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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

OR

For the transition period from ____________ to ____________

Commission File Number 000-28843

TURNSTONE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

2220 Central Expressway, Santa Clara, California 95050

(Address of principal executive offices) (Zip Code)

(408) 907-1400

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value

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

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

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

As of June 28, 2002, the aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant (based on the closing price for the common stock on the Nasdaq National Market on such date) was approximately $142,130,899. This amount excludes shares held by the Registrant and its directors, executive officers, and holders of five percent or more of the Registrant’s outstanding common stock.

As of February 28, 2003, there were 65,957,107 shares of the Registrant’s common stock outstanding.

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TURNSTONE SYSTEMS, INC.

FORM 10-K

DECEMBER 31, 2002

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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements represent our expectations or beliefs and include, but are not limited to, the following:

Readers are urged to carefully review and consider the various disclosures we make which attempt to advise them of the factors which affect our business, including, without limitation, the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and under the caption “Business—Risk Factors Affecting Future Results” included herein. These important factors, which could cause actual results to differ materially from the forward-looking statements contained herein, include, without limitation:

We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

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PART I

Item 1.    Business

Company History and Recent Developments

We were incorporated in Delaware in January 1998. Our principal executive offices are located at 2220 Central Expressway, Santa Clara, California 95050, and our telephone number there is (408) 907-1400. All of our public filings with the Securities and Exchange Commission are accessible from our corporate website at www.turnstone.com. Information contained on the website is not a part of this annual report.

We are a provider of hardware and software products that enable local exchange carriers to rapidly deploy and efficiently maintain copper local loop services. We began shipping the Copper CrossConnect^® CX100, our first volume product, in the first quarter of 1999. In January 2000, we completed an initial public offering of our common stock, which began trading on the Nasdaq National Market under the symbol “TSTN”. By August 2000 we had shipped more than 10,000 CX100s.

Beginning in the fourth quarter of 2000 and continuing through 2001, however, substantially all of our competitive local exchange carrier customers were unable to obtain additional financing or generate sufficient cash flows to fund their operations. They either reduced or discontinued the build-out of their networks, including purchases of our products. Many of them ultimately ceased business operations or filed for bankruptcy protection. As a result, our sales were negatively impacted and we incurred significant operating losses. In response to reduced demand for our products, we restructured our operations by reducing overall company headcount and closing our New Zealand engineering facility. In addition, our future success became increasingly dependent upon penetrating the incumbent local exchange carrier market and developing new frame automation products for that market.

In 2002, we continued to focus on the incumbent carrier market and on research and development efforts related to new frame automation products. In the third quarter of 2002, BellSouth Corporation completed a field trial of and purchased one of our unbundled network element, or UNE, management systems. However, in the fourth quarter of 2002, BellSouth decided not to budget for additional network deployment of our UNE management solution in 2003. We also experienced weak demand for our existing products and a lack of visibility into future demand for our products under development.

On January 9, 2003, we announced that we were exploring various strategic alternatives, including possible merger and asset sale transactions, licensing arrangements, and dissolution of the company and distribution of assets to stockholders. We also announced that we had engaged Goldman Sachs & Co. as our financial advisor. While we explore our strategic alternatives, our operating activities will be focused primarily on in-process research and development related to our next generation copper automation products for incumbent local exchange carriers. While a limited supply of our existing products remain available for sale, we have generally ceased all direct sales efforts related to them, and do not expect to generate material revenues from them for the foreseeable future. In connection with these decisions, we further reduced our headcount by approximately 40%, or 29 employees, in January 2003.

Company Overview

We design, engineer, market and support hardware and software products that enable local exchange carriers to rapidly deploy and efficiently maintain copper local loop services. The “local loop” refers to the network of existing telephone lines that extend from telephone companies’ central offices out to end customers. Incumbent local exchange carriers originally built this network to deliver traditional voice services. Through deregulation under the U.S. Telecommunications Act of 1996 and similar legislation in some other countries, competitive local exchange carriers have gained access to, and are also allowed to deliver their services through, the incumbent carriers’ local loop infrastructure. In particular, with the advent and rapid growth of the Internet

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and the increasing demand for faster Internet access, both incumbent and competitive carriers have been offering high-speed digital subscriber line, or DSL, services over the local loop.

Efficient management of the local loop is challenging for incumbent local exchange carriers. This labor-intensive management process typically involves the incumbent carriers’ personnel manually completing or removing connections inside central offices, at subscribers’ sites and possibly at various points throughout the local loop, which often results in faulty connections. In addition, the ability to deliver certain types of local loop services, such as DSL, is dependent upon the length and quality of the copper line. In order to verify and properly prepare the copper line for service delivery, the length of the line must be correctly measured and various devices connected to, or faults occurring on, the line must be identified in advance. Finally, monitoring and maintenance of the delivered services can be labor intensive and costly. Local exchange carriers often must dispatch technicians to individual central offices to diagnose problems, reconnect lines, to correct equipment failures or to change subscriber services.

Our products enable incumbent and competitive local exchange carriers to more effectively deliver their services. Our CX loop management systems are deployed to assist with copper loop installation, qualification, service verification and maintenance. Our SX Smart Splitter^® platform combines signal splitting capabilities with test access to assist in the delivery of asynchronous DSL, or ADSL, services. Our MX Copper CrossConnect^® solution provides remote switching and service verification capabilities to facilitate the management of unbundled local loops. Our next generation frame automation solution, currently under development, is intended to provide fast, high capacity, automated copper line switching and connection verification capabilities. Finally, our CrossWorks^™ and ONYX automation software suites enable service providers to remotely control our network equipment and seamlessly integrate loop management functions into their back-office operations support systems, or OSS.

