NEXT LEVEL COMMUNICATIONS INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
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 NO. 0-27877

NEXT LEVEL COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 95-3342408
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

6085 STATE FARM DRIVE
ROHNERT PARK, CA 94928
(Address of principal executive offices)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(707) 584-6820

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:

Indicate by check mark whether 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 files such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

The aggregate market value of our voting and non-voting common equity held
by non-affiliates is $32,045,212 as of March 20, 2002.

As of March 20, 2002, we have 85,999,133 outstanding shares of common
stock.

DOCUMENTS INCORPORATED BY REFERENCE

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TABLE OF CONTENTS

1

PART I

ITEM 1. BUSINESS

This Annual Report on Form 10-K of Next Level Communications, Inc. includes
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We intend
these forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Litigation Reform
Act of 1995, and we are including this statement for purposes of complying with
these safe harbor provisions. We have based these forward-looking statements on
our current expectations and projections about future events. These
forward-looking statements are not guarantees of future performance and are
subject to risks, uncertainties and assumptions, including those in the section
entitled "Risk Factors" in this annual report. Actual results may vary
materially from these forward-looking statements as a result of these and other
risks.

Words such as "expect," "anticipate," "intend," "plan," "believe,"
"estimate" and variations of these words and similar expressions are intended to
identify forward-looking statements. We undertake no obligations to publicly
update or revise any forward-looking statements, whether as a result of new
information, future events or otherwise, unless we are required to do so by law.
In light of these risks, uncertainties and assumptions, the forward-looking
events discussed below might not occur.

OVERVIEW

We design and market broadband communications equipment that enables
telephone companies and other communications service providers to
cost-effectively deliver a full suite of voice, high-speed data and digital
video services over the existing copper telephone wire infrastructure. Service
providers who deploy our equipment can either offer voice, data and video
services in a single product offering or offer each service separately depending
on subscriber demand and the service provider's objectives. We believe that by
installing our equipment, telephone companies and other emerging communications
service providers will be able to capitalize on, and compete effectively in, the
emerging market for integrated voice, data and video services. Our products
consist of equipment located at the telephone company's central office or
exchange, in the field and at the subscriber's home or business.

We commenced operations in July 1994 and recorded our first sale in
September 1997. From January 1998 until November 1999, we operated through Next
Level Communications L.P., which was formed as the result of the transfer of all
of the net assets, management and workforce of a wholly-owned subsidiary of
General Instrument. In November 1999, the business and assets of that
partnership were merged into Next Level Communications, Inc. as part of our
recapitalization. In November 1999, we completed an initial public offering of
our common stock, raising approximately $177.0 million in net proceeds. In
January 2000, General Instrument was acquired by Motorola, Inc., making us an
indirect subsidiary of Motorola. As a result of the transactions that occurred
in connection with our recapitalization and subsequent borrowings, Motorola owns
64,103,724 shares of our common stock and warrants to acquire an additional 7.4
million shares of our common stock constituting approximately 61% of our
outstanding common stock on a fully diluted basis as of December 31, 2001.

Our equipment is designed to provide the following key benefits:

Flexible, Integrated Products. We designed our products are designed with
the flexibility to allow our customers to deliver voice, data and video services
in a single packaged offering or to offer them individually. This flexibility
allows telephone companies to immediately serve the varying needs of their
diverse end-user base, including residential, corporate and telecommuter
customers. By offering the flexibility inherent in an integrated system, our
products enable telephone companies to effectively time their network equipment
expenditures and rapidly introduce new services as demand warrants.

Cost-Effective Product Deployment. Our product design reduces the cost and
complexity often associated with deploying multiple services to end-users.
Because telephone companies often use separate equipment for each communications
service, they require multiple equipment purchases, installations, training

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procedures, maintenance procedures and network management packages. In contrast,
our products deliver all services from a single system. By integrating many
traditionally separate functions, our products allow telephone companies to add
services incrementally by simply installing new modules into our existing
equipment, rather than purchasing entirely new infrastructure equipment.
Additionally, our products installed in the house or office deliver video and
data services from a single networked set-top box, thus eliminating the need for
set-top boxes or modems for different services or separately located TVs and
PCs. We believe our products provide cost savings, reduce trouble calls and ease
installation compared to other equipment that often consists of separate
systems, each of which corresponds to one service and which may not operate
effectively together.

Complete Solution For Delivery of Voice, Data and Video. By supplying
equipment for the telephone company central office, the field and the
subscriber's home or office, we offer a single integrated system for the
delivery of voice, data and video services. With our products, telephone
companies initially deploying voice service can subsequently activate data
and/or video service with a simple addition and installation of equipment at the
subscriber's home or office. We believe the flexibility found in our products
cannot currently be accomplished by attempting to integrate multiple systems
from multiple vendors.

Reliable and Compatible Technology. Because our products provide multiple
services, including voice, they are engineered to comply with rigorous industry
standards for reliability and safety. We have also designed our products to
operate with existing telephone company switches and billing systems, thereby
minimizing the cost of using our products.

Security. We believe that our products produce greater security compared
to cable systems that are based on shared network design in which data is
broadcast to all users simultaneously. Security has always been important to
individuals and businesses in voice transmission and is becoming increasingly
important as e-commerce applications and video-on-demand services become more
prevalent.

PRODUCTS

Our products include equipment located at a telephone company's central
office, in the field and at a subscriber's home or business.

Broadband Digital Terminal. The Broadband Digital Terminal is the central
element of our product suite, providing centralized access to both broadband and
narrowband core networks and related voice, data and video services. The
Broadband Digital Terminal is typically located in a telephone company's central
office, or at a remote building basement or hut where it connects with central
office equipment including voice and data switches and billing systems. On the
subscriber side, the Broadband Digital Terminal provides high-speed connections
to remote Universal Service Access Multiplexers or Broadband Network Units that
can support several thousand telephone subscribers or combinations thereof. The
Broadband Digital Terminal has the capacity for broadband applications such as
video-on-demand and high definition television. Also, because the Broadband
Digital Terminal supports different remote terminals, changes to network layouts
or transmission media, copper or fiber, do not require different Broadband
Digital Terminals.

Universal Service Access Multiplexer. We designed the Universal Service
Access Multiplexer to use existing copper wire to connect to a customer's home
or office. This product can be connected with fiber optic cable to the Broadband
Digital Terminal. Each Universal Service Access Multiplexer can support up to 32
video and/or data subscribers via Very High Bit Rate Digital Subscriber Line of
Asymmetric Digital Subscriber Line technology or up to 96 voice subscribers. By
using modular components, a single Universal Service Access Multiplexer enables
multiple voice, data and video services. The Universal Service Access
Multiplexer can be deployed in the telephone company's central office or
remotely. Because the Universal Service Access Multiplexer is flexible in terms
of where it can be located in the network, as well as the services it can
support, its use can reduce both the costs and the complexity of deploying new
high-speed data and video services.

Broadband Service Access Multiplexer. The Broadband Service Access
Multiplexer is our latest remote terminal solution enabling the intelligent
transport of voice, video, and data over a single twisted pair to the

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home. This is the first commercially available Digital Subscriber Line service
shelf that utilizes the global 998 standard for VDSL transport. The 998 standard
provides an ADSL spectrally compatible spectrum plan and is designed to provide
a means for multi-vendor equipment interoperability. The Broadband Service
Access Multiplexer can be deployed in the telephone company's central office or
remotely. The Broadband Service Access Multiplexer provides increased density of
VDSL ports per shelf, substantially decreasing the cost per subscriber, and
supports both Very High Bit Rate Digital Subscriber Line and Asymmetric Digital
Subscriber Line cards, with 12 ports per card. The capacity is 12 line cards per
shelf, totalling 144 Digital Subscriber Line ports per Broadband Service Access
Multiplexer. Transport from the Broadband Digital Terminal to the Broadband
Service Access Multiplexer is over a 622 megabit per second Optical Distribution
Unit. The high-speed transport coupled with multicasting capability, which
provides the intelligence to share the bandwidth of a single video channel over
multiple homes, reduces costs of deploying high-speed as well as providing
digital cable television competitive broadcast services.

Broadband Network Unit. The Broadband Network Unit is used with Fiber to
the Curb installations where fiber optic cable is deployed up to a location
relatively close to the customer's home or office. The Broadband Network Unit
supports voice, data and video services, and can be mounted on a telephone pole,
a pedestal or a wall. The Broadband Network Unit provides voice, high-speed data
and video service for clusters of up to 16 video and/or data and up to 36 voice
subscribers. Our Broadband Network Unit is particularly suited to situations
where a new network is being built, or where existing copper wire is being
upgraded by the installation of fiber optic cable as the transmission medium for
residences or larger apartment buildings or offices. The advanced design and
environmentally secure housing of the Broadband Network Unit helps to reduce
in-field trouble calls.

N3 Residential Gateway 2000. Our N3 Residential Gateway product is a
single set-top box that delivers integrated data and video services. One N3
Residential Gateway enables multiple televisions and PCs to be served from the
same copper line coming into the customer's home or office. Traditionally, the
high cost of customer home or office equipment for broadband services has been a
limiting factor in the deployment of broadband services to multiple televisions
or personal computers. Historically, a customer would have to obtain multiple
modems or set-top boxes to support services to multiple televisions or personal
computers. In contrast, our N3 Residential Gateway simultaneously provides three
independent high quality digital video streams that can be distributed
throughout a home or office using standard coaxial cable. The N3 Residential
Gateway also supports enhanced telephone services, such as an indicator on the
television that a message is waiting on the customer's answering machine or
service as well as on-screen caller ID. The data port in our N3 Residential
Gateway supports high-speed connectivity to the Internet or remote work-at-home
access.

N3 Residential Gateway 2100. The N3 Residential Gateway 2100 product is
our latest single set-top box that delivers integrated data and video services.
The form factor of this set-top box is both sleeker and lighter. The N3
Residential Gateway 2100 contains all of the advantages of three independent
high quality digital video streams and enhanced telephone services as the N3
Residential Gateway 2000, but also contains increased memory, 16 bit graphics,
home network options, applications on all streams, and lower deployment costs
from integrated equipment. Additionally, this set-top box supports the global
998 standard for VDSL transport.

N3 ETHERset. Our N3 ETHERset is a data-only, desktop device that provides
a powerful, low-cost solution for delivering high-speed Internet or data
services to subscribers in residences, small businesses and branch offices and
the like. Individual or multiple PCs can be connected to a single N3 ETHERset.

Element Management Systems. Our products can be managed remotely by our N3
View-1 Element Management System and our N3 View-2 Service Manager. The View-1
Element Management System enables service providers to manage our equipment and
their other systems and products. The View-2 Service Manager enables service
providers to manage delivery of voice, data and video services to their
customers.

CUSTOMERS

We market and sell our products through our direct sales force to service
providers. Qwest (formerly US WEST) accounted for 41%, 56% and 67% of our
revenues in 2001, 2000 and 1999. Accordingly, we have
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increased the percentage of our sales to the local, independent and
international telephone companies. During 2001, we had 72 customers that had
purchased at least $100,000 of our products.

We recorded our first sale to Qwest in September 1997 for deployment of
video and data service to Qwest's customers in Phoenix, Arizona. In October
1998, Qwest selected our product to provide voice applications in six of the 14
states that Qwest serves. As a result of the merger between U S WEST and Qwest,
Qwest slowed its purchases of our equipment in 2001 while it re-evaluates its
plans regarding the deployment of VDSL across its network. Sales to Qwest in the
future are dependent upon their decision regarding the deployment of our
product.

Our customers also include All West Communications, Bell Canada,
Brandenburg Telephone Company, Cablevision, Centurytel Supply Group, Chibardun
Telephone, Chillicothe Telephone, Citizens, Clearlake, Horizon, Horry Telephone
Cooperative, Hutchinson Telephone, New ULM Telecom, Paul Bunyan Rural Telephone,
South Central Rural Telephone Cooperative, Tri County Telephone, Unite Broadband
Services, Warwick Valley, Wood County and XIT Communications.

TECHNOLOGY

We believe the following key technologies have been instrumental in our
ability to provide what we believe is the world's only integrated, complete
solution for the delivery of integrated voice, high-speed data and digital video
services over the existing telephone copper wires.

Advanced Application Specific Circuits Architecture. Applications Specific
Circuits are custom-designed silicon circuits that are optimized for a specific
task or set of tasks. These circuits are critical because they are
performance-optimized to minimize gate counts, packaging size, power dissipation
and cost. In addition, one of these circuits may be the only way to provide a
new or novel function that is not available in an off-the-shelf circuit. Our
engineers have substantial experience in the design of these circuits and have
developed a portfolio of over 50 of these circuits, which enables flexible
delivery of voice, data and video from a single system. We will continue to
pursue additional service and system level Application Specific Circuits as a
mechanism for protecting our intellectual property and to achieve ongoing cost
reductions.

System Design and Integration Expertise. We employ a team of experienced
system design and integration engineers in our research and development group.
These individuals provide research, design and development resources and ensure
that our products can be integrated by our customers. System integration by our
customers is required on our specific access products, equipment at the
consumer's home or business, and management systems, as well as the integration
of our products into our customers' networks. System integration expertise is
critical to the successful deployment of new advanced full service
telecommunications systems and services by our customers.

Wavelength Division Multiplexing Technology. Our system uses a technology
known as wavelength division multiplexing. This technology allows multiple
optical signals to be carried on the same optical fiber. In particular, this
technology is used to communicate two-way voice, data and video over a single
optical fiber. This enables our customers to save fiber costs and increase
bandwidth.

Software and Protocol Stacks. Most of the system software in our products
has been developed internally using modern design principles and processes.
Where appropriate, various third-party software packages have been integrated
into the access system. Some examples include the real time operating system and
various protocol stack software packages.

Standards-based Architecture. We support multiple industry standards to
minimize interoperability issues and leverage industry hardware and software
capabilities, and improve time to market. On the customer side of the network,
we are working with industry standards for asynchronous digital subscriber line
and very high-speed digital subscriber line standards to support various
equipment at the customer's home or business. In addition, we are providing an
open middleware environment for our family of Residential Gateway products that
enable support for various third party interactive applications.

5

RESEARCH AND DEVELOPMENT

As of March 20, 2002, we have 112 full time employees and one independent
contractor engaged in research and development. We believe that our future
success depends on our ability:

- to adapt to the rapidly changing telecommunications environment;

- to maintain our expertise in core technologies; and

- to continue meeting and anticipating the evolving needs of telephone
companies.

We continually review and evaluate technological changes affecting the
telecommunications market and invest substantially in applications-based
research and development. We are committed to an ongoing program of new product
development that combines internal development efforts with strategic
relationships and licensing or marketing arrangements relating to new products
and technologies from outside sources.

We have focused our research and development expenditures for the past
several years on creating a complete solution for the delivery of voice, data
and video services using the existing infrastructure of telephone companies. We
have also concentrated on developing the associated customer premises equipment,
including our N3 Residential Gateway, and on developing our N3 View-1 Element
Management Systems. In 2001, 2000 and 1999, research and development expenses
were $46.9 million, $55.8 million and $48.5 million. We believe that our
extensive experience in designing and implementing high-quality network
components has enabled us to develop integrated systems solutions. We
continually seek to constantly improve our existing products, including
developing additional home and office products and higher speed interfaces for
our products.

SALES AND MARKETING

We primarily market and sell our products through a direct sales force
located in North America that consists of 34 people as of March 20, 2002. To
date, sales activities have been focused primarily on Qwest and local,
independent and international telephone markets. Because of the potential
importance of our products to our customers' networks, we focus our selling
efforts at many levels within each customer's organization.

We have a variety of marketing programs and initiatives to support the sale
and distribution of our products. As of March 20, 2002, we have 14 full time
employees engaged in marketing activities focusing on reaching technical experts
within telephone companies and creating product awareness and credibility for
our systems among telephone companies. A key factor to building brand awareness
for our products is promoting the success of our customers deploying our
products. We seek to educate telephone companies regarding the benefits of
deploying broadband-ready equipment across a diverse subscriber base. We also
build our brand name through continued publicity and referral efforts in both
media and industry-centered activities, including editorial presence in various
trade magazines, press releases, public speaking opportunities, national and
regional trade show participation, advertising, Internet-based communication and
promotion, media sponsorships and participation in industry standards
activities.

MANUFACTURING

We seek to deliver our products on time and defect-free by capitalizing on
the experience and expertise of strategic contract manufacturers. Based on their
quality assurance and strengths in the volume manufacture of our products, we
have established our primary contract manufacturing relationships with
Sanmina-SCI Systems and Flextronics Enclosures. Using contract manufacturers
allows us to reduce the costly investment in manufacturing capital.

We maintain only a limited in-house manufacturing capability for final
assembly, testing and integration of our products. Our internal manufacturing
expertise is focused on product design for testability, design for
manufacturability and the transfer of products from development to
manufacturing. Our contract manufacturers typically assemble an account team of
personnel representing all the essential functions to deliver products from
prototype through volume production. This team works with our design, test and
manufacturing engineers, and our quality, materials, logistics and program
management teams. Our primary contract

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manufacturers are certified under international quality standards. Although our
contract manufacturers manage material procurement for the majority of the
components that are incorporated in our products, we continue to manage the
evaluation and selection of certain key components.

Our engineering team designs circuits and tests these designs using
computer simulations. When the fundamental design is stable, our outsourced
manufacturers make the circuits for testing. Upon completion of these tests,
vendors such as Metalink, Oki Semiconductor, Broadcom, STMicroelectronics,
Philips and Motorola manufacture the circuit in volume. Warranty and repair
support is performed off-site by our contract manufacturers and by us at our
Rohnert Park, California facility.

CUSTOMER SERVICE AND SUPPORT

We believe that successful long-term relationships with our customers
require a service organization committed to customer satisfaction. As of March
20, 2002, we have 22 technical support employees at our headquarters or in the
field. While not essential to the functionality of the product, we also offer a
five-day training course for all new customers prior to receiving and installing
a system. To date, revenues from customer service and support have been
immaterial.

We provide direct support by telephone or at a customer's office or other
location at any time. To monitor service activities, we maintain a customer call
tracking system. We also maintain a dial-up analog modem connection or an
Internet-based management interface to our equipment to assist with diagnostics.

COMPETITION

The market for providing equipment for local telecommunications networks is
extremely competitive. The principal competitive factors in this market include,
or are likely to include:

- product performance and price;

- features and reliability;

- technical support and service;

- relationships with phone companies and systems integrators;

- compliance with industry standards;

- compatibility with the products of other suppliers;

- sales and distribution capabilities;

- strength of brand name;

- long-term cost of ownership to communications providers; and

- general industry and economic conditions.

Many of our current and potential competitors have longer operating
histories and greater name recognition and resources than we do. These
competitors may undertake more extensive marketing campaigns than we do. In
addition, these competitors may adopt more aggressive pricing policies than we
do. Also, these competitors may devote substantially more resources to
developing new products than we do. Many of our competitors have been
consolidated with larger companies and now have even greater resources to
compete with us.

Our significant current and potential competitors include Advanced Fibre
Communications, Alcatel, Cisco Systems, Efficient Networks, Lucent Technologies,
Nokia, Nortel Networks, RELTEC Corporation, BAE Systems, CNI Division, formerly
GEC Marconi, Siemens and our largest stockholder, Motorola. Some of these
competitors have existing relationships with our current and prospective
customers, which could give them a competitive advantage over us as a preferred
provider. In addition, we anticipate that other large companies, such as
Matsushita Electric Industrial, which markets products under the Panasonic brand
name,

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Microsoft, Network Computer, Philips, Sony Corp., STMicroelectronics and Toshiba
America, will likely introduce products that compete with our N3 Residential
Gateway product in the future.

In addition, we are likely to face increasing competition from alternative
technologies. In particular, cable operators are currently deploying products
that deliver voice, high-speed data and video services over cable. Cable service
providers that offer these packaged services will give subscribers the
alternative of purchasing all communications services from a single service
provider. If these services are implemented successfully, they will compete
directly with the services offered by telephone companies using our products.

Consolidation in the telecommunications equipment industry may strengthen
our competitors' position in our market. Consolidation of our competitors has
occurred, and we expect it to continue to occur in the foreseeable future. For
example, Alcatel acquired DSC Communications, Lucent acquired Ascend
Communications, and GEC Marconi acquired RELTEC Corporation. Acquisitions such
as these further strengthen our competitors' financial, technical and marketing
resources and provide access to regional Bell operating company customers. As a
result, these competitors are able to devote greater resources to the
development, promotion, sale and support of their products. This consolidation
may allow some of our competitors to penetrate new markets that we have
targeted, such as the domestic local, independent and international telephone
markets. If our competitors are successful in these markets, we will be harmed.

INTELLECTUAL PROPERTY

We rely on a combination of patent, copyright and trademark laws, and on
trade secrets, confidentiality provisions and other contractual provisions to
protect our intellectual property. These measures afford only limited
protection. As of March 20, 2002, we have 25 issued patents in the United States
and eight issued patents in foreign countries. We have 24 pending U.S. patent
applications and 51 pending international patent applications. We market our
products primarily under our own name and mark. We consider our trademarks to be
valuable assets. We rely on patent, trademark, trade secret and copyright laws
both to protect our proprietary technology and to protect us against claims from
others. We believe that we have direct intellectual property rights or rights
under cross-licensing arrangements covering substantially all of our material
technologies. Given the technological complexity of our systems and products,
however, we cannot assure that claims of infringement will not be asserted
against us or against our customers in connection with their use of our systems
and products, nor can we assure the outcome of any such claims.

SOURCES AND AVAILABILITY OF MATERIALS

We contract for the manufacture of all of our products and have limited
in-house manufacturing capabilities. We rely primarily on two large contract
manufacturers: Sanmina-SCI Systems and Flextronics Enclosures. For a detailed
discussion of these relationships and the risks associated with our dependence
upon third-party manufacturers, see "Business -- Manufacturing" and "Risk
Factors."

Some parts, components and equipment used in our products are obtained from
sole sources of supply. If our sole source suppliers or we fail to obtain
components in sufficient quantities when required, delivery of our products
could be delayed. Additional sole-sourced components may be incorporated into
our equipment in the future. We do not have any long-term supply contracts to
ensure sources of supply. In addition, our suppliers may enter into exclusive
arrangements with our competitors, stop selling their products or components to
us at commercially reasonable prices or refuse to sell their products or
components to us at any price, which could harm our operating results.

ENVIRONMENTAL MATTERS

Our research and development operations are subject to certain federal,
state, local and foreign environmental protection laws and regulations. These
laws and regulations relate to the use, handling, storage, discharge and
disposal of certain hazardous materials and wastes, the pre-treatment and
discharge of process waste waters and the control of process air pollutants. We
believe that we are in compliance in all material respects with applicable
environmental regulations. If those laws and regulations become more stringent
over time, we may not be able to comply in a timely manner, or comply at all.
Compliance with new laws and

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regulations could create significant compliance expenses, result in production
suspension and delay, restrictions on expansion at present locations and require
the acquisition of costly equipment. Non-compliance with laws and regulations
could result in penalties and suspension of operations.

REGULATION OF CUSTOMERS

Although our products are not now directly subject to significant
regulation by the Federal Communications Commission, (or "FCC"), or any other
federal or state communications regulatory agency, our customers and their
networks, into which our products are incorporated, are subject to government
regulation. Accordingly, the effects of regulation on our customers may, in
turn, affect our business, operating results and financial condition. FCC
regulatory policies affecting either the willingness or the ability of telephone
companies or cable operators to offer certain services and to purchase and
install our products in their networks, or the terms on which these companies
offer the services and conduct their businesses, may impede sales of our
products.

Several FCC regulatory policies may affect the degree to which or way in
which incumbent local exchange carriers, which we refer to as incumbent
carriers, principally the regional Bell operating companies, can or choose to
make integrated voice, data and video offerings available. For example, the
Telecommunications Act of 1996 requires incumbent carriers to offer their
competitors cost-based access to certain parts of their networks to enable these
competitors to provide telecommunications services. Current FCC rules identify
the specific network elements that incumbent carriers must offer to their
competitors to enable them to provide telecommunications services. The list of
elements that must be unbundled, which is currently under review by the FCC,
include the facilities and equipment used to provide broadband services,
including high-speed data services. Over the past year, the FCC has initiated
several related proceedings to evaluate the appropriate regulatory framework for
incumbent carriers to provide broadband services. The Commission has tentatively
concluded that it intends to develop a consistent framework for regulation of
broadband services offered by cable and telephone companies. The Commission also
has tentatively concluded that wireline broadband services are not subject to
all the requirements that regulate the offerings of common carriers under Title
II of the Communications Act of 1934. Finally, the Commission recently decided
that broadband service provided by cable operators via a cable modem is not
subject to regulation as a telecommunications service. This ruling, combined
with the FCC's review of rules governing the incumbent carriers, indicates that
change in the regulatory climate affecting incumbent carriers is possible.
However, we will not know for certain the FCC's position until it issues orders
in these proceedings and any legal challenges have been decided, which is not
expected to occur until later this year at the earliest.

The Telecommunications Act of 1996 also requires incumbent carriers to
offer for resale, at wholesale rates, any telecommunications services that
incumbent carriers offer to customers. As explained above, existing regulations
currently define Internet access services as "telecommunications services," and
thus incumbent carriers must offer such services for resale to competitors. This
requirement also is implicated by on-going FCC proceedings, but the outcome is
uncertain until the FCC issues orders in these proceedings and any legal
challenges have been resolved.

Legislation pending in Congress, namely "The Internet Freedom and Broadband
Deployment Act," also would have the effect of changing the requirements on
incumbent carriers by reducing the regulation of incumbent carriers' provision
of video and high-speed data services. If enacted, this bill would make it
easier for the incumbent Bell companies to offer broadband services by allowing
them to provide interstate broadband service without prior FCC approval. This
legislation was approved by the U.S. House of Representatives earlier this year,
but again there is no way to predict whether this legislation will be adopted.

Incumbent carriers can provide video services through a structurally
separate subsidiary that is not subject to the unbundling and resale
requirements. Our equipment is designed to allow carriers to provide video,
high-speed data, and digital voice on an integrated basis. Because of the
regulatory restrictions, if incumbent carriers choose to offer video or data
services through a separate affiliate, incumbent carriers may prefer vendors
whose equipment does not provide for integration of service offerings. A
separate affiliate may choose to purchase less sophisticated equipment because
it might not be able to utilize fully our equipment's

9

integrated features. The FCC may change the separate subsidiary requirement, but
we will not know for certain until the FCC issues an order and any legal
challenges have been resolved.

In its order approving the merger of two Bell operating companies, SBC and
Ameritech, the FCC permitted the merged entity to avoid its statutory resale
obligations on "advanced services" provided that such services were offered
through a separate subsidiary. Recently, however, the U.S. Court of Appeals for
the D.C. Circuit vacated, in part, the FCC's order and held that the FCC may not
permit an incumbent carrier to avoid its statutory obligations under the
Telecommunications Act of 1996 by setting up an affiliate to offer such
services.

Distribution of our N3 Residential Gateway could be adversely affected by
the FCC's "navigation devices" rules. Those rules require video program
distributors, including those who use our system to deliver video, to allow
set-top boxes and other navigation devices owned by customers or manufactured by
third parties to be connected to the video program distributor's system. The
rules require video program distributors to disclose technical details of their
interfaces so as to permit third parties to manufacture the navigation devices
and retail customers to connect them. We believe these rules are not readily
applicable to our system because our N3 Residential Gateway is in many ways
different from a cable set-top box, and currently there is little likelihood of
an independent market for our N3 Residential Gateway separate from our entire
system. However, if these rules could be applied to our N3 Residential Gateway
or other parts of our system, our customers might be required to disclose
proprietary technical information including patented data about our technology,
to allow competing vendors to access the system.

The uncertainties caused by pending regulatory proceedings and possible
appeals of FCC decisions, and by pending legislation, could cause potential
customers to delay purchasing decisions. In addition, the outcomes of the
various regulatory proceedings and legislation may cause potential customers not
to deploy all of the services for which our products are designed or to delay
the widespread introduction of one or more of these services.

BACKLOG

Our backlog primarily consists of purchase orders for products to ship
within the next six months. At December 31, 2001, backlog was approximately $3.2
million. We consider backlog to be an indicator, but not the sole predictor, of
future sales because our customers may cancel or defer orders without penalty.
Cancellation or reduction of pending purchase orders could seriously harm our
future revenues.

EMPLOYEES

As of March 20, 2002, we have a total of 238 full-time employees and 7
independent contractors. The total number of employees consists of 112 in
research and development, 14 in marketing, 21 in operations, 55 in sales and
sales support and 36 in administration. The total number of contractors consists
of one in research and development, one in operations, three in marketing and
sales support and two in administration. Our employees are not represented by
any collective bargaining agreement with respect to their employment, and we
have never experienced an organized work stoppage. Satisfactory relations have
generally prevailed between our employees and us. Our future success is heavily
dependent upon our ability to hire and retain qualified technical, marketing and
management personnel. The competition for personnel is intense, particularly for
engineering personnel.

ITEM 2. PROPERTIES

Our principal corporate offices, which include two main buildings, are
located in Rohnert Park, California. We lease one of the buildings and own the
other. We lease three sales offices, in Parsippany, New Jersey, Englewood,
Colorado and Highland Ranch, Colorado. We also lease sales support offices in
Phoenix, Arizona and Boulder, Colorado and Englewood, Colorado. In addition, we
lease two facilities for our technology department in Parsippany, New Jersey and
San Diego, California. We also lease one administrative office in Schaumburg,
Illinois. We believe our current facilities are suitable and adequate and have
sufficient productive capacity to meet our current needs.

10

ITEM 3. LEGAL PROCEEDINGS

Securities Litigation. In July 2001, a class action complaint entitled
Zichron Yakov Menachem Inc. v. Next Level Communications, Inc., et al, was filed
in the United States District Court for the Southern District of New York,
alleging various violations of law, including alleged violations of Sections 11,
12 and 15 of the Securities Act of 1933, Section 10(b) of the Securities
Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, based on alleged
excessive commissions, and agreements to engage in after-market transactions,
received by underwriters in exchange for the receipt of allocations of stock in
our initial public offering. Plaintiff seeks to represent a class comprised of
all persons who purchased our common stock during the period from November 9,
1999 through December 6, 2000. Based upon information presently known to us, we
do not believe that the ultimate resolution of these lawsuits will have a
material adverse effect on our business.

On January 28, 2002, a complaint entitled Next Level Communications, Inc.
v. Virtual Access plc was filed by us in the Superior Court of the State of
California, County of Sonoma. The complaint relates to a demand made by Virtual
Access that Next Level invest an additional $2 million in Virtual Access
pursuant to various investment and settlement agreements between the two
companies. The complaint by Next Level seeks declaratory relief that Next Level
has no obligation to make any further payments to Virtual Access, as well as
restitution and rescission. Virtual Access did not file a timely response to the
lawsuit and the court entered a Notice of Default in favor of Next Level.
Default judgment has not yet been sought or entered.

Other Matters. From time to time, we are a party to other actions which
arise in the normal course of business. In our opinion, the ultimate disposition
of the items discussed above and these other matters will not have a material
adverse effect on our consolidated financial statements taken as a whole.

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

No matters were submitted to a vote of our stockholders during the quarter
ended December 31, 2001.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS

During November 1999, we completed our initial public offering in which we
sold 9,775,000 shares of our common stock at a price of $20.00 per share
pursuant to a Registration Statement on Form S-1 (File No. 333-85999). Our
common stock is listed on The NASDAQ Stock Market's National Market under the
symbol "NXTV." The following table sets forth the high and low closing prices
for our common stock for the periods indicated as reported on The NASDAQ
National Market.

On March 20, 2002, the last reported sale price for our common stock on the
NASDAQ National Market was $1.47 per share. At March 20, 2002, the number of
record holders of our common stock was 260.

We have never declared or paid any cash dividends on our common stock and
do not anticipate paying any cash dividends in the foreseeable future. We intend
to retain all available funds and any future earnings for use in the operation
of our business. In addition, our loan agreement with Motorola restricts our
ability to pay dividends.

11

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data set forth below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the historical consolidated financial statements and notes
included in this report.

The following table sets forth unaudited statement of operations data for
our eight most recent quarters in the period ended December 31, 2001 (in
millions, except per share data).

13

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Some of the statements in the following discussion and elsewhere in this
report constitute forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of
1934. We intend these forward-looking statements to be covered by the safe
harbor provisions for forward-looking statements contained in the Private
Securities Litigation Reform Act of 1995, and we are including this statement
for purposes of complying with these safe harbor provisions. 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" or the negative of such terms or other comparable
terminology. These statements involve known and unknown risks, uncertainties and
other factors that may cause our or our industry's actual results, levels of
activity, performance or achievements to be materially different from any future
results, levels of activity, performance or achievements expressed or implied by
such forward-looking statements. These factors include, among other things,
those listed under "Risk Factors" below and elsewhere in this report.

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.

OVERVIEW

We design and market broadband communications equipment that enables
telephone companies and other communications service providers to
cost-effectively deliver a full suite of voice, data and video services over the
existing copper wire telephone infrastructure. We commenced operations in July
1994 and recorded our first sale in September 1997. From January 1998 until
November 1999, we operated through Next Level Communications L.P., which was
formed in connection with the transfer of all of the net assets, management and
workforce of a wholly-owned subsidiary of General Instrument. In November 1999,
the business and assets of that partnership were merged into Next Level
Communications, Inc. as part of our recapitalization. In January 2000, General
Instrument was acquired by Motorola, Inc., making us an indirect subsidiary of
Motorola.

We generate our revenues primarily from sales of our equipment. A small
number of customers have accounted for a large part of our revenues to date, and
we expect this concentration to continue in the future. Qwest, formerly U S
WEST, accounted for 41%, 56% and 67% of our total revenues in 2001, 2000 and
1999. Our agreements with our largest customers do not obligate the customers to
purchase any products. In addition, our significant customer agreements
generally contain fixed-price provisions. As a result, our ability to generate a
profit on these contracts depends upon our ability to produce and market our
products at costs lower than these fixed prices.

The timing of our revenues is difficult to predict because of the length
and variability of the sales cycle for our products. Customers view the purchase
of our products as a significant and strategic decision. As a result, customers
typically undertake significant evaluation, testing and trial of our products
before deploying them. This evaluation process frequently results in a lengthy
sales cycle, typically ranging from nine months to more than a year. While our
customers are evaluating our products and before they place an order, if at all,
we may incur substantial sales and marketing expenses and expend significant
management efforts.

RESULTS OF OPERATIONS

Revenues. Total revenues in 2001 decreased to $93.2 million from $150.1
million in 2000. The decrease was primarily due to a decrease in equipment sales
to Qwest. An equipment revenue analysis by channel is detailed in the following
chart. Our equipment revenue is analyzed using three channels: independent
operating companies (IOC), major carriers which currently include Qwest and
other North American regional bell operating companies (MAJOR CARRIERS) and
other customers which include, among others, multiple service organizations and
international customers (OTHER).

14

Sales to Qwest were significantly reduced in 2001 due to an overall
reduction in capital spending by Qwest. Additionally, Qwest has slowed its
purchases of our equipment while it re-evaluates its plans regarding the
deployment of VDSL across its network. The re-evaluation by Qwest is continuing,
and sales to Qwest in the future are dependent upon its decision regarding the
deployment of our products. Sales to IOCs and our other customers decreased in
2001 due to a general slowdown in the telecommunications industry and the
resulting reduction of our customers' capital expenditures.

We expect to continue to derive substantially all of our revenues from
sales of equipment to regional bell operating companies and local, foreign and
independent telephone companies for the foreseeable future. Revenue levels in
future quarters will depend significantly upon Qwest's future decisions and
general economic conditions, as well as whether and how quickly our existing
customers roll out broadband services in their coverage areas and whether and
how quickly we obtain new customers.

Cost of Revenues. Total cost of revenues increased to $158.0 million in
2001 from $125.2 million in 2000. The increase in our cost of revenues in 2001
was primarily attributable to inventory charges taken in the year totaling $76.8
million related to excess inventory, obsolescence and lower of cost or market
adjustments. Included in 2001 and 2000 cost of revenues are inventory charges
totaling $76.8 million and $9.0 million. Excluding the inventory charges, cost
of revenues were $81.2 million and $116.2 million in 2001 and 2000. The 2001
decrease was primarily due to lower sales of equipment.

To meet forecasted demand and reduce the anticipated component supply
constraints that had existed in the past, in late 2000 we increased inventory
levels for certain components and entered into purchase commitments for certain
components with long lead times. However, in the quarter ended June 30, 2001,
our estimates of forecasted sales in 2001 and 2002 for our current generation of
products declined significantly. As a result, inventory related charges were
required and were calculated based upon (i) the substantial completion of the
negotiation process with our contract manufacturers and their suppliers and our
other vendors regarding purchase commitments and cancellations made by us, (ii)
the inventory levels in excess of forecasted demand and (iii) our estimates of
salvage or recovery value for each raw material or finished good on an item by
item basis. We do not currently anticipate that the excess inventory included in
this provision will be used based on our current demand forecast. At December
31, 2001, we updated our estimates and recorded an additional inventory charge.
These write-downs were included in cost of revenues in 2001 and consisted of the
following:

Significant estimates included in the calculation of the inventory
write-downs above include forecasted demand for our products, sales prices for
residential gateways and other finished goods and estimated salvage

15

or recovery value for excess raw materials and finished goods. Actual results
could differ from those estimates, and therefore additional inventory
write-downs may be necessary in future periods.

During 2000, we recorded a $9.0 million inventory write-down primarily
related to a lower of cost or market adjustment to certain residential gateway
products and other obsolescence provisions.

Excluding the inventory charges in both 2001 and 2000, our gross margin
percentage decreased to 13% in 2001 from 23% in 2000. The decline in our gross
margin percentage was primarily related to spreading the manufacturing overhead
elements of product cost over reduced sales volumes. In the future, gross margin
percentage may fluctuate due to a wide variety of factors, including customer
mix, product mix, the timing and size of orders which are received, the
availability of adequate supplies of key components and assemblies, our ability
to introduce new products and technologies on a timely basis, the timing of new
product introductions or announcements by us or our competitors, price
competition and unit volume. Our overhead reductions and the improved product
cost attributes of our new standards compliant product platform are intended to
improve the gross margin percentage in future periods.

Research and development. Research and development expenses decreased to
$46.9 million in 2001 from $55.8 million in 2000. The decrease in the research
and development expenses was primarily due to cost cutting measures, including a
reduction in research and development personnel, implemented in the current
year.

Selling, general and administrative. Selling, general and administrative
expenses increased to $53.3 million in 2001 from $46.9 million 2000. The
increase was attributable to increased goodwill amortization arising from the
purchase of SoftProse in July 2000 and higher recruiting and relocation expenses
in the first half of the year. We reduced our workforce in October 2001 and
January 2002 by approximately 15% and 33%.

Non-cash compensation charge. Substantially all of our employees in 1999
were granted contingently exercisable stock options that became options to
purchase our common stock upon our recapitalization in 1999. In addition, tandem
stock options were granted in January 1997 to some of our employees. As a
result, non-cash compensation expense was recognized upon the completion of our
initial public offering based on the difference between the exercise price of
these options and the initial public offering price of our common stock. The
non-cash compensation expense related to these option grants in 2000 was $2.4
million. There was no such expense in 2001, and we do not expect any such
expenses to be material in the future.

Asset impairments and disposals, net. Asset impairments and disposals in
2001 consisted of (i) the write-off of goodwill related to SoftProse of $8.4
million, (ii) loss on disposal of property, plant and equipment and other assets
of $2.6 million and (iii) the gain on sale of our software product line of $2.6
million (see Note 5 to the consolidated financial statements).

Interest income (expense), net. Interest expense was $14.5 million in
2001. Interest income was $5.6 million in 2000. Interest expense in 2001
included non-cash interest expense of $10.4 million related to our loan
agreement with Motorola. Interest income in 2000 related primarily to interest
earned on our initial public offering proceeds.

Other income (expense), net. Other expense in 2001 was $20.8 million, and
was primarily related to the write-down of certain long-term investments in
Virtual Access of $13.0 million, $4.0 million in Outreach Communications and
$3.0 million in Expanse Networks, Inc.

COMPARISON OF 2000 TO 1999

Revenues. Total revenues in 2000 increased to $150.1 million from $57.6
million in 1999. The increase was primarily due to an increase in equipment
sales. Total revenues for the period included $146.3 million of equipment sales,
compared to $54.3 million in 1999. Qwest accounted for $83.4 million of
equipment revenue in 2000 as compared to $38.5 million in 1999. This increase
was primarily attributable to Qwest's increased deployment in the first three
quarters of 2000.

Cost of Revenues. Total cost of revenues increased to $125.2 million in
2000 from $51.6 million in 1999. Included in 2000 cost of sales was a $9.0
million charge to inventory that was primarily related to a lower of
16

cost or market adjustment to certain residential gateway products due to
decreases in our sales price per unit and other obsolescence reserves. Our gross
margin percentage, including the inventory charge, increased to 17% in 2000 from
10% in 1999. Excluding the inventory charge, the gross margin percentage
increased to 23% in 2000 from 10% in 1999. The increase in the gross margin
percentage was primarily the result of higher unit volumes, leading to greater
efficiencies, including lower fixed costs per unit.

Research and development. Research and development expenses increased to
$55.8 million in 2000 from $48.5 million in 1999. The increase was primarily due
to an increase in research and development personnel.

Selling, general and administrative. Selling, general and administrative
expenses increased to $46.9 million in 2000 from $30.5 million in 1999. The
increase was primarily attributable to the increase in the scale of our
operations including additional personnel in our operations, administration,
sales and marketing organizations, promotional expenses and other administrative
expenses. We generated higher sales expenses through the hiring of new sales
representatives in our efforts to increase the number and size of our customer
accounts.

Non-cash compensation charge. Substantially all of our employees had been
granted contingently exercisable stock options that became options to purchase
our common stock upon our recapitalization in 1999. In addition, tandem stock
options were granted in January 1997 to some of our employees. As a result,
non-cash compensation expense was recognized upon the completion of our initial
public offering based on the difference between the exercise price of these
options and the initial public offering price of our common stock. The non-cash
compensation expense related to these option grants was $2.4 million in 2000 and
$128.3 million in 1999.

Interest income (expense), net. Interest income in 2000 was $5.6 million,
and represents interest income earned on proceeds from our initial public
offering. In 1999, interest expense was $3.6 million, and related to interest on
a $75.0 million note and accrued interest thereon payable to General Instrument
that General Instrument contributed to us in exchange for shares of our common
stock immediately prior to our initial public offering.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operating activities was $127.8 million in 2001, $103.3
million in 2000 and $56.6 million in 1999. In 2001, the use of cash in operating
activities was primarily due to our net losses of $208.6 million, less non-cash
charges of approximately $136.0 million, and an increase in inventory net
purchases of $42.7 million and a reduction in accounts payable of $25.1 million,
partially off-set by a reduction in accounts receivable of $17.0 million. During
2000, the cash used in operating activities was primarily due to net losses of
$74.8 million, and an increase in inventory and receivables of $73.2 million and
$20.6 million, partially off-set by an increase in liabilities of $40.1 million.
In 1999, net loss of $205.1 million included $128.3 million in non-cash
compensation charges.

Net cash provided by investing activities was $17.8 million in 2001. Net
cash used by investing activities was $12.5 million in 2000 and $78.7 million in
1999. The 2001 amount was primarily attributable to the sale of marketable
securities, partially off-set by capital expenditures made to support our
engineering and testing activities as well as an additional $8.0 million
investment in Virtual Access. In 2001, we also received $4.9 million for the
sale of our software product line. In 2000, net cash used in investing
activities also included investments in Expanse Networks, Inc., OutReach
Communications L.L.C. and Virtual Access totaling approximately $15.0 million,
off-set by the sale of $18.0 million in marketable securities. Net cash used in
1999 also included purchases of $45.1 million of marketable securities with the
proceeds from our initial public offering.

Net cash provided by financing activities was $94.7 million in 2001, $22.9
million in 2000 and $235.0 million in 1999. The 2001 amount is primarily related
to borrowings of $83.0 million from Motorola, mortgage proceeds of $20.0 million
and $14.3 million in proceeds related to our Tax Sharing Agreement with
Motorola. The 2001 amount was partially off-set by the repayment of a $25.0
million note. The 2000 amount was primarily related to $15.0 million in proceeds
related to the Tax Sharing Agreement with Motorola and

17

$9.3 million related to the issuance of common stock in connection with the
exercise of stock options. Net cash provided by financing activities in 1999
included $177.0 million net proceeds from our initial public offering, $34.0
million contributed by General Instrument (acquired by Motorola, Inc. in January
2000) and borrowings of $24.9 million.

Motorola Loan Commitment -- During 2001 we entered into a note agreement
with Motorola for $83.0 million which matures on May 17, 2003. Interest is
payable monthly and is determined on either the base rate, as defined in the
agreement, plus 2% or the Eurodollar rate plus 3 1/2% (5.4% at December 31,
2001).

In connection with the note agreement we granted warrants to purchase up to
10,000,000 shares of our common stock; 7,500,000 warrants have an exercise price
of $7.39 per share and 2,500,000 warrants have an exercise price of $4.29 per
share. Warrants to purchase 7,000,000 shares of our common stock were
exercisable at December 31, 2001. The remaining warrants become exercisable as
follows:

- 1,000,000 shares become exercisable unless, prior to May 17, 2002, all
borrowings under the note agreement have been repaid in full, and it has
been terminated;

- 1,000,000 shares become exercisable unless, prior to November 17, 2002
all borrowings under the note agreement have been repaid in full, and it
has been terminated; and

- 1,000,000 shares become exercisable unless, prior to February 17, 2003,
all borrowings under the note agreement have been repaid in full, and it
has been terminated.

We do not expect to repay amounts due under the agreement until its
maturity date of May 17, 2003. As a result, the debt discount related to the
estimated fair value of the remaining 3,000,000 warrants will be adjusted in
subsequent periods, up to their respective measurement dates, to reflect changes
in our stock price.

The fair value of the warrants of $37.4 million was recorded as a discount
to the note payable with a corresponding increase to additional paid-in capital.
The fair value of the warrants was estimated using the Black-Scholes option
pricing model with the following assumptions: no dividends; risk free interest
rate that ranged from 4.3% to 4.9%; volatility of 101%; and a contractual life
of five years. As of December 31, 2001, no shares of common stock had been
purchased under the warrants.

We are amortizing the discount under the effective interest method up to
the maturity date (May 17, 2003) of the related note. During the year ended
December 31, 2001 we amortized $10.4 million of the discount, which has been
reflected as interest expense in our statement of operations. As of December 31,
2001, the Motorola note was recorded at $56.0 million, net of $27.0 million of
unamortized discount.

The note agreement with Motorola contains various covenants, including
compliance with net worth requirements, and restrictions on additional
indebtedness, capital expenditures, and payment of dividends. As of December 31,
2001, we were not in compliance with the net worth financial covenant. On March
22, 2002, we and Motorola amended the note agreement to waive the debt covenant
violation and established revised financial covenants for net worth.

Tax sharing and allocation agreement with Motorola -- In December 2000, we
received a $15.0 million advance from Motorola related to a tax sharing and
allocation agreement (the "Tax Sharing Agreement"). During 2001 we received an
additional $17.3 million in January 2001, and the Tax Sharing Agreement was
finalized in February 2001. The amount advanced to us of $32.3 million was based
on an estimate of the present value of income tax benefits to Motorola from the
inclusion of our operating losses for the period from January 6, 2000 to May 17,
2000 in Motorola's consolidated tax return. On October 10, 2001, we received a
revised calculation of the estimated present value of income tax benefits to
Motorola based upon actual net losses that were included in Motorola's 2000 tax
return. The revised amount was $29.3 million. Under the original agreement, we
were required to repay the $3.0 million difference by October 15, 2001. On
October 15, 2001, the Loan Agreement between us and Motorola was amended to
include such $3.0 million (see above). To the extent Motorola does not achieve
the expected tax benefits by September 30, 2006, we must repay any difference.

18

In the event of a debt or equity security offering or a sale of assets in
excess of $25.0 million, the first $25.0 million of proceeds may be retained by
us; the next $25.0 million (between $25.0 million and $50.0 million) of such
proceeds will be allocated at least one-third to repay our obligations under the
Tax Sharing Agreement, and the balance may be retained by us; the next $25.0
million of such proceeds (between $50.0 million and $75.0 million) will be
allocated at least one-half to repay our obligations under the Tax Sharing
Agreement and the balance may be retained by us; amounts of such proceeds in
excess of $75.0 million must be used 100% first to repay our obligations under
the Tax Sharing Agreement (to the extent of such obligations) and then to repay
and reduce the amount owed under the note agreement.

Mortgage Financing -- On October 30, 2001, we received $20.0 million under
a mortgage loan for a company-owned office building. The loan is amortized over
a 12-year period with a ten-year term and bears interest at an annual fixed rate
of 7.51%. The entire unpaid principal balance, plus accrued interest thereon is
due and payable on November 1, 2011.

The mortgage was guaranteed by Motorola. In consideration for the
guarantee, we issued to Motorola warrants to purchase up to 400,000 shares of
common stock with an exercise price of $3.82 per share. Accordingly, the
warrants were recorded at the fair value of $0.7 million, with a discount to the
mortgage loan note payable and a corresponding increase to additional paid-in
capital. The fair value of the warrants was estimated using the Black-Scholes
option pricing model with the following assumptions: no dividends; risk free
interest rate that ranged from 4.3% to 4.9%; volatility of 101%; and a
contractual life of five years.

Vendor Note Payable -- At December 31, 2001, we had a $24.3 million note
payable to a vendor. The note bears interest at 10% per year. Accrued interest
at December 31, 2001 was $1.5 million. On March 28, 2002, the Vendor Note
Payable was amended. The revised principal and interest payment terms are as
follows: $5.0 million on March 29, 2002, $13.0 million on May 18, 2002 and the
balance of $9.5 million on March 31, 2003. Such amended due dates have been
considered in the table below.

Contractual Obligations -- The following table depicts our contractual
obligations as of December 31, 2001:

2001 RESULTS AND MANAGEMENT'S PLANS FOR 2002

In 2001, net loss was $208.6 million and net cash used in operating
activities was $127.8 million. As of December 31, 2001, our accumulated deficit
was $488.5 million. Our ability to generate operating income and positive
operating cash flows is dependent on our ability to increase sales, convert our
inventory and accounts receivable to cash, negotiate favorable terms with our
vendors, effectively manage our operating costs and to continue to raise
sufficient operating capital.

Since late 2000, we have been significantly dependent on Motorola for
financial resources. Advances from Motorola totaled $15.0 million in 2000 and
loans and advances totaled $97.3 million in 2001. In addition, on February 20,
2002, we issued $30.0 million of redeemable convertible preferred stock
("preferred stock") to

19

Motorola comprised of 6,912,442 shares at a purchase price of $4.34 per share.
Each share of preferred stock is convertible, at the option of the holder, into
two shares of our common stock, or 13,824,884 shares in total. The preferred
stock is redeemable, at the option of the holder, at an initial redemption price
of $5.21 per share, on or after February 19, 2007. Dividends are cumulative at a
rate of 7.5%, payable in cash or additional shares of preferred stock, at our
option. Liquidation value is $10.85 per share. In conjunction with this
financing, we issued to Motorola warrants to purchase 3,456,221 shares of common
stock at an exercise price of $2.17 per share and warrants to purchase 3,456,221
shares of common stock at an exercise price of $2.60 per share. The warrants
have a term of five years.

During 2001, in addition to the Motorola financing described above, we
instituted the following measures to improve liquidity:

- Closed our operation in Vietnam eliminating 84 employees in April, 2001;

- reduced our workforce by approximately 36 employees in April, 2001;

- received $20.0 million in October 2001 through the mortgage of our
largest office building;

- sold our software product line in October 2001 and received $4.9 million
in net proceeds;

- reduced our workforce by approximately 60 employees, or 15% in October
2001;

- reduced our commitments to purchase raw materials from vendors from
approximately $78.0 million in the second quarter of 2001 to
approximately $19.1 million as of December 31, 2001, primarily due to
inventory purchases, along with vendor negotiations; and

- extended payments terms for $24.3 million of vendor payables (see Note 10
to the consolidated financial statements).

In 2002, in addition to the issuance of $30.0 million of preferred stock to
Motorola:

- we reduced our workforce by approximately 120 employees or 33% in January
2002; and

- on March 29, 2002, Motorola agreed to make available to us an additional
$35.0 million in financing (see Note 16 to the consolidated financial
statements).

At March 29, 2002, we had cash and cash equivalents of $26.0 million.
Management believes that the cash on hand and amounts available under the March
29, 2002 $35.0 million financing with Motorola will be sufficient to enable us
to meet our financial obligations and sustain our operations through at least
December 31, 2002.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in conformity with accounting principles generally accepted in the
United States of America. Our preparation of these consolidated financial
statements requires us to make judgments and estimates that affect the reported
amounts of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. We base our estimates on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances. Actual results may differ from such
estimates under different assumptions or conditions. The following summarizes
our critical accounting policies and significant estimates used in preparing our
consolidated financial statements:

Revenue -- We recognize revenue when contractual obligations have been
satisfied, title and risk of loss have been transferred to the customer and
collection of the resulting receivable is reasonably assured. Generally, we
recognize revenue from equipment sales upon shipment. In cases where title and
risk of loss pass upon delivery, we recognize revenue from equipment sales upon
receipt by the customer. We accrue a provision for estimated sales returns as a
reduction of revenue at the time of revenue recognition.

20

Inventory impairment and loss on purchase commitments -- During 2001, we
recorded a write-down of inventory excess and obsolete quantities and lower of
cost or market adjustments related to our current generation product platform
and related communications equipment totaling $76.8 million. Inventory related
charges were calculated based upon (i) the substantial completion of the
negotiation process with our contract manufacturers and their suppliers and our
other vendors regarding purchase commitments and cancellations made by us, (ii)
the inventory levels in excess of forecasted demand and (iii) our estimates of
salvage or recovery value for each raw material or finished good on an item by
item basis. Significant estimates included in the calculation of the inventory
write-downs above include forecasted demand for our products, sales prices for
residential gateways and other finished goods and estimated salvage or recovery
value for excess raw materials and finished goods. Actual results could differ
from those estimates, and therefore additional inventory write-downs may be
necessary in future periods.

Impairment of long-term assets -- We periodically evaluate the
recoverability of our long-term assets, and recognize an impairment loss when
changes in circumstance indicate that the carrying amount of that asset may not
be recoverable. When the sum of the undiscounted future net cash flows to result
from the use of the asset and its eventual disposition is less than the carrying
amount, an impairment loss would be recorded to reduce the carrying amount to
fair value. During 2001, we recorded impairment losses of $31.0 million.
Included within our impairment losses are write-downs of certain long term
investments, acquired goodwill and certain other long-term assets. Significant
estimates included in the calculation of the impairment loss are estimates of
the future operating cash flows and the ultimate sales price of the underlying
assets, if any.

Accrued Warranty Reserves -- We accrue the estimated cost of product
warranties at the time revenues are recognized. While we engage in extensive
product quality programs and processes, including actively monitoring and
evaluating the quality of our contract manufacturers, our warranty obligation is
affected by actual warranty costs including, material usage and service delivery
costs incurred in correcting a product failure. If actual product failure rates,
material usage or service delivery costs differ from our estimates, revisions to
the estimated warranty liability would be required.

Employee stock-based compensation -- We account for employee stock-based
compensation under Accounting Principles Board Opinion No. 25. If we were to
account for this compensation under Statement of Financial Accounting Standards
No. 123, results would have changed as described in Note 12 to our consolidated
financial statements.

NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations" and
Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and
Other Intangible Assets." SFAS 141 requires that all business combinations
initiated after June 30, 2001 be accounted for under the purchase method and
addresses the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination. SFAS 142 provides that
intangible assets with finite useful lives be amortized and that goodwill and
intangible assets with indefinite lives will not be amortized, but will rather
be tested at least annually for impairment. We adopted SFAS 142 as of January 1,
2002, as required. Upon the adoption of SFAS 142, we will no longer amortize
goodwill of $0.2 million at December 31, 2001. We do not expect that the
adoption of SFAS No. 142 will have a significant effect on our consolidated
financial statements.

In October 2001, the Financial Accounting Standards Board issued SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS 144
supersedes SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of," and the accounting and reporting
provisions of APB No. 30, "Reporting the Results of Operations -- Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions," and addresses financial
accounting and reporting for the impairment of disposal of long-lived assets. We
adopted SFAS 144 on January 1, 2002. We do not expect that the adoption of SFAS
144 will have a material impact on our consolidated financial statements.

21

RISK FACTORS

You should carefully consider the risk factors set forth below.

WE HAVE INCURRED NET LOSSES AND NEGATIVE CASH FLOW FOR OUR ENTIRE HISTORY, WE
EXPECT TO INCUR FUTURE LOSSES AND NEGATIVE CASH FLOW, AND WE HAVE BEEN
FINANCIALLY DEPENDENT ON MOTOROLA.

We incurred net losses of $208.6 million in 2001. Our ability to achieve
positive operating cashflow and ultimate profitability will depend on the
successful design, development, testing, introduction, marketing and broad
commercial distribution of our broadband equipment products. Since late 2000, we
have been significantly dependent on Motorola for financial resources. Loans
from Motorola totaled $15.0 million in 2000 and $97.3 million in 2001. We also
issued $30.0 million in redeemable convertible preferred stock to Motorola in
February 2002, and entered into a $35.0 million financing agreement with
Motorola in March, 2002.

We expect to incur significant product development, sales and marketing,
and administrative expenses. In addition, we depend in part on cost reductions
to improve gross profit margins because the fixed-price nature of most of our
long-term customer agreements prevents us from increasing prices. As a result,
we will need to generate significant revenues and improve gross profit margins
to achieve and maintain profitability. We may not be successful in reducing our
costs or in selling our products in sufficient volumes to realize cost benefits
from our manufacturers. We cannot be certain that we can achieve sufficient
revenues or gross profit margin improvements to generate profitability.

OUR CUSTOMER BASE OF TELEPHONE COMPANIES IS EXTREMELY CONCENTRATED AND THE
LOSS OF OR REDUCTION IN BUSINESS FROM EVEN ONE OF OUR CUSTOMERS, PARTICULARLY
QWEST, COULD CAUSE OUR SALES TO FALL SIGNIFICANTLY.

A small number of customers have accounted for a large part of our revenues
to date. We expect this concentration to continue in the future. If we lose one
of our significant customers, our revenues could be significantly reduced. Qwest
accounted for 41%, 56% and 67% of total revenues in 2001, 2000 and 1999. Our
agreements with our customers are cancelable by these customers on short notice,
without penalty, do not obligate the customers to purchase any products and are
not exclusive. As a result of the merger between U S WEST and Qwest, Qwest
slowed its purchases of our equipment while it re-evaluates its plans regarding
the deployment of VDSL across its network. Sales to Qwest in the future are
dependent upon their decision regarding the deployment of our product. Any
continued significant reduction in purchases of our equipment by Qwest could
have a material adverse effect on us.

A SIGNIFICANT MARKET FOR OUR PRODUCTS MAY NOT DEVELOP IF TELEPHONE COMPANIES
DO NOT SUCCESSFULLY DEPLOY BROADBAND SERVICES SUCH AS HIGH-SPEED DATA AND
VIDEO; RECENT RELUCTANCE OF TELEPHONE COMPANIES TO MAKE SIGNIFICANT CAPITAL
EXPENDITURES MAY HEIGHTEN THIS ISSUE.

Telephone companies have recently begun offering high-speed data services,
and most telephone companies have not offered video services at all. Unless
telephone companies make the strategic decision to enter the market for
providing broadband services, a significant market for our products may not
develop. Sales of our products largely depend on the increased use and
widespread adoption of broadband services and the ability of our customers to
market and sell broadband services, including video services, to their
customers. Certain critical issues concerning use of broadband services are
unresolved and will likely affect their use. These issues include security,
reliability, speed and volume, cost, government regulation and the ability to
operate with existing and new equipment. In addition, telephone companies have
recently been reluctant to make significant capital expenditures.

Even if telephone companies decide to deploy broadband services, this
deployment may not be successful. Our customers have delayed deployments in the
past and may delay deployments in the future. Factors that could cause telephone
companies not to deploy, to delay deployment of, or to fail to deploy
successfully the services for which our products are designed include the
following:

- industry consolidation;

- regulatory uncertainties and delays affecting telephone companies;
22

- varying quality of telephone companies' network infrastructure and cost
of infrastructure upgrades and maintenance;

- inexperience of telephone companies in obtaining access to video
programming content from third-party providers;

- inexperience of telephone companies in providing broadband services and
the lack of sufficient technical expertise and personnel to install
products and implement services effectively;

- uncertain subscriber demand for broadband services; and

- inability of telephone companies to predict return on their investment in
broadband capable infrastructure and equipment.

Unless our products are successfully deployed and marketed by telephone
companies, we will not be able to achieve our business objectives and increase
our revenues.

OUR LIMITED OPERATING HISTORY MAKES IT DIFFICULT FOR YOU TO EVALUATE OUR
BUSINESS AND PROSPECTS.

We recorded our first sale in September 1997. As a result, we have only a
limited operating history upon which you may evaluate our business and
prospects. You should consider our prospects in light of the heightened risks
and unexpected expenses and difficulties frequently encountered by companies in
an early stage of development. These risks, expenses and difficulties, which are
described further below, apply particularly to us because the market for
equipment for delivering voice, data and video services is new and rapidly
evolving. Due to our limited operating history, it will be difficult for you to
evaluate whether we will successfully address these risks.

WE EXPECT OUR QUARTERLY REVENUES AND OPERATING RESULTS TO FLUCTUATE, AND THESE
FLUCTUATIONS MAY MAKE OUR STOCK PRICE VOLATILE.

Our quarterly revenues and operating results have fluctuated in the past
and are likely to fluctuate significantly in the future. As a result, we believe
that quarter-to-quarter comparisons of our operating results may not be
meaningful. Fluctuations in our quarterly revenues or operating results may
cause volatility in the price of our stock. It is likely that in some future
quarter our operating results may be below the expectations of public market
analysts and investors, which may cause the price of our stock to fall. Factors
likely to cause variations in our quarterly revenues and operating results
include:

- delays or cancellations of any orders by Qwest, which accounted for
approximately 41% of our revenues in 2001, or by any other customer
accounting for a significant portion of our revenues;

- variations in the timing, mix and size of orders and shipments of our
products throughout a quarter or year;

- new product introductions by us or by our competitors;

- the timing of upgrades of telephone companies' infrastructure;

- variations in capital spending budgets of telephone companies; and

- increased expenses, whether related to sales and marketing, product
development or administration.

The amount and timing of our operating expenses generally will vary from
quarter to quarter depending on the level of actual and anticipated business
activity. Because most of our operating expenses are fixed in the short term, we
may not be able to quickly reduce spending if our revenues are lower than we had
projected and our results of operations could be harmed.

CONSOLIDATION AMONG TELEPHONE COMPANIES MAY REDUCE OUR SALES.

Consolidation in the telecommunications industry may cause delays in the
purchase of our products and cause a reexamination of strategic and purchasing
decisions by our customers. In addition, we may lose

23

relationships with key personnel within a customer's organization due to budget
cuts, layoffs, or other disruptions following a consolidation. For example, our
sales to NYNEX, previously one of our largest clients, have decreased
significantly as a result of a shift in focus resulting from its merger with
Bell Atlantic. In addition, as a result of the merger between U S WEST and
Qwest, Qwest has slowed its purchases of our equipment while it re-evaluates its
plans regarding deployment of VDSL across its network.

BECAUSE OUR SALES CYCLE IS LENGTHY AND VARIABLE, THE TIMING OF OUR REVENUE IS
DIFFICULT TO PREDICT, AND WE MAY INCUR SALES AND MARKETING EXPENSES WITH NO
GUARANTEE OF A FUTURE SALE.

Customers view the purchase of our products as a significant and strategic
decision. As a result, customers typically undertake significant evaluation,
testing and trial of our products before deployment. This evaluation process
frequently results in a lengthy sales cycle, typically ranging from nine months
to more than a year. Before a customer places an order, we may incur substantial
sales and marketing expenses and expend significant management efforts. In
addition, product purchases are frequently subject to unexpected administrative,
processing and other delays on the part of our customers. This is particularly
true for customers for whom our products represent a very small percentage of
their overall purchasing activities. As a result, sales forecasted to be made to
a specific customer for a particular quarter may not be realized in that
quarter; and this could result in lower than expected revenues.

WE INCURRED SIGNIFICANT WRITE-DOWNS OF OUR INVENTORY IN THE YEAR ENDED
DECEMBER 31, 2001 BASED ON ESTIMATES WHICH MAY VARY FROM ACTUAL RESULTS;
THEREFORE, ADDITIONAL INVENTORY WRITE-DOWNS MAY BE NECESSARY IN FUTURE
PERIODS.

In the quarter ended June 30, 2001, we recorded an inventory write-down
(including purchase commitments) related to our current generation product
platform and related communications equipment totaling $72.0 million. In the
quarter ended December 31, 2001, we recorded an additional inventory write-down
of $4.8 million. To meet forecasted demand and reduce the anticipated component
supply constraints that had existed in the past, we had increased inventory
levels for certain components and had entered into purchase commitments for
certain components with long lead times. In the quarter ended June 30, 2001, our
estimates of forecasted sales in 2001 and 2002, for our current generation of
products declined significantly. As a result, the inventory charges were
calculated based on:

- the substantial completion of the negotiation process with our contract
manufacturers and their suppliers and our other vendors regarding
purchase commitments and cancellations made by us;

- the inventory levels in excess of forecasted demand through June 30,
2003; and

- our estimates of salvage or recovery value for each raw material of
finished good on an item by item basis.

We do not currently anticipate that the excess inventory included in this
provision will be used after June 30, 2003 based on our current demand forecast.
Significant estimates included in the calculation of the inventory write-downs
include forecasted demand for our products, sales prices for residential
gateways and other finished goods and estimated salvage or recovery value for
excess raw materials and finished goods. Actual results could differ from those
estimates, and therefore additional inventory write-downs may be necessary in
future periods.

GOVERNMENT REGULATION OF OUR CUSTOMERS AND RELATED UNCERTAINTY COULD CAUSE OUR
CUSTOMERS TO DELAY THE PURCHASE OF OUR PRODUCTS.

The Telecommunications Act requires telephone companies, such as the
regional Bell operating companies, to offer their competitors cost-based access
to some elements of their networks, including facilities and equipment used to
provide high-speed data and video services. These telephone companies may not
wish to make expenditures for infrastructure and equipment required to provide
broadband services if they will be forced to allow competitors access to this
infrastructure and equipment. The Federal Communications Commission announced
that, except in limited circumstances, it will not require incumbent carriers to
offer

24

their competitors access to the facilities and equipment used to provide
high-speed data services. Nevertheless, other regulatory and judicial
proceedings relating to telephone companies' obligations to provide elements of
their network to competitors are pending. The FCC also requires incumbent
carriers to permit competitive carriers to collocate their equipment with the
local switching equipment of the incumbents. The FCC's collocation rules
recently have been vacated in part and continue to be subject to regulatory and
judicial proceedings. Recently, the FCC issued a ruling that classified cable
modem service as an interstate information service that is subject to FCC
jurisdiction but not subject to common carrier regulation. As a result, such
services are not currently regulated by the FCC and should not be subject to
separate state and local regulation. This ruling may improve the competitive
position of cable providers who compete with our customers who provide
wireline-based broadband services. There is currently a pending rulemaking
proceeding in which the FCC proposes to classify broadband Internet access
services provided by wireline-based telephone companies as interstate
information services. We cannot predict when or how this rulemaking will be
decided. The uncertainties caused by these regulatory proceedings may cause
these telephone companies to delay purchasing decisions at least until the
proceedings and any related judicial appeals are completed. The outcomes of
these regulatory proceedings, as well as other FCC regulation, may cause these
telephone companies not to deploy services for which our products are designed
or to further delay deployment. Additionally, telephone companies' deployment of
broadband services may be slowed down or stopped because of the need for
telephone companies to obtain permits from city, state or federal authorities to
implement infrastructure.

OUR CUSTOMERS AND POTENTIAL CUSTOMERS WILL NOT PURCHASE OUR PRODUCTS IF THEY
DO NOT HAVE THE INFRASTRUCTURE NECESSARY TO USE OUR PRODUCTS.

The copper wire infrastructures over which telephone companies may deliver
voice, data and video services using our products vary in quality and
reliability. As a result, some of these telephone companies may not be able to
deliver a full set of voice, data and video services to their customers, despite
their intention to do so, and this could harm our sales. Even after installation
of our products, we remain highly dependent on telephone companies to continue
to maintain their infrastructure so that our products will operate at a
consistently high performance level. Infrastructure upgrades and maintenance may
be costly, and telephone companies may not have the necessary financial
resources. This may be particularly true for our smaller customers and potential
customers such as independent telephone companies and domestic local telephone
companies. If our current and potential customers' infrastructure is inadequate,
we may not be able to generate anticipated revenues from them.

IF COMPETING TECHNOLOGIES THAT OFFER ALTERNATIVE SOLUTIONS TO OUR PRODUCTS
ACHIEVE WIDESPREAD ACCEPTANCE, THE DEMAND FOR OUR PRODUCTS MAY NOT DEVELOP.

Technologies that compete with our products include other
telecommunications-related wireline technologies, cable-based technologies,
fixed wireless technologies and satellite technologies. If these alternative
technologies are chosen by our existing and potential customers, our business,
financial condition and results of operations could be harmed. In particular,
cable operators are currently deploying products that will be capable of
delivering voice, high-speed data and video services over cable, including
products from General Instrument, our principal stockholder, and Motorola, its
parent. Our technology may not be able to compete effectively against these
technologies on price, performance or reliability.

Our customers or potential customers that also offer cable-based services
may choose to purchase cable-based technologies. Cable service providers that
offer not only data and video but also telephony over cable systems will give
subscribers the alternative of purchasing all communications services from a
single communications service provider, allowing the potential for more
favorable pricing and a single point of contact for bill payment and customer
service. If these services are implemented successfully over cable connections,
they will compete directly with the services offered by telephone companies
using our products. In addition, several telephone companies have commenced the
marketing of video services over direct broadcast satellite while continuing to
provide voice and data services over their existing copper wire

25

infrastructure. If any of these services are accepted by consumers, the demand
for our products may not develop and our ability to generate revenues will be
harmed.

WE FACE INTENSE COMPETITION IN PROVIDING EQUIPMENT FOR TELECOMMUNICATIONS
NETWORKS FROM LARGER AND MORE WELL-ESTABLISHED COMPANIES, AND WE MAY NOT BE
ABLE TO COMPETE EFFECTIVELY WITH THESE COMPANIES.

Many of our current and potential competitors have longer operating
histories, greater name recognition and significantly greater financial,
technical, marketing and distribution resources than we do. These competitors
may undertake more extensive marketing campaigns, adopt more aggressive pricing
policies and devote substantially more resources to developing new products than
we are able to, which could result in the loss of current customers and impair
our ability to attract potential customers.

Our significant current competitors include Advanced Fibre Communications,
Alcatel, Cisco Systems, Efficient Networks, Ericsson, Lucent Technologies,
Nokia, Nortel Networks, RELTEC (acquired by BAE Systems, CNI Division, formerly
GEC Marconi), Scientific Atlanta, Siemens and our largest stockholder, General
Instrument/Motorola, as well as emerging companies that are developing new
technologies. Some of these competitors have existing relationships with our
current and prospective customers. In addition, we anticipate that other large
companies, such as Matsushita Electric Industrial which markets products under
the Panasonic brand name, Microsoft, Network Computer, Philips, Sony,
STMicroelectronics and Toshiba America will likely introduce products that
compete with our N(3) Residential Gateway product in the future. Our customer
base may be attracted by the name and resources of these large, well-known
companies and may prefer to purchase products from them instead of us.

CONSOLIDATION OF OUR COMPETITORS MAY CAUSE US TO LOSE CUSTOMERS AND NEGATIVELY
AFFECT OUR SALES.

Consolidation in the telecommunications equipment industry may strengthen
our competitors' positions in our market, cause us to lose customers and hurt
our sales. For example, as a result of the merger between U S WEST and Qwest,
Qwest has slowed its purchases of our equipment while it re-evaluates its plans
regarding the deployment of VDSL across its network. In addition, Alcatel
acquired DSC Communications, Lucent acquired Ascend Communications and BAE
Systems, CNI Division, formerly GEC Marconi, acquired RELTEC. Acquisitions such
as these may strengthen our competitors' financial, technical and marketing
resources and provide them access to regional Bell operating companies and other
potential customers. Consolidation may also allow some of our competitors to
penetrate new markets that we have targeted, such as domestic local, independent
and international telephone companies. This consolidation may negatively affect
our ability to increase revenues.

IF WE DO NOT RESPOND QUICKLY TO CHANGING CUSTOMER NEEDS AND FREQUENT NEW
PRODUCT INTRODUCTIONS BY OUR COMPETITORS, OUR PRODUCTS MAY BECOME OBSOLETE.

Our position in existing markets or potential markets could be eroded
rapidly by product advances. The life cycles of our products are difficult to
estimate. Our growth and future financial performance will depend in part upon
our ability to enhance existing products and develop and introduce new products
that keep pace with:

- the increasing use of the Internet;

- the growth in remote access by telecommuters;

- the increasingly diverse distribution sources for high quality digital
video; and

- other industry and technological trends.

We expect that our product development efforts will continue to require
substantial investments. We may not have sufficient resources to make the
necessary investments. If we fail to timely and cost-effectively develop new
products that respond to new technologies and customer needs, the demand for our
products may fall and we could lose revenues.

26

OUR EXECUTIVE OFFICERS AND CERTAIN KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS
AND THE LOSS OF THEIR SERVICES COULD DISRUPT OUR OPERATIONS AND OUR CUSTOMER
RELATIONSHIPS.

Except for J. Michael Norris, our President and Chief Executive Officer,
none of our executive officers or key employees is bound by an employment
agreement. Many of these employees have a significant number of options to
purchase our common stock. Many of these options are currently vested and some
of our key employees may leave us once they have exercised their options. In
addition, our engineering and product development teams are critical in
developing our products and have developed important relationships with our
regional Bell operating company customers and their technical staffs. The loss
of any of these key personnel could harm our operations and customer
relationships.

OUR LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY MAY AFFECT OUR
ABILITY TO COMPETE, AND WE COULD LOSE CUSTOMERS.

We rely on a combination of patent, copyright and trademark laws, and on
trade secrets and confidentiality provisions and other contractual provisions to
protect our intellectual property. There is no guarantee that these safeguards
will protect our intellectual property and other valuable confidential
information. If our methods of protecting our intellectual property in the
United States or abroad are not adequate, our competitors may copy our
technology or independently develop similar technologies and we could lose
customers. In addition, the laws of some foreign countries do not protect our
proprietary rights as fully as do the laws of the United States. If we fail to
adequately protect our intellectual property, it would be easier for our
competitors to sell competing products, which could harm our business.

THIRD-PARTY CLAIMS REGARDING INTELLECTUAL PROPERTY MATTERS COULD CAUSE US TO
STOP SELLING OUR PRODUCTS, LICENSE ADDITIONAL TECHNOLOGY OR PAY MONETARY
DAMAGES.

From time to time, third parties, including our competitors and customers,
have asserted patent, copyright and other intellectual property rights to
technologies that are important to us. We expect that we will increasingly be
subject to infringement claims as the number of products and competitors in our
market grows and the functionality of products overlaps, and our products may
currently infringe on one or more United States or international patents. The
results of any litigation are inherently uncertain. In the event of an adverse
result in any litigation with third parties that could arise in the future, we
could be required:

- to pay substantial damages, including paying treble damages if we are
held to have willfully infringed;

- to halt the manufacture, use and sale of infringing products;

- to expend significant resources to develop non-infringing technology;
and/or

- to obtain licenses to the infringing technology.

Licenses may not be available from any third party that asserts
intellectual property claims against us, on commercially reasonable terms, or at
all. In addition, litigation frequently involves substantial expenditures and
can require significant management attention, even if we ultimately prevail. In
addition, we indemnify our customers for patent infringement claims, and we may
be required to obtain licenses on their behalf, which could subject us to
significant additional costs.

WE DEPEND ON THIRD-PARTY MANUFACTURERS AND ANY DISRUPTION IN THEIR MANUFACTURE
OF OUR PRODUCTS WOULD HARM OUR OPERATING RESULTS.

We contract for the manufacture of all of our products and have limited
in-house manufacturing capabilities. We rely primarily on two large contract
manufacturers: Sanmina-SCI Systems and Flextronics Enclosures. The efficient
operation of our business will depend, in large part, on our ability to have
Sanmina-SCI Systems, Flextronics Enclosures and other companies manufacture our
products in a timely manner, cost-effectively and in sufficient volumes while
maintaining consistent quality. As our business grows, Sanmina-SCI Systems,
Flextronics Enclosures and other contracted manufacturing companies may not have

27

the capacity to keep up with the increased demand. Any manufacturing disruption
could impair our ability to fulfill orders and could cause us to lose customers.

WE HAVE NO LONG-TERM CONTRACTS WITH OUR MANUFACTURERS, AND WE MAY NOT BE ABLE
TO DELIVER OUR PRODUCTS ON TIME IF ANY OF THESE MANUFACTURERS STOP MAKING OUR
PRODUCTS.

We have no long-term contracts or arrangements with any of our contract
manufacturers that guarantee product availability, the continuation of
particular payment terms or the extension of credit limits. If our manufacturers
are unable or unwilling to continue manufacturing our products in required
volumes, we will have to identify acceptable alternative manufacturers, which
could take in excess of three months. It is possible that a source may not be
available to us when needed or be in a position to satisfy our production
requirements at acceptable prices and on a timely basis. If we cannot find
alternative sources for the manufacture of our products, we will not be able to
meet existing demand. As a result, we may lose existing customers, and our
ability to gain new customers may be significantly constrained.

OUR INABILITY TO PRODUCE SUFFICIENT QUANTITIES OF OUR PRODUCTS BECAUSE OF OUR
DEPENDENCE ON COMPONENTS FROM KEY SOLE SUPPLIERS COULD RESULT IN DELAYS IN THE
DELIVERY OF OUR PRODUCTS AND COULD HARM OUR REVENUES.

Some parts, components and equipment used in our products are obtained from
sole sources of supply. If our sole source suppliers or we fail to obtain
components in sufficient quantities when required, delivery of our products
could be delayed resulting in decreased revenues. Additional sole-sourced
components may be incorporated into our equipment in the future. We do not have
any long-term supply contracts to ensure sources of supply. In addition, our
suppliers may enter into exclusive arrangements with our competitors, stop
selling their products or components to us at commercially reasonable prices or
refuse to sell their products or components to us at any price, which could harm
our operating results.

THE OCCURRENCE OF ANY DEFECTS, ERRORS OR FAILURES IN OUR PRODUCTS COULD RESULT
IN DELAYS IN INSTALLATION, PRODUCT RETURNS AND OTHER LOSSES TO US OR TO OUR
CUSTOMERS OR END USERS.

Our products are complex and may contain undetected defects, errors or
failures. These problems have occurred in our products in the past and
additional problems may occur in our products in the future and could result in
the loss of or delay in market acceptance of our products. In addition, we have
limited experience with commercial deployment and we expect additional defects,
errors and failures as our business expands from trials to commercial deployment
at certain customers. We will have limited experience with the problems that
could arise with any new products that we introduce. Further, our customer
agreements generally include a longer warranty for defects than our
manufacturing agreements. These defects could result in a loss of sales and
additional costs and liabilities to us as well as damage to our reputation and
the loss of our customers.

WE DO NOT HAVE SIGNIFICANT EXPERIENCE IN INTERNATIONAL MARKETS AND MAY HAVE
UNEXPECTED COSTS AND DIFFICULTIES IN DEVELOPING INTERNATIONAL REVENUES.

We plan to extend the marketing and sales of our products internationally.
International operations are generally subject to inherent risks and challenges
that could harm our operating results, including:

- unexpected changes in telecommunications regulatory requirements;

- limited number of telephone companies operating internationally;

- expenses associated with developing and customizing our products for
foreign countries;

- tariffs, quotas and other import restrictions on telecommunications
equipment;

- longer sales cycles for our products; and

- compliance with international standards that differ from domestic
standards.

28

To the extent that we generate international sales in the future, any
negative effects on our international business could harm our business,
operating results and financial condition. In particular, fluctuating exchange
rates may contribute to fluctuations in our results of operations.

MOTOROLA MAY EXERCISE SIGNIFICANT INFLUENCE OVER OUR BUSINESS AND AFFAIRS AND
OUR STOCKHOLDER VOTES AND, FOR ITS OWN REASONS, COULD PREVENT TRANSACTIONS
WHICH OUR OTHER STOCKHOLDERS MAY VIEW AS FAVORABLE.

Motorola beneficially owns approximately 75% of the outstanding shares of
our common stock as of March 20, 2002. Motorola will be able to exercise
significant influence over all matters relating to our business and affairs,
including approval of significant corporate transactions, which could delay or
prevent someone from acquiring or merging with us and could prevent you from
receiving a premium for your shares.

We do not know whether Motorola's plans for our business and affairs will
be different than our existing plans and whether any changes that may be
implemented under Motorola's control will be beneficial or detrimental to our
other stockholders.

OUR PRINCIPAL STOCKHOLDER AND ITS PARENT MAY HAVE INTERESTS THAT CONFLICT WITH
THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS AND US AND MAY CAUSE US TO FORGO
OPPORTUNITIES OR TAKE ACTIONS THAT DISPROPORTIONATELY BENEFIT OUR PRINCIPAL
STOCKHOLDER.

It is possible that Motorola could be in a position involving a conflict of
interest with us. In addition, individuals who are officers or directors of
Motorola and of us may have fiduciary duties to both companies. For example, a
conflict may arise if our principal stockholder were to engage in activities or
pursue corporate opportunities that may overlap with our business. These
conflicts could harm our business and operating results. Our certificate of
incorporation contains provisions intended to protect our principal stockholder
and these individuals in these situations. These provisions limit your legal
remedies.

THE PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE HIGHLY VOLATILE.

The stock markets have in general, and with respect to high technology
companies, including us, in particular, recently experienced extreme stock price
and volume volatility, often unrelated to the financial performance of
particular companies. The price at which our common stock will trade in the
future is likely to also be highly volatile and may fluctuate substantially due
to factors such as:

- actual or anticipated fluctuations in our operating results;

- changes in or our failure to meet securities analysts' expectations;

- announcements of technological innovations by us or our competitors;

- introduction of new products and services by us or our competitors;

- limited public float of our common stock;

- conditions and trends in the telecommunications and other technology
industries; and

- general economic and market conditions.

SALES OF SHARES OF OUR COMMON STOCK BY EXISTING STOCKHOLDERS COULD CAUSE THE
MARKET PRICE OF OUR COMMON STOCK TO DROP SIGNIFICANTLY.

As of March 20, 2002, Motorola owned 64,100,000 shares of our common stock,
6,900,000 shares of convertible preferred stock and warrants to purchase an
additional 14,300,000 shares of our common stock; Kevin Kimberlin Partners, LP
and its affiliates owned 6,800,000 shares and warrants to acquire additional
shares of our common stock; and FMR Corporation owned 1,300,000 shares of our
common stock. If Motorola, Kevin Kimberlin Partners LP and its affiliates, FMR,
or any of our other stockholders sells substantial amounts of common stock,
including shares issued upon exercise of outstanding options and warrants, in
the public market, the market price of the common stock could fall. In addition,
any distribution

29

of shares of our common stock by Motorola to its stockholders could also have an
adverse effect on the market price.

Motorola and Kevin Kimberlin Partners LP and its related persons and their
transferees are entitled to registration rights pursuant to which they may
require that we register their shares under the Securities Act.

In addition, as of March 20, 2002, there were outstanding options to
purchase approximately 23,900,000 shares of our common stock. Subject to vesting
provisions and, in the case of our affiliates, volume and manner of sale
restrictions, the shares of common stock issuable upon the exercise of our
outstanding employee options will be eligible for sale into the public market at
various times.

ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD
PREVENT OR DELAY A CHANGE IN CONTROL OF OUR COMPANY THAT A STOCKHOLDER MAY
CONSIDER FAVORABLE.

Several provisions of our certificate of incorporation and by laws and
Delaware law may discourage, delay or prevent a merger or acquisition that a
stockholder may consider favorable. These provisions include:

- authorizing the issuance of preferred stock without stockholder approval;

- providing for a classified board of directors with staggered, three-year
terms;

- prohibiting cumulative voting in the election of directors;

- restricting business combinations with interested stockholders;

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

- prohibiting stockholder action by written consent;

- establishing advance notice requirements for nominations for election to
the board of directors and for proposing matters that can be acted on by
stockholders at stockholder meetings; and

- requiring super-majority voting to effect amendments to our certificate
of incorporation and by laws.

Some of these provisions do not currently apply to Motorola and its
affiliates.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk is limited to interest rate fluctuation.
Interest on our debt to Motorola is variable, payable monthly and is determined
on either the base rate, as defined in the agreement, plus 2% or the Eurodollar
rate plus 3 1/2% (5.4% at December 31, 2001). If annual interest rates increased
by 10% (0.5% change in interest rate), our interest expense on this debt would
increase by approximately $0.4 million. We do not engage in any hedging
activities, and we do not use derivatives or equity investments for cash
investment purposes.

30

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

TABLE OF CONTENTS

31

INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of Next Level Communications, Inc.:

We have audited the accompanying consolidated balance sheets of Next Level
Communications, Inc. and subsidiary (the "Company") (a majority owned subsidiary
of Motorola, Inc.) as of December 31, 2001 and 2000 and the related consolidated
statements of operations, stockholders' equity (deficit)/partners' deficit and
cash flows for each of the three years in the period ended December 31, 2001.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Next Level Communications, Inc.
and subsidiary as of December 31, 2001 and 2000 and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001 in conformity with accounting principles generally accepted in
the United States of America.

DELOITTE & TOUCHE LLP

SAN FRANCISCO, CALIFORNIA
MARCH 29, 2002

32

NEXT LEVEL COMMUNICATIONS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999

See notes to consolidated financial statements.

33

NEXT LEVEL COMMUNICATIONS, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2001 AND 2000

See notes to consolidated financial statements.

34

NEXT LEVEL COMMUNICATIONS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DEFICIT)/PARTNERS' DEFICIT
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999

See notes to consolidated financial statements.

35

NEXT LEVEL COMMUNICATIONS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999

See notes to consolidated financial statements.
36

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND BUSINESS

Next Level Communications, Inc. (the "Company") is a leading provider of
broad-band communications systems that enable telephone companies and other
emerging communications service providers to cost-effectively deliver voice,
data and video services over the existing copper wire telephone infrastructure.

Next Level Communications ("NLC" or the "Limited Partner") was incorporated
as a California corporation in 1994. In September 1995, NLC was acquired by
General Instrument Corporation ("General Instrument"). In January 1998, NLC
transferred its net assets, management and workforce to a newly formed limited
partnership, Next Level Communications L.P. (the "Partnership"), in exchange for
an 89% limited partnership interest. The Partnership recorded the net assets
transferred at their historical cost. At the same time, Spencer Trask (the
"General Partner") acquired an 11% general partner interest in the Partnership
in exchange for a $10.0 million cash contribution.

On August 24, 1999 the Partnership formed the Company as a wholly-owned
subsidiary. Management of NLC effected a 1-for-3 reverse stock split on October
14, 1999. All share amounts in the accompanying financial statements have been
restated to give effect to the reverse stock split.

On November 9, 1999, the Company issued 9,775,000 shares of common stock at
$20.00 per share for net proceeds of $177.0 million in an initial public
offering (the "Offering"). Prior to the completion of the offering, the
following recapitalization transactions (the "Recapitalization") occurred:

A note payable and accrued interest to General Instrument of $86.8 million
was converted into 4,337,633 shares of the Company's common stock.

The Partnership and NLC (a wholly-owned subsidiary of General Instrument)
were merged into the Company. As part of this merger, the General Partner
received 5,863,329 shares of the Company's common stock and General Instrument
received 55,366,091 shares of the Company's common stock in exchange for their
respective partnership interests.

The Company issued a common stock dividend of 4,400,000 shares to General
Instrument to reflect the additional value, $88.0 million, which will be
received by the Company upon exercise of the warrants described below. In
accordance with the Partnership agreement NLC was entitled to receive the $88.0
million exercise price. As a result of the Recapitalization, such amounts are to
be received by the Company as these warrants are exercised. Accordingly, General
Instrument received $88.0 million of common stock (4,400,000 shares) because it
would have received that amount under the Partnership agreement.

The General Partner's option and the Partnership agreement to acquire up to
11% of NLC upon an initial public offering was converted into warrants to
acquire 8,480,102 shares of the Company's common stock at $10.38 per share. In
2000, warrants to purchase 2,369,000 shares of common stock were exercised. The
exercise price of these warrants was paid through the surrender of additional
warrants to purchase 519,493 shares of common stock. The Company did not receive
any cash proceeds. At December 31, 2001, warrants to acquire 5,600,000 shares of
common stock were outstanding under this agreement.

The Recapitalization was accounted for at historical cost. The accompanying
financial statements represent those of the Company from November 10, 1999, and
those of the Partnership from January 1, 1998 to November 9, 1999. In January
2000, General Instrument was acquired by Motorola, Inc.

2. SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates -- The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenue and expenses during the year.

37

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Significant estimates include the inventory write-down and loss on purchase
commitments (see Note 4) and long-term investment and property and equipment
write-downs (see Note 5). Actual results could differ from those estimates.

Principles of Consolidation -- These consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiary, SoftProse,
Inc. All significant intercompany transactions and balances have been
eliminated.

Revenue Recognition -- The Company recognizes revenue when contractual
obligations have been satisfied, title and risk of loss have been transferred to
the customer and collection is reasonably assured. Generally, the Company
recognizes revenue from equipment sales upon shipment. In cases where title and
risk of loss pass upon delivery, the Company recognizes revenue from equipment
sales upon receipt by the customer. The Company accrues a provision for
estimated sales returns as a reduction of revenue at the time of revenue
recognition. Deferred revenue relates to advance payments received on equipment
sales contracts in advance of revenue recognition.

Software license revenues are recognized when software revenue recognition
criteria have been met, pursuant to Statement of Position 97-2, Software Revenue
Recognition, as revised. License revenue is recognized when a noncancelable
license agreement has been signed, delivery has occurred, the fees are fixed and
determinable and collection is probable. The portion of revenues from new
license agreements which relate to the Company's obligations to provide customer
support are deferred, based upon the price charged for customer support when it
is sold separately, and recognized ratably over the maintenance period. Revenue
from the renewal of customer support contracts is recognized ratably over the
term of the agreement. The Company sold its software product line in October
2001. Accordingly, the Company has no deferred software license revenue at
December 31, 2001.

Product Warranty -- The Company provides for the estimated costs to fulfill
customer warranty obligations upon the recognition of the related equipment
revenue. Actual warranty costs incurred are charged against the warranty reserve
when paid.

Research and Development Costs -- Research and development costs are
charged to operations as incurred.

Stock-Based Compensation -- The Company accounts for employee stock-based
compensation in accordance with Accounting Principles Board Opinion ("APB") No.
25, "Accounting for Stock Issued to Employees," and Financial Accounting
Standards Board Interpretation No. 44, "Accounting for Certain Transactions
Involving Stock Compensation" ("FIN 44").

Cash and Cash Equivalents -- The Company considers all highly liquid debt
instruments with a maturity of three months or less at the date of purchase to
be cash equivalents.

Inventories are stated at the lower of cost, determined on a first-in,
first-out basis, or market.

Property and Equipment -- Property and equipment are stated at cost.
Provisions for depreciation are based on estimated useful lives of the assets
using the straight-line method. Useful lives range from 20 years for buildings,
the shorter of five to ten years or the lease term for leasehold improvements
and two to seven years for machinery and equipment.

Long-term investments -- Long-term investments represent preferred stock
and other equity holdings in nonpublic companies. The Company accounts for its
long term investments under the cost method when the Company's interest in the
investee is less than 20%; and under the equity method when the Company's
interest is greater than 20% or the Company has significant influence. Under the
equity method the Company recognizes its pro-rata share of the investee's
earnings/losses in the period in which they occur.

38

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Goodwill -- Through December 31, 2001, the Company amortized goodwill on a
straight line basis over three to seven years.

Impairment of Long-Lived Assets -- The Company evaluates its long-lived
assets for impairment whenever events or changes in circumstances indicate that
the carrying amount of that asset may not be recoverable. When the sum of the
undiscounted future net cash flows expected to result from the use of the asset
and its eventual disposition is less than its carrying amount, an impairment
loss is recorded to reduce the carrying amount to fair value.

Income taxes -- The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standard ("SFAS") No. 109, "Accounting for
Income Taxes," which prescribes the use of the asset and liability method
whereby deferred tax asset or liability account balances are calculated at the
balance sheet date using current tax laws and rates in effect. Valuation
allowances are established when necessary to reduce deferred tax assets when it
is more likely than not that a portion or all of the deferred tax assets will
not be realized. For the period from January 6, 2000 to May 17, 2000 the
Company's results of operations were included in the consolidated federal income
tax return of Motorola. Federal income taxes for that period of time are
provided in accordance with an intercompany tax sharing agreement, whereby
income taxes or credits for the Company are reported as if the Company filed a
separate federal income tax return (see Note 8).

Net Loss Per Share -- Basic net loss per share excludes dilution and is
computed by dividing net loss by the weighted average number of common shares
outstanding for the period. Diluted net loss per share is computed based on the
weighted average number of common shares outstanding plus the dilutive effect of
outstanding stock options and warrants. Diluted net loss per common share was
the same as basic net loss per common share for all periods presented since the
effect of any potentially dilutive common stock equivalents is excluded, as they
are anti-dilutive.

Fair Value of Financial Instruments -- The carrying amounts of cash and
cash equivalents, accounts receivable and accounts payable approximate fair
value because of the short-term nature of these instruments. The fair value of
notes payable is based upon current interest rates for debt instruments with
comparable maturities and characteristics. It is not practicable to determine
the fair value of the long term debt to Motorola due to the related party nature
of the borrowings.

Comprehensive (Loss) -- SFAS No. 130, Reporting Comprehensive Income,
requires that all items recognized under accounting standards as components of
comprehensive income be reported in an annual financial statement that is
displayed with the same prominence as other annual financial statements.
Comprehensive loss was the same as net loss for all periods presented.

Concentration of Risk -- One customer comprised 41%, 56% and 67% of the
Company's total revenues in 2001, 2000 and 1999, respectively. The loss of this
customer or any substantial reduction in orders by this customer could have a
material adverse affect on the Company's operating results. Additionally, the
Company relies on certain contract manufacturers to perform substantially all of
its manufacturing activities. The inability of its contract manufacturers to
fulfill their obligations to the Company could adversely impact future results.

39

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company performs ongoing credit evaluations of its customers and
generally does not require collateral from its customers. The Company maintains
allowances for potential losses, and has not incurred any significant losses to
date. Allowance for doubtful accounts activity consists of (in millions):

New Accounting Pronouncements -- In June 2001, SFAS No. 141, "Business
Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" were
issued. SFAS 141 requires that all business combinations initiated after June
30, 2001 be accounted for under the purchase method and addresses the initial
recognition and measurement of goodwill and other intangible assets acquired in
a business combination. SFAS 142 provides that intangible assets with finite
useful lives be amortized and that goodwill and intangible assets with
indefinite lives will not be amortized, but will rather be tested at least
annually for impairment. The Company will adopt SFAS 142 as of January 1, 2002.
Upon the adoption of SFAS 142, the Company will no longer amortize the carrying
value of goodwill of $0.2 million at December 31, 2001. The Company does not
expect the adoption of SFAS 142 to have a significant effect on the Company's
consolidated financial statements.

In October 2001, SFAS No. 144, "Accounting for the Impairment or Disposal
of Long-Lived Assets" was issued. SFAS 144 supersedes SFAS 121, "Accounting for
the Impairment of Long-Lived Assets, and for Long-Lived Assets to be Disposed
Of," and the accounting and reporting provisions of APB No. 30, "Reporting the
Results of Operations -- Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," and addresses financial accounting and reporting for the
impairment of disposal of long-lived assets. The Company will adopt SFAS 144 as
of January 1, 2002. The Company does not expect the adoption of SFAS 144 will
have a material impact on the Company's consolidated financial statements.

Reclassifications -- Certain 2000 and 1999 amounts have been reclassified
to conform to the 2001 presentation.

3. 2001 RESULTS AND MANAGEMENT'S PLANS FOR 2002

In 2001, net loss was $208.6 million and net cash used in operating
activities was $127.8 million. As of December 31, 2001, the Company's
accumulated deficit was $488.5 million. The Company's ability to generate
positive operating cash flow is dependent on its ability to increase sales,
convert its inventory and accounts receivable to cash, negotiate favorable terms
with its vendors, effectively manage its operating costs and to continue to
raise sufficient operating capital.

Since late 2000, the Company has been significantly dependent on Motorola
for financial resources. Advances from Motorola totaled $15.0 million in 2000
and loans and advances totaled $97.3 million in 2001. The Company also issued
$30.0 million in redeemable convertible preferred stock to Motorola in February
2002, and entered into a $35.0 million financing agreement with Motorola in
March 2002.

During 2001, in addition to the Motorola financing described above, the
Company instituted the following measures to improve liquidity:

- closed its operation in Vietnam eliminating 84 employees in April 2001;

- reduced its workforce by approximately 36 employees in April 2001;

40

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

- received $20.0 million in October 2001 through the mortgage of its
largest office building;

- sold its software product line in October 2001 and received $4.9 million
in net proceeds;

- reduced its workforce by approximately 60 employees, or 15% in October
2001;

- reduced commitments to purchase raw materials from vendors from
approximately $78.0 million in the second quarter of 2001 to
approximately $19.1 million as of December 31, 2001, primarily due to
inventory purchases, along with vendor negotiations; and

- extended payments terms for $24.3 million of vendor payables (see Note
10).

In 2002, in addition to the issuance of $30.0 million of preferred stock to
Motorola:

- the Company reduced its workforce by approximately 120 employees or 33%
in January 2002; and

- on March 29, 2002, Motorola agreed to make available to the Company an
additional $35.0 million in financing (see Note 16).

At March 29, 2002, the Company had cash and cash equivalents of $26.0
million. Management believes that the cash on hand and amounts available under
the March 29, 2002 $35.0 million financing with Motorola will be sufficient to
enable the Company to meet its financial obligations and sustain its operations
through at least December 31, 2002.

4. INVENTORY

Inventories at December 31, 2001 and 2000 consisted of:

During 2000 the Company recorded a $9.0 million inventory write-down
comprised of a lower of cost or market adjustment to certain residential gateway
products and obsolescence of other inventory items.

During 2001, the Company recorded inventory write-downs totaling $76.8
million. To meet forecasted demand and reduce the anticipated component supply
constraints that had existed in the past, the Company had increased inventory
levels for certain components and entered into purchase commitments for certain
components with long lead times. However, in the quarter ended June 30, 2001,
the Company's estimates of forecasted sales in 2001 and 2002, for its current
generation of products declined significantly. As a result, inventory related
charges of $72.0 million were required and were calculated based upon (i) the
substantial completion of the negotiation process with the Company's contract
manufacturers and their suppliers and the Company's other vendors regarding
purchase commitments and cancellations made by the Company, (ii) the inventory
levels in excess of forecasted demand and (iii) the Company's estimates of
salvage or recovery value for each raw material or finished good on an item by
item basis. The Company does not currently anticipate that the excess inventory
included in this provision will be used based on the Company's current demand

41

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

forecast. At December 31, 2001, the Company updated its estimates and recorded
additional charges of $4.8 million. Such write-downs were included in cost of
revenues in 2001 and consisted of the following:

Significant estimates included in the calculation of the inventory
write-downs above include forecasted demand for the Company's products, sales
prices for residential gateways and other finished goods and estimated salvage
or recovery value for excess raw materials and finished goods. Actual results
could differ from those estimates, and therefore additional inventory
write-downs may be necessary in future periods.

5. IMPAIRMENTS AND DISPOSALS OF ASSETS AND INVESTMENTS

Asset impairments and disposals, net, in 2001 consisted of the following:

In the fourth quarter of 2001, the Company wrote off the remaining goodwill
of $8.4 million related to the 2000 SoftProse acquisition based on the Company's
annual assessment of the recoverability of goodwill.

In the fourth quarter of 2001, the Company sold its software product line
for net proceeds of $5.5 million. The Company recorded a gain on the sale of
$2.6 million. The final payment of $0.6 million is in escrow.

Investment impairments of $20.0 million in 2001 consisted of:

As of December 31, 2001, the Company determined that the estimated fair
value of its investments in Virtual Access and Expanse Networks was zero and the
decline from their carrying amounts was other than temporary, and accordingly
wrote off the entire interests in the fourth quarter of 2001. The investment in
Outreach had been reduced to estimated fair value in the second quarter of 2001.

42

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6. PROPERTY AND EQUIPMENT

Property and equipment at December 31 consisted of:

Machinery and equipment included assets acquired under capital leases of
$1.6 million at December 31, 2001 and 2000. Related accumulated depreciation at
December 31, 2001 and 2000 was $1.6 million and $1.3 million, respectively.

7. ACCRUED LIABILITIES

Accrued liabilities at December 31 consisted of:

8. DUE TO MOTOROLA

Note Payable -- During 2001 the Company entered into a note agreement with
Motorola, for $83.0 million which matures on May 17, 2003. Interest is payable
monthly and is determined on either the base rate, as defined in the agreement,
plus 2% or the Eurodollar rate plus 3 1/2% (interest rate in effect at December
31, 2001 was 5.4%).

In connection with the note agreement the Company granted warrants to
purchase up to 10,000,000 shares of the Company's common stock; 7,500,000
warrants have an exercise price of $7.39 per share, and 2,500,000 warrants have
an exercise price of $4.29 per share. Warrants to purchase 7,000,000 shares of
the Company's common stock were exercisable at December 31, 2001. The remaining
warrants become exercisable as follows:

- 1,000,000 shares become exercisable unless, prior to May 17, 2002, all
borrowings under the note agreement have been repaid in full and it has
been terminated;

- 1,000,000 shares become exercisable unless, prior to November 17, 2002,
all borrowings under the note agreement have been repaid in full and it
has been terminated; and

- 1,000,000 shares become exercisable unless, prior to February 17, 2003,
all borrowings under the note agreement have been repaid in full and it
has been terminated.

43

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The fair value of the warrants of $37.4 million was recorded as a discount
to the note payable with a corresponding increase to additional paid-in capital.
The fair value of the warrants was estimated using the Black-Scholes option
pricing model with the following assumptions: no dividends; risk free interest
rate that ranged from 4.3% to 4.9%; volatility of 101%; and a contractual life
of five years.

The Company does not expect to repay amounts due under the agreement until
its maturity date of May 17, 2003. As a result, the debt discount related to the
estimated fair value of the remaining 3,000,000 warrants will be adjusted in
subsequent periods, up to their respective measurement dates, to reflect changes
in the Company's stock price.

The Company is amortizing the discount under the effective interest method
up to the maturity date (May 17, 2003) of the related note. During the year
ended December 31, 2001 the Company amortized $10.4 million of the discount,
which has been reflected as interest expense in the accompanying statement of
operations. As of December 31, 2001, the Motorola note was recorded at $56.0
million, net of $27.0 million of unamortized discount.

The note agreement with Motorola contains various covenants, including
compliance with net worth requirements, and restrictions on additional
indebtedness, capital expenditures, and payment of dividends. As of December 31,
2001, the Company was not in compliance with the net worth financial covenant.
On March 26, 2002, the Company and Motorola amended the note agreement to waive
the debt covenant violation and established revised financial covenants for net
worth.

Tax sharing and allocation agreement with Motorola -- In December 2000, the
Company received a $15.0 million advance from Motorola related to a tax sharing
and allocation agreement. During 2001 the Company received an additional $17.3
million in January 2001 and the Tax Sharing Agreement (the "Tax Sharing
Agreement") was finalized in February 2001. The amount advanced to the Company
of $32.3 million was based on an estimate of the present value of income tax
benefits to Motorola from the inclusion of the Company's operating losses for
the period from January 6, 2000 to May 17, 2000 in Motorola's consolidated tax
return. On October 10, 2001, the Company received a revised calculation of the
estimated present value of income tax benefits to Motorola based upon actual net
losses that were included in Motorola's 2000 tax return. The revised amount was
$29.3 million. Under the original agreement, the Company was required to repay
the $3.0 million difference by October 15, 2001. On October 15, 2001, the Loan
Agreement between the Company and Motorola was amended to include such $3.0
million (see above). To the extent Motorola does not achieve the expected tax
benefits by September 30, 2006, the Company must repay any difference.

In the event of a debt or equity security offering or a sale of assets in
excess of $25.0 million, the first $25.0 million of proceeds may be retained by
the Company; the next $25.0 million (between $25.0 million and $50.0 million) of
such proceeds will be allocated at least one-third to repay the Company's
obligations under the Company's Tax Sharing Agreement and the balance may be
retained by the Company; the next $25.0 million of such proceeds (between $50.0
million and $75.0 million) will be allocated at least one-half to repay the
Company's obligations under the Tax Sharing Agreement and the balance may be
retained by the Company; amounts of such proceeds in excess of $75.0 million
must be used 100% first to repay the Company's obligations under the Tax Sharing
Agreement (to the extent of such obligations) and then to repay and reduce the
amount owed under the note agreement.

9. MORTGAGE FINANCING

On October 30, 2001, the Company received $20.0 million under a mortgage
loan collateralized by a Company-owned office building. The loan is amortized
over 12 years with a ten-year repayment period and bears interest at an annual
fixed rate of 7.51%. Future principal payments are as follows: 2002 -- $1.1
million; 2003 -- $1.2 million; 2004 -- $1.3 million; 2005 -- $1.4 million;
2006 -- $1.5 million; thereafter -- $13.5 million. The unpaid principal balance,
plus accrued interest thereon is due and payable on November 1, 2011.

44

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The mortgage is guaranteed by Motorola. In consideration for the guarantee,
the Company granted to Motorola warrants to purchase up to 400,000 shares of
common stock with an exercise price of $3.82 per share. The fair value of the
warrants ($0.7 million) was recorded as a discount to the mortgage loan with a
corresponding increase to additional paid-in capital. The fair value of the
warrants was estimated using the Black-Scholes option pricing model with the
following assumptions: no dividends; risk free interest rate of 4.3%; volatility
101%; and a contractual life of five years.

The Company is amortizing the discount under the effective interest method
up to the maturity date of the related mortgage. During the year ended December
31, 2001 the Company amortized $.01 million of the discount, which has been
reflected as interest expense in the accompanying statement of operations.

10. NOTES PAYABLE

At December 31, 2000, the Company had $25.0 million outstanding under its
revolving bank line of credit. The line was repaid and closed in 2001, and
therefore, no amounts were outstanding under the line at December 31, 2001.

At December 31, 2001, the Company had a $24.3 million note payable to a
vendor. The note bears interest at 10% per year. Accrued interest at December
31, 2001 was $1.5 million. On March 28, 2002, the Vendor Note Payable was
amended. The revised principal and interest payment terms are as follows: $5.0
million was paid on March 29, 2002, $13.0 million is due on May 18, 2002 and the
balance of $9.5 million is due on March 31, 2003.

11. NET LOSS PER SHARE

The following is a reconciliation of the components of the pro forma basic
and diluted net loss per share:

- ---------------

(1) Basic and diluted net loss per share for 1999 is computed by dividing the
pro forma net loss by the pro forma shares outstanding for the period giving
effect to the Recapitalization as if it had occurred on January 1, 1999. Pro
forma basic and diluted net loss per share give effect to the contribution
of the note and accrued interest thereon payable to General Instrument and
the related elimination of interest expense of $5.8 million for 1999. The
pro forma shares outstanding exclude warrants and stock options to purchase
approximately 20,700,000 shares of common stock since the inclusion of these
shares would be antidilutive.

12. EMPLOYEE STOCK PLANS

1999 STOCK PLAN

Options to purchase 5,400,000 shares of common stock were granted under the
1999 Stock Plan. These options vest with respect to 25% of the shares after 12
months of service and the remaining 75% in equal

45

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

monthly installments over the next 36 months of service and expire not later
than 10 years after the date of grant. No future awards under the 1999 Stock
Plan are expected to be made.

1999 EQUITY INCENTIVE PLAN

Options to purchase 17,400,000 shares of common stock are available for
grant under the 1999 Equity Incentive Plan. Depending on the grant, shares vest
over either a three or four-year period with a pro rata portion vesting after
one year of service and the remaining shares vesting in equal monthly
installments over the remaining months of service. Options expire not later than
10 years after the date of grant.

Certain employees of the Partnership were granted contingently exercisable
stock options (included in the table which follows) in NLC which vest over a
period ranging from two to three years and which expire in ten years. Such
options were exercisable only in the event of an initial public offering or a
change in control of NLC (the "Event").

In November 1999, in conjunction with the Recapitalization (see Note 1),
the outstanding options granted under the NLC stock plan were converted into
options to purchase 7,000,000 shares of the Company's common stock with
equivalent terms and exercise prices. As a result of the initial public offering
of the Company, compensation expense of $96.9 million was recognized in 1999
related to the contingently exercisable stock options. The compensation expense
was determined based on the difference between the exercise price of the vested
portion of such options and the initial offering price for the Company's common
stock. The Company recorded compensation expense of $2.4 million in 2000 related
to the remaining vesting of these options, as a result of the Motorola
acquisition.

In addition, in 1997, as part of a tandem stock option grant, certain
employees of NLC were granted options at $1.11 per share for a total of
1,900,000 shares of common stock of NLC, or options at $15.75 per share for a
total of 1,500,000 shares of General Instrument common stock (the "GI Options").
The NLC options were exercisable only upon an Event. The options have a ten-year
life and vest over three years. At December 31, 1999, it was determined that the
NLC options granted as part of the tandem stock grant were more likely to be
exercised than the related GI options. As a result, the Company recorded $31.4
million in compensation expense in 1999 related to the tandem stock grant. The
compensation expense was calculated based on the difference between the exercise
price of the vested portion of the NLC options and the initial offering price of
the Company's common stock.

During 2001, the Company issued non-qualified stock options to consultants
to purchase 26,000 shares of common stock at prices between $2.60 and $3.35. The
options all vested within the quarter they were issued. The fair value of the
options issued was $.05 million, was recorded as compensation expense, and was
estimated using the Black-Scholes option pricing model with the following
assumptions: no dividends, risk-free interest rate of 4.3%, volatility of 101%,
and a contractual life of 5 years.

During 2001, the Company extended the contractual life of certain options
held by terminated employees. In accordance with FIN 44, the modification
resulted in a new measurement date for these options. As such, the Company
recorded an expense of $0.2 million, as determined by the excess of market value
of the Company's common shares over the exercise price of the modified options.

STOCK OPTION EXCHANGE PROGRAM

In August 2001, the Company implemented a stock option exchange program in
which certain employees could exchange options with an exercise price greater
than or equal to $40.00 per share for new options to be granted at least six
months and one day from the date of cancellation at the then fair market value.
As a result, 5,500,000 options were cancelled in connection with the program.
Eligible employees received a one-for-one option re-grant on February 11, 2002
at an exercise price equal to the market price on the replacement grant

46

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

date of $2.06. Total shares re-granted under the program in 2002 were 4,700,000.
The Company did not incur any compensation expense relative to this stock option
exchange program.

The following table summarizes activity relating to the NLC Stock Plan
(including those granted as part of the tandem stock option grant) and the 1999
Stock Plan and 1999 Equity Incentive Plan (the "Plans"):

The following table summarizes information about options granted under the
Plans and outstanding at December 31, 2001:

47

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

1999 EMPLOYEE STOCK PURCHASE PLAN

In 1999, the Company adopted the 1999 Employee Stock Purchase Plan (the
"Purchase Plan") under which 1,000,000 shares of the Company's common stock were
reserved for issuance.

All employees are eligible to participate. Eligible employees may begin
participating in the 1999 Employee Stock Purchase Plan at the start of any
offering period each of which lasts 24 months. Overlapping offering periods
start on May 1 and November 1 of each year. Under the Purchase Plan eligible
employees may purchase the Company's common stock at a price that is the lower
of 85% of either the fair market value at the beginning of the offering period
or the fair market value at the end of the period.

During 2001 and 2000,the Company issued 396,500 and 318,208 shares of
common stock under the Purchase Plan.

ADDITIONAL STOCK PLAN INFORMATION

SFAS No. 123, Accounting for Stock-Based Compensation, requires the
disclosure of pro forma net loss and net loss per share had the Company adopted
the fair value method. Under SFAS No. 123, the fair value of stock-based awards
to employees is calculated through the use of option pricing models which were
developed to estimate the fair value of freely tradable, fully transferable
options without vesting restrictions. Such options differ significantly from the
Company's stock-based awards. These models require subjective assumptions,
including future stock price volatility and expected time to exercise, which
greatly affect the calculated values. The Company's calculations for options
granted after the offering were made using the Black-Scholes option pricing
model. Cancellations are recognized when they occur.

The estimated fair value of an option grant is based, in part, on the
estimated term of the option. Prior to the Company's initial public offering,
NLC options granted under the NLC Stock Plan were not exercisable. As a result,
it is not practicable to determine the expected term of NLC options and
therefore it is not possible to estimate the fair value of such options. As a
result, disclosure of the estimated grant date fair value of such options and
the related pro forma compensation expense for such options is not possible.

The following weighted average assumptions are included in the estimated
fair value calculations of grants for the stock option and stock purchase
programs:

Under SFAS No. 123, had the Company recorded compensation expense based on
the estimated grant date fair value for awards based on grants under the Plans
and the tandem stock grant, the Company's net loss and net loss per share would
have changed. The amounts below represent the pro forma amounts for fiscal 2001
(including the cancellation of 5.5 million options, under the stock option
exchange program), 2000 and 1999:

48

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

13. EMPLOYEE BENEFIT PLANS

In January 2000, the Company adopted the Next Level Communications 401(k)
Plan ("NLC Plan") to which employees could contribute up to 12% of the
employees' salary subject to the legal maximum. The Company contributes an
amount equal to 100% of the first 5% of the employee's salary that the employee
contributes. The Company's expense related to the NLC Plan was $1.5 million and
$1.4 million in 2001 and 2000, respectively. The Company's expense related to
the General Instrument 401(k) Plan was $0.6 million in 1999.

14. COMMITMENTS AND CONTINGENCIES

The Company leases certain of its facilities and equipment under
non-cancelable operating leases. Leases expire at various dates from 2002 to
2006 and certain facility leases have renewal options.

Future minimum lease payments at December 31, 2001 under operating leases
are as follows:

Rent expense was $3.0 million, $1.7 million and $4.3 million in 2001, 2000
and 1999, respectively.

At December 31, 2001, the Company had commitments with various suppliers to
purchase approximately $19.1 million of components in 2002.

The Company is a party to various claims, litigation and other matters.
Management believes the ultimate resolution of these matters will not have a
material adverse effect on the Company's consolidated financial statements taken
as a whole.

15. INCOME TAXES

For the period from January 1, 1999 through November 9, 1999, the Company
was a limited partnership entity. For federal and state tax purposes, limited
partnership entities pass all items of income and expense through to the
respective partners of the entity. Consequently, all items of income and expense
attributable to the period in which the Company was a limited partnership were
allocated directly to the respective partners.

For the period from November 10, 1999 through January 5, 2000, the Company
was a corporation filing its tax returns on a stand-alone basis. As a result of
the acquisition by Motorola of General Instrument, from January 6, 2000 through
May 17, 2000, the Company's taxable loss was included in the consolidated
federal tax return of Motorola. Subsequent to May 17, 2000, due to the exercise
of various warrants and stock options, Motorola's ownership interest in the
Company declined below 80% and the Company was no longer eligible to be included
in Motorola's consolidated federal tax return and will file its federal income
tax return on a stand-alone basis.

49

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company's deferred income tax assets as of December 31, 2001 and 2000
consisted of the following in millions:

No tax benefit has been recorded through December 31, 2001 because of the
net operating losses incurred and full valuation allowance provided. A valuation
allowance is provided when it is more likely than not that some portion of the
deferred tax assets will not be realized. The Company established a 100%
valuation allowance at December 31, 2001 and 2000 due to the uncertainty of
realizing future tax benefits from its net operating loss carryforwards and
other deferred tax assets.

At December 31, 2001, for tax purposes, the Company had approximately
$301.0 million in federal net operating loss carryforwards, approximately $153.0
million in state net operating loss carryforwards, and approximately $7.3
million in research and development credit carryforwards. The Company's federal
net operating loss and research and development credit carryforwards begin to
expire in 2020. The Company's state net operating loss and foreign tax credit
carryforwards have various expiration dates beginning in 2002.

Internal Revenue Code Section 382 places an annual limitation (the "Section
382 Limitation") on the amount of taxable income which can be offset by NOL
carryforwards after a change in control (generally greater than or equal to a
50% change in ownership) of a loss corporation. California has similar rules.
Generally, after a control change, a loss corporation cannot deduct NOL
carryforwards in excess of the Section 398 Limitation. Future ownership changes
may result in expiration of net operating losses and credits before utilization.

50

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

16. SUBSEQUENT EVENTS

On February 20, 2002, the Company issued $30.0 million of redeemable
convertible preferred stock ("preferred stock") to Motorola, comprised of
6,912,442 shares at a purchase price of $4.34 per share. Each share of preferred
stock is convertible, at the option of the holder, into two shares of the
Company's common stock, or 13,824,884 shares in total. The preferred stock is
redeemable, at the option of the holder, at an initial redemption price of $5.21
per share, on or after February 19, 2007. Dividends are cumulative at a rate of
7.5%, payable in cash or additional shares of preferred stock, at the Company's
option. Liquidation value is $10.85 per share. In conjunction with this
financing, the Company also issued to Motorola warrants to purchase 3,456,221
shares of common stock at an exercise price of $2.17 per share and warrants to
purchase 3,456,221 shares of common stock at an exercise price of $2.60 per
share. The warrants have a term of five years.

On March 29, 2002, Motorola agreed to make available to the Company up to
an additional $35.0 million in financing. Draw downs by the Company, when they
occur, will be treated, at Motorola's option, as either (i) additions to the
existing Note Payable Agreement with Motorola and subject to substantially the
same terms (interest rate, maturity in May 2003, warrants, etc.) under such
agreement (see Note 8) or (ii) additional issuances of redeemable convertible
preferred stock, subject to substantially the same terms as the February 2002
issuance of redeemable convertible preferred stock described above.

51

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT OFFICERS AND
DIRECTORS

Information concerning this item will be in our definitive proxy statement
to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934
for our 2002 annual meeting of stockholders and is incorporated herein by
reference.

ITEM 11. EXECUTIVE COMPENSATION

Information concerning this item will be in our definitive proxy statement
to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934
for our 2002 annual meeting of stockholders and is incorporated herein by
reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information concerning this item will be in our definitive proxy statement
to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934
for our 2002 annual meeting of stockholders and is incorporated herein by
reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information concerning this item will be in our definitive proxy statement
to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934
for our 2002 annual meeting of stockholders and is incorporated herein by
reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

FINANCIAL STATEMENTS AND SCHEDULES

The Financial Statements which are filed with this Form 10-K are set forth
in the Index to Financial Statements at page 36, which immediately precedes such
financial statements. No schedules are required under the applicable
instructions or are inapplicable and have therefore been omitted.

52

EXHIBITS

The following exhibits are, as indicated below, either filed herewith or
have previously been filed with the SEC and are referred to and incorporated
herein by reference to such filings.

- ---------------

* Management contract or compensatory plan or arrangement.

** Confidential Treatment has been granted as to certain portions of these
exhibits.

*** Filed herewith.

54

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

NEXT LEVEL COMMUNICATIONS, INC.

By: /s/ J. MICHAEL NORRIS
------------------------------------
Chief Executive Officer and
President

Date: March 29, 2002

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below does hereby constitute and appoint J. Michael Norris and Keith A.
Zar, with full power of substitution and resubstitutions and full power to act
without the other, his or her true and lawful attorneys-in-fact and agents to
act for him or her in his or her name, place or stead, in any and all
capacities, to sign any amendments to this report and to file such amendments,
together with exhibits and other documents in connection therewith, with the
Securities and Exchange Commission, granting to each attorney-in-fact and agent
full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully as he or
she might or could do in person, and ratifying and confirming all that the
attorneys-in-fact and agents, or his or her substitute or substitutes, may
lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

56

INDEX TO EXHIBITS

- ---------------

* Management contract or compensatory plan or arrangement.

** Confidential Treatment has been granted as to certain portions of these
exhibits.

*** Filed herewith.