
|7% van Embden note due June, 2005 (less unamortized debt discount of $25,710)(convertible into 26,050 shares of common stock) |  | $ | 76 
|7% Amstgeld note due June, 2005 (less unamortized debt discount of $32,113)(convertible into 32,539 shares of common stock)   |  |   | 95 
|                                                                                                                              |  |   |    
|                                                                                                                              |  | $ | 171
|                                                                                                                              |  |   |    



Long-term notes
payable consist of the following at September 30, 2004:



|                                                                                                                              |  |   |      |  
|----------------------------------------------------------------------------------------------------------------------------- |  | - | ---- | -
|7% van Embden note due June, 2005 (less unamortized debt discount of $25,710)(convertible into 26,050 shares of common stock) |  | $ | 76   |  
|7% Amstgeld note due June, 2005 (less unamortized debt discount of $32,113)(convertible into 32,539 shares of common stock)   |  |   | 95   |  
|Less: Current maturities included in current liabilities                                                                      |  |   | (171 | )
|                                                                                                                              |  |   |      |  
|                                                                                                                              |  | $ |     |  
|                                                                                                                              |  |   |      |  



At September 30, 2004,
the maturities of long-term debt, net of unamortized discount, are as follows:



|     |  |   |    
|---- |  | - | ---
|2004 |  | $ |   
|2005 |  |   | 171
|     |  |   |    
|     |  | $ | 171
|     |  |   |    



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Forward Looking Statements



This document may contain forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can
identify forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict,
potential or continue, the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.



Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for



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the accuracy and completeness of the forward-looking statements. Except to the extent required by federal law, we
disclaim any duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.



You are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested
parties of the factors which affect our business, including without limitation the disclosures made in this Item 2 or in our annual report on Form 10-K and other reports and filings made with the Securities and Exchange Commission.



OVERVIEW



The most important challenge that we, as an emerging company, now face is to execute efficiently and effectively in the key
areas of our operations as we commercialize our technology products. We are making important changes in our senior management as part of our effort to demand and achieve better focus and results in our operations. We continue to believe that our
technology is attractive to the marketplace and in particular we see good short-term opportunities with our long-haul transmission products and with a strategy of augmenting our indirect selling channels with more direct sales and marketing efforts.
On the other hand, our product line is relatively small and some of our larger competitors have an advantage over us by being able to offer customers a more complete solution.



We are an industry leader in developing and supplying video router or gateway products that transport and distribute
real-time, high-quality video over Internet Protocol (IP) networks, such as the networks that comprise the Internet. Our products are currently used in two principal markets. Our products are used by a variety of providers such as carriers and
broadcasters to transmit high-quality, real-time video to one or more locations throughout the United States or the world (which we refer to as long-haul transmission). Our products are also used by cable companies to supply
video-on-demand services. We do not sell our products to individual consumers. Our customers include cable, broadcast and satellite companies, movie studios, carriers, and government and educational institutions and system integrators that supply
them. We refer to these customers as communication service providers, or simply as providers.



Our net losses have reduced our cash reserves, and we need to raise additional capital in the near term. We have engaged Silverwood Partners LLC to assist us with identifying and structuring further financing (as well
as other strategic opportunities).



Long Haul & Broadcast Service



Broadcasters and news organizations need to move high
quality video over long distances. In the broadcast industry, video is both distributed (for example, a video program that a broadcaster broadcasts to its viewers) as well as contributed (for instance, the video clips from multiple sources that are
transported between and among broadcast studios or affiliates to be assembled into a video segment such as a news report or feature story that is, in turn, distributed for broadcast to viewers). For the distribution and contribution of broadcast
quality video, broadcasters have traditionally used satellite links or procured dedicated bandwidth on fiber lines, both of which are very expensive and usually require multi-year contracts. Our products now allow the same video to be moved over
existing IP networks at significantly reduced cost. In 2003, roughly 50%, and in the third quarter of 2004, 74%, of our product revenue was derived from the long haul broadcast market.



Our Cx1000 product is currently being used by dedicated bandwidth providers to deliver broadcast video in key US and
international cities. Customers using our products for long-haul transmission include the Vyvx LLC unit of WilTel Communications which recently used our Cx1000 to carry both the live primary and backup high definition (HD) broadcasts of
Super Bowl XXXVIII® over Vyvxs HD VenueNet at
40.5 Mbps and 270 Mbps, respectively. Vyvx accounted for 17% and 32% of our product revenue in 2003 and 2004, respectively. Cox Communications broadcasts the home games of the San Diego Padres baseball team in high definition using our products.
C-SPAN uses our products to televise real-time, interactive classrooms between Washington, D.C. and the University of Denver. RTVI, a Russian television network, runs live broadcast-quality Russian language programming between Moscow and New York
using our long haul product, and is expanding its network internationally. Currently, Level (3) offers full and part-time video services using our Cx1000 product to deliver broadcast video in key US and European cities.



Cable Companies



The versions of our Chameleon vidX product line designed for cable companies allows them to use existing digital set-top boxes already in consumer homes
to provide video-on-demand services, a significant competitive advantage over satellite providers. The more efficient use of existing bandwidth (both into the home and within the network) allows cable companies to increase the volume of content
(whether movies, television or live events) available for delivery whenever requested by the cable subscriber, or to increase the number of subscribers served with existing content volume.



Today, consumers who desire to have personalized video recording in the home,
must purchase the necessary digital video recorder (DVR) and subscribe to a service. We believe that the drawbacks to DVRs are requiring the purchase of additional equipment in the home or the swapping out of the existing in-home set top
box for a new set top box with local storage. Using our



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products, cable companies could in the future offer network-based (with our equipment sitting at the edge of the network)
personalized video recorder capabilities to their subscribers to compete with in-home DVR service providers. Cable company subscribers in this case would not require a DVR in the home to enjoy on-demand viewing.



We believe that the desire for video-on-demandindeed, all
content-on-demandwill continue to rise as consumers become increasingly aware of its availability and benefits, and as IP networks enabled by our products provide access to significant amounts of interactive programming previously unavailable.
Cable companies currently using our products include companies such as Time-Warner and Cablevision.



Additionally, our products enable cable companies to deliver HD television that can potentially overwhelm the bandwidth capacity of current delivery
technologies. HD television requires at least five times the bandwidth currently required for standard television transmissions. Using our products, providers can avoid incurring significant capital expenditures to increase the capacity of existing
infrastructure, and can avoid significant recurring costs to maintain and support the expanded networks resulting from HD television and increased numbers of channels. Should these providers use existing methods of transmission, they might
eventually be forced to decrease programming or other services to conserve bandwidth.