Products

Loop Management Family.    Our loop management product family consists of the CX40 and CX100 hardware platforms, optimized for remote terminal and central office environments, respectively, and a variety of expansion modules as well as CrossWorks^™ loop management application software. The base system, which depends on customer configuration, typically consists of: one CX series chassis; one P150 module that provides the management, testing and control functions of the chassis; and one or more modules that provide additional testing, test access, cross connecting, service verification and/or central office equipment management functions. The base system is typically installed and cabled in a central office, with additional modules added over time as subscriber count increases and as more DSL access multiplexer modules are added. All modules may be inserted or removed while the system is operational and are automatically recognized and inventoried by the system upon insertion. All modules, indicators and switches are accessible from the front of the system, consistent with current industry practices. The CX series platform supports dual 48-volt power feeds. In the event of a loss of power, the CX series platform maintains all connections with no loss of subscriber service. The CX100 chassis is available in the 19 inch configuration which supports 425 lines, and the 23 inch configuration, which supports 550 lines. The following modules are currently available for the CX series platforms:

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Smart Splitter^® Family.    Our Smart Splitter^® product family consists of the Smart Splitter^® SX500 and its expansion modules. The SX500 incorporates signal splitting and test access for the efficient provisioning of ADSL and voice services over the same line and in line sharing arrangements. The system consists of one SX500 chassis, one SP series module that provides management and control functions and one or more SL24 splitter modules that provide signal splitting functionality and test access for 24 lines per module. Additional modules may be added over time as subscriber count increases. All modules may be inserted or removed while the system is operational, and a continuous dial tone is assured even during these module changes. The SX500 supports dual 48-volt power feeds. The SX500 is available in the 19 inch configuration, which supports 456 lines, and the 23 inch version which supports 576 lines. The following modules are currently available in volume for the SX500:

Crossworks^™.    CrossWorks^™ is a suite of software products that enables service providers to automate physical management of a large volume of copper lines when using CX series systems. When the CX series systems and the SX500 systems are deployed together, CrossWorks^™ can be used to manage both systems. CrossWorks^™ employs a client-server architecture that offers flexible integration with existing operational support systems. Alternatively, a service provider can use CrossWorks^™ as a standalone client-server application. With either of these approaches, CrossWorks^™ is designed to interface with the service provider’s existing database through a standard application programming interface. These options are designed to provide the service provider with automated system capabilities while leveraging its existing operational support systems infrastructure.

UNE Management Family.    Our unbundled network element, or UNE, management product family consists of the MX500 Copper CrossConnect^® platform and ONYX UNE software. The MX500 platform is placed in central offices, serving as a demarcation point between incumbent local exchange carriers and alternate providers. It offers metallic switching capabilities that are used to handle the cut-over of unbundled copper loops from one service provider to another. An integrated testhead is used to provide remote service verification, corroborating the accuracy of the cut-over procedure during the allocated time window. ONYX UNE software is used to identify, coordinate, schedule and analyze all tasks involved in the cut-over process. The ONYX UNE software automatically schedules all work steps required for service transfer, and remotely controls the MX500 to insure that these transfers are performed accurately.

By using ONYX UNE software in conjunction with the MX500, a single network center technician can manage service transfers remotely. By eliminating the need for coordinated inside and outside central office dispatches, this improves the speed with which cut-overs are delivered and reduces the costs associated with wholesale service delivery. In addition, our UNE management solution improves the accuracy of service transfer, which helps service providers avoid labor costs and regulatory penalties that may be associated with missed delivery windows. Finally, by preserving dial tone throughout the entire transfer process, our solution helps to make the loop cut-over process seamless to end users.

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Customers

Revenues from significant customers as a percentage of our total revenues for the years ended December 31, 2002 and 2001 were as follows:

We have no long-term contracts with any of our customers, and they may reduce or discontinue their purchases at any time. Our sales declined materially in 2002. We anticipate that our revenues will continue to decline until we achieve substantial sales of our UNE management and frame automation solutions, if any.

Sales and Marketing

We sell and market our products through our direct sales force and through reseller arrangements.

Direct Sales.    As of February 1, 2003, our direct sales effort in North America was managed by three account executives and one systems engineer. We are primarily focused on North American incumbent local exchange carriers who may be interested in testing and purchasing our UNE management and frame automation product families. We have closed our international sales and marketing subsidiaries in Australia, Brazil, Hong Kong, Singapore and the United Kingdom.

Indirect Sales.    In June 2001, we entered into a worldwide, non-exclusive original equipment manufacturer agreement with Alcatel S.A. for our loop management and Smart Splitter product families. Under the terms of our agreement with Alcatel, Alcatel will market, sell and support our products in conjunction with its own suite of broadband access solutions. The Alcatel agreement expires in June 2004, may be renewed by agreement of both parties for an additional twelve-month period, and is terminable by either party on a yearly basis. The agreement contains no minimum purchase requirements, and products are shipped against individual purchase orders. As of February 1, 2003, sales of our products under the Alcatel agreement have been minimal.

