UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED September 30, 2004

OR

COMMISSION FILE NUMBER: 000-24597

CARRIER ACCESS CORPORATION

(Exact name of registrant as specified in its charter)

5395 Pearl Parkway, Boulder, CO 80301

(Address of principal executive offices) (Zip Code)

(303) 442-5455

(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 o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes o No x

     The number of shares outstanding of the issuer’s common stock, par value $0.001 per share, as of November 8, 2004 was 34,248,449 shares.

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CARRIER ACCESS CORPORATION

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED FINANCIAL STATEMENTS

CARRIER ACCESS CORPORATION

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CARRIER ACCESS CORPORATION

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CARRIER ACCESS CORPORATION

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CARRIER ACCESS CORPORATION

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CARRIER ACCESS CORPORATION

Note 1. Summary of Significant Accounting Policies

     a. Business and Basis of Presentation. Carrier Access Corporation (the “Company”) is a provider of broadband digital access equipment to communications service providers, including incumbent local exchange carriers (“ILECs”), wireless service providers, competitive local exchange carriers (“CLECs”), interexchange carriers (“IXCs”), independent operating companies (“IOCs”), internet service providers (“ISPs”) and wireless service providers, which is used for the provisioning of enhanced voice and high-speed Internet services by service providers to end-users such as small and medium-sized businesses and government and educational institutions. The Company sells its products through distributors and directly to end-user customers. The Company operates in one business segment and substantially all of its sales and operations are domestic.

     The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to SEC regulations. The unaudited condensed consolidated financial statements reflect all adjustments and disclosures that are, in the opinion of management, necessary for a fair presentation. All such adjustments are of a normal recurring nature. Certain amounts in the 2003 consolidated financial statements have been reclassified to conform to the 2004 presentation. Management does not believe the effects of such reclassifications are material. The results of operations for the interim period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full fiscal year or any fiscal quarter. For further information, refer to the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

     The preparation of consolidated 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 disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

     b. Earnings Per Share. Basic earnings per share (“EPS”) is computed by dividing net income or loss by the weighted average number of common shares outstanding during the period. Diluted EPS reflects basic EPS adjusted for the potential dilution, computed using the treasury stock method, which could occur if securities or other contracts to issue common stock were exercised or converted and resulted in the issuance of common stock. For the three months ended September 30, 2004, all potentially dilutive securities are considered antidilutive due to the Company’s net loss and are therefore excluded from the computation of diluted earnings per share.

     A reconciliation of the weighted average shares used in computing basic and diluted earnings per share amounts is presented below. There were no adjustments to net income in order to determine diluted earnings per share.

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     c. Stock-Based Compensation. The following table summarizes relevant information regarding reported results under the intrinsic value method of accounting for stock awards, with supplemental information provided as if the fair value recognition provisions of SFAS No. 123, Accounting for Stock Based Compensation, had been applied for the three months and nine months ended September 30, 2004 and 2003 (in thousands, except per share amounts):

     The weighted average fair values of options granted during the three and nine months ended September 30, 2004 and 2003 were estimated using the Black-Scholes option-pricing model with the following assumptions:

     d. Exit and Disposal Activities. In December 2002, the Company completed a restructuring plan designed to reduce its expenses in accordance with anticipated reductions in revenue. Included in this plan were reductions in salary-related expenses, facility closures or downsizing, and disposal of excess or unused assets. As a result of these expense reductions, the Company took a charge in the fourth quarter of 2002 of $2.0 million. The Company paid $400,000 of this charge in the fourth quarter of 2002 and $1.1 million during 2003. During the first three quarters of 2004, the Company paid an additional $405,000 in connection with the restructuring plan. The remaining cash disbursements related to the restructuring plan are anticipated to be paid by the end of 2005. The Company has revised certain assumptions during the first nine months of 2004, relating to its ability to sublease one of its abandoned properties. The assumption change resulted in an increase in the restructuring reserve of $92,000.

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Restructuring reserve activity resulting from the 2002 fourth quarter restructuring plan for 2004 is detailed below (in thousands):

Note 2. Inventory

     The components of inventory are as follows (in thousands):

Note 3. Commitments and Contingencies

     On August 16, 2002, SMTC Manufacturing Corporation of Colorado (“SMTC”) filed a breach of contract claim and related claims against the Company in District Court, County of Adams, Colorado. The claim was based on an inventory-purchasing dispute and SMTC sought damages of $13.4 million. On October 17, 2002, the Company filed a breach of contract counterclaim and other related counterclaims in District Court, County of Adams, Colorado for $1.0 million. On December 5, 2002, the Company amended its counterclaim to seek damages of $27.0 million. The Company settled the SMTC lawsuit in September 2004 and as a result recorded a charge for the quarter ending September 30, 2004, in the amount of $2.1 million to reflect the settlement amount and legal expenses associated with the settlement.

Note 4. Subsequent Events

On October 13, 2004, the Company purchased its 5395 Pearl Parkway headquarters in Boulder Colorado for approximately $7.0 million.

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

NOTICE CONCERNING FORWARD-LOOKING STATEMENTS

     This Management’s Discussion and Analysis contains “forward-looking statements” within the meaning of the federal securities laws, including forward-looking statements regarding future sales of our products to our customers, inventory levels, our expectations regarding selling, general and administrative expenses, customer revenue mix, sources of revenue, gross margins, our tax liability, operating costs and expenses, and our capital expenditures. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” “potential,” or “continue, “ or the negative thereof or other comparable terminology. These statements are based on current expectations and projections about our industry and assumptions made by the management and are not guarantees of future performance. Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, these expectations or any of the forward-looking statements could prove to be incorrect, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition, as well as any forward-looking statements, are subject to risks and uncertainties, including but not limited to the factors set forth under the heading “Risk Factors” in Item 2 of this Quarterly Report on Form 10-Q. All forward looking statements and reasons why results may differ included in this report are made as of the date hereof, and, unless required by law, we undertake no obligation to update any forward-looking statements or reasons why actual results may differ in this Quarterly Report on Form 10-Q.

Overview

     We design, manufacture and sell next-generation broadband access communications equipment to wireline and wireless communications service providers. We were incorporated in September 1992 as a successor company to Koenig Communications, Inc., an equipment systems integration and consulting company which had been in operation since 1986. In the summer of 1995, we ceased our systems integration and consulting business and commenced our main product sales with the commercial deployment of our first network access products, which was followed by the introduction of our Wide Bank products in November 1997, Access Navigator products in January 1999, Adit products in December 1999, Broadmore products in October 2000, which we acquired from Litton Network Access Systems, Inc., and Axxius products in June 2002. In November 2003 we acquired the MASTERSeries and Broadway product lines through our acquisition of Paragon Networks International, Inc. (“Paragon”), a provider of wireless transport products to mobile wireless operators worldwide. In September 2004 we introduced the Adit 3000 product line.

     In November 2003, we completed the acquisition of Paragon. In exchange for all of the outstanding shares of Paragon capital stock, we issued 1,334,521 shares of our common stock and distributed $411,407 in cash to the Paragon stockholders. During the first quarter of 2004, we began the integration of some of the operations of Paragon. By the end of the third quarter, we completed our scheduled integration of customer service and manufacturing of Paragon products into our Colorado operations.

     During the late 1990s, a substantial number of service providers, including CLECs, invested heavily in network infrastructure and service delivery projects, which accelerated growth in the telecommunications equipment market. By 2000, when our annual net revenues reached $148.1 million, we relied on a limited number of CLECs for a significant portion of our net revenue. However, starting in late 2000, many of these CLECs encountered sharp declines in the amount of capital they had available to fund network infrastructure and service delivery projects. As a result, there was a significant decline in the demand for telecommunications equipment, including demand for our products.