Satellite Providers



Satellite
providers broadcast signals to earth from satellites 22,000 miles above sea level. Because of the coverage area (or footprint) from that altitude, satellite broadcasts are capable of reaching vast areas. Uplinking content to the
satellite for subsequent broadcast back to Earth, however, must be done at earth stations located in areas with characteristics favorable for uplinking. Currently, many satellite providers collect content at these uplink earth stations. As a result,
information often hops from its source to and from the Earth via interim earth stations and satellites until its reaches the uplink earth station positioned to deliver the content to the end-user. Satellites have a maximum 15-year useful
life, requiring satellite providers to periodically revisit the extreme expense of launching and maintaining a satellite in orbit.



Our Cx1000 product line allows satellite providers to gather content at uplink earth stations without the need to hop the content through interim
satellites, reducing the strain on, and cost of, satellite networks and their maintenance. In addition to the cost-savings, collecting information at uplink earth stations via IP networks, as opposed to satellite hops, increases the speed by which
information moves from source to consumer. Use of our products enables satellite providers to avoid the delay associated with live satellite feeds. Each satellite hop introduces a half-second delay whereas an existing terrestrial fiber
international circuit has less than a quarter-second delay. PanAmSat is an example of a satellite provider using our Cx1000 product over terrestrial fiber to interconnect earth stations for video routing with the least delay.



Movie Studios and Government Agencies



Certain industries require delivery of exceptionally high resolution,
real-time video. Military and other government units require a unique level of sound and picture quality upon which they can make critical, high-consequence decisions. Movie studios demand similar standards upon which to make artistic or editorial
decisions regarding their multi-million dollar productions.



To
attain the level of resolution required by studios and for government applications requires data to be delivered uncompressed. Compression, a common means for transporting high-resolution data, is designed to eliminate what would typically be
redundant or unnecessary information, or to allow data to fit on satellites limited bandwidth. Because of the unerring detail required by these industries, what is generally acceptable TV-quality degradation becomes unacceptable. The opposing
requirements of exceptionally high resolution and high bit-rate make most delivery methods (such as satellite) unusable. Our Cx1000 enables the delivery of exceptionally high resolution, high bit-rate, and real-time video. Our products are currently
in limited use by DreamWorks SKG for domestic and international creative collaborations using high-definition video cameras. DreamWorks SKG accounted for 5% of our 2003 revenues. Additionally, C-SPAN, which accounted for 3% of our 2002 sales, has
used our Cx1000 product to televise real-time, interactive classrooms between Washington, D.C. and the University of Denver.



LIQUIDITY AND CAPITAL RESOURCES



Since our inception on January 30, 1998 through July 2003 we financed our operations primarily through the sale of common equity securities to investors
and strategic partners, as well as from the issuance of convertible notes. On July 31, 2003, we successfully completed a $13,500,000 public offering of 1.25 million units and the listing of our common stock and units on the American Stock Exchange.
A unit consisted of three shares of common stock and two warrants, each warrant to purchase a share of common stock at $5.40 per share. On August 29, 2003, our underwriters exercised their over-allotment option and we raised additional proceeds of
$2,025,000 from the sale of 187,500 units, bringing total gross proceeds from the public offering (the IPO) to $15.5 million. On August 30, 2003, the units separated in accordance with their terms, and the IPOs common stock
(4,312,500 shares) and warrants (2,875,000 warrants) now trade on the American Stock Exchange directly rather than as components of units.



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From January 30, 1998 through September 30, 2004, we incurred losses totaling $44.2 million. We have not
yet achieved profitability, and we remain a risky enterprise. At September 30, 2004, we had working capital of $2.6 million. Cash and cash equivalents at September 30, 2004 totaled $2.4 million.



In February 2003, we entered into a $1 million revolving line of credit with
Laurus. This revolving line of credit (the LOC) is secured by our accounts receivables and other assets, and we have the ability to draw down advances under the LOC subject to limits. Under the terms of the LOC, Laurus can convert
advances made to us into our common stock at a fixed conversion price of $6.78 per share. The balance outstanding on our LOC was nil at September 30, 2004.



Given our projected cash burn rate, we will be required to raise additional capital in the near term (well less than one year). We cannot ensure that
financing would be available to us on acceptable terms, if at all. Our investment bankers, Silverwood Partners LLC, may not be able to successfully find any financing or other strategic opportunities for us. Our inability to raise capital when
needed would seriously harm our business. In addition, additional equity financing may dilute our stockholders interest, and debt financing, if available, may involve restrictive covenants and could result in a substantial portion of our
operating cash flow being dedicated to the payment of principal and interest on debt. If adequate funds are not available, we would need to curtail our operations significantly.



At September 30, 2004, we had no material commitments other than our operating leases and convertible notes with a face
amount of $228,000 that are due in 2005. Our future capital requirements will depend upon many factors, including the timing of research and product development efforts, the possible need to acquire new technology, the expansion of our sales and
marketing efforts, and our expansion internationally. We expect to continue to expend significant amounts in all areas of our operations.



Cash used in operations was approximately $5.4 million for the nine months ended September 30, 2004, compared to $3.9 million for the same period in 2003.
The increase in cash used in operations for the nine months ended September 30, 2004, compared to the same period in the prior year, was due primarily to our higher operating loss in the first half of the current year.



Cash used in investing activities for the nine months ended September 30,
2004, was $180,000, compared to $121,000 for the same period ended September 30, 2003. In the 2004 period, we purchased $76,000 of equipment for use in our engineering lab, $30,000 of office equipment and furnishings and $74,000 of equipment for
sales and marketing display.



Cash provided by financing
activities for the nine-month period ended September 30, 2004, was $224,000,compared to cash provided of $13.8 million for the same period ended September 30, 2003. The cash provided by financing activities in 2004 resulted primarily from the
first-quarter 2004 exercise of warrants issued in 2003 in our 7% convertible notes offering.



RESULTS OF OPERATIONS



Three Months Ended September 30, 2004 vs. Three Months Ended September 30, 2003



For the quarter ended September 30, 2004, net revenue decreased $31,000, or 4%, to $756,000, compared to $787,000 during the three-month period ended
September 30, 2003. Revenues from sales of products in the quarter ended September 30, 2004, increased $147,000 to $734,000, or approximately 25%, from $587,000 in the quarter ended September 30, 2003. The increase in product revenues in the quarter
ended September 30, 2004, versus the same period in the prior year, was principally the result of increased demand for our long-haul products which accounted for 74% of our product revenue. Our most significant customers in the third quarter of 2004
were Vyvx ($245,000), Frontiers ($239,000) and Ciena ($100,000). At September 30, 2004 the Company had deferred revenues totaling $214,000 principally related to units shipped during 2004 to our resellers that had not been purchased for the
resellers own use or sold-through to end users by September 30, 2004. Contract revenues in the quarter ended September 30, 2004 were $20,000, down from $200,000 in the same quarter last year. We have reclassified prior year revenue previously
presented as license revenue as product revenue to conform with current year presentation. The revenue previously presented as license revenue was related to the delivery of high-definition upgrades to existing products to Scientific-Atlanta during
2003 totaling approximately $182,000. In the current quarter reported, we have characterized as product revenue the sale to Vyvx of our replication feature as an upgrade for $88,000. We believe this presentation best describes the operations of the
Company, as the continuing sale of this imbedded product feature is presented as product revenue on a going-forward basis.



Cost of revenues decreased by $259,000, or nearly 52%, to $240,000 in the quarter ended September 30, 2004, from $499,000 in the same quarter last year.
The decrease in cost of sales results principally from a charge taken in the 2003 period for inventory obsolescence ($141,000), aggressive product cost reduction efforts ($74,000) and from lowered warranty risk ($50,000). Cost of products sold
consists primarily of raw material costs, warranty costs and labor associated with manufacturing, which we outsource on a turn-key basis.



Gross profit for the quarter ended September 30, 2004 totaled $516,000, compared to gross profit of $288,000 in the same quarter last year, representing
an increase in gross profit of nearly 80%. The increase in gross profit for the current year period versus the prior year period is mainly attributable to a favorable product mix shift toward sales of higher margin long-haul products combined with
the effect of lower overall product costs and warranty risk.



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Engineering, research and development expenses for the quarter ended September 30, 2004 increased roughly
$22,000, or 5%, to $466,000 from $444,000 in the quarter ended September 30, 2003. The increase is due primarily to higher levels of staffing of engineering personnel. We have increased engineering headcount and other engineering expenses for new
product development and other sustaining engineering efforts; thus, engineering, research and development expenses are expected to be higher in future quarters.



Sales and marketing expenses for the quarter ended September 30, 2004, decreased approximately 17% to $398,000 from $480,000 for the quarter ended
September 30, 2003. The $82,000 decrease in sales and marketing expenses is primarily due to diminished costs associated with consultants ($112,000), partially offset by higher recruitment costs ($63,000). We continue to seek to hire highly skilled
sales personnel to improve our sales performance.



General and
administrative expenses for the quarter ended September 30, 2004, decreased $938,000, or approximately 60%, to $636,000 from $1,574,000 in the same quarter of the prior year. The decrease results principally from lower debt conversion expense
($505,000), amortization expense ($223,000), consulting fees ($55,000), corporate development costs ($44,000) and investor relations expense ($36,000).



Net interest expense for the quarter ended September 30, 2004 was $22,000 versus $434,000 of expense in the same quarter ended September 30, 2003. The
decrease in interest expense predominantly results from there being no 2004 counterpart to 2003s amortization of debt discount. Other expense in the third quarter of the prior year totaling $262,000 was principally the result of a charge
related to the early extinguishment of 7% convertible notes issued earlier in 2003. Other expense in the third quarter of 2004 was nil.



Nine Months Ended September 30, 2004 vs. Nine Months Ended September 30, 2003



For the nine months ended September 30, 2004, net revenue increased by $492,000, or nearly 23%, from $2,162,000 to
$2,654,000. The increase in revenues results from higher revenues from the sale of products, partially offset by lower contract and license revenues. Revenues from the sale of products in the nine months ended September 30, 2004 increased to
$2,593,000, or just less than 63%, from $1,595,000 for the same period a year ago. Most of this increase resulted from increased sales of our cable products ($693,000). License revenues in the nine month period ended September 30, 2004 decreased to
$21,000, down $32,000 from the prior year, while contract revenues were $20,000 in the current period versus $507,000 in the prior period, as our contract with Aurora expired. The contract revenues in 2004 were unrelated to the contract revenues in
2003. We have reclassified prior year revenue previously presented as license revenue as product revenue to conform with current presentation. The revenue previously presented as license revenue was related to the delivery of high-definition
upgrades to existing products to Scientific-Atlanta totaling approximately $182,000. In the current year reported, we have characterized as product revenue the sale to Vyvx of our replication feature as an upgrade. We believe this presentation best
depicts the operations of the Company, as the continuing sale of this product feature would be presented as product revenue on a going-forward basis.



Cost of revenues increased $764,000, or approximately 71%, to $1,835,000 in the nine months ended September 30, 2004 as compared to $1,071,000 for the
same period a year ago. The increase in cost of revenues results primarily from increased unit sales of the Companys products, exacerbated by manufacturing problems earlier in 2004.



Gross profit for the nine months ended September 30, 2004 decreased $272,000 to $819,000 from $1,091,000 in the nine months
ended September 30, 2003. The decrease in gross profit during the current year period versus the prior year period is mostly attributable to the benefit derived in the 2003 period from the additional gross profit provided by contract services
($294,000). In addition, the gross profit provided by 2004 product sales was limited by the low margins on some large product orders earlier in 2004.



Engineering, research and development expenses for the nine months ended September 30, 2004 totaled $1,472,000, up 20% from the $1,225,000 for the nine
months ended September 30, 2003. The increase in engineering, research and development costs is primarily the result of higher staffing levels. We have increased engineering headcount and other engineering expenses for new product development and
product sustaining engineering efforts. We expect engineering, research and development costs to be higher in future periods.



Sales and marketing expenses for the nine months ended September 30, 2004, increased $1,151,000, or approximately 106%, from $1,091,000 in the same period
last year. The increase in sales and marketing expense is predominantly the result of costs associated with developing channel partners ($449,000), the repurchase from Aurora Networks of the exclusive marketing rights to the integrated QAM product
we had developed for them and most-favored-nation pricing right which Aurora Networks had as a reseller of our products ($400,000), and increased sales and marketing personnel costs ($234,000). We have made substantial changes in our sales and
marketing operations and personnel and expect our sales and marketing expenses for the rest of 2004 to be lower than in the first nine months of 2004.



General and administrative expenses for the nine-month period ended September 30, 2004 totaled $2,545,000, down $218,000 from $2,763,000 for the same
period last year. The decrease in general and administrative expenses results principally from



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lower amortization and debt conversion expenses ($840,000), partially offset by a one-time charge for Mr. Carys
severance pay as provided in his employment agreement ($260,000), higher legal fees ($137,000), greater spending on investor relations ($94,000), increased liability insurance costs ($73,000) and increased outside accounting fees ($67,000). The
increase in legal and outside accounting fees in the current year resulted principally from our Form S-3/A amended securities registration filings completed during May of 2004 and these professional fees are not expected to continue at this level in
future periods.



Stock based compensation for the nine months
ended September 30, 2004, was $272,000 compared to $50,000 in the prior year period ended September 30, 2003. The current year expense results from the vesting of a restricted stock award in favor of Patrick Bohana upon his early retirement from his
positions as vice president of sales and general manager. The $50,000 charge in the prior year resulted from the vesting of stock options granted to employees and contractors that were priced lower than the fair market value at the date of grant.



Net interest expense for the nine months ended September 30,
2004, was $72,000 compared to $919,000 for the same period a year ago. The $847,000 decrease in interest expense primarily results from there being no 2004 counterpart to 2003s amortization of debt discount. Other expense for the nine months
ended September 30, 2004 was $3,000 as compared to $262,000 in the same period a year ago. The prior year other expense was principally the result of a charge related to the early extinguishment of 7% convertible notes issued earlier in 2003.



RISK FACTORS



Investment in our common stock involves a high degree of risk. The risks and
uncertainties described below are not the only ones we face. If any of the following risks actually occurs, our business, financial condition or results of operations could suffer.



OUR LIMITED SALES HISTORY AND LIMITED REVENUES TO DATE MAKE IT DIFFICULT TO EVALUATE OUR PROSPECTS.



We were founded in January 1998 and have only been selling our products
commercially since 2002, which makes an evaluation of our prospects difficult. Because of our limited sales history, we have limited insight into trends that may emerge and affect our business. In addition, we have generated only limited revenues to
date from sales of our products and the income potential of our business and market are unproven. An investor in our securities must consider the challenges, expenses and difficulties we face as our sales and marketing efforts mature.



WE NEED TO RAISE ADDITIONAL CAPITAL IN THE NEAR FUTURE.



Our net losses have reduced our cash position to $2.4 million at September
30, 2004. Given our projected cash burn rate, we will be required to raise additional capital in the near term (well less than one year). We cannot ensure that financing would be available to us on acceptable terms, if at all. Our investment
bankers, Silverwood Partners LLC, may not be able to successfully find any financing or other strategic opportunities for us. Our inability to raise capital when needed would seriously harm our business. In addition, additional equity financing may
dilute our stockholders interest, and debt financing, if available, may involve restrictive covenants and could result in a substantial portion of our operating cash flow being dedicated to the payment of principal and interest on debt. If
adequate funds are not available, we would need to curtail our operations significantly.



PRICING PRESSURE ON OUR PRODUCTS HAS PLACED US AT A COMPETITIVE DISADVANTAGE.



We have recently experienced significant pricing pressure in some of the markets, predominantly the cable market, for our products. Due to competitive
factors, cable customers have been willing to pay only reduced amounts for our products. This has placed us at a competitive disadvantage with our competitors who have the financial strength to withstand pricing pressures. If we are unable to regain
larger margins on our product sales, we may be forced to exit certain market segments and our results of operations and profitability will be negatively affected.



WE HAVE INCURRED LOSSES SINCE INCEPTION AND WILL LIKELY NOT BE PROFITABLE AT LEAST FOR THE NEXT SEVERAL QUARTERS.



We have incurred operating losses since our inception in January 1998, and
we expect to incur losses and negative cash flow for at least the next several quarters. As of September 30, 2004, our accumulated deficit was approximately $44.2 million. We expect to continue to incur significant operating, sales, marketing,
research and development and general and administrative expenses and, as a result, we will need to generate significant revenues to achieve profitability. Even if we do achieve profitability, we cannot assure you that we can sustain or increase
profitability on a quarterly or annual basis in the future.



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OUR RECENT CHANGE IN SENIOR MANAGEMENT MAY RESULT IN DIFFICULTIES



On March 29, 2004, Frederick Cary resigned as our chief executive officer
and president and was replaced by John Zavoli. On April 26, 2004, Patrick Bohana accepted early retirement from his position as Vice President, Sales and General Manager; on September 1, we hired Jeff Hale to replace him as Vice President, Sales.
Changes in senior management of small companies are inherently disruptive, and efforts to implement any new strategic or operating goals may also prove to be disruptive. In addition, until we hire new senior executives to assist him, there is a risk
that Mr. Zavolis many responsibilities (he is also our chief financial officer, general counsel and secretary) will overwhelm him to the point that he will not be able to devote sufficient attention to one or more of his important roles.



WE FACE COMPETITION FROM ESTABLISHED AND DEVELOPING COMPANIES, MANY OF
WHICH HAVE SIGNIFICANTLY GREATER RESOURCES, AND WE EXPECT SUCH COMPETITION TO GROW.



The markets for our products, future products and services are competitive. We face direct and indirect competition from a number of established companies, including Scientific-Atlanta, as well as development stage
companies, and we anticipate that we will face increased competition in the future as existing competitors seek to enhance their product offerings and new competitors emerge. Many of our competitors have greater resources, sell a more complete
product line or solution, have higher name recognition, have more established reputations within the industry and maintain stronger marketing, manufacturing, distribution, sales and customer service capabilities than we do.



The technologies that our competitors and we offer are expensive to design,
develop, manufacture and distribute. Competitive technologies may be owned and distributed by established companies that possess substantially greater financial, marketing, technical and other resources than we do and, as a result, such companies
may be able to develop their products more rapidly and market their products more extensively than we can.



Competitive technologies that offer a similar or superior capacity to converge and transmit audio, video and telephonic data on a real-time basis over
existing networks may currently exist or may be developed in the future. We cannot assure you that any technology currently being developed by us is not being developed by others or that our technology development efforts will result in products
that are competitive in terms of price or performance. If our competitors develop products or services that offer significant price or performance advantages as compared to our current and proposed products and services, or if we are unable to
improve our technology or develop or acquire more competitive technology, we may find ourselves at a competitive disadvantage and our business could be adversely affected. In addition, competitors with greater financial, marketing, distribution and
other resources than we have may be able to leverage such resources to gain wide acceptance of products inferior to ours.



Our smaller size reflects, in part, that our product line is small whereas many of our competitors can offer customers a complete solution. This is a
significant competitive disadvantage for us.



OUR CUSTOMER BASE IS
CONCENTRATED AND THE LOSS OF ONE OR MORE OF OUR KEY CUSTOMERS WOULD HARM OUR BUSINESS.



Historically, a significant majority of our sales have been to relatively few customers. We expect that sales to relatively few customers will continue to account for a significant percentage of our net sales for the
foreseeable future. Almost all of our sales are made on a purchase order basis, and none of our customers has entered into a long-term agreement requiring it to purchase our products. The loss of, or any reduction in orders from, a significant
customer would harm our business.



OUR QUARTERLY FINANCIAL RESULTS ARE
LIKELY TO FLUCTUATE SIGNIFICANTLY.



Our quarterly
operating results are difficult to predict and may fluctuate significantly from period to period, particularly because our sales prospects are uncertain and our sales are made on a purchase order basis. In addition, we have not proven our ability to
execute our business strategy with respect to establishing and expanding sales and distribution channels. Fluctuations may result from:



| |  | decreased spending on new products such as ours by communication service providers or their suppliers,
| | - | ------------------------------------------------------------------------------------------------------



| |  | the timing of new product offerings, acquisitions, licenses or other significant events by us or our competitors,
| | - | -----------------------------------------------------------------------------------------------------------------



| |  | problems in our execution of key functions such as manufacturing, marketing and/or sales,
| | - | -----------------------------------------------------------------------------------------



| |  | our ability to establish a productive sales force or partner with communication service providers or their suppliers,
| | - | ---------------------------------------------------------------------------------------------------------------------



| |  | demand and pricing of the products we offer,
| | - | --------------------------------------------



| |  | purchases of our products by communication service providers in large, infrequent amounts consistent with past practice,
| | - | ------------------------------------------------------------------------------------------------------------------------



| |  | consumer acceptance of the services our products enable,
| | - | --------------------------------------------------------



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| |  | interruption in the manufacturing or distribution of our products, and
| | - | ----------------------------------------------------------------------



| |  | general economic and market conditions, including war, and other conditions specific to the telecommunications industry.
| | - | ------------------------------------------------------------------------------------------------------------------------



As a result, we may experience significant, unanticipated (or unexpectedly
large) quarterly losses.



THE RATE OF MARKET ADOPTION OF OUR TECHNOLOGY IS
UNCERTAIN AND WE COULD EXPERIENCE LONG AND UNPREDICTABLE SALES CYCLES, ESPECIALLY IF THE SLOWDOWN IN THE TELECOMMUNICATIONS INDUSTRY PERSISTS.



Our products are based on new technology and, as a result, it is extremely difficult to predict the timing and rate of market adoption of our products, as
well the rate of market adoption of applications enhanced by our products such as video-on-demand. Accordingly, we have limited visibility into when we might realize substantial revenue from product sales. This is compounded by our inability to
foresee when, if ever, delivery of video over IP networks will be significantly embraced by communication service providers.



We are providing new and highly technical products and services to enable new applications. Thus, the duration of our sales efforts with prospective
customers in all market segments is likely to be lengthy as we seek to educate them on the uses and benefits of our products. This sales cycle could be lengthened even further by potential delays related to product implementation as well as delays
over which we have little or no control, including:



| |  | the length or total dollar amount of our prospective customers planned purchasing programs in regard to our products;
| | - | ----------------------------------------------------------------------------------------------------------------------



| |  | changes in prospective customers capital equipment budgets or purchasing priorities;
| | - | -------------------------------------------------------------------------------------



| |  | prospective customers internal acceptance reviews; and
| | - | -------------------------------------------------------



| |  | the complexity of prospective customers technical needs.
| | - | ---------------------------------------------------------



These uncertainties, combined with the worldwide slowdown in capital spending in the telecommunications business that began in 2001, and the slowdown in
corporate spending on technology generally as well as new technologies such as ours, substantially complicate our planning and may reduce prospects for sales of our products. If our prospective customers curtail or eliminate their purchasing
programs, decrease their budgets or reduce their purchasing priority, our results of operations could be adversely affected.



THE SUCCESS OF OUR BUSINESS IS DEPENDENT ON ESTABLISHING AND EXPANDING SALES AND DISTRIBUTION CHANNELS FOR OUR PRODUCTS.



Third-Party Collaborations. We intend to partner with leading
suppliers to communication service providers to promote and distribute our products, both as an outside equipment manufacturer to suppliers and with suppliers acting as resellers of our products. We may not be able to identify adequate partners, and
even if identified, we may not be able to enter into agreements with these entities on commercially reasonable terms, or at all. To the extent that we enter into any such agreements with third parties, any revenues we receive from sales of our
products in those markets will depend upon the efforts of such third parties, which in most instances will not be within our control. If we are unable to effectively leverage a partner to market our products more broadly than we can through our
internal sales force, our business could be adversely affected.



Internal Sales Force. We have limited experience in marketing and selling our products. We intend to expand our direct and indirect sales force and independent channel partners domestically and internationally for the promotion of
our product lines and other future products to suppliers and communication service providers of all kinds. Competition for quality sales and marketing personnel and channel partners is intense. In addition, new employees, particularly new sales and
marketing employees, will require training and education concerning our products and will also increase our operating expenses. There can be no assurance that we will be successful in attracting or retaining qualified sales and marketing personnel
and partners. As a result, there can be no assurance that the sales force we are able to build will be of a sufficient size or quality to effectively market our products.



WE MAY NOT BE ABLE TO PROFIT FROM GROWTH IF WE ARE UNABLE TO EFFECTIVELY MANAGE THE GROWTH.



We anticipate that we will need to grow in the future. This anticipated
growth will place strain on our managerial, financial and personnel resources. The pace of our anticipated expansion, together with the complexity of the technology involved in our products and the level of expertise and technological sophistication
incorporated into the provision of our design, engineering, implementation and support services, demands an unusual amount of focus on the operational needs of our future customers for quality and reliability, as well as timely delivery and
post-installation and post-consultation field and remote support. In addition, new customers, especially customers that purchase novel and technologically sophisticated products such as ours, generally require significant engineering support.
Therefore, adoption of our platforms and products by customers would increase the strain on our resources.



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To reach our goals, we will need to hire rapidly, while at the same time investing in our infrastructure.
We expect that we will also have to expand our facilities. In addition, we will need to successfully train, motivate and manage new employees; expand our sales and support organization; integrate new management and employees into our overall
operations; and establish improved financial and accounting systems. Indeed, even without consideration of future needs imposed by any future growth of our business, we need to upgrade several of these areas even to support our present levels of
business, because during the pre-IPO periods of tight cash, we focused our resources on areas other than business infrastructure.



We may not succeed in anticipating all of the changing demands that growth would impose on our systems, procedures and structure. If we fail to
effectively manage our expansion, if any, our business may suffer.



WE WILL
DEPEND ON BROADCASTING, CABLE AND SATELLITE INDUSTRY SPENDING FOR A SUBSTANTIAL PORTION OF OUR REVENUE AND ANY DECREASE OR DELAY IN SPENDING IN THESE INDUSTRIES WOULD NEGATIVELY IMPACT OUR RESOURCES, OPERATING RESULTS AND FINANCIAL CONDITION.



Demand for our products will depend on the magnitude and
timing of spending by cable television operators, broadcasters, satellite operators and carriers for adopting new products for installation with their networks.



These spending patterns are dependent on a variety of factors, including:



| |  | access to financing;
| | - | --------------------



| |  | annual budget cycles;
| | - | ---------------------



| |  | the status of federal, local and foreign government regulation of telecommunications and television broadcasting;
| | - | -----------------------------------------------------------------------------------------------------------------



| |  | overall demand for communication services and the acceptance of new video, voice and data services;
| | - | ---------------------------------------------------------------------------------------------------



| |  | evolving industry standards and network architectures;
| | - | ------------------------------------------------------



| |  | competitive pressures;
| | - | ----------------------



| |  | discretionary customer spending patterns;
| | - | -----------------------------------------



| |  | general economic conditions.
| | - | ----------------------------



Recent developments in capital markets have reduced access to funding for potential and existing customers causing delays in the timing and scale of
deployments of our equipment, as well as the postponement of certain projects by our customers. The timing of deployment of our equipment can be subject to a number of other risks, including the availability of skilled engineering and technical
personnel.



WE NEED TO DEVELOP AND INTRODUCE NEW AND ENHANCED PRODUCTS IN A
TIMELY MANNER TO REMAIN COMPETITIVE.



Broadband
communications markets are characterized by continuing technological advancement, changes in customer requirements and evolving industry standards. To compete successfully, we must design, develop, manufacture and sell new or enhanced products that
provide increasingly higher levels of performance and reliability. However, in addition to the technological and managerial risks inherent in any product development effort, we may not be able to successfully develop or introduce these products if
the development effort requires more financial resources than we are able to bring to bear, or if our products:



| |  | are not cost effective,
| | - | -----------------------



| |  | are not brought to market in a timely manner,
| | - | ---------------------------------------------



| |  | are not in accordance with evolving industry standards and architectures, or
| | - | ----------------------------------------------------------------------------



| |  | fail to achieve market acceptance.
| | - | ----------------------------------



In order to successfully develop and market certain of our planned products for digital applications, we may be required to enter into technology
development or licensing agreements with third parties. We cannot assure you that we will be able to enter into any necessary technology development or licensing agreement on terms acceptable to us, or at all. The failure to enter into technology
development or licensing agreements when necessary could limit our ability to develop and market new products and, accordingly, could materially and adversely affect our business and operating results.



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DELIVERY OF REAL-TIME, BROADCAST-QUALITY VIDEO VIA IP NETWORKS IS A NEW MARKET AND SUBJECT TO EVOLVING STANDARDS.



Delivery of real-time, broadcast-quality video over IP
networks is novel and evolving and it is possible that communication service providers or their suppliers will adopt alternative architectures and technologies for delivering real-time, broadcast-quality video over IP networks that are incompatible
with our current or future products. If we are unable to design, develop, manufacture and sell products that incorporate or are compatible with these new architectures or technologies, our business could suffer.



PRODUCT QUALITY PROBLEMS MAY NEGATIVELY AFFECT OUR REVENUES AND RESULTS FROM OPERATIONS,
AS WELL AS DISRUPT OUR RESEARCH AND DEVELOPMENT EFFORTS.



We produce highly complex products that incorporate leading edge technology including hardware, software and embedded firmware. In addition to problems relating to the physical quality of manufacturing, our software and other technology may
contain bugs that can prevent our products from performing as intended. There can be no assurance that our pre-shipment testing programs will be adequate to detect all defects either in individual products or which could affect numerous
shipments that, in turn, could create customer dissatisfaction, reduce sales opportunities, or affect gross margins if the cost of remedying the problems exceed our reserves established for this purpose. Our inability to cure a product defect may
result in the failure of a product line, serious damage to our reputation, and increased engineering and product re-engineering costs that individually or collectively would have a material adverse impact on our revenues and operating results.



In 2004, we have experienced a need to divert engineers from
research and development efforts in favor of sustaining engineering efforts to satisfy our customers needs relative to existing products. This could harm our development of new products.



WE RELY ON SEVERAL KEY SUPPLIERS OF COMPONENTS, SUB-ASSEMBLIES AND MODULES THAT WE USE TO
MANUFACTURE OUR PRODUCTS, AND WE ARE SUBJECT TO MANUFACTURING AND PRODUCT SUPPLY CHAIN RISKS.



We purchase components, sub-assemblies and modules from a limited number of vendors and suppliers that we use to manufacture and test our products. Our
reliance on these vendors and suppliers involves several risks including, but not limited to, the inability to purchase or obtain delivery of adequate supplies of such components, sub-assemblies or modules, increases in the prices of such items,
quality, and overall reliability of our vendors and suppliers. Although in many cases we use standard parts and components for our products, certain components are presently available only from a single source or limited sources. Some of the
materials used to produce our products are purchased from foreign suppliers. We do not generally maintain long-term agreements with any of our vendors or suppliers. Thus we may thus be unable to procure necessary components, sub-assemblies or
modules in time to manufacture and ship our products, thereby harming our business.



We operate under an agreement with a leading parts vendor to provide turnkey outsourced manufacturing services. To reduce manufacturing lead times and to ensure adequate component supply, we have instructed our vendor
to procure inventory based on criteria and forecasts as defined by us. If we fail to anticipate customer demand properly, an oversupply of parts, obsolete components or finished goods could result, thereby adversely affecting our gross margins and
results of operations.



We may also be subject to disruptions
in our manufacturing and product-testing operations that could have a material adverse affect on our operating results.



UNANTICIPATED DELAYS OR PROBLEMS ASSOCIATED WITH OUR PRODUCTS AND IMPROVEMENTS MAY CAUSE CUSTOMER DISSATISFACTION OR DEPRIVE US OF OUR FIRST TO MARKET
ADVANTAGE.



Delays in developing and releasing products
and improvements are not uncommon in the industry in which we compete. In the event of performance problems with our product offerings, delays of more than a few months in releasing improvements could result in decreased demand for a particular
product and adverse publicity, which could further reduce demand for particular products or our products generally.



WE MAY NOT BE ABLE TO HIRE AND ASSIMILATE KEY EMPLOYEES.



Our future success will depend, in part, on our ability to attract and retain highly skilled employees, including management, technical and sales
personnel. Despite the recent economic slowdown, significant competition exists for employees in our industry and in our geographic region. We may be unable to identify and attract highly qualified employees in the future. In addition, we may not be
able to successfully assimilate these employees or hire qualified personnel to replace them. The loss of services of any of our key personnel, the inability to attract or retain key personnel in the future, or delays in hiring required personnel,
particularly engineering and sales personnel, could make it difficult to meet key objectives such as timely and effective product introductions.



WE ARE DEPENDENT ON OUR KEY EMPLOYEES FOR OUR FUTURE SUCCESS.



Our success depends on the efforts and abilities of our senior management, in particular John R. Zavoli, and certain other key personnel. If any of these
key employees leaves or is seriously injured and unable to work and we are unable to find a qualified replacement, then our business and results of operations could be materially harmed.



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CHANGES IN THE MIX OF OUR PRODUCT SALES, PRODUCT DISTRIBUTION MODEL OR CUSTOMER BASE COULD NEGATIVELY IMPACT OUR SALES
AND MARGINS.



We may encounter a shift in the mix of the
various products that we sell  products that have varying selling prices based in part on the type of product sold, competitive conditions in the particular market into which the product is sold, applicable sales discounts, licensed product
feature sets, whether we sell our products as an OEM, and whether the sale is a direct sale or an indirect channel sale through our VARs and resellers. Any change in any of these variables could result in a material adverse impact on our gross
sales, gross margins and operating results.



WE MAY BE UNABLE TO OBTAIN FULL
PATENT PROTECTION FOR OUR CORE TECHNOLOGY AND THERE IS A RISK OF INFRINGEMENT.



Since the beginning of 2001, we have submitted several patent applications and provisional patent applications on topics surrounding our core technologies to supplement our existing patent portfolio. There can be no
assurance that these or other patents will be issued to us, or, if additional patents are issued, that they or our three existing patents will be broad enough to prevent significant competition or that third parties will not infringe upon or design
around such patents to develop competing products. In addition, we have filed patent applications in several foreign countries. There is no assurance that these or any future patent applications will be granted, or if granted, that they will not be
challenged, invalidated or circumvented.



In addition to
seeking patent protection for our products, we intend to rely upon a combination of trade secret, copyright and trademark laws and contractual provisions to protect our proprietary rights in our products. There can be no assurance that these
protections will be adequate or that competitors have not or will not independently develop technologies that are substantially equivalent or superior to ours.



There has been a trend toward litigation regarding patent and other intellectual property rights in the telecommunications industry. Although there are
currently no lawsuits pending against us regarding possible infringement claims, there can be no assurance such claims will not be asserted in the future or that such assertions will not materially adversely affect our business, financial conditions
and results of operations. Any such suit, whether or not it has merit, would be costly to us in terms of employee time and defense costs and could materially adversely affect our business.



If an infringement or misappropriation claim is successfully asserted against
us, we may need to obtain a license from the claimant to use the intellectual property rights. There can be no assurance that such a license will be available on reasonable terms if at all.



WE ARE SUBJECT TO LOCAL, STATE AND FEDERAL REGULATION.



Legislation affecting us (or the markets in which we compete) could
adversely impact our ability to implement our business plan on a going-forward basis. The telecommunications industry in which we operate is heavily regulated and these regulations are subject to frequent change. Future changes in local, state,
federal or foreign regulations and legislation pertaining to the telecommunications field may adversely affect prospective purchasers of telecommunications equipment, which in turn would adversely affect our business.



THE MARKET PRICE OF OUR COMMON STOCK COULD BE VOLATILE AND YOUR INVESTMENT COULD SUFFER A
DECLINE IN VALUE.



The market prices for our common stock
is likely to be volatile and could be susceptible to wide price fluctuations due to a number of internal and external factors, many of which are beyond our control, including:



| |  | quarterly variations in operating results and overall financial condition;
| | - | --------------------------------------------------------------------------



| |  | economic and political developments affecting technology spending generally and adoption of new technologies and products such as ours;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------



| |  | customer demand or acceptance of our products and solutions;
| | - | ------------------------------------------------------------



| |  | short-selling programs;
| | - | -----------------------



| |  | changes in IT spending patterns and the rate of consumer acceptance of video-on-demand;
| | - | ---------------------------------------------------------------------------------------



| |  | product sales progress, both positive and negative;
| | - | ---------------------------------------------------



| |  | the stock markets perception of the telecommunications equipment industry as a whole;
| | - | --------------------------------------------------------------------------------------



| |  | technological innovations by others;
| | - | ------------------------------------



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| |  | cost or availability of components, sub-assemblies and modules used in our products;
| | - | ------------------------------------------------------------------------------------



| |  | the introduction of new products or changes in product pricing policies by us or our competitors;
| | - | -------------------------------------------------------------------------------------------------



| |  | proprietary rights disputes or litigation;
| | - | ------------------------------------------



| |  | initiation of or changes in earnings estimates by analysts;
| | - | -----------------------------------------------------------



| |  | additions or departures of key personnel; and
| | - | ---------------------------------------------



| |  | sales of substantial numbers of shares of our common stock or securities convertible into or exercisable for our common stock.
| | - | ------------------------------------------------------------------------------------------------------------------------------



In addition, stock prices for many technology companies, especially
early-stage companies such as us, fluctuate widely for reasons that may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as interest rate increases, recessions or military or
political conflicts, may materially and adversely affect the market price of our common stock, thereby causing you to lose some or all of your investment.



In addition, if the average daily trading volume in our common stock is low, the resulting illiquidity could magnify the effect of any of the above
factors on our stock price.



OUR OUTSTANDING WARRANTS AND THE STOCK OPTIONS
AND BONUS STOCK WE OFFER TO OUR EMPLOYEES, NON-EMPLOYEE DIRECTORS, CONSULTANTS AND ADVISORS COULD RESULT IN ONGOING DILUTION TO ALL STOCKHOLDERS.



We maintain three equity compensation plans: (i) the 2000 Stock Option/Stock Issuance Plan (the 2000 Plan), pursuant to which we may issue an
aggregate of 710,000 options and shares of common stock to employees, officers, directors, consultants and advisors, (ii) the 2001 Employee Stock Purchase Plan (the Purchase Plan), pursuant to which our employees are provided the
opportunity to purchase our stock through payroll deductions, and (iii) the 2004 Equity Incentive Plan (the 2004 Plan), pursuant to which we may issue a total of 900,000 options and shares of common stock to employees, officers,
directors, consultants and advisors. As of September 30, 2004, 405,000 shares of stock had been granted directly to current and former executives of the Company and there were options outstanding to purchase 287,606 shares of common stock under our
2000 Plan; 14,147 shares of common stock remained available for issuance under the 2000 Plan. A maximum of 41,667 shares of common stock have been authorized for issuance under the Purchase Plan. As of September 30, 2004, there were options
outstanding to purchase 381,000 shares of common stock under our 2004 Plan; 519,000 shares of common stock remained available for issuance under the 2004 Plan.



In addition, as of September 30, 2004, there were 89,952 shares of common stock subject to outstanding options granted other than under the 2004 Plan,
the 2000 Plan or the Purchase Plan. These non-plan options were granted in prior years to various employees, directors, consultants and advisors before the creation of any stock option plan.



We plan to continue to provide our employees opportunities to participate in
the Purchase Plan. We also plan to issue options to purchase sizable numbers of shares of common stock to new and existing employees, officers, directors, advisors, consultants or other individuals as we deem appropriate and in our best interests.
This could result in substantial dilution to all stockholders and increased control by management.



Currently, there are outstanding warrants to purchase up to 3,135,516 shares of our common stock with a weighted average exercise price of $5.58 per
share. The weighted average remaining life for all of the currently outstanding warrants is 3.7 years from September 30, 2004.



WE DO NOT INTEND TO PAY CASH DIVIDENDS.



We have never paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We would be exposed to changes in interest rates primarily from any marketable securities and investments in certain available-for-sale securities. Under our current policies, we do not use interest rate derivative
instruments to manage exposure to interest rate changes. At September 30, 2004, we did not have any marketable securities or investments in available-for-sale securities, nor did we have any sales denominated in a currency other than the United
States dollar. Our cash equivalents principal would not be materially changed by changes in interest rates, but as the short term instruments mature and roll over, we would be able to earn more interest in the future if interest rates rise. A
one percentage point (100 basis point) increase in interest rates would result in approximately a $25,000 annual increase in our income from cash equivalents, assuming our cash equivalents principal balance remained at its September 30, 2004 level.
Our $1 million revolving line of credit from Laurus (which currently has a zero balance outstanding) has a variable interest rate.



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ITEM 4. CONTROLS AND PROCEDURES



John
R. Zavoli, who is both our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Securities Exchange Act of 1934 Rule 13a15(e)),
concluded that as of September 30, 2004, our disclosure controls and procedures were effective.



|PART | II - OTHER INFORMATION
|---- | ----------------------



|ITEM | 1. LEGAL PROCEEDINGS
|---- | --------------------



We are not a defendant in any material legal proceedings.



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



On July 30, 2003, the SEC declared effective the registration statement (SEC file no. 333-105638) for our initial public offering of units through underwriters led by Paulson Investment Company, Inc.



Through September 30, 2004, we have used the $13,055,136 net proceeds of the
offering to pay $1,380,000 in accrued accounts payable, to repurchase $1,180,000 principal amount of our 7% convertible debentures for $1,382,000, to repurchase 27,777 shares of common stock from Ronald Fellman for $92,997, and to fund our
continuing negative cash flow, including the payment of cash bonuses to Frederick Cary and John Zavoli totaling $100,000. Except as discussed in the previous sentence, none of these payments went directly or indirectly to our directors, officers,
general partners, affiliates, 10% owners, or any of their associates. We have used approximately $9,028,000 to fund negative cash flows from operations and approximately $482,000 to fund negative cash flows from investing activities. Pending use for
working capital, research and development efforts and marketing and sales programs, we have invested the remaining $690,000 of net proceeds in short-term government obligations and money market accounts.



ITEM 3. DEFAULTS UPON SENIOR SECURITIES



Not applicable.



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



Not applicable.



ITEM 5. OTHER INFORMATION



Not
applicable.



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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



Exhibits.The following exhibits are included as part of this report.



|              |  |                                                                                           
|------------- |  | ------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                               
|              | 
|10.65 * #     |  | Form of Notice of Grant/Stock Option Agreement under the 2004 Equity Incentive Plan       
|              | 
|10.66 * #     |  | Jeff C. Hale employment letter agreement                                                  
|              | 
|10.67 *       |  | Mark Buckner letter agreement                                                             
|              | 
|10.68 * #     |  | David Houillion Restricted Stock Award Agreement                                          
|              | 
|10.69 * #     |  | Lester Briney Restricted Stock Award Agreement                                            
|              | 
|10.70 * #     |  | John Zavoli Amendment of Employment Letter Agreement                                      
|              | 
|10.71 * #     |  | Amendment to John Zavoli Restricted Stock Award Agreement                                 
|              | 
|10.72 * #     |  | Amendment to David Carnevale Restricted Stock Award Agreement                             
|              | 
|10.73*        |  | Amendment to Stock Option Agreement of Dr. Moshe Nazarathy                                
|              | 
|31*           |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a)   
|              | 
|32*           |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350

---

|* | Filed Herewith
|- | --------------



|# | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------



Reports on Form 8-K.



We furnished, on Form 8-K, Item 12, during this fiscal quarter, a copy of an announcement of historical financial results. Pursuant to SEC staff guidance,
such furnished Form 8-K information need not be listed in this Item 6 of Part II of Form 10-Q.



On a Form 8-K filed on September 2, 2004, we reported (under items 1.01, 5.02 and 9.01) regarding the hiring of Jeff C. Hale as Vice President of Sales and the resignation of Dr. Moshe Nazarathy as a Director, each
effective September 1, 2004, and the amendment of Dr. Nazarathys stock options to extend the period of time (after his departure) during which he may exercise them.



On a Form 8-K filed on September 16, 2004, we reported (under items 8.01 and 9.01) that Vyvx LLC had upgraded certain of its
existing Path 1 products.



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SIGNATURES



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



Path 1 Network Technologies Inc.



|    |  |                                                                                                             
|--- |  | ------------------------------------------------------------------------------------------------------------
|By: |  | /s/    JOHN R. ZAVOLI                                                                                       
|    |  | John R. Zavoli President and Chief Executive Officer, Chief Financial Officer, General Counsel and
Secretary



Date: November 5, 2004



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##### Table of Contents

Exhibit List



|              |  |                                                                                           
|------------- |  | ------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                               
|              | 
|10.65 * #     |  | Form of Notice of Grant/Stock Option Agreement under the 2004 Equity Incentive Plan       
|              | 
|10.66 * #     |  | Jeff C. Hale employment letter agreement                                                  
|              | 
|10.67 *       |  | Mark Buckner letter agreement                                                             
|              | 
|10.68 * #     |  | David Houillion Restricted Stock Award Agreement                                          
|              | 
|10.69 * #     |  | Lester Briney Restricted Stock Award Agreement                                            
|              | 
|10.70 * #     |  | John Zavoli Amendment of Employment Letter Agreement                                      
|              | 
|10.71 * #     |  | Amendment to John Zavoli Restricted Stock Award Agreement                                 
|              | 
|10.72 * #     |  | Amendment to David Carnevale Restricted Stock Award Agreement                             
|              | 
|10.73*        |  | Amendment to Stock Option Agreement of Dr. Moshe Nazarathy                                
|              | 
|31*           |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a)   
|              | 
|32*           |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350

---

|* | Filed Herewith
|- | --------------



|# | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------



26