Customer Service and Support

We believe a high level of continuing service and support is critical to our long-term success. We offer comprehensive hardware and software maintenance and support programs for our products. The majority of our service and support activities are related to training, troubleshooting and network management. These services are provided by telephone, email, web access and directly at customer locations using personnel from our customer support group. We also offer various training courses for our direct customers and resellers. Due to decreased demand for customer support services, we have substantially reduced the size of our customer support organization and our sales and marketing efforts related to our maintenance and support programs.

Research and Development

We are currently investing significant resources to develop next-generation frame automation and switching products and related operational support system interfaces and capabilities. We have assembled a team of highly skilled engineering professionals and operations specialists who are experienced in designing networking equipment and network management software. Our engineering personnel have expertise in a number of fields, including digital loop carrier design, voice and data switching technology, local loop equipment design and operations support systems. During 2002, we spent $15.0 million on research and development, exclusive of non- cash compensation expense. As of February 1, 2003, we had a total of 35 engineering and operations employees

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engaged in research and development. They are primarily focused on the development of our next-generation frame automation products.

Competition

The market for telecommunications equipment is highly competitive. A number of companies that have traditionally produced products for analog voice and circuit-based networks also sell products that compete with our loop management and Smart Splitter products.

These companies include: ADC Telecommunications, Inc.; Harris Corporation; Marconi; Nortel Networks; Sunrise Telecom; Spirent plc; Teradyne Corporation; and Tollgrade Communications. Our primary competitors in the copper switching and unbundled network management market include Avaya, Con-X Corporation, NHC Communications and Simpler Networks.

We also compete with DSL equipment providers including Alcatel, Lucent and Nokia, who have each announced plans to incorporate competitive features and functionality into their DSL access multiplexers. To the extent we expand the capabilities of our products to incorporate functionality traditionally contained in other equipment, we may also face increased competition from other vendors.

Remaining competitive in our markets will require a continued high level of investment in research and development, marketing, and customer service. The principal competitive factors in our market include:

Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and financial resources, including other large telecommunications equipment manufacturers, may enter our markets, thereby further intensifying competition. We may not have sufficient resources to continue to make the investments or achieve the technological advances necessary to compete successfully.

The markets for telecommunications products are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, frequent changes in end user requirements, evolving industry standards and governmental regulations. The emerging nature of these products and services and their rapid evolution requires us to continually improve the performance, features and reliability of our products, particularly in response to competitive product offerings. Current or future competitors may foresee the course of market developments more accurately than we do and may introduce products incorporating superior or alternative technologies that could render our products obsolete.

Manufacturing

Our manufacturing operation is entirely outsourced. We and Fine Pitch Technologies, Inc., a subsidiary of Solectron Corporation, are parties to a contract manufacturing agreement, under which we subcontract manufacturing of our products. Fine Pitch, located in San Jose, California, is an established contract

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manufacturer with ISO 9002 and Telecordia, formerly Bellcore, certifications. These certifications relate to the manufacturer’s compliance with industry standards for quality control procedures and telecommunications products. This subcontracting arrangement includes material procurement, board level assembly, final assembly, testing and shipment to our customers. We utilize automated design, manufacturing and test processes to minimize cycle times and improve product quality. We design and implement all of the tests that are required to meet internal and external quality standards, and routinely monitor product quality via on-site inspections.

Intellectual Property

We rely on a combination of copyright, patent, trademark, trade secret and other intellectual property laws, nondisclosure agreements and other protective measures to protect our intellectual property. We have filed 21 patent applications as of February 1, 2003, from which six patents have been issued. We have also registered Turnstone Systems, the Turnstone Systems logo, Copper CrossConnect CX100 and Smart Splitter SX500 as trademarks.

We attempt to protect our intellectual property rights by limiting access to the distribution of our software, documentation and other proprietary information. In addition, we enter into confidentiality agreements with our employees and certain customers, vendors and strategic partners. These steps may fail to prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our intellectual property as fully as in the United States. Other parties may independently develop competing technology. Attempts may be made to copy aspects of our products or to obtain and use information that we regard as proprietary. Our existing and future patent applications, if any, may not be approved, any issued patents may not protect our intellectual property, and any issued patents may be challenged by third parties. Any failure to adequately protect our intellectual property could result in our competitors offering similar products, potentially resulting in loss of a competitive advantage and decreased revenues.

Employees

As of February 1, 2003, we had a total of 48 full-time employees based in the United States. Of the total, 35 engineering and operations professionals were engaged in research and development, 5 were engaged in sales, marketing and customer support and 8 were engaged in administration and finance. None of our employees is subject to a collective bargaining agreement and we believe that our relations with our employees are good.

Risk Factors Affecting Future Results

In addition to other information in this Form 10-K, the following risk factors should be carefully considered in evaluating us and our business because such factors may have a significant impact on our business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-K, and the risks discussed in our other Securities and Exchange Commission filings, actual results could differ materially from those projected in any forward-looking statements.

Our exploration of strategic alternatives may be unsuccessful and may have an adverse effect on our operating results and stock price.

In January 2003, we engaged Goldman, Sachs & Co. as our financial advisor to explore various strategic alternatives to maximize our stockholder value, including possible merger and asset sale transactions, licensing arrangements, and dissolution of the company and distribution of assets to our stockholders. We are uncertain as to what strategic alternatives may be available to us or what impact any particular strategic alternative will have on our stock price if accomplished. Uncertainties and risks relating to our exploration of strategic alternatives include:

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Even if interested third parties are willing to explore strategic transactions with us, we may not be successful in executing and consummating any transactions because of the risks and uncertainties associated with our business.

