FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-15135

TEKELEC

26580 W. Agoura Road, Calabasas, California 91302
(Address and zip code of principal executive offices)

(818) 880-5656
(Registrant’s telephone number, including area code)

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

     Indicate by check mark whether the registrant is an accelerated filer. Yes [X] No [   ]

     As of October 25, 2004, there were 64,070,061 shares of the registrant’s common stock, without par value, outstanding.

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TABLE OF CONTENTS
TEKELEC
FORM 10-Q

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PART I - FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

Tekelec

See notes to condensed consolidated financial statements

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Tekelec

See notes to condensed consolidated financial statements.

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Tekelec

See notes to condensed consolidated financial statements.

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Tekelec

See notes to condensed consolidated financial statements.

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Tekelec

Note A. Basis of Presentation

     The condensed consolidated financial statements are unaudited, other than the condensed consolidated balance sheet at December 31, 2003, and reflect all adjustments, consisting only of normal recurring adjustments which are, in the opinion of management, necessary for a fair statement of our financial condition, operating results and cash flows for the interim periods. The condensed consolidated financial statements include the accounts and operating results of our wholly owned subsidiaries, including VocalData from the acquisition date of September 20, 2004 (see Note B – Acquisition of VocalData, Inc.) and Taqua from the acquisition date of April 8, 2004 (see Note C- Acquisition of Taqua, Inc.) and our majority owned subsidiary, Santera, less minority interest from the acquisition date of June 10, 2003 (See note D - Acquisition of Majority Interest in Santera).

     As more fully described in Note E – Convertible Note Receivable from Disposition of Network Diagnostics Business, we sold our Network Diagnostics Division (“NDD”) effective August 30, 2002.

     The results of operations for the current interim periods are not necessarily indicative of results to be expected for the current year. Certain items shown in the prior condensed consolidated financial statements have been reclassified to conform with the presentation of the current period.

     We operate under a thirteen-week calendar quarter. For financial statement presentation purposes, however, the reporting periods are referred to as ended on the last calendar day of the quarter. The accompanying consolidated financial statements for the three and nine months ended September 30, 2004 and 2003 are for the thirteen and thirty-nine weeks ended October 1, 2004 and September 26, 2003, respectively.

     We conduct business in a number of foreign countries. We expect international sales to account for a significant portion of our revenues in future periods. Accordingly, we have identified four geographic territories for analyzing and reporting sales data. The four territories are: (1) North America, comprised of the United States and Canada, (2) “EMEA,” comprised of Europe, the Middle East and Africa, (3) “CALA,” comprised of the Caribbean and Latin America including Mexico, and (4) Asia Pacific, comprised of Asia and the Pacific region including China. These territories are presented for the three months and nine months ended September 30, 2004, with comparative information reclassified for the three and nine months ended September 30, 2003.

     These consolidated financial statements should be read in conjunction with the consolidated financial statements for the year ended December 31, 2003 and the notes thereto in our Annual Report on Form 10-K for the year ended December 31, 2003.

Recent Accounting Pronouncements

     In March 2004, the Financial Accounting Standards Board (“FASB”) issued Emerging Issue Task Force (“EITF”) Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” EITF No. 03-1 provides new guidance for assessing impairment losses on investments and includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. Adoption of EITF 03-1 will not have a material impact on our financial position, results of operations or cash flows.

     In October 2004, the EITF reached final consensuses on Issue 04-8 “Accounting

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share” (“EITF No. 04-8”). EITF No. 04-8 requires the dilutive effect of contingently convertible debt investments (“Co-Cos”) to be included in diluted earnings per share computations regardless of whether the market price trigger (or other contingent feature) has been met. The scope of EITF No. 04-8 includes all securities issued with embedded contingently convertible features that are based on a market price contingency involving an entity’s own stock. EITF No. 04-8 is effective for fiscal periods ending after December 15, 2004, and prior period earnings per share amounts presented for comparative purposes should be restated to conform to the consensus guidance. Because our Notes are not contingently convertible, this pronouncement does not impact our earnings per share calculation. Therefore, we do not expect the adoption of ETIF No. 04-8 to impact our financial condition, results of operations, or earnings per share calculation.

Note B. Acquisition of VocalData, Inc.

     On September 20, 2004, we completed the acquisition of all of the outstanding shares of capital stock of privately held VocalData, Inc. (“VocalData”). VocalData is a provider of hosted Internet protocol (IP) telephony applications that enable the delivery of advanced telecom services and applications to business and residential customers. The acquisition was accomplished by means of a reverse triangular merger of a new wholly owned subsidiary of Tekelec. As a result of the acquisition, VocalData is the surviving corporation and became a wholly owned subsidiary of Tekelec.

     We paid to the preferred stockholders of VocalData, in exchange for their interests in VocalData, consideration in the total amount of approximately $27.6 million, consisting of (i) an aggregate cash amount of $14.5 million, and (ii) 779,989 shares of our common stock, of which the number of shares are subject to reduction for certain working capital adjustments. The value of the 779,989 shares is equal to approximately $13.0 million based on the closing sales price of our common stock on the Nasdaq National Market on or around September 20, 2004. The number of shares was determined pursuant to the terms of the merger agreement by dividing $14.5 million by the average of the closing sales price per share of our common stock on the Nasdaq National Market for the ten trading days ending on the second trading day prior to the closing of the merger transaction.

     The transaction has been accounted for using the purchase method of accounting, and resulted in a step-up of approximately $27.6 million of VocalData’s assets and liabilities to fair value as follows:

     Through this acquisition, we gained a meaningful presence in the next-generation switching space, specifically for IP Centrex applications. This is consistent with our strategy focused on next-generation switching and signaling solutions, and value-added applications. We believe the combination of our signaling products and expertise, combined with the acquired VocalData assets, provide a unique value-proposition to our customers. These factors contributed to a purchase price in excess of fair market value of VocalData’s net tangible and intangible assets acquired, and as a result, we have recorded goodwill in connection with the transaction.

     The total purchase price step-up was allocated among the VocalData assets acquired and liabilities assumed based on their estimated fair values determined with the assistance of a third party appraisal as follows:

     Based on the purchase price allocation, $2.4 million of the purchase price represented acquired in-process research and development (“IPRD”) that had not yet reached technological feasibility and had no alternative future use. IPRD was valued using a discounted cash flow approach commonly known as the “excess earnings” approach. The IPRD amount was recorded as an expense in the third quarter of 2004. The identifiable assets created as a result of the acquisition will

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

be amortized over their respective estimated useful lives were as follows:

     Amortization expense of purchased technology, including the one time IPRD charge of $2.4 million amounted to $2.5 million for the three and nine months ended September 30. 2004.

     The following table shows our pro forma revenue, net income and earnings per share giving effect to the VocalData acquisition as of the beginning of 2003:

Note C. Acquisition of Taqua, Inc.

     On April 8, 2004, we completed the acquisition of all of the outstanding shares of capital stock of privately held Taqua, Inc., (“Taqua”). Taqua develops, markets and sells solutions for next-generation switches optimized for the small switch service provider market. The acquisition was accomplished by means of a reverse triangular merger of a new wholly owned subsidiary of Tekelec (“Merger Sub”), with and into Taqua (the “Acquisition”). As a result of the Acquisition, Taqua is the surviving corporation and a wholly owned subsidiary of Tekelec.

     We paid an aggregate cash amount of approximately $86.0 million to the common and preferred stockholders and warrant holders of Taqua in exchange for their interests in Taqua. As part of the acquisition, we assumed all unexercised outstanding options to purchase shares of common stock of Taqua. The assumed options were converted, based on exchange ratios specified in the merger agreement, into options to purchase an aggregate of approximately 500,000 shares of Tekelec Common Stock with an estimated fair value of $7.8 million using the Black-Scholes option-pricing model. This amount includes approximately $4.2 million related to the intrinsic value of unvested stock options recorded as deferred stock-based compensation, which will be amortized over the vesting period of the assumed options. The transaction has been accounted for as an acquisition by us under the purchase method, with the Taqua assets acquired and the liabilities assumed reflected at their estimated fair values. The acquisition of Taqua resulted in the recognition of deferred tax assets of approximately $30.3 million primarily related to acquired temporary differences and net operating loss carryforwards and deferred tax liabilities of approximately $11.7 million related to acquired intangible assets. The Taqua acquired deferred tax assets are based on a preliminary purchase allocation and may be adjusted upon completion of the final Taqua tax returns through the acquisition date. Taqua’s operating results are included in our consolidated results since the date of acquisition.

     The transaction has been accounted for using the purchase method of accounting, and resulted in a step-up of

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

     approximately $68.8 million of Taqua’s assets and liabilities to fair value as follows:

     Through this acquisition, we gained a meaningful presence in the next-generation switching space, specifically for the small size wireline switching market. This is consistent with our strategy focused on next-generation switching and signaling solutions, and value-added applications. We believe the combination of our signaling products and expertise, combined with the acquired Taqua switching assets, provide a unique value-proposition to our customers. These factors contributed to a purchase price in excess of fair market value of Taqua’s net tangible and intangible assets acquired, and as a result, we have recorded goodwill in connection with the transaction.

     The total purchase price step-up was allocated among the Taqua assets acquired and liabilities assumed based on their estimated fair values determined with the assistance of a third party appraisal as follows:

     Based on the purchase price allocation, $8.0 million of the purchase price represented acquired in-process research and development (“IPRD”) that had not yet reached technological feasibility and had no alternative future use. IPRD was valued using a discounted cash flow approach commonly known as the “excess earnings” approach. The IPRD amount was recorded as an expense in the second quarter of 2004. The identifiable assets created as a result of the acquisition will be amortized over their respective estimated useful lives as follows:

     Amortization expense of purchased technology and other intangible assets of Taqua amounted to $1.1 million and $10.0 million for the three and nine months ended September 30, 2004, including the one time IPRD charge of $8.0 million in the second quarter of 2004.

     The following table shows our pro forma revenue, net income (loss) and earnings (loss) per share giving effect to the Taqua acquisition as of the beginning of 2003:

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note D. Acquisition of Majority Interest in Santera

     On June 10, 2003, we acquired a 51.6% controlling voting ownership interest (57.5% on an as converted basis) in Santera in exchange for cash contribution of $28.0 million and the contribution of the business operations and certain assets and liabilities of our Packet Telephony Business Unit (“PTBU”). Santera develops, markets and sells solutions for carrier-class, next-generation switches. As part of the acquisition and combination, Santera was recapitalized and we contributed the $28.0 million in cash to Santera in exchange for 28,000 shares of Santera Series B Preferred Stock. In addition, we received 38,000 shares of Santera Series A Preferred Stock and one share of Santera common stock in exchange for the PTBU. Santera’s existing stockholders received 62,000 shares of Series A Preferred Stock in exchange for their existing shares in Santera and a cash contribution to Santera of $12.0 million. Each share of Santera’s Series B Preferred Stock has a liquidation preference equal to $2,000 and is convertible into 1.63 shares of Santera’s common stock. Each share of Santera’s Series A Preferred Stock has a liquidation preference equal to $1,000 and is convertible into one share of Santera common stock. Under terms of the original purchase agreement, we made additional cash investments of $12.0 million in Santera, $6.0 million in March 2004 and $6.0 million in May 2004, in exchange for 12,000 shares of Santera Series B Preferred Stock. As a result of this cash investment, our ownership percentage increased to 55.7% (62.5% on an as converted basis). In accordance with generally accepted accounting principles, the capital structure of Santera has been eliminated in consolidation and the minority stockholders’ interest in Santera is reflected in our consolidated balance sheet as minority interest. The minority stockholders’ interest in Santera is reflected at the fair value of the Santera assets acquired on the date of acquisition.

     The transaction has been accounted for using the purchase method of accounting, and resulted in a step-up of approximately $56.9 million of Santera’s assets and liabilities to fair value as follows:

     Through this acquisition we gained a meaningful presence in the next-generation switching space, specifically for medium to large size wireline switching markets and wireless markets. This is consistent with our strategy focused on next-generation switching and signaling solutions, and value-added applications. We believe the combination of our signaling products and expertise, combined with the acquired Santera switching assets, provide a unique value-proposition to our customers. These factors contributed to a purchase price in excess of fair market value of Santera’s net tangible and intangible assets acquired, and as a result, we have recorded goodwill in connection with the transaction.

     The total purchase price step-up were allocated among the Santera assets acquired and liabilities assumed based on their estimated fair values determined with the assistance of a third party appraisal as follows:

     The PTBU assets and liabilities contributed remain at historical cost.

     Based on the purchase price allocation, $2.9 million of the purchase price represented acquired in-process research and development (“IPRD”) that had not yet reached technological feasibility and had no alternative future use. IPRD was valued using a discounted cash flow approach commonly known as the “excess earnings” approach. The IPRD amount was recorded as an expense in the second quarter of 2003. The identifiable assets created as a result of the acquisition will be amortized over their estimated useful lives of 15 years, with the exception of acquired backlog, which has an estimated life of one year. Amortization expense of purchased technology and other intangible assets of Santera, including the intangible assets contributed by PTBU, amounted to $ 912 thousand and $3.8 million for the three and nine months ended September 30, 2004, respectively.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

     The following table shows our pro forma revenue, net income and net income per share giving effect to the Santera acquisition as of the beginning of 2003:

     The net income and losses of Santera are allocated between Tekelec and the minority stockholders based on their relative interests in the equity of Santera and the related liquidation preferences. This approach requires net losses to be allocated first to the Series A Preferred Stock until fully absorbed and then to the Series B Preferred Stock. Subsequent net income will be allocated first to the Series B Preferred Stock to the extent of previously recognized net losses allocated to Series B Preferred Stock. Additional net income will then be allocated to the Series A Preferred Stock to the extent of previously recognized losses allocated to Series A Preferred Stock and then to Common Stock in proportion to their relative ownership interests in the equity of Santera. The loss allocated to minority interest of Santera for the nine months ended September 30, 2004 was computed as follows (dollars in thousands):

     Since our acquisition of a majority interest in Santera, the total net losses that are allocable to the Series A Preferred Stock are $73.4 million, leaving $27.1 million of losses to be allocated to the Series A Preferred Stock until fully absorbed. After the Series A Preferred Stock is fully absorbed, all subsequent net losses of Santera will be allocated to the Series B Preferred Stock, of which Tekelec owns 100%.

     In addition to our current ownership interest, we have the right, exercisable during the period from July 1, 2005 through December 31, 2007, to acquire the remaining outstanding shares of Santera from the holders thereof at a price determined in accordance with the terms of the definitive agreements (the “Tekelec Option Price”). In addition, the other stockholders of Santera will have the right, exercisable during the period from January 2006 through February 2008, to require us to purchase their shares at a price equal to 80% of the Tekelec Option Price, provided Santera has been profitable for the two calendar quarters preceding such exercise.

Note E. Convertible Note Receivable from Disposition of Network Diagnostics Business

     In August 2002, we completed the sale of NDD to Catapult Communications Corporation (“Catapult”) for $59.8 million, consisting of $42.5 million in cash and convertible subordinated promissory notes (the “Notes”) issued by Catapult’s wholly owned Irish subsidiary and guaranteed by Catapult in the total principal amount of $17.3 million. The Notes were reflected at fair market value as determined with the assistance of a third party appraisal. The sale resulted in a pre-tax gain of approximately $41.7 million ($28.3 million after taxes) in 2002.

     During the third quarter of 2003, an additional $3.3 million gain on the sale was recognized based on post closing adjustments, including working capital, resulting from the final settlement with Catapult in accordance with the asset purchase agreement.

     On August 30, 2004, the Notes matured and we exercised the conversion option of the Notes into 1.1 million shares of Catapult common stock at the conversion rate of 62.50 shares of Catapult common stock per $1,000 principal. In September 2004, we sold our Catapult shares resulting in a pretax gain of approximately $2.2 million.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note F. Certain Balance Sheet Items

Note G. Restructuring Costs

     In January 2004, we announced a cost reduction initiative that is expected to result in employee terminations and relocations. The cost reduction initiative resulted in restructuring charges of $275,000 and $1.3 million for the three and nine months ended September 30, 2004, including $874,000 in severance costs, $73,000 in retention bonuses, $146,000 in facility relocation costs and $234,000 in employee relocation costs. These restructuring costs relate to the implementation of a global strategic manufacturing plan which includes the outsourcing of the majority of our manufacturing operations and the relocation of our remaining signaling product manufacturing operations from Calabasas, California to our facilities in Morrisville, North Carolina which is expected to be complete by the end of 2004.

     For the restructuring charges related to relocation costs and retention bonuses, we have applied the provisions of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The principal difference between SFAS No. 146 and previous accounting standards relates to the timing of when restructuring charges are recorded. Under SFAS No. 146, restructuring charges are recorded as liabilities are incurred. Under prior accounting standards, restructuring related liabilities were recorded at the time we committed to a restructuring plan. Retention bonuses are being recognized proratably over the service period. We have applied the provisions of SFAS 112, “Employers’ Accounting for Postemployment Benefits” for severance costs because the severance benefits provided as part of this restructuring were part of an ongoing benefit arrangement and we accrued a liability for the severance costs.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

     The costs related to the restructuring were as follows:

     The restructuring activity has resulted in the following accrual as of September 30, 2004:

     As of September 30, 2004, total restructuring liabilities amounted to $311,000 and are included in accrued expenses and accrued payroll and related expenses in the accompanying balance sheet. Additional restructuring charges estimated at approximately $515,000 in total are likely to be incurred throughout the fourth quarter of 2004, and possibly into the first half of 2005, as a result of the global strategic manufacturing plan and other consolidation activities.

Note H. Sale of Investment in Privately Held Company

     In August 2004 following the acquisition of Telica by Lucent Technologies Inc. (“Lucent”), we received freely tradable common stock of Lucent in exchange for our investment in Telica. In September 2004, we sold 90% of our shares of Lucent stock (with 10% of our holdings in Lucent retained in escrow) for proceeds of approximately $17.9 million, resulting in a gain of $9.9 million, which gain is included in other income in the accompanying condensed consolidated statement of operations. As of September 30, 2004, the proceeds from this sale were not yet received, and accordingly, are reflected in other receivables in the accompanying condensed consolidated balance sheet.

Note I. Financial Instruments

     We use derivative instruments, such as forward contracts, to manage our exposure to market risks such as interest rate and foreign exchange risks. We record derivative instruments as assets or liabilities on the Consolidated Balance Sheet, measured at fair value.

     Corresponding gains and losses on these contracts, as well as gains and losses on the items being hedged, are included as a component of other income and expense in our consolidated statement of operations. When we elect not to designate a derivative instrument and hedged item as a fair value hedge at inception of the hedge, or the relationship does not qualify for fair value hedge accounting, the full amount of changes in the fair value of the derivative instrument will be recognized in the consolidated financial statements.

     As of September 30, 2004, we had three foreign currency forward contracts outstanding to sell approximately 19.0 million Euros, 300,000 British Pounds, and 1.5 million Australian Dollars in order to hedge certain receivable balances denominated in those currencies. These contracts had an expiration date of October 29, 2004, and did not meet specific hedge accounting requirements.

     Corresponding gains and losses on these contracts, as well as gains and losses on the items being hedged, are included

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

as a component of other income and expense in our consolidated statement of operations. For the three and nine months ended September 30, 2004 our losses from foreign currency forward contracts were $482,781 and $732,781, respectively. For the three and nine months ended September 30, 2003, our gain (loss) from foreign currency forward contracts was $10,000 and ($412,000), respectively.

     In July 2004, we entered into a forward contract for 1.2 million CAD to hedge foreign currency exchange losses on a pending sales order with an external customer. The contract expires on December 31, 2004 and has been designated as a cash flow hedge in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Hedging Activities — An Amendment to FASB Statement No. 133.” The effective portion of the gain or loss on this contract is recognized in Other Comprehensive Income, while the ineffective portion is reported in earnings. For the three and nine months ended September 30, 2004, our net loss from this contract was $43,872.

     We expect to continue to use foreign currency forward contracts to manage foreign currency exchange risks in the future.

Note J. Income Taxes

     The income tax provisions from continuing operations for the three and nine months ended September 30, 2004 were $13.9 million and $27.1 million, respectively, and reflected the effect of non-deductible acquisition-related costs, partially offset by benefits of $571,000 and $1.8 million, respectively, from the utilization of deferred tax liabilities related to certain of these acquisition-related costs.

     Our provision for income taxes does not include any benefit from the losses generated by Santera due to their losses not being included on our federal consolidated tax return because our ownership interest in Santera does not meet the threshold to consolidate under income tax rules and regulations and a full valuation allowance being established on the tax benefits generated by Santera as a result of their historical operating losses.

     Excluding the effect of acquisition-related items and Santera’s operating results, our effective tax rate was 35% and 34%, respectively for continuing operations for the three and nine month periods ended September 30, 2004 and 2003, and represented federal, state and foreign taxes on our income, reduced primarily by research and development credits, foreign tax credits, and other benefits from foreign sourced income.

Note K. Lines of Credit, Notes Payable and Long-Term Convertible Debt

     We have a $20.0 million line of credit with a U.S. financial institution. Our $20.0 million credit facility is collateralized by a stock pledge of our holdings in Santera, bears interest at or, in some cases, below the lender’s prime rate (4.75% at September 30, 2004) and expires on December 31, 2004, if not renewed. Under the terms of this facility, we are required to maintain certain financial ratios and meet certain net worth and indebtedness covenants. We are in compliance with these covenant requirements as of September 30, 2004. There have been no borrowings under this credit facility.

     As a result of the Santera transaction (see Note D — Acquisition of Majority Interest in Santera), we also have two notes payable to U.S. financial institutions with monthly installments of principal and interest. One of the notes has an outstanding balance of $332,000 and is secured by the assets purchased under the note, bears interest at 10% and expires in February 2005. The second note for $2.6 million is secured by the assets purchased under the note and substantially all of Santera’s assets, excluding the assets secured under the $332,000 note, bears interest at a variable rate based on the two-year treasury note rate (6.36% at September 30, 2004) and expires in November 2005. Under the terms of this facility, we are required to maintain certain financial reporting covenants. We are in compliance with these covenant requirements as of September 30, 2004.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

     As a result of the Taqua transaction (see Note C — Acquisition of Taqua, Inc.), we have a $1.0 million credit facility with a U.S. financial institution. The $1.0 million credit facility is collaterized by substantially all assets of Taqua, Inc., bears interest at 1.0% above the lenders prime rate (4.75% at September 30, 2004) and expires in April 2005. Under the terms of this facility, Taqua is required to maintain certain financial ratios and meet certain net worth and indebtedness covenants. Taqua is not in compliance with these covenant requirements. There are no outstanding borrowings under this credit facility and none are planned prior to expiration of the facility.

     In June 2003, we issued and sold $125.0 million principal amount of our 2.25% Senior Subordinated Convertible Notes due 2008 (the “Notes”). The Notes were issued in a private offering in reliance on Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”). The initial purchaser of the Notes was Morgan Stanley & Co. Incorporated, which resold the Notes to qualified institutional buyers pursuant to Rule 144A promulgated under the Securities Act. The aggregate offering price of the Notes was $125.0 million and the aggregate proceeds to Tekelec were approximately $121.2 million after expenses. The Notes mature on June 15, 2008, and are convertible prior to the close of business on their final maturity date into shares of our common stock at a conversion rate of 50.8906 shares per $1,000 principal amount of the Notes, subject to adjustment in certain circumstances. There are no financial covenants related to the Notes, and there are no restrictions on us paying dividends, incurring debt or issuing or repurchasing securities.

Note L. Commitments and Contingencies

Indemnities, Commitments and Guarantees

     In the normal course of our business, we make certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These indemnities, commitments and guarantees include, among others, intellectual property indemnities to our customers in connection with the sale of our products and licensing of our technology, indemnities for liabilities associated with the infringement of other parties’ technology based upon our products and technology, guarantees of timely performance of our obligations, and indemnities to our directors and officers to the maximum extent permitted by law. The duration of these indemnities, commitments and guarantees varies, and, in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments that we could be obligated to make. We have not recorded a liability for these indemnities, commitments or guarantees in the accompanying balance sheets as to date no payments have ever been required under any of these indemnities, commitments or guarantees.

Legal Claims

     From time to time, various claims and litigation are asserted or commenced against us arising from or related to contractual matters, intellectual property matters, product warranties and personnel and employment disputes. As to such claims and litigation, including those matters discussed below, we can give no assurance that we will prevail. While we currently do not believe that the ultimate outcome of these matters, individually or in the aggregate, will have a material adverse effect on our business or consolidated financial position, results of operations or cash flows litigation is subject to inherent uncertainties. An unfavorable outcome in any of these matters could have a material adverse effect on our business or our consolidated financial position, results of operation or cash flows in the quarter or annual period in which one or more of these matters are resolved.

Lemelson Medical, Education and Research Foundation, Limited Partnership vs. Tekelec

     In March 2002, the Lemelson Medical, Education & Research Foundation, Limited Partnership (“Lemelson”) filed a complaint against thirty defendants, including Tekelec, in the United States District Court for the District of Arizona. The complaint alleges that all defendants make, offer for sale, sell, import, or have imported products that infringe eighteen patents assigned to Lemelson, and the complaint also alleges that the defendants use processes that infringe the same patents. The patents at issue relate to computer image analysis technology and automatic identification technology.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

Lemelson has not identified the specific Tekelec products or processes that allegedly infringe the patents at issue. Several Arizona lawsuits, including the lawsuit in which Tekelec is a named defendant, involve the same patents and have been stayed pending a non-appealable resolution of a lawsuit involving the same patents in the United States District Court for the District of Nevada. On January 23, 2004, the Court in the District of Nevada case issued an Order finding that certain Lemelson patents covering bar code technology and machine vision technology were: (1) unenforceable under the doctrine of prosecution laches; (2) not infringed by any of the accused products sold by any of the eight plaintiffs; and (3) invalid for lack of written description and enablement. In July 2004, Lemelson filed a notice of appeal with the Court of Appeals for the Federal Circuit, but Lemelson has not yet filed its appeal brief. Tekelec currently believes that the ultimate outcome of the lawsuit will not have a material adverse effect on our financial position, results of operations or cash flows.

Syndia Corporation

     In January 2002, Syndia Corporation (“Syndia”) sent a letter to Tekelec accusing Tekelec of infringing two patents and offering to license these and other patents to Tekelec. The patents at issue relate to integrated circuit technology. Syndia has not identified the specific Tekelec products or processes that allegedly infringe the patents at issue. Tekelec currently believes that the ultimate outcome of the lawsuit will not have a material adverse effect on our financial position, results of operations or cash flows.

Note M. Stock-Based Compensation

     As of September 30, 2004, we have five stock-based employee compensation plans. We account for employee stock option plans in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related interpretations of FIN No. 44, “Accounting for Certain Transactions Involving Stock Compensation.” Accordingly, compensation expense related to employee stock options is recorded, if on the date of the grant, the fair value of the underlying stock exceeds the exercise price.

     Seventy-two new Tekelec employees hired throughout the second quarter of 2004 were granted employment inducement stock options on July 21, 2004, under Tekelec’s equity incentive plan for new employees to purchase a total of 437,950 shares of Tekelec common stock, pursuant to NASDAQ Marketplace Rule 4350(i)(1)(A)(iv). The number of shares involved in these grants amounts to less than 1% of the outstanding common shares of Tekelec. All option grants have an exercise price equal to Tekelec’s closing price on July 21, 2004 of $16.32, and will vest over a four-year period.

     We also have an Employee Stock Purchase Plan (ESPP), with a maximum term of ten years, the latest of which expires in the year 2006, and under which 1.8 million shares of our Common Stock have been authorized and reserved for issuance. Eligible employees may authorize payroll deductions of up to 10% of their compensation to purchase shares of Common Stock at 85% of the lower of the market price per share at the beginning or end of each six-month offering period.

     To date, options have been granted at exercise prices that equal or exceed market value of the underlying common stock on the grant date. However, we have modified certain option grants that did require remeasurement on the modification date and accordingly have resulted in stock-based compensation as the exercise prices were below the fair market value on the date of the modification. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services.”

     SFAS No. 123 encourages but does not require companies to record compensation cost for stock-based employee compensation plans at fair value for awards granted subsequent to December 31, 1995. We have chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in related interpretations. However, in accordance with the disclosure only requirements of SFAS 123, we have computed the fair value of our stock option grants using the Black-Scholes option-pricing model with the following assumptions: (i) dividend yield of 0%, (ii) expected volatility of 78% and 85%, respectively, for 2004 and 2003, (iii) weighted average risk-free interest rates of

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

2.6% and 2.1% for 2004 and 2003, respectively, (iv) weighted average expected option lives of 4.1 and 5.0 years for 2004 and 2003, respectively, and (v) assumed forfeiture rate of 49% and 43% for 2004 and 2003, respectively.

     The following table illustrates the effect on stock-based compensation, net income (loss) in total and per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

Note N. Operating Segment Information

     During the fourth quarter of 2004, we renamed our three main operating segments. First, our network signaling product line has become the Network Signaling Group, second, our next-generation product line has become the Switching Solutions Group, third, our contact center product line has become the IEX Contact Center Group. As a result of our acquisition of Steleus in October 2004, we intend to form a fourth operating segment in the fourth quarter of 2004. The new operating segment will be the Communications Software Solutions Group and will include Steleus products as well as certain of our existing business intelligence applications and other network element independent solution products that were formally included in the Signaling product line. (See Note P — Subsequent Events).

     The Network Signaling Group (formerly Network Signaling) operating segment develops, markets and sells our Eagle signaling products and portfolio of value-added applications based on our high capacity Tekelec Eagle 5 Signaling Application System (SAS) platform. The Network Signaling segment’s product family also includes the Tekelec 1000 Applications Server (APS) (formerly TekServer), a high-density, high-speed processing platform that is backward compatible with existing technology; the Tekelec 500 Signaling Edge (formerly SS7/IP gateway) for signaling in converged networks, and other convergence products; Sentinel, a network monitoring and revenue assurance system; and

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

the ASi 4000 Service Control Point, an advanced database server used for the provisioning of telephony applications. During the fourth quarter of 2004, certain Network Signaling products, including Sentinel, which generated revenues of $3.0 million and $10.5 million for the three and nine months ended September 30, 2004, respectively, will be combined with Steleus to become our new Communications Software Solutions Group. (See Note P — Subsequent Events).

     The IEX Contact Center Group (formerly Contact Center) operating segment develops, markets and sells software-based solutions for call centers, including TotalView Workforce Management and TotalNet Call Routing.

     The Switching Solutions Group (formerly Next-Generation Switching) operating segment develops, markets and sells our Santera, Taqua and VocalData portfolio of switching solutions that allow network providers to migrate their network infrastructure from circuit-based technology to packet-based technology. Santera’s product portfolio includes the Tekelec 3000 Multimedia Gateway Controller (MGC) (formerly SanteraOne OFX) and the Tekelec 8000 Multimedia Gateway (MG) (formerly SanteraOne BoX), a carrier-grade, integrated voice and data switching solution which delivers applications like IXC tandem, Class 4/5, PRI offload, packet/cell switching and Voice over Broadband services. Taqua’s product portfolio includes the Tekelec 200 Applications Server (APS) (formerly Taqua EFX200), Tekelec 700 Line Access Gateway (LAG) (formerly Taqua iX700), and Tekelec 7000 Class 5 Packet Switch (C5) (formerly Taqua iX7000). During the third quarter of 2004, VocalData was added to our switching solutions group business unit. VocalData is a North American market share leader in IP Centrex hosted applications.

     Transfers between operating segments are made at prices reflecting markets conditions. The allocation of revenues from external customers by geographical area is determined by the destination of the sale.

     We conduct business in a number of foreign countries. We expect international sales to account for a significant portion of our revenues in future periods. Accordingly, we have identified four geographic territories for analyzing and reporting sales data. The four territories are: (1) North America, comprised of the United States and Canada, (2) “EMEA”, comprised of Europe, Middle East and Africa, (3) “CALA”, comprised of the Caribbean and Latin America including Mexico, and (4) Asia Pacific, comprised of Asia and the Pacific region including China. These territories are presented for the three and nine months ended September 30, 2004, with comparative information reclassified for the three and nine months ended September 30, 2003.

     Our operating segments and geographical information are as follows (in thousands):

Operating Segments

     The following table sets forth, for the periods indicated, revenues from external customers by principal product line.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

(1)		Results for Switching Solutions Group (formerly Next-Generation Switching) are for the period subsequent to the acquisition of Santera on June 10, 2003, the acquisition of Taqua on April 8, 2004 and the acquisition of VocalData on September 20, 2004.
(2)		General Corporate includes acquisition-related charges and amortization of $2,015 and $3,364 for the three months ended September 30, 2004 and 2003, respectively, and $15,988 and $11,961 for the nine months ended September 30, 2004 and 2003, respectively.

Enterprise-Wide Disclosures

     The following table sets forth, for the periods indicated, revenues from external customers by geographic territory:

     The following table sets forth, for the periods indicated, long-lived assets by geographic area in which we hold assets:

     Sales to two customers individually accounted for 16% and 12% of revenues for the three months ended September 30, 2004. The first customer, who accounted for 16% of our sales, included sales from our network signaling group and IEX contact center group operating segments. Sales to the second customer, who accounted for 12% of our revenue, included sales from our network signaling group operating segment. Sales to one customer accounted for 10% of our revenues for the nine months ended September 30, 2004, and included sales from our network signaling group and IEX contact center group operating segments.

     Sales to one customer accounted for 11% of revenues for the three and nine months ended September 30, 2003 and included sales from all operating segments. Sales to another other customer accounted for 11% of the revenues for the nine months ended September 30, 2003 and included sales from both the network signaling group and IEX contact center group operating segments. A third customer accounted for 15% of revenue for the three months ended September 30,

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

2003 and included sales from the network signaling group and IEX contact center group operating segments.

     Note O. Earnings Per Share

     The following table provides a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for the three and nine months ended September 30, 2004 and 2003:

     For the three and nine months ended September 30, 2004, the calculation of earnings per share includes, for the purposes of the calculation, the add-back to net income of $ 581 and $1,743 respectively, for assumed after-tax interest cost related to the convertible debt using the “if-converted” method of accounting for diluted earnings per share. The weighted average number of shares outstanding for the three and nine months ended September 30, 2004 includes 6,361 shares related to the convertible debt using the “if-converted” method.

     For the three and nine months ended September 30, 2003, the calculation of earnings per share includes, for the purposes of the calculation, the add-back to net income of $591 and $684, respectively, for assumed after-tax interest cost related to the convertible debt using the “if-converted” method of accounting for diluted earnings per share. The weighted average number of shares outstanding for the three and nine months ended September 30, 2003 includes 6,361 shares related to the convertible debt using the “if-converted” method.

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Tekelec
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note P — Subsequent Events

Acquisition of Steleus

     On October 14, 2004, we completed the acquisition of Steleus Group Inc. (“Steleus”), a real-time performance management company that supplies network-related intelligence to telecom operators. We paid an aggregate cash amount of approximately $55 million (“the Purchase Price) for 100% of Steleus’ outstanding stock. In addition, we incurred approximately $2.5 million in direct acquisition-related costs.

     In connection with the acquisition, 119 Steleus officers and employees were granted options to purchase a total of 881,550 shares of Tekelec common stock, of which options to purchase 200,000 shares were granted to Rick Mace, president and CEO of Steleus. In addition, seven Steleus officers and key employees were granted Restricted Stock Units (RSUs) representing the right to receive a total of 98,510 shares of Tekelec common stock, of which RSUs covering 34,478 shares of Tekelec common stock were granted to Mr. Mace. The RSU’s were valued at $1.7 million and will vest on October 14, 2005 with periodic charges to expense.

     The number of shares subject to such options and RSUs amounts to less than 2% of the outstanding shares of Tekelec common stock. The option and RSU grants were made under Tekelec’s 2004 Equity Incentive Plan for New Employees and met the “employee inducement” exception to the Nasdaq rules requiring shareholder approval of equity-based incentive plans.

     The acquisition will be accounted for using the purchase method of accounting. The financial results of Steleus subsequent to the acquisition will form the cornerstone of our new Communications Software Solutions Group (CSSG), along with Tekelec’s existing business intelligence applications, such as billing verification and other network element-independent applications. CSSG will be reported as a SFAS 131 operating segment beginning in the fourth quarter of 2004.

Employment Inducement Stock Options

     On October 25, 2004, eighty-five new Tekelec employees hired throughout the third quarter of 2004 were granted options to purchase a total of 537,550 shares of Tekelec common stock. The number of shares subject to such options amounts to less than 1% of the outstanding shares of Tekelec common stock. The option grants were made under Tekelec’s 2004 Equity Incentive Plan for New Employees and met the “employee inducement” exception to the Nasdaq rules requiring shareholder approval of equity-based incentive plans.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report and the Consolidated Financial Statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2003. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

Overview

     Tekelec is a leading developer of now and next-generation switching and signaling telecommunications solutions, network performance management technology, and value-added applications. Tekelec’s innovative solutions are widely deployed in traditional and next-generation wireline and wireless networks and contact centers worldwide. Corporate headquarters are located in Calabasas, California with research and development facilities and sales offices throughout the world. For more information, please visit www.tekelec.com.

     Our products are organized into four major operating groups. These four operating groups were created principally as a result of a rebranding initiative underway due to recent acquisitions. First, our network signaling product line has become the Network Signaling Group; second, our next-generation product line has become the Switching Solutions Group; third, our contact center product line has become the IEX Contact Center Group; and fourth, our new Communications Software Solutions Group will comprise Steleus products as well as certain of our existing business intelligence applications and other network element independent solution products that were formally included in the network signaling product line. (See Note P - Subsequent Events).

     Network Signaling Group (formerly Network Signaling). Our network signaling group consists principally of the Tekelec Eagle 5 SAS, Tekelec 1000 APS and Tekelec 500 Signaling Edge, as well as our local number portability solution and other convergence products. During the fourth quarter of 2004, certain Network Signaling products, including Sentinel, have been combined with Steleus to become our new Communications Software Solutions Group. (See Note P - - Subsequent Events).

     IEX Contact Center Group (formerly Contact Center). Our IEX contact center group products provide planning, management and call routing and control tools for single contact centers and for complex, multiple site contact center environments. This product line includes the TotalView Workforce Management and TotalNet Call Routing solutions.

     Switching Solutions Group (formerly Next-Generation Switching). This group comprises our Santera, Taqua, and VocalData switching solutions portfolio. Santera’s portfolio of switching solutions allows network service providers to migrate their network infrastructure from circuit-based technology to packet-based technology. Santera’s product portfolio includes the Tekelec 3000 MGC, and the Tekelec 8000 MG, a carrier-grade, integrated voice and data switching solution which delivers applications like IXC tandem, Class 4/5, PRI offload, packet/cell switching and Voice over Broadband services. Taqua’s product portfolio includes the Tekelec 200 APS, Tekelec 700 LAG, and Tekelec 7000 C5. VocalData’s IP Centrex application server is being integrated into the switching solutions group business unit.

     Our revenues are currently organized into four distinct geographical territories: North America, EMEA, CALA and Asia/Pacific. North America is comprised of the United States and Canada. EMEA is comprised of Europe, the Middle East and Africa. CALA is comprised of the Caribbean and Latin America including Mexico. Asia Pacific is comprised of Asia and the Pacific region including China.

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     On April 8, 2004, we completed our acquisition of Taqua, Inc., a privately held provider of next-generation packet switching systems, located in Richardson, Texas. (See Note C - Acquisition of Taqua, Inc.) Taqua offers a portfolio of circuit and IP voice switching products and services, including next-generation packet Class 5 switches, intelligent line access gateways, application servers, and an element management system. In addition, Taqua offers a suite of professional services including network design and capacity planning, as well as installation and cutover services. Taqua products became part of our switching solutions group in the second quarter of 2004.

     On September 20, 2004, we completed the acquisition of all of the outstanding shares of capital stock of privately held VocalData. (See Note B - Acquisition of VocalData, Inc.) VocalData is a provider of hosted Internet protocol (IP) telephony applications that enable the delivery of advanced telecom services and applications to business and residential customers. As a result of the acquisition, VocalData is the surviving corporation and a wholly owned subsidiary of Tekelec. Following our acquisition of VocalData, its products became part of our switching solutions group.

     On October 14, 2004, we completed the acquisition of Steleus Group Inc. (“Steleus”), a real-time performance management company that supplies network-related intelligence to telecommunications operators. (See Note P - Subsequent Events.) Steleus will be combined with certain existing Tekelec business intelligence applications, such as billing verification, and other network element-independent applications during the fourth quarter of 2004 to form Tekelec’s new communications software solutions business unit. The acquisition represents our ongoing strategy to offer more value-added applications to our customers and to further enhance and differentiate our switching solutions and signaling product offerings. Steleus products enable operators to monitor their service and network performance as they transition from circuit to packet technology, helping to speed up the implementation of packet networks, while lowering the risk.

Results of Operations

     The following table sets forth, for the periods indicated, the percentages that certain income statement items bear to total revenues:

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