     We now sell our product portfolio into multiple markets, including wireless service providers and incumbent wireline carriers. In 2000, 62% of our net revenue was derived from CLECs, 13% from ILECs, and 5% from wireless service providers compared to 16%, 11% and 48%, respectively, for the third quarter of 2004. Currently, the wireless and ILEC markets are dominated by a small number of large companies, and we continue to rely upon a small number of customers in the wireless markets for a significant portion of our revenue. Cingular Wireless, LLC, a wireless service provider, directly and indirectly through our original equipment manufacturer, or OEM, channel, accounted for over 20% of our net revenue for the quarter ended September 30, 2004.

     When the downturn in the telecommunications industry adversely affected our net revenue and operating results in late 2000, we reduced our operating expenses in an effort to better position our business for the long term. In December 2002, we initiated a restructuring plan designed to reduce our expenses and align our workforce and operations to be more in line with anticipated net

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revenues. Our objective has been to focus on cost controls while continuing to invest in advancing our product line in wireless and enterprise broadband access. We believe this will position us to take advantage of sales opportunities as economic conditions improve and demand recovers. However, we believe current economic conditions could continue to cause our customers and potential customers to defer and reduce capital spending.

     Historically, most of the sales of our products have been through a limited number of distributors. As a percentage of net revenue, one distributor, Walker & Associates, accounted for 16% in 2002, 11% in 2003, and 10% in the third quarter of 2004. Recently, however, an increasing proportion of our product sales have been made directly to OEMs. For the quarter ended September 30, 2004, one OEM, Ericsson, Inc., accounted for over 10% of net revenue. We expect that the sale of our products will continue to be made to a small number of distributors, OEMs, and direct customers. As a result, the loss of, or reduction of sales to, any of these customers would have a material adverse effect on our business.

     There has been and will continue to be consolidations in the telecommunications industry. Following the announcement of a consolidation, some of our customers may experience disruptions in their business operations. The effects of a consolidation involving any of our customers could result in postponed orders decreased orders or canceled orders. In the quarter ended September 30, 2004, market consolidation in the wireless industry relating to the merger of Cingular and AT&T Wireless and T-Mobile’s purchase of spectrum from Cingular resulted in reduced sales to our wireless customers and OEMs. Our net revenue continues to be affected by consolidation within the communications industry, the timing and number of orders for our products, which continue to vary from quarter to quarter due to factors such as demand for our products, economic conditions, and the financial stability and ordering patterns of our direct customers, distributors, and OEMs. In addition, a significant portion of our net revenue has been derived from a limited number of large orders. We believe that this trend will continue in the future, especially if the percentage of OEM and direct sales to customers continues to increase since such customers typically place larger orders than our distributors. The timing of such orders and our ability to fulfill them has caused material fluctuations in our operating results, and we anticipate that such fluctuations will continue in the future.

Results of Operations

Net Revenue and Cost of Goods Sold

     Net revenue for the three months ended September 30, 2004 increased to $21.6 million from $15.9 million reported for the three months ended September 30, 2003. The increase in revenue was primarily due to sales of our MASTERSeries products as well as increased sales of our Broadmore products. Net revenue for the nine months ended September 30, 2004 increased to $81.0 million from $39.3 million reported for the nine months ended September 30, 2003. The increase in revenue was primarily due to increases in sales of our Axxius, Broadmore and MASTERSeries products. The increase in sales of these products was partially due to the deployment of these products by some wireless carriers to comply with FCC mandated E911 location services, the addition of new cell sites and expansion of cell site bandwidth capacity. We also saw sales increases in our Adit product line due to increased deployment of voice, data, and voice over IP, or VoIP, offerings by our wireline customers. As a result of our acquisition of Paragon, we started selling the MASTERSeries product in the fourth quarter of 2003. These increases were partially offset by decreases in sales of our Wide Bank and Navigator product lines. Our net revenue also improved due to improving economic conditions and the lessening of capital market constraints in the telecommunications sector.

     During the first nine months of 2004, approximately 49% of our revenue was derived from the sales of our products through our distributors and OEMs. Our success depends in part on the continued sales and customer support efforts of our network of distributors and OEMs as well as increased sales to our direct customers. For the quarter ended September 30, 2004, Ericsson, Inc., an OEM, and Walker & Associates, a distributor, each accounted for over 10% of net revenue. We expect that the sale of our products will continue to be made to a small number of distributors and OEMs. Accordingly, the loss of, or a reduction in sales to, any of our key distributors or OEMs could have a material adverse effect on our business.

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     Cost of goods sold for the quarter ended September 30, 2004 was $13.0 million compared to $9.2 million in the quarter ended September 30, 2003. For the nine months ended September 30, 2004, cost of goods sold was $45.5 million compared to $22.0 million for the nine months ended September 30, 2003. The increases in cost of goods sold in 2004 were due to increased sales.

Gross Margins

          Our gross profit for the three months ended September 30, 2004 increased to $8.5 million from $6.8 million for the three months ended September 30, 2003. Gross profit for the nine months ended September 30, 2004 increased to $35.4 million from $17.3 million for the nine months ended September 30, 2003. This increase was caused by the increased shipments of our products in 2004. Gross margin declined to 40% for the quarter ended September 30, 2004 as compared to the quarter and nine months ended September 30, 2003. Gross margins were negatively impacted by shifts in product mix to lower margin products in addition to decreases in selling prices of some products.

     We believe that gross margins could increase in for the three months ended December 31, 2004 if sales of our products increase and if we are able to reduce the cost of our products at a greater rate than anticipated price reductions, or if we are able to gain additional manufacturing efficiencies. Conversely, new product introductions could potentially harm gross margins until production volumes increase. However, we believe these new product introductions will position us to take advantage of the anticipated market demand for such products in 2005. We believe that average selling prices and gross margins for our products will decline as such products mature, as volume price discounts in distributor contracts and direct sales relationships take effect, and as competition intensifies, among other factors. The average selling prices for the Wide Bank products and Adit products have decreased in the past two years. These decreases were due to unfavorable general economic conditions and the introduction of competitive products. In addition, discounts to distributors vary among product lines and are based on volume shipments, each of which affects gross margins. Our gross margins may also fluctuate based on product mix and channel mix.

Research and Development Expenses

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     Research and development expenses for the three months ended September 30, 2004 increased to $5.2 million from $2.5 million for the three months ended September 30, 2003. Research and development expenses for the nine months ended September 30, 2004 increased to $13.9 million from $7.6 million for the nine months ended September 30, 2003. The increase for the nine month period ended September 30, 2004 was primarily related to an increase in personnel expense of $3.3 million and approximately $1.3 million of prototype expenses to support the development and release of our converged IP voice and data network solutions. We believe our investment in research and development will position us for additional fiscal year 2005 product delivery. Overall, we believe that research and development expenses may decrease in the three months ended December 31, 2004 as compared to the three months ended September 30, 2004, due to an expected reduction of costs associated with prototypes.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses for the three months ended September 30, 2004 increased to $7.8 million from $3.6 million for the three months ended September 30, 2003. Selling, general and administrative expenses for the nine months ended September 30, 2004 increased to $20.4 million from $9.0 million for the nine months ended September 30, 2003. Going forward, we believe that expenses in this area will be reduced by approximately $200,000 quarterly due to the net cost savings obtained from purchasing the 5395 Pearl Parkway headquarters in Boulder Colorado.

     Sales and marketing expenses for the three months ended September 30, 2004 increased to $3.7 million from $2.8 million for the three months ended September 30, 2003. Sales and marketing expenses for the nine months ended September 30, 2004 increased to $12.3 million from $8.2 million for the nine months ended September 30, 2003. Sales and marketing expenses increased primarily as a result of a $3.4 million increase in personnel expense and commissions during the nine months ended September 30, 2004. Most of the increases in sales and marketing expenses were the result of the addition in sales and marketing personnel that occurred in November of 2003 with the acquisition of Paragon. We believe that the expenses in this area are strategic in developing new channels and new revenue in the wireless market. We anticipate that sales and marketing expenses could decrease in the three months ended December 31, 2004 as compared to the three months ended September 30, 2004.

     General and administrative expenses for the three months ended September 30, 2004 increased to $1.8 million from $1.3 million for the three months ended September 30, 2003. General and administrative expenses for the nine months ended September 30, 2004 increased to $5.4 million from $3.8 million for the nine months ended September 30, 2003. The increase was primarily attributable to an increase in personnel cost of $650,000 related to the acquisition of Paragon and $307,000 of costs for activities associated with compliance with the Sarbanes Oxley Act. We recovered bad debt expense of $165,000 for the quarter ended September 30, 2004 and

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$423,000 for the quarter ended September 30, 2003, as we continued to recover certain delinquent receivables from customers for which we had previously reserved. For the nine months ended September 30, 2004 we recovered bad debt of $446,000 compared to $3.0 million for the nine months ended September 30, 2003.

Settlement and the related legal expenses for the three months and nine months ended September 30, 2004 were $2.1 million. We settled the SMTC lawsuit in September 2004 and as a result recorded a charge for the quarter ending September 30, 2004, in the amount of $2.1 million to reflect the settlement amount and legal expenses associated with the settlement.

Interest and Other Income, Net

     Interest and other income, net for the quarter ended September 30, 2004 increased to $621,000 from $86,000 for the three months ended September 30, 2003. For the nine months ended September 30, 2004 interest and other income, net increased to $1.3 million from $258,000. The increase was attributable to higher interest rates and interest earned on larger cash balances due to the proceeds from our January 2004 public stock offering, along with a gain on the sale of a company asset of $143,000. We believe that net interest and other income will decline for the three months ended December 31, 2004 as compared to the three months ended September 30, 2004 due to lower cash and investment balances due primarily to the purchase of our Boulder Colorado headquarters.

Income Taxes

     We recorded an income tax expense of approximately $52,000 in the first nine months of 2004, due to Canadian income taxes. We also recorded approximately $15,000 of estimated AMT, state, and local income taxes. As such, in 2004, we are expecting no additional income tax expense and an increase to the valuation allowance. The $89,000 benefit from income taxes in the first nine months of 2003 relates to refunds received in excess of previous estimates. However, our income tax provision has differed from the expense that would be expected using the federal statutory rate of 34% due to the fact that beginning in the second quarter of 2002, we recorded a valuation allowance against our net deferred tax asset. We have identified net operating loss carryforwards of $51.5 million and $59.0 million for federal and state purposes, respectively. We cannot conclude that realization of the resulting deferred tax assets is more likely than not. Therefore, we have recorded a full valuation allowance to offset the deferred tax assets. Future reductions in the valuation allowance, if any, will be recorded as a benefit to income tax expense, an increase to goodwill, or an increase to additional paid in capital. To the extent, the valuation allowance associated with the deferred tax assets acquired in the 2003 acquisition of Paragon is reversed, there will be an increase to the amount of acquired goodwill and no impact will be recorded on our current income tax expense. A portion of our net operating loss in 2002, 2003, and 2004 is attributable to the benefit for the exercise of non-qualified stock options. If we reverse the valuation allowance related to this benefit, it will be reflected as an increase to additional paid in capital and will have no impact upon our current income tax expense. The reversal of the valuation allowance associated with the deferred tax assets other than the items discussed above will be recorded as a deferred income tax benefit that is an offset to current income tax expense.

Liquidity and Capital Resources

     At September 30, 2004, our principal sources of liquidity included cash and cash equivalents and marketable securities available for sale of approximately $120.0 million. At September 30, 2004, our working capital was approximately $152.5 million. We have no significant capital spending or purchase commitments other than facilities leases and inventory purchases.

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     Operating activities provided net cash of approximately $4.3 million for the nine months ended September 30, 2004, compared to $6.0 million for the nine months ended September 30, 2003. The decrease in cash provided by operating activities was primarily due to the payment of $2.1 million for the settlement amount and legal expenses associated with the settlement of the litigation with SMTC Manufacturing Corporation of Colorado during the third quarter of 2004, increases in inventory of $3.5 million, and decreases in accounts payable of $1.7 million. This was partially offset by decreases in our accounts receivable of $4.0 million and decreases of prepaids of $871,000.

     Cash used by investing activities for the nine months ended September 30, 2004 was $16.0 million compared to $6.8 million for the nine months ended September 30, 2003. For the nine months ended September 30, 2004, we had net purchases of $14.6 million of marketable securities compared to net purchases of $6.2 million for the nine months ended September 30, 2003. Our capital expenditures for the nine months ended September 30, 2004 were $1.8 million for equipment to support research, development, and manufacturing activities compared to $555,000 for the nine months ended September 30, 2003. We believe our current facilities are sufficient to meet our current operating requirements. We expect capital expenditures in the fourth quarter to increase over the third quarter due to the purchase of the Boulder, Colorado headquarters for approximately $7 million in October 2004.

     Net cash from financing activities provided $80.5 million for the nine months ended September 30, 2004, which was primarily due to $78.4 million in cash received from the January 2004 public offering as well as $2.1 million received from the exercise of stock options, compared to $51,000 received upon the exercise of stock options for the nine months ended September 30, 2003.

     Our net inventory levels increased approximately $3.8 million to $29.9 million at September 30, 2004 from $26.1 million at December 31, 2003. The increase was primarily the result of the inventory obtained to fulfill orders for our wireless service provider customers. We have placed non-cancelable purchase orders for $8.8 million of inventory from some of our vendors for delivery in 2004. These orders are generally placed up to four months in advance based on the lead-time of the inventory. We anticipate that inventory levels will decline in the three months ended December 31, 2004 as compared to the three months ended September 30, 2004 as we have decreased our purchasing relative to expected shipments of our current inventory.

     We believe that our existing cash and investment balances are adequate to fund our projected working capital and capital expenditure requirements for a period greater than 12 months. Although operating activities may provide cash in certain periods, to the extent we experience growth in the future, we anticipate that our operating and investing activities may use cash. We may consider using our capital to make strategic investments, acquisitions of companies, or to acquire or license technology or products. However, we cannot assure you that additional funds or capital will be available to us in adequate amounts and with reasonably acceptable terms.

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue and product returns, inventory valuations, allowance for doubtful accounts, intangible assets, deferred income taxes and warranty reserves. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We consider the following accounting areas to have the most significant impact on the reported financial results and financial position of our company.

     Revenue Recognition. We recognize revenue from product sales at the time of shipment and passage of title using guidance from SEC Staff Accounting Bulletin No. 104 “Revenue Recognition in Financial Statements.” In addition, we also offer certain of our customers the right to return products for a limited time after shipment as part of a stock rotation. We estimate what future stock rotation returns may occur based upon actual historical return rates and reduce our revenue by these estimated returns. If future returns exceed our estimates, revenue could be further reduced. In addition, modifications to generally accepted accounting principles could result in unanticipated changes in our revenue recognition policies and such changes could significantly affect future revenue and results of operations.

     Inventory Reserves. We value our inventory at the lower of standard cost, which approximates the actual cost to purchase and/or manufacture the inventory computed on a first-in, first-out basis, or the current estimated net realizable value. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements. We write down our inventory for estimated obsolescence or unmarketable

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inventory equal to the difference between the cost of inventory and the estimated net realizable value based upon assumptions about future demand and market conditions. If actual future demand or market conditions are less favorable than our estimates, then additional inventory write-downs may be required.

     Allowance for Doubtful Accounts. We perform ongoing credit evaluations of our customers and adjust open account status based upon payment history and the customer’s current creditworthiness, as determined by our review of current credit information. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon the age of outstanding invoices and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Because our accounts receivable are concentrated in a relatively few number of customers, a significant change in the liquidity or financial position of any one of these customers could have a material adverse impact on our ability to collect our accounts receivable and on our future operating results.

     Valuation of Intangible Assets. We evaluate the potential impairment of goodwill and other intangible assets from our purchase business acquisitions annually or more often as circumstances change. In assessing whether the value of our goodwill and other intangibles has been impaired, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of these assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges.

     Deferred Income Taxes. We account for our deferred tax assets pursuant to SFAS No. 109 “Accounting for Income Taxes” (“SFAS No. 109”). Under SFAS No. 109, a deferred tax asset is recognized for temporary differences that will result in tax deductions in future years and for tax credit carryforwards. Current income tax expense (benefit) represents actual or estimated amounts payable or receivable on tax return filings each year. Deferred tax assets and liabilities are recorded for the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying balance sheets, and for operating loss and tax credit carryforwards. The changes in deferred tax assets and liabilities for the period measure the deferred tax provision or benefit for the period. Effects of changes in enacted tax laws on deferred tax assets and liabilities are reflected as adjustments to the tax provision or benefit in the period of enactment. A valuation allowance is required under SFAS No. 109 to reduce deferred tax assets if management cannot conclude that realization of such assets is more likely than not at the balance sheet date. In the second quarter of 2002, we recorded a full valuation allowance against our deferred tax assets because we concluded that it was more likely than not that we would not realize these assets. Our decision was based on the cumulative losses we had incurred to that point as well as the full utilization of our loss carryback potential. We have maintained our policy of providing a full valuation allowance against all future tax benefits produced by our operating results. We expect to continue to provide a full allowance on any future tax benefits until we can sustain a level of profitability that demonstrates our ability to utilize these assets.

     Warranty Reserves. We offer warranties of various lengths to our customers depending on the specific product and the terms of our customer purchase agreements. Our standard warranties require us to repair or replace defective product returned to us during the warranty period at no cost to the customer. We record an estimate for warranty related costs based on our actual historical return rates and repair costs at the time of sale. On an on-going basis, management reviews these estimates against actual expenses and makes adjustments when necessary. While our warranty costs have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same warranty return rates or repair costs that we have in the past. A significant increase in products return rates or the costs to repair our products could have a material adverse impact on our operating results.

RISK FACTORS

The following is a discussion of certain factors that currently impact our business, operating results and/or financial condition. You should carefully consider the risks described below before making an investment decision.

As a result of declining sales of our products, we experienced large net losses and decreases in net revenue in 2001 and 2002, which caused a significant decline in the market price of our common stock. We experienced a decline in our third quarter 2004 revenue with a large net loss. We could experience similar declines in net revenue in the future, which could negatively impact the market price of our common stock.

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     Our quarterly and annual operating results have fluctuated significantly in the past and may continue to vary significantly in the future. Although we were profitable on an annual basis from 1997 to 2000, we experienced net losses of $14.9 million and $52.7 million in 2001 and 2002, respectively. Our net revenue decreased from $148.1 million in 2000 to $100.7 million and $50.2 million in 2001 and 2002, respectively. In addition, our net revenue decreased from $31.0 million for the quarter ended June 30, 2004 to $21.6 million for the quarter ended September 30, 2004, and we experienced a loss of $3.8 million for the quarter ended September 30, 2004.

     We face a number of risks that could cause our future net revenue and operating results to experience similar fluctuations, including the following:

•

the loss of, or significant reduction in purchases by, any of our large customers who directly and indirectly through our original equipment manufacturer, or OEM, channel;

•

reductions in capital spending for equipment by the telecommunications industry, a factor that resulted in a large decline in our product sales starting in 2000; and

•

costs related to acquisitions of technologies or businesses such as our acquisition of Paragon Networks International Inc.

We rely on a limited number of distributors and OEMs, the loss of any of which could cause a decline in our net revenue and have an adverse effect on our results of operations and the price of our common stock.

     A significant portion of the sales of our products are through distributors and OEMs, which generally are responsible for warehousing products, fulfilling product orders, servicing end-users and, in some cases, customizing and integrating our products at end-users’ sites. We rely on a limited number of distributors and OEMs to sell our products. One distributor, Walker & Associates, accounted for 16% and 11% of our net revenue in 2002 and 2003, respectively. In the quarter ended September 30, 2004, Walker & Associates and Ericsson, Inc., an OEM customer, each accounted for over 10% of our revenue. We expect that, in the future, a significant portion of our products will continue to be sold to a small number of distributors and OEMs. Accordingly, if we lose any of our significant distributors and OEMs or experience reduced sales to such distributors and OEMs, our net revenue would decline, which would have an adverse effect on our operating results and could cause a decline in the price of our common stock.

If our distributors are not successful both in terms of operating their own businesses and in selling our products to their customers, we could experience a decline in net revenue, an increase in inventory and bad debt, and deterioration in our operating results.

     In the past, some of our distributors have experienced problems with their financial and other resources that have impaired their ability to pay us. In 2002 we incurred bad debt of approximately $1.2 million from one of our distributors when it declared bankruptcy. Although we continually monitor and adjust our reserves for bad debts, we cannot assure you that any future bad debts that we incur will not exceed our reserves. Furthermore, we cannot assure you that the financial instability of one or more of our distributors will not result in decreased net revenue for us and deterioration of our operating results. Distributors have, in the past, reduced planned purchases of our products due to overstocking and such reductions may occur again in the future. Moreover, distributors who have overstocked our products have, in the past, reduced their inventories of our products by selling such products at significantly reduced prices. This may occur again in the future. Any reduction in planned purchases or sales at reduced prices by distributors in the future could harm our business by, among other things, reducing the demand for our products and creating conflicts with other distributors and our direct sales efforts.

Some of our distributors and OEMs have stock rotation and price protection rights as well as delivery penalties which could cause a material decrease in the average selling prices and gross margins of our products, either of which would have an adverse effect on our operating results and financial condition.

     We generally provide certain of our distributors and OEMs with limited stock rotation rights. Three times a year, these customers can return up to 15% of our unsold products to us in return for an equal dollar amount of new products. The returned products must have been held in stock by such distributor or OEM and have been purchased within the four-month period prior to the return date. We cannot assure you that we will not experience significant returns of our products in the future or that we will make adequate allowances to offset these returns.

     We also provide certain distributors and OEMs with price protection rights in which we provide these customers with 60-days notice of price increases. Orders we receive from distributors or OEMs within the 60-day period are filled at the lower product price. In the event of a price decrease, we are sometimes required to credit distributors and OEMs the difference in price for any stock they

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have in their inventory. In addition, we grant certain of our distributors and OEMs “most favored customer” terms, pursuant to which we have agreed not to knowingly grant another distributor or OEM the right to resell our products on terms more favorable than those granted to the existing distributor or OEM, without offering the more favorable terms to the existing distributor or OEM. It is possible that these price protection and “most favored customer” clauses could cause a material decrease in the average selling prices and gross margins of our products, which could in turn have a material adverse effect on distributor or OEM inventories, our business, financial condition, or results of operations.

     In addition, we provide certain distributors and OEMs with the right to liquidating damages in the event delivery date delays.

We do not have exclusive agreements with our distributors, which sell other broadband communications equipment that competes with our products. As a result, our distributors may not recommend or continue to use and offer our products or devote sufficient resources to market and support our products, which could result in a reduction in sales of our products.

     Our agreements with our distributors generally do not grant exclusivity, prevent the distributor from carrying competing products or require the distributor to purchase any minimum dollar amount of our products. Additionally, our distribution agreements do not attempt to allocate certain territories for our products among our distributors. To the extent that different distributors target the same end-users of our products, distributors may come into conflict with one another, which could damage our relationship with, and sales to, such distributors.

     Most of our existing distributors also distribute the products of our competitors. Our distributors may not recommend or continue to use and offer our products, or our distributors may not devote sufficient resources to market and provide the necessary customer support for our products. In addition, it is possible that our distributors will give a higher priority to the marketing and customer support of competitive products or alternative solutions.

     Our distributors do not have any obligation to purchase additional products, and accordingly, they may terminate their purchasing arrangements with us, or significantly reduce or delay the amount of our products that they order, without penalty. Any such termination, change, reduction, or delay in orders would harm our business.

We continue to rely on a limited number of direct customers, the loss of any of which could result in a decline in net revenue and the price of our common stock.

     A significant portion of our net revenue has been derived from a limited number of large orders to direct customers, and we believe that this trend will continue in the future. The majority of our direct customers do not have any obligation to purchase additional products, and, accordingly, they may terminate their purchasing arrangements with us or significantly reduce or delay the amount of our products that they order without penalty. We have experienced cancellations and delays of orders in the past, and we expect to continue to experience order cancellations and delays from time to time in the future. Any such termination, change, reduction or delay in orders would harm our business. The timing of customer orders and our ability to fulfill them can cause material fluctuations in our operating results, and we anticipate that such fluctuations will continue in the future.

     Additionally, there has been and will continue to be consolidations in the telecommunications industry. Following the announcement of a consolidation, some of our customers may experience disruptions in their business operations. The effects of a consolidation involving any of our customers could result in postponed orders, decreased orders, or canceled orders. In the quarter ended September 30, 2004, market consolidation in the wireless industry relating to the merger of Cingular and AT&T Wireless and T-Mobile’s purchase of spectrum from Cingular resulted in reduced sales to our wireless customers and OEMs. Such consolidations increase the uncertainty of our revenue, which makes quarterly revenues difficult to predict and quarterly comparisons less meaningful.

If our direct customers do not successfully operate their own businesses, their capital expenditures could be limited, which could result in a delay in payment for, or a decline in the purchase of, our products, which could result in a decrease in our net revenue and a deterioration of our operating results.

     In the past, some of our direct customers have experienced problems with their financial and other resources that have impaired their ability to pay us. In 2002, one of our direct customers filed for bankruptcy protection, and, as a result, we incurred approximately $1.1 million in bad debt. We cannot assure you that any bad debts that we incur in connection with direct sales will not exceed our

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reserves or that the financial instability of one or more of our direct customers will not continue to adversely affect future sales of our products or our ability to collect on accounts receivable for current sales of our products.

     In addition, we sell a moderate volume of products to competitive service providers. The competitive service provider market is overbuilt and is experiencing consolidation. Many of our competitive service provider customers do not have a strong financial position and have limited ability to access the public financial markets for additional funding for growth and operations. Neither equity nor debt financing may be available to these companies on favorable terms, if at all. To the extent that these companies are unable to obtain the financing they need, our ability to make future sales to these customers and realize revenue from any such sales could be harmed. In addition, if one or more of these competitive service providers fail, we could face a loss in revenue and an increased bad debt expense, due to their inability to pay outstanding invoices, as well as a corresponding decrease in customer base and future revenue. Furthermore, a significant portion of our sales to competitive service providers is made through independent distributors. The failure of one or more competitive service providers could cause a distributor to experience business failure and/or default on payments to us.

We grant certain of our direct customers “most favored customer” terms, which could cause a material decrease in the average selling prices and gross margins of our products, which would have an adverse effect on our operating results and financial condition.

     In agreements with direct customers that contain “most favored customer” terms, we have agreed to not knowingly provide another direct customer with similar terms and conditions or a better price than those provided to the existing direct customer without offering the more favorable terms, conditions or prices to the existing direct customer. It is possible that these “most favored customer” clauses could cause a material decrease in the average selling prices and gross margins of our products, which could, in turn, have an adverse effect on our operating results and financial condition.

A longer than expected sales cycle could cause our revenues and operating results to vary significantly from quarter to quarter.

     Our sales cycle averages approximately four to 18 months but can take longer in the case of incumbent local exchange carriers, or ILECs, and other end-users. This process is often subject to delays because of factors over which we have little or no control, including:

•

a distributor’s, OEM’s or service provider’s budgetary constraints;

•

a distributor’s, OEM’s or service provider’s internal acceptance reviews;

•

a distributor’s, OEM’s or service providers staffing levels and availability of lab time for product testing;

•

the success and continued internal support and development of a service provider’s product offerings;

•

the possibility of cancellation or delay of projects by distributors, OEMs or service providers; and

•

the possibility of a regulatory investigation of our distributors, OEMs or service providers.

     In addition, as service providers have matured and grown larger, their purchase processes have typically become more institutionalized, requiring more of our time and effort to gain the initial acceptance and final adoption of our products by these customers. Although we attempt to develop our products with the goal of facilitating the time to market of our customer’s products, the timing of the commercialization of a new distributor or service provider applications or services based on our products is primarily dependent on the success and timing of a customer’s own internal deployment program. Delays in purchases of our products can also be caused by late deliveries by other vendors, changes in implementation priorities and slower than anticipated growth in demand for our products. A delay in, or a cancellation of, the sale of our products could cause our results of operations to vary significantly from quarter to quarter.

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     In the industry in which we compete, a supplier must first obtain product approval from an ILEC or other carrier to sell its products to them. This process can last from four to 18 months or longer depending on the technology, the service provider, and the demand for the product from the service provider’s subscribers. Consequently, we are involved in a constant process of submitting for approval succeeding generations of products, as well as products that deploy new technology or respond to new technology demand from certain carriers or other end-users. We have been successful in the past in obtaining such approvals. However, we cannot be certain that we will obtain such approvals in the future or that sales of such products will continue to occur. Furthermore, the delay in sales until the completion of the approval process, the length of which is difficult to predict, could result in fluctuations of revenue and uneven operating results from quarter to quarter or year to year.

Communications service providers face capital constraints which have restricted and may continue to restrict their ability to buy our products, thereby resulting in longer sales cycles, deferral or delay of purchase commitments for our products, and increased price competition.

     Our customers consist primarily of communications service providers, including wireless service providers, local exchange carriers, multi-service cable operators, and competitive local and international communications providers. These service providers require substantial capital for the development, construction, and expansion of their networks and the introduction of their services. The general slowdown in the economy and the fact that an oversupply of communications bandwidth exists have resulted in a constraint on the availability of capital for these service providers and have had a material adverse effect on many of our customers, with numerous customers going out of business or substantially reducing their capital spending. If our current or potential customers cannot successfully raise necessary funds or if they experience any other adverse effects with respect to their operating results or profitability, their capital spending programs could continue to be adversely impacted. These conditions adversely impacted the sale of our products and our operating results most severely in the fourth quarter of 2000, and they continued to have an adverse impact throughout 2001, 2002, and 2003. These conditions may continue to result in longer sales cycles, deferral or delay of purchase commitments for our products, and increased price competition. In addition, to the extent we choose to provide financing to these prospective customers, we will be subject to additional financial risk, which could increase our expenses.

If we are unable to develop new or enhanced products that achieve market acceptance, we could experience a reduction in our future product sales, which would cause the market price of our common stock to decline.

     The communications industry is characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements, each of which may render our existing products obsolete or unmarketable. Our success depends on our ability to enhance our existing products and to timely and cost-effectively develop new products with features that meet changing end-user requirements and emerging industry standards. The development of new, technologically advanced products is an expensive, complex and uncertain process requiring high levels of innovation, as well as the accurate anticipation of technological and market trends. We may not be successful in identifying, developing, manufacturing, and marketing product enhancements or new products that will respond to technological change or evolving industry standards. It is possible that our new products and enhancements will not adequately meet the requirements of the marketplace and achieve market acceptance. Announcements of currently planned or other new product offerings by our competitors or us have in the past caused, and may in the future cause, distributors or end-users to defer or cancel the purchase of our existing products. Our inability to develop new products or enhancements to existing products on a timely basis, or the failure of such new products or enhancements to achieve market acceptance, could result in a decline in our future product sales and the price of our common stock.

The introduction of new or enhanced products could cause disruptions in our distribution channels and the management of our operations, which could cause us to record lower net revenue or adversely affect our gross margins.

     Our introduction of new or enhanced products will require us to manage the transition from older products in order to minimize disruption in customer ordering patterns, avoid excessive levels of older product inventories, and ensure that adequate supplies of new products can be delivered to meet customer demand. We have historically reworked certain of our products in order to add new features that were included in subsequent releases of the products, which generally resulted in reduced gross margins for those products until such time as production volumes of these new products increase. We can give no assurance that these historical practices will not occur in the future and cause us to record lower net revenue or negatively affect our gross margins.

We rely on the introduction of new or enhanced products to offset the declining sales prices and gross margins of our older products, and the failure of our new or enhanced products to achieve market acceptance could result in a decline in our net revenue and operating results.

     We believe that average selling prices and gross margins for our products will decline as such products mature and as competition intensifies. The average selling price for our Wide Bank products and Adit products has decreased substantially in the past two years.

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These decreases were due to general economic conditions and the introduction of competitive products. To offset declining selling prices, we believe that, in addition to reducing the costs of production of our existing products, we must introduce and sell new and enhanced products on a timely basis at a low cost or incorporate features in these products that enable them to be sold at higher average selling prices. To the extent that we are unable to reduce costs sufficiently to offset any declining average selling prices or that we are unable to introduce enhanced products with higher selling prices, our gross margins would decline, and such decline could adversely affect our operating results and the price of our common stock.

To develop new products or enhancements to our existing products, we will need to continue to invest in research and development, which could adversely affect our financial condition and operating results, especially if we need to increase the amount of our investment to successfully respond to developing industry standards.

     As standards and technologies evolve, we will be required to modify our products or develop and support new versions of our products. As a result, we may not have sufficient resources allocated to the development of new and enhanced products to remain competitive. The failure of our products to comply, or delays in achieving compliance, with the various existing and evolving technological changes and industry standards could harm sales of our current products or delay introduction of our future products.

We have limited supply sources for some key parts and components of our products, and our operations could be harmed by supply interruptions, component defects or unavailability of these parts and components.

     Many key parts and components are purchased from sole source suppliers for which alternative sources are not currently available. We currently purchase approximately 988 key components from suppliers for which there are currently no substitutes, and we purchase approximately 61 key components from single source suppliers. Lead times for materials and components vary significantly and depend on many factors, some of which are beyond our control, such as specific supplier performance, contract terms and general market demand for components. If product orders vary significantly from forecasts, we may not have enough inventories of certain materials and components to fill orders. In addition, many companies utilize the same materials and supplies as we do in the production of their products. Companies with more resources than our own may have a competitive advantage in obtaining materials and supplies due to greater buying power. These factors can result in reduced supply, higher prices of certain materials, and delays in the receipt of certain of our key components, which in turn may generate increased costs, lower margins, and delays in product delivery. Furthermore, due to general economic conditions in the U.S. and globally, our suppliers may experience financial difficulties, which could result in increased delays, additional costs, or loss of a supplier. We attempt to manage these risks through developing alternative sources, through engineering efforts designed to obviate the necessity of certain components, and by building long-term relationships and maintaining close personal contact with each of our suppliers. However, delays in or failures of deliveries of key components, either to us or to our contract manufacturers, and consequent delays in product deliveries, may occur in the future.

     We currently do not have long-term supply contracts for many of our key components. Our suppliers may enter into exclusive arrangements with our competitors, be acquired by our competitors, stop selling their products or components to us at commercially reasonable prices, refuse to sell their products or components to us at any price, or be unable to obtain or have difficulty obtaining components for their products from their suppliers.

     Our distributors, OEMs and direct customers frequently require rapid delivery after placing an order. Our inability to obtain sufficient quantities of the components needed to fulfill such orders has in the past resulted in, and may in the future result in, delays or reductions in product shipments, which could have an adverse effect on sales and customer relationships, our business, financial condition, or results of operations. In the event of a reduction or interruption of supply, it could take up to nine months or more for us to begin receiving adequate supplies from alternative suppliers. Furthermore, we may not be able to engage an alternative supplier who could be in a position to satisfy our production requirements on a timely basis, if at all. Delays in shipment by one of our suppliers have led to lost or delayed sales and sales opportunities in the past and may do so again in the future. In the third quarter of 2003, we were not able to fulfill all of our open purchase orders of our Axxius product due to unforecasted demand and an insufficient availability of parts.

     In addition, the manufacturing process for certain single or sole source components is extremely complex. Our reliance on suppliers for these components, especially for newly designed components, exposes us to potential production difficulties and quality variations that the suppliers experience. In the past, this reliance on outside suppliers for these components has negatively impacted cost and the timely delivery of our products to our customers.

Our industry is highly competitive; if we fail to compete successfully against our competitors, our market share and product sales could be adversely affected, resulting in a decline in our net revenue and deterioration of our operating results.

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     The market for our products is intensely competitive, with a large number of equipment suppliers providing a variety of products to diverse market segments within the telecommunications industry. Our existing and potential competitors include many large domestic and international companies, including companies that have longer operating histories, greater name recognition, larger customer bases and substantially greater financial, manufacturing, technological, sales and marketing, distribution, and other resources. Our principal competitors include Adtran, Inc., Advanced Fibre Communications, Inc., Cisco Systems, Inc., Eastern Research, Inc., Lucent Technologies, Inc., NMS Communications Corporation, Telco Systems, Inc., Tellabs, Inc., Verilink Corporation, Zhone Technologies, Inc. and other small independent systems integrators and private and public companies. Most of these companies offer products competitive with one or more of our product lines. We expect that our competitors that currently offer products competitive with only one of our products will eventually offer products competitive with all of our products. Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and financial resources, including large telecommunications equipment manufacturers and computer hardware and software companies, may enter these markets through acquisition, thereby further intensifying competition.

     Many of our current and potential competitors are substantially larger than we are and have significantly greater financial, sales and marketing, technical, manufacturing, and other resources and more established channels of distribution. As a result, such competitors may be able to respond more rapidly to new or emerging technologies and changes in customer requirements, or to devote greater resources than we can devote to the development, promotion, and sale of their products. In addition, such competitors may enter our existing or future markets with solutions, either developed internally or through acquisition, that may be less costly, provide higher performance or additional features, or be introduced earlier than our solutions. Successful new product introductions or enhancements by our competitors could cause a significant decline in sales or loss of market acceptance of our products. Competitive products may also cause continued intense price competition or render our products or technologies obsolete or noncompetitive.

     To be competitive, we must continue to invest significant resources in research and development and sales and marketing. We may not have sufficient resources to make such investments or be able to make the technological advances necessary to be competitive. In addition, our current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced gross margins, and loss of market share, any of which could cause a decline in the price of our common stock.

Our customers are subject to heavy government regulation in the telecommunications industry, and regulatory changes could adversely affect our customers’ capital expenditure budgets and result in reduced sales of our products and significant fluctuations in the price of our common stock.

     Competitive local exchange carriers, or CLECs, are allowed to compete with ILECs in the provisioning of local exchange services primarily as a result of the adoption of regulations under the Telecommunications Act of 1996, or the 1996 Act, that imposed new duties on ILECs to open their local telephone markets to competition. Although the 1996 Act was designed to expand competition in the telecommunications industry, the realization of the objectives of the 1996 Act is subject to many uncertainties. Such uncertainties include actions by the Federal Communications Commission, or the FCC, judicial and administrative proceedings designed to define rights and obligations pursuant to the 1996 Act, actions or inaction by ILECs or other service providers that affect the pace at which changes contemplated by the 1996 Act occur, resolution of questions concerning which parties will finance such changes, and other regulatory, economic, and political factors. Any changes to the 1996 Act or the regulations adopted thereunder, the adoption or repeal of new regulations by federal or state regulatory authorities apart from or under the 1996 Act, including the E911 FCC mandate or any legal challenges to the 1996 Act could have a material adverse impact upon the market for our products.

     We are aware of certain litigation challenging the validity of the 1996 Act and local telephone competition rules adopted by the FCC for the purpose of implementing the 1996 Act. Furthermore, Congress has indicated that it may hold hearings to gauge the competitive impact of the 1996 Act, and it is possible that Congress will propose changes to the 1996 Act. This litigation and potential regulatory change may delay further implementation of the 1996 Act, which could negatively impact demand for our products. Moreover, our distributors or service provider customers may require that we modify our products to address actual or anticipated changes in the regulatory environment, or we may voluntarily decide to make such modifications. Our inability to modify our products in a timely manner or address such regulatory changes could cause a reduction in demand for our products, a loss of existing customers or the failure to attract new customers, which would result in lower than expected net revenue and a decline in the price of our common stock.

Our dependence on third-party manufacturers could result in product delivery delays, which would adversely affect our ability to successfully sell and market our products and could result in a decline in our net revenue and operating results.

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     We currently use several third-party manufacturers to provide certain components, printed circuit boards, chassis, and subassemblies. Our reliance on third-party manufacturers involves a number of risks, including the potential for inadequate capacity, the unavailability of, or interruptions in, access to certain process technologies, transportation interruptions, and reduced control over product quality delivery schedules, manufacturing yields, and costs. Some of our manufacturers are undercapitalized and may be unable in the future to continue to provide manufacturing services to us. If these manufacturers are unable to manufacture our components in required volumes, we will have to identify and qualify acceptable additional or alternative manufacturers, which could take in excess of nine months. We cannot assure you that any such source would become available to us or that any such source would be in a position to satisfy our production requirements on a timely basis. Any significant interruption in our supply of these components would result in delays, the payment of damages for such delays, or reallocation of products to customers, all of which could have a material adverse effect on our ability to successfully sell and market our products and could result in a decline in our net revenue and operating results. Moreover, since a significant portion of our final assembly and test operations are performed in one location, any fire or other disaster at our assembly facility could also have an adverse effect on our net revenue and operating results.

Our executive officers and certain key personnel are critical to our business, and any failure to retain these employees could adversely affect our ability to manage our operations and develop new products or enhancements to current products.

     Our success depends to a significant degree upon the continued contributions of our Chief Executive Officer and key management, sales, engineering, finance, customer support, and product development personnel, many of whom would be difficult to replace. In particular, the loss of Roger L. Koenig, President and Chief Executive Officer and our co-founder, could adversely affect our ability to manage our operations. We believe that our future success will depend in large part upon our ability to attract and retain highly skilled managerial, sales, customer support and product development personnel. We do not have employment contracts with any of our key personnel. The loss of the services of any such persons, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel, particularly engineering personnel and qualified sales personnel, could adversely affect our ability to manage our operations and develop new products or enhancements to current products.

Our customers are subject to numerous and changing regulations and industry standards. If the products they purchase from us do not meet these regulations or are not compatible with these standards, our ability to continue to sell our products could be seriously harmed.

     Our products must comply with a significant number of voice and data regulations and standards, which vary between U.S. and international markets, and may also vary within specific foreign markets. We also need to ensure that our products are easily integrated with various telecommunications systems. Standards for new services continue to evolve, requiring us to continuously modify our products or develop new versions to meet new standards. Testing to ensure compliance and interoperability requires significant investments of time and money. If our systems fail to timely comply with evolving standards in U.S. and international markets, if we fail to obtain compliance on new features or if we fail to maintain interoperability with equipment from other companies, our ability to sell our products would be significantly impaired. We could thereby experience, among other things, customer contract penalties, delayed or lost customer orders and decreased revenues.

     We have maintained compliance with ISO 9001:2000 since we were first certified in May 2000, with Telcordia OSMINE since we were first certified in the fourth quarter of 2001 and with Network Equipment Building Standards Level 3 since we were first certified in April 1998. ISO 9001:2000 is a set of comprehensive standards that provide quality assurance requirements and quality management guidance. These standards act as a model for quality assurance for companies involved with the design, testing, manufacture, delivery and service of products. Telecordia, formerly known as Bellcore, developed the Osmine program, which is a process designed to ensure that all of the network equipment used by Regional Bell Operating Companies, or RBOCs, can be managed by the same software programs. NEBS, or Network Equipment Building Standards, is a set of performance, quality and safety requirements — which were developed internally at Bell Labs and later at Telecordia — for network switches. RBOCs and local exchange carriers rely on NEBS-compliant hardware for their central office telephone switching. We cannot assure that we will maintain these certifications. The failure to maintain any of these certifications may adversely impair the competitiveness of our products.

Our products may suffer from defects or errors that may subject us to product returns and product liability claims, which could adversely affect our reputation and seriously harm our results of operations.

     Our products have contained in the past, and may contain in the future, undetected or unresolved errors when first introduced or when new versions are released. Despite our extensive testing, errors, defects, or failures are possible in our current or future products or enhancements. If such defects occur, we may be subject to:

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•

delays in or losses of market acceptance and sales;

•

product returns;

•

diversion of development resources resulting in new product development delay;

•

injury to our reputation; or

•

increased service and warranty costs.

     Delays in meeting deadlines for announced product introductions, or enhancements or performance problems with such products, could undermine customer confidence in our products, which would harm our customer relationships.

     Our agreements with our distributors, OEMs and direct customers typically contain provisions designed to limit our exposure to potential product liability claims. However, it is possible that the limitation of liability provisions contained in our agreements may not be effective or adequate under the laws of certain jurisdictions. It is also possible that our errors and omissions insurance may be inadequate to cover any potential product liability claim. Although we have not experienced any product liability claims to date, the sale and support of our products entails the risk of such claims, and it is possible that we will be subject to such claims in the future. Product liability claims brought against us could harm our business.

The operations of acquisitions may prove difficult to integrate into our own, and we may not achieve the anticipated benefits of the acquisition.

     We recently completed the acquisition of Paragon Networks International Inc. The Paragon acquisition is the largest acquisition we have completed, and the complex process of integrating Paragon with our operations required significant resources. We will also face ongoing business challenges that principally include the geographic dispersion of our operations and generating market demand for an expanded product line. Failure to achieve the anticipated benefit of an acquisition or to successfully integrate the operations of an acquired company could harm our financial position and results of operations.

     We incurred and expect to continue to incur significant costs and commit significant management time integrating Paragon’s operations, technology, development programs, products, information systems, customers and personnel. We would expect to incur similar substantial costs with additional acquisitions for:

•

integrating and reorganizing operations, including combining teams, facilities and processes in various functional areas;

•

fees and expenses of professionals and consultants involved in completing the integration process;

•

settling existing acquired liabilities;

•

integrating technology and products; and

•

other transaction costs associated with the acquisition, including financial advisor, attorney, accountant and other fees.

     Some of these costs will result in an increase in our operating expenses, which, if not offset by an increase in net revenue if and when we are able to successfully sell and market the acquired product lines, would decrease our operating profits and adversely affect our cash flows and operating results, which could result in a decline in the price of our common stock.

Difficulties in integrating past or future acquisitions could adversely affect our operating results and result in a decline in the price of our common stock.

     We have spent and may continue to spend significant resources identifying businesses to be acquired by us. The efficient and effective integration of any businesses we acquire into our organization is critical to our growth. Our acquisition of Paragon, and any future acquisitions, involves numerous risks including difficulties in integrating the operations, technologies and products of the acquired companies, the diversion of our management’s attention from other business concerns and the potential loss of key employees of the acquired companies. Failure to achieve the anticipated benefits of these and any future acquisitions or to successfully integrate the operations of the companies we acquire could also harm our business, results of operations and cash flows. Additionally, we cannot assure you that we will not incur material charges in future quarters to reflect additional costs associated with any future acquisitions we may make.

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If we have insufficient proprietary rights or if we fail to protect those rights we have, third parties could develop and market products that are equivalent to our own, which would harm our sales efforts and could result in a decrease in our net revenue and the price of our common stock.

     We rely primarily on a combination of patent, copyright, trademark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights. As of September 30, 2004, we held a total of 14 issued U.S. patents and had approximately 11 pending U.S. patent applications. We have no U.S. trademark applications pending and have 14 registered trademarks. We cannot assure you that our pending patent or trademark applications will be granted or, if granted, will be sufficient to protect our rights. We have entered into confidentiality agreements with our employees and consultants, and non-disclosure agreements with our suppliers, customers, and distributors in order to limit access to and disclosure of our proprietary information. However, such measures may not be adequate to deter and prevent misappropriation of our technologies or independent third-party development of similar technologies. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy our products or obtain and use trade secrets or other information that we regard as proprietary. Furthermore, we may be subject to additional risks as we enter into transactions in foreign countries where intellectual property laws do not protect our proprietary rights as fully as the laws of the U.S. Because of the effort and cost associated with enforcing foreign intellectual property protections as compared with the comparative value of such protections, we suspended our activities related to obtaining international trademark and patent registrations in the first quarter of 2003. We cannot assure that our competitors will not independently develop similar or superior technologies or duplicate any technology that we have. Any such events could harm our ability to sell and market our products, which could result in a decrease in net revenue and the price of our common stock.

We may face intellectual property infringement claims that could result in significant expense to us, divert the efforts of our technical and management personnel, or cause product shipment delays.

     The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. As the number of entrants in our markets increases and the functionality of our products is enhanced and overlaps with the products of other companies, we may become subject to claims of infringement or misappropriation of the intellectual property rights of others. From time to time, third parties may assert patent, copyright, trademark, and other intellectual property rights to technologies that are important to us. Any future third-party claims, whether or not such claims are determined adversely to us, could result in significant expense, divert the efforts of our technical and management personnel, or cause product shipment delays. In the event of an adverse ruling in any litigation, we might be required to discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology, or obtain licenses from third parties. In addition, any public announcements related to litigation or interference proceedings initiated or threatened against us, even if such claims are without merit, could cause our stock price to decline.

     In our customer agreements, we agree to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks, or copyrights of third parties. In certain limited instances, the amount of such indemnities may be greater than the net revenue we may have received from our customer.

Increased sales volume in international markets could result in increased costs or loss of revenue due to factors inherent in these markets.

     We are in the process of expanding into international markets, and we anticipate increased sales from these markets. A number of factors inherent to these markets expose us to significantly more risk than domestic business, including:

•

local economic and market conditions;

•

exposure to unknown customs and practices;

•

legal regulations & requirements in foreign countries;

•

potential political unrest;

•		foreign exchange exposure;
•		unexpected changes in or impositions of legislative or regulatory requirements;

•

less regulation of patents or other safeguards of intellectual property; and

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•

difficulties in collecting receivables and inability to rely on local government aid to enforce standard business practices.

     Any of these factors, or others, of which we are not currently aware, could result in increased operating costs or loss of net revenue.

Failure to meet future capital needs would adversely affect our ability to fund our business operations and result in a decline in the price of our common stock.

     We require substantial working capital to fund our business. As of September 30, 2004, we had approximately $120.0 million in cash and marketable securities. We believe that our cash and marketable securities, together with cash generated by operations, if any, will be sufficient to meet our capital requirements for at least the next 12 months. However, our capital requirements depend on several factors, including the rate of market acceptance of our products, our ability to expand our client base and the growth of sales and marketing. If our capital requirements vary materially from those currently forecasted, we may need to obtain additional financing. Additional financing may not be available when needed on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to develop or enhance our services, take advantage of future opportunities, or respond to competitive pressures, which would adversely affect our business and result in a decline in the price of our common stock.

While we believe we currently have adequate internal control over financial reporting, we are required to evaluate our internal control over financial reporting under Section 404 of the Sarbanes Oxley Act of 2002 and any adverse results from such evaluation could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

     While we currently believe our internal control over financial reporting is effective, we are still performing the system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting, we will be unable to assert such internal control is effective unless we remediate such material weakness before December 31, 2004. If we are unable to assert that our internal control over financial reporting is effective as of December 31, 2004 (or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price.

     While we currently anticipate being able to satisfy the requirements of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and any required remediation due in large part to the fact that there is no precedent available by which to measure compliance with the new Auditing Standard No. 2. In this regard, our auditors have advised us that it is of critical importance that we diligently continue to complete our Section 404 work and to provide our results and assessments to our auditors on a timely basis so that our auditors can have available the staff necessary to complete their work and issue their attestation report by the required date. If we were not able to comply with the requirements of Section 404 in a timely manner our report would be unable to conclude that our internal control over financial reporting is effective as of December 31, 2004.

A small number of shareholders can exert significant influence on the outcome of matters requiring the approval of a majority of the outstanding shares of our common stock.

     As of September 30, 2004, our directors and executive officers, together with members of their families and entities that may be deemed affiliates of, or related to, such persons or entities, beneficially owned approximately 41% of our outstanding shares of common stock. In particular, Mr. Koenig, a director and our President and Chief Executive Officer, and Ms. Pierce, a director and our Secretary and Corporate Development Officer, are married. As of September 30, 2004, Mr. Koenig and Ms. Pierce together beneficially owned approximately 40% of our outstanding shares of common stock. Accordingly, these two stockholders can exert significant influence over the election of members of our Board of Directors and the outcome of all corporate actions requiring stockholder approval of a majority of the voting power held by our stockholders, such as mergers and acquisitions. This level of ownership by such persons and entities may delay, defer, or prevent a change in control and may harm the voting and other rights of other holders of our common stock.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Market risk represents the risk of loss that may impact the financial position, results of operations, or our cash flows of the due to adverse changes in financial and commodity market prices and rates. Historically, and as of September 30, 2004, we have had little or no exposure to market risk in the area of changes in foreign currency exchange rates as measured against the United States dollar. Historically, and as of September 30, 2004, we have not used derivative instruments or engaged in hedging activities. Interest rate risk is not significant to our investments.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

(b) Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

     In connection with preparation for its Report on Financial Reporting Controls, during the 2004 third quarter we identified and initiated a number of measures to improve the effectiveness of its internal control over financial reporting. In general, these measures included improved documentation, improved system access controls, additional segregation of duties, and documented reviews and approvals of work performed or procedures executed. These improvements in controls were implemented to address identified control deficiencies and also to strengthen existing controls.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On August 16, 2002, SMTC Manufacturing Corporation of Colorado filed a breach of contract claim and related claims, against us in District Court, County of Adams, Colorado. The claim was based on an inventory-purchasing dispute and SMTC sought damages of $13.4 million. On October 17, 2002, we filed a breach of contract counterclaim, and other related counterclaims, in District Court, County of Adams, Colorado for $1.0 million. On December 5, 2002, we amended our counterclaim to seek damages of $27.0 million. Carrier Access settled the SMTC lawsuit in September 2004 and as a result recorded a charge $2.1 million for the quarter ending September 30, 2004 to reflect the settlement amount and legal expenses associated with the settlement

     We are involved in certain disputes and legal actions arising in the ordinary course of our business. While it is not feasible to predict or determine the outcome of these proceedings, in our opinion, based on a review with legal counsel, none of these disputes and legal actions is expected to have a material effect on our consolidated financial position, results of operations, or cash flows. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business.

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

     None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None.

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

At our Annual Meeting of Stockholders, held on May 26, 2004, the following matters were approved by the requisite vote:

     The following individuals were elected to serve on the Board of Directors until the next annual meeting of stockholders:

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     The vote for the ratification of the appointment by the Board of Directors of KPMG LLP as our independent auditors for the fiscal year ended December 31, 2004 was as follows:

ITEM 5. OTHER INFORMATION

     None.

ITEM 6. EXHIBITS

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Signature

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

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EXHIBIT INDEX

* Filed herewith.

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