We have a number of risks and uncertainties associated with our business that may prevent the consummation of a strategic transaction, including but not limited to:

These and other risks and uncertainties may prevent us and interested third parties from exploring and consummating mutually acceptable strategic alternatives.

We may elect to dissolve and distribute assets to our stockholders if our board of directors determines that such action is in the best interest of our stockholders.

As a result of our exploration of strategic alternatives, our board of directors may deem it advisable to dissolve the company and distribute assets to stockholders. Liquidation and dissolution may not create value to our stockholders or result in any remaining capital for distribution to our stockholders. The precise nature, amount and timing of any distribution to our stockholders would depend on and could be delayed by, among other things, sales of our non-cash assets, claim settlements with creditors and resolution of outstanding litigation matters. Our stockholders may also experience adverse tax consequences to the extent they receive any distributions from us.

We have lost money in the past, are currently experiencing losses and expect to record net losses for the foreseeable future, which could cause the market price of our common stock to decline further.

We have experienced losses in the past, are currently incurring net operating losses and expect to record net losses and generate negative cash flow for the foreseeable future. Our revenues have declined substantially since the third quarter of 2000 and are insufficient to offset operating expenses. As of December 31, 2002, we had an accumulated deficit of approximately $88.7 million. We expect to continue to incur significant research, product development and sales and marketing expenses as we continue to focus on developing our next generation copper automation products and penetrating the incumbent local exchange carrier market. As we expect to continue to generate negative cash flow, the amount of assets available to stockholders may be reduced, which could cause the market price of our common stock to decline further.

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If we fail to penetrate the incumbent local exchange carrier market, our business will be adversely affected.

If we cannot overcome the challenges inherent in penetrating the incumbent local exchange carrier market, we will not be able to sell our copper automation products. These challenges include our inexperience in selling to incumbent carriers, a long sales cycle, costs associated with customer evaluations of our products, cutbacks in carrier capital spending, competition from established suppliers and stringent customer service and support requirements. In addition, the incumbent carriers have repeatedly delayed or reduced their network maintenance and buildout plans and may decide not to make additional infrastructure investments. Furthermore, as a result of our January 2003 reduction in force, we have very limited marketing, sales and customer support resources to devote to penetrating the incumbent carriers. The incumbent carriers may also be reluctant to purchase products from a supplier that is seeking strategic alternatives or with whom they have not previously worked.

If incumbent local exchange carriers decide not to automate their existing local loop management systems and processes, we will not be successful in selling our UNE management and frame automation products to them.

If incumbent carriers decide not to upgrade their existing local loop switching and management systems, we will not be successful in selling our UNE management and frame automation products to them. We believe the local loop switching and management systems and processes currently implemented by the incumbent local exchange carriers are inefficient, labor-intensive and error prone. Our products are designed to automate these processes and allow incumbent carriers to more rapidly and effectively deploy and maintain copper local loop services. Incumbent carriers may consider a number of different factors when deciding whether or not to upgrade and automate their switching and management systems, including the cost of purchasing new systems and replacing existing infrastructure, the rate of return on their capital investments, issues arising from displaced union laborers, risks associated with the installation and deployment of a new generation of products and potential disruptions in copper local loop services.

Changes to regulations affecting, or the lack of demand from competitive carriers for, unbundled network elements may significantly reduce or eliminate the need for our unbundled network element management products.

Adjustments to the Federal Communications Commission (FCC) regulations regarding unbundled network elements, new FCC regulations or regulations set forth by other regulatory bodies or new congressional legislation may reduce or eliminate the demand for our unbundled network element management products. If the FCC or state public utility regulators should decide that incumbent carriers are no longer required to lease unbundled lines to competitive carriers, our unbundled network element management products would be made obsolete.

Demand for our unbundled network element management products may also be reduced or eliminated if competitive carriers fail to order unbundled lines in large volumes from incumbent carriers. Competitive carriers have experienced financial difficulties and have either reduced or delayed the buildout of their networks. In addition, some competitive carriers have chosen to utilize UNE-P, a form of resale, instead of deploying their own facilities, thus eliminating their need for the physical unbundled lines that create demand for our unbundled network element management products. If, as a result, such competitive carriers stop or delay or reduce their orders for physical unbundled lines, the incumbent carriers may have no incentive to purchase and install our unbundled network element management products.

Even if we succeed in obtaining product deployment approval from the incumbent local exchange carriers, they may not allocate capital to purchase and deploy our products.

If the incumbent carriers do not or cannot allocate enough capital spending for the purchase and deployment of our products, our business will suffer. As a result of the current downturn in the telecommunications market

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and reduced demand for their services, incumbent carriers have repeatedly lowered their capital spending budgets for the foreseeable future and delayed or canceled infrastructure investments. For example, BellSouth Corporation recently decided not to budget for additional network deployment of our UNE management solution in 2003. These carriers may decide not to or may simply lack the capital necessary to make the substantial investments required to deploy our products, regardless of the quality, performance and functionality of our products.

Our limited operating history, the limited visibility we are experiencing with our target customers and our recent decision to seek strategic alternatives make forecasting difficult, and if our operating results are below expectations, the price of our common stock could decline further.

As a result of our limited operating history, the limited visibility we are experiencing with our target customers and our recent decision to seek strategic alternatives, it is difficult to forecast accurately our revenues and operating expenses. Prior to the fourth quarter of 2001, we derived substantially all of our revenues from new and emerging competitive local exchange carriers. Substantially all of these competitive carriers have experienced financial difficulties and have discontinued their purchases of our products. Our target incumbent carrier customers have repeatedly announced cutbacks in capital spending, and we have limited visibility as to if or when they may purchase our products. Even if a target incumbent carrier customer decides to purchase our products, it may deploy our products more slowly than we or our investors or market analysts expect. Recently, we decided to seek strategic alternatives and reduce our headcount by approximately 40%, which may affect our ability to broadly market and sell our products. As a result of these various factors, our operating results have declined in the past and may fall below our expectations and the expectations of investors and market analysts in the future, and the price of our common stock could decline further.

If we fail to overcome the development risks associated with our next-generation copper automation products, we will not be able to introduce and recognize revenues from them in a timely manner.

We face a number of development risks associated with our next-generation copper automation products, which if not successfully overcome, could cause their introduction to be delayed indefinitely. We have in the past devoted, and expect to continue to devote, substantial research and development resources toward designing and building our next-generation products. Our product designs incorporate new and unproven technologies currently under development, and we cannot assure you that we will be successful in perfecting these new technologies. Furthermore, even if we are able to perfect these new technologies, incorporating them into our new products may be cost-prohibitive. In addition, we utilize third-party design firms and contract manufacturers to produce the components needed for our next-generation products. Several of these companies have recently experienced financial difficulties. If these companies were to go out of business, our development efforts could be delayed as we transition to new vendors. If we experience delay with the development of our next-generation products as a result of technology challenges, cost, vendor difficulties or otherwise, we will not be able to introduce and recognize revenues from such products.

Because our products are deployed in complex environments, they may have errors or defects that are found only after full deployment, which could result in liability claims against us.

Errors or other problems in our products could result in:

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Because our products are designed to provide critical services, if errors, defects or failures are discovered in our current products, or after new versions or future products are released, we may be exposed to significant legal claims. Any claims, with or without merit, could damage our reputation and our business, increase our expenses and impair our operating results. Although we maintain product liability insurance covering some damages arising from implementation and use of our products, our insurance may not fully cover claims brought against us. Liability claims could require us to spend significant time and money in litigation or to pay significant damages.

Our products are designed for large and complex networks and either have never been deployed or have only been deployed on a limited basis. Consequently, our customers may discover errors or defects in our hardware or software only after it has been fully deployed and operated as part of their infrastructure in connection with products from other vendors.

Our products incorporate numerous component parts designed and manufactured by third parties. We cannot assure you that these third-party parts are free of defects or errors. Given the complex nature of our products and our dependence on a large number of highly intricate third-party component parts, our products may contain defects or errors not detectable during our quality assurance and testing procedures. Any such defects or errors could delay or cost us market acceptance of our products or result in legal claims against us.

Intense competition in our industry could result in our losing customers or being unable to attract new customers.

The market for telecommunications equipment is highly competitive. Our primary competitors in the copper switching and unbundled network management market include Avaya, Con-X Corporation, NHC Communications and Simpler Networks. A number of companies produce products that compete with our loop management and Smart Splitter products, including ADC Telecommunications, Inc.; Harris Corporation; Marconi; Nortel Networks; Sunrise Telecom; Spirent plc; Teradyne Corporation; and Tollgrade Communications. We also compete with DSL equipment providers, including Alcatel, Lucent and Nokia, which have each announced plans to incorporate features and functionality provided by our loop management and Smart Splitter products into their DSL access multiplexers. Many of our current and potential competitors have significantly greater sales and marketing, technical, manufacturing, financial and other resources than we do. Due to the rapidly evolving market in which we compete, additional competitors with significant market presence and financial resources, including other large telecommunications equipment manufacturers, may enter the market, thereby further intensifying competition.

We could incur substantial costs and our management’s attention and resources could be diverted as a result of the outstanding securities class actions and shareholder derivative litigation against us.

We dispute, but cannot assure you that we will be successful in our defense of, the outstanding shareholder lawsuits against us. If we are unsuccessful, these lawsuits could have a material adverse effect on our business, financial condition and results of operations. Even if we are successful in defending against these claims, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our results of operations.

On March 28, 2001, the Louisiana School Employees’ Retirement System filed a putative class action lawsuit against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California alleging claims under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The case, which also names as defendants the underwriters of the Company’s September 21, 2000

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secondary offering of common stock, is encaptioned Louisiana School Employees’ Retirement System v. Turnstone Systems, Inc. et al. (formerly CV-01-1256 JL). The complaint alleges that the defendants issued false and misleading statements in our prospectus issued in connection with our secondary offering. At or about the same time, four other purported class action lawsuits were filed against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California, encaptioned as follows: Huang v. Turnstone Systems, Inc., et al. (formerly C-01-1342-CW) (filing date 4/04/01); Riskin v. Turnstone Systems, Inc., et al. (formerly C-01-1355-CW) (filing date 4/05/01); Bojsza v. Turnstone Systems, Inc., et al. (formerly C-01-1411-CW) (filing date 4/10/01); and Greenberg, et al. v. Turnstone Systems, Inc. et al. (formerly C-01-1454-CW) (filing date 4/12/01). These latter complaints allege that the defendants made false or misleading statements during the class period of June 5, 2000 through January 2, 2001, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder.

All five cases were consolidated before Judge Saundra B. Armstrong in the United States District Court for the Northern District of California on October 26, 2001. The consolidated complaint is encaptioned In re Turnstone Systems, Inc. Securities Litigation, Case No. CV 01-1256 SBA. By order dated December 3, 2001, Judge Armstrong designated Radiant Advisors, LLC as lead plaintiff and the law firms of Bernstein Litowitz Berger & Grossman LLP and Bernstein Liebhard & Lifshitz, LLP as co-lead counsel for the consolidated actions. The lead plaintiff filed two separate consolidated amended complaints on March 19, 2002. On June 20, 2002, Judge Armstrong issued an order for plaintiff to show cause as to why the action should not be dismissed with prejudice for plaintiff’s failure to file one consolidated amended complaint. The lead plaintiff filed a certificate of counsel in response to the order on June 27, 2002. We filed a response on July 3, 2002. On August 30, 2002, Judge Armstrong struck the two separate amended complaints previously filed by the lead plaintiff and ordered that a single amended complaint be filed. The lead plaintiff filed a single amended complaint on September 13, 2002. We filed a motion to dismiss the amended complaint on October 8, 2002. On February 4, 2003, Judge Armstrong issued an order denying in part and granting in part, with leave to amend, our motion to dismiss.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit in state court in California, County of Santa Clara, alleging claims against us, a nominal defendant in the action, and certain of our officers and directors. The lawsuit is encaptioned Okino v. Tinsley, et al., Case No. CV 798814. The complaint alleges that the individual defendants caused us harm by either making or permitting the corporation to make false and misleading statements between June 5, 2000 and January 2, 2001 and by permitting certain officers to profit from stock sales during that period. It asserts claims against the individual defendants for breach of fiduciary duty, waste of corporate assets, abuse of control and gross mismanagement.

We demurred to the complaint on July 9, 2001. On September 28, 2001, Judge Conrad L. Rushing issued an order sustaining the demurrer and granting plaintiff limited discovery. On December 19, 2001, subsequent to the completion of the court-ordered discovery, plaintiff filed a first amended derivative complaint alleging the same causes of action asserted in the initial complaint. We filed a demurrer to the first amended derivative complaint on January 10, 2002. On February 22, 2002, Judge Jack Komar issued an order sustaining the demurrer and granting plaintiff leave to amend its complaint. The plaintiff filed an amended complaint on March 19, 2002. We filed a demurrer to the second amended derivative complaint on April 22, 2002. On May 28, 2002, Judge Komar issued an order sustaining the demurrer and dismissing the complaint with prejudice. The plaintiff filed a notice of appeal on August 1, 2002.

On November 9, 2001, Arthur Mendoza filed a securities class action lawsuit in the United States District Court for the Southern District of New York alleging claims against us, certain of our current and former officers and directors, and the underwriters of our initial public offering of stock. The complaint is encaptioned Mendoza v. Turnstone Systems, Inc. et al., Case No. 01 CV 9981, and is purportedly brought on behalf of a class of individuals who purchased common stock in the initial public offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and commissions received by the underwriters and asserts claims against the defendants under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, and Section 10(b)

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of the Exchange Act of 1934. The case has been coordinated for pre-trial purposes with over 300 cases raising the same or similar issues and also currently pending in the Southern District of New York. On April 18, 2002, Michael Szymanowski was appointed lead plaintiff in the action. On April 22, 2002, an amended complaint was filed. On July 1, 2002, the underwriter defendants filed an omnibus motion to dismiss. On July 15, 2002, we, collectively with the other issuer defendants, also filed an omnibus motion to dismiss. The lead plaintiff filed an opposition to the underwriters’ motion to dismiss on August 15, 2002 and to the issuers’ motion to dismiss on August 27, 2002. The underwriters’ reply to the opposition was filed on September 13, 2002, and our reply to the opposition was filed on September 27, 2002. On February 19, 2003, the court issued an order denying the motions to dismiss with respect to substantially all of the plaintiffs’ claims, including those against us.

Each of our current and former officers who were named in the New York securities class action lawsuit has entered into a tolling agreement, effective as of July 20, 2002, with the plaintiff. Pursuant to the tolling agreement, the plaintiff agreed to dismiss our current and former officers from the lawsuit in exchange for a tolling of the statute of limitations with respect to any claims that may be asserted against them through the earlier of (i) thirty days after the termination of the tolling agreement or (ii) September 30, 2003. On October 9, 2002, the court entered an order dismissing our current and former officers from the lawsuit.

Some of our customers have filed or may file for bankruptcy protection, and as a result, we may be required to return some or all of the payments we receive from them as part of the bankruptcy proceedings.

Because of their inability to obtain additional financing or generate sufficient revenues to fund their operations, a number of our customers that previously purchased loop management products from us have filed or may file for bankruptcy protection. For example, in August 2002 the Official Committee of Unsecured Creditors of Digital Broadband Communications, Inc., one of our former customers that filed for Chapter 11 bankruptcy, filed a complaint in the United States Bankruptcy Court for the District of Delaware, seeking recovery of alleged preferential transfers to us in the aggregate amount of $3,522,714.85. The bankruptcy court may require us, or we may agree as part of a settlement, to return some or all of the payments we have received or will receive in the future from such customers prior to their initiation of bankruptcy proceedings, which would negatively affect our financial results.

If we successfully develop, market and sell our next-generation copper automation products, we may in the future face a number of additional business risks associated with growing our company.

In the future, we may face additional business risks if we successfully develop, market and sell our next-generation copper automation products. Risks associated with growing our company at that time may include:

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Control by our existing stockholders may limit your ability to influence matters requiring stockholder approval and could delay or prevent a change in control, which could prevent you from realizing a premium in the market price of our common stock.

The concentration of ownership of our common stock by existing stockholders could delay or prevent a change in our control or discourage a potential acquirer from attempting to obtain control of us, which could cause the market price of our common stock to fall or prevent our stockholders from realizing a premium in the market price associated with an acquisition. As of February 1, 2003, our executive officers, directors and principal stockholders and their affiliates owned 29,118,658 shares, or approximately 46.4%, of the outstanding shares of common stock. These stockholders, acting together, would be able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval or disapproval of any strategic business transactions.

We expect to experience volatility in our stock price, which could negatively affect your investment.

An active public market for our common stock may not be sustained in the future. The market for technology stocks has been extremely volatile. In 2002 the per-share closing market price of our common stock on the Nasdaq National Market reached a high of $5.55 and a low of $2.00. The following factors could cause the market price of our common stock to fluctuate significantly from the original purchase prices paid by investors:

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Item 2.    Properties

Our principal administrative, sales, marketing and research and development facility occupies approximately 62,500 square feet in Santa Clara, California under a lease that expires in June 2010. We also have regional sales offices and/or employees in four other states.

During fiscal 2001, we recorded a $2.7 million provision for estimated losses on the operating lease for our headquarters facility. The provision relates to the portion of our leased headquarters facility that we intend to sublease at prevailing market rates, which are less than the rates that we are obligated to pay under our contractual lease commitment. If business conditions and the real estate market were to deteriorate such that we are unable to sublease the unused portion of our headquarters facility as estimated, additional provisions may be required.

Item 3.    Legal Proceedings

We dispute, but cannot assure you that we will be successful in our defense of, the outstanding lawsuits against us described below. If we are unsuccessful, these lawsuits could have a material adverse effect on our business, financial condition and results of operations. Even if we are successful in defending against these claims, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our results of operations.

Shareholder Litigation

On March 28, 2001, the Louisiana School Employees’ Retirement System filed a putative class action lawsuit against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California alleging claims under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The case, which also names as defendants the underwriters of the Company’s September 21, 2000 secondary offering of common stock, is encaptioned Louisiana School Employees’ Retirement System v. Turnstone Systems, Inc. et al. (formerly CV-01-1256 JL). The complaint alleges that the defendants issued false and misleading statements in our prospectus issued in connection with our secondary offering. At or about the same time, four other purported class action lawsuits were filed against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California, encaptioned as follows: Huang v. Turnstone Systems, Inc., et al. (formerly C-01-1342-CW) (filing date 4/04/01); Riskin v. Turnstone Systems, Inc., et al. (formerly C-01-1355-CW) (filing date 4/05/01); Bojsza v. Turnstone Systems, Inc., et al. (formerly C-01-1411-CW) (filing date 4/10/01); and Greenberg, et al. v. Turnstone Systems, Inc. et al. (formerly C-01-1454-CW) (filing date 4/12/01). These latter complaints allege that the defendants made false or misleading statements during the class period of June 5, 2000 through January 2, 2001, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder.

All five cases were consolidated before Judge Saundra B. Armstrong in the United States District Court for the Northern District of California on October 26, 2001. The consolidated complaint is encaptioned In re Turnstone Systems, Inc. Securities Litigation, Case No. CV 01-1256 SBA. By order dated December 3, 2001, Judge Armstrong designated Radiant Advisors, LLC as lead plaintiff and the law firms of Bernstein Litowitz Berger & Grossman LLP and Bernstein Liebhard & Lifshitz, LLP as co-lead counsel for the consolidated actions. Plaintiff filed a single amended complaint on September 13, 2002. We filed a motion to dismiss the amended complaint on October 8, 2002. On February 4, 2003, Judge Armstrong issued an order denying in part and granting in part, with leave to amend, our motion to dismiss.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit in state court in California, County of Santa Clara, alleging claims against us, a nominal defendant in the action, and certain of our officers and directors. The lawsuit is encaptioned Okino v. Tinsley, et al., Case No. CV 798814. The complaint alleges that the individual defendants caused us harm by either making or permitting the corporation to

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make false and misleading statements between June 5, 2000 and January 2, 2001 and by permitting certain officers to profit from stock sales during that period. It asserts claims against the individual defendants for breach of fiduciary duty, waste of corporate assets, abuse of control and gross mismanagement.

We demurred to the complaint on July 9, 2001. On September 28, 2001, Judge Conrad L. Rushing issued an order sustaining the demurrer and granting plaintiff limited discovery. On December 19, 2001, subsequent to the completion of the court-ordered discovery, the plaintiff filed a first amended derivative complaint alleging the same causes of action asserted in the initial complaint. We filed a demurrer to the first amended derivative complaint on January 10, 2002. On February 22, 2002, Judge Jack Komar issued an order sustaining the demurrer and granting the plaintiff leave to amend the complaint. The plaintiff filed an amended complaint on March 19, 2002. We filed a demurrer to the second amended derivative complaint on April 22, 2002. On May 28, 2002, Judge Komar issued an order sustaining the demurrer and dismissing the complaint with prejudice. The plaintiff filed a notice of appeal on August 1, 2002.

On November 9, 2001, Arthur Mendoza filed a securities class action lawsuit in the United States District Court for the Southern District of New York alleging claims against us, certain of our current and former officers and directors, and the underwriters of our initial public offering of stock. The complaint is encaptioned Mendoza v. Turnstone Systems, Inc. et al., Case No. 01 CV 9981, and is purportedly brought on behalf of a class of individuals who purchased common stock in the initial public offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and commissions received by the underwriters and asserts claims against the defendants under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, and Section 10(b) of the Exchange Act of 1934. The case has been coordinated for pre-trial purposes with over 300 cases raising the same or similar issues and also currently pending in the Southern District of New York. On April 18, 2002, Michael Szymanowski was appointed lead plaintiff in the action. On April 22, 2002, an amended complaint was filed. On July 1, 2002, the underwriter defendants filed an omnibus motion to dismiss. On July 15, 2002, we, collectively with the other issuer defendants, also filed an omnibus motion to dismiss. The lead plaintiff filed an opposition to the underwriters’ motion to dismiss on August 15, 2002 and to the issuers’ motion to dismiss on August 27, 2002. The underwriters’ reply to the opposition was filed on September 13, 2002, and our reply to the opposition was filed on September 27, 2002. On February 19, 2003, the court issued an order denying the motions to dismiss with respect to substantially all of the plaintiffs’ claims, including those against us.

Each of our current and former officers who were named in the New York securities class action lawsuit has entered into a tolling agreement, effective as of July 20, 2002, with the plaintiff. Pursuant to the tolling agreement, the plaintiff agreed to dismiss our current and former officers from the lawsuit in exchange for a tolling of the statute of limitations with respect to any claims that may be asserted against them through the earlier of (i) thirty days after the termination of the tolling agreement or (ii) September 30, 2003. On October 9, 2002, the court entered an order dismissing our current and former officers from the lawsuit.

In Re: Digital Broadband Communications, Inc. Bankruptcy

On August 12, 2002, the Official Committee of Unsecured Creditors of Digital Broadband Communications, Inc., one of our former customers that filed for Chapter 11 bankruptcy on December 27, 2000, filed a complaint in the United States Bankruptcy Court for the District of Delaware, seeking recovery of alleged preferential transfers to us in the aggregate amount of $3,522,714.85. We filed our answer on September 10, 2002.

Item 4.    Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security-holders during the fourth quarter of the fiscal year covered by this report.

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PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters

Our common stock has traded on the Nasdaq National Market under the symbol “TSTN” since February 1, 2000. The price range per share reflected in the table below is the highest and lowest sale price for our stock as reported by the Nasdaq National Market during each quarter the stock has been publicly traded in the last two fiscal years. Our present policy is to retain earnings, if any, to finance future growth. We have never paid cash dividends and have no present intention to pay cash dividends. At February 28, 2003, there were approximately 282 stockholders of record and the price per share of our common stock was $2.80.

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Item 6.    Selected Consolidated Financial Data

The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report. The consolidated statement of operations data for the years ended December 31, 2002, 2001 and 2000 and the consolidated balance sheet data as of December 31, 2002 and 2001 are derived from our audited consolidated financial statements included herein. The consolidated statement of operations data for the year ended December 31, 1999 and for the period from January 2, 1998 (inception) to December 31, 1998 and the consolidated balance sheet as of December 31, 2000, 1999 and 1998 are derived from our audited consolidated financial statements not included herein.

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes appearing elsewhere in this report.

Overview

We design, engineer, market and support hardware and software products that enable local exchange carriers to rapidly deploy and efficiently maintain copper local loop services. Our CX loop management systems are deployed in central offices to assist with copper loop installation, qualification, service verification and maintenance. Our SX Smart Splitter^™ platform combines signal splitting capabilities with test access to assist in the delivery of ADSL services. Our MX Copper CrossConnect^® solution is used to provide remote switching and service verification capabilities to facilitate the management of unbundled network elements. Our next generation frame automation solution, currently under development, is intended to provide fast, high capacity, automated copper line switching and connection verification capabilities. Finally, our CrossWorks^™ and ONYX software suites enable service providers to remotely control our network equipment and seamlessly integrate loop management functions into their back-office operations support systems.

On January 9, 2003, we announced that we were exploring various strategic alternatives, including possible merger and asset sale transactions, licensing arrangements and dissolution of the company and distribution of assets to stockholders. We also announced that we had engaged Goldman Sachs & Co. as our financial advisor. While we explore our strategic alternatives, our operating activities will be focused primarily on in-process research and development related to our next generation copper automation products for incumbent local exchange carriers. While a limited supply of our products remain available for sale, we have generally ceased all direct sales efforts related to them, and do not expect to generate material revenues from them for the foreseeable future. In connection with these decisions, we reduced headcount by approximately 40%, or 29 employees, in January 2003.

Prior to the fourth quarter of 2001, we derived substantially all of our revenues from sales of our CX100 product and, to a lesser extent, from our maintenance programs. Revenues from our CrossWorks software have not been significant. During the fourth quarter of 2001, we recognized revenue from our SX500 product for the first time and, although not significant, from our CX40 product. During the third quarter of 2002, we recognized revenue from one of our UNE management systems. Our success will depend on our ability to penetrate the incumbent local exchange carrier market and our ability to develop and sell additional products.

We sell our products to domestic and international local exchange carriers through our direct sales force, third-party resellers and through indirect original equipment manufacturer channels. A customer’s network

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planning and purchase decisions normally involve a significant commitment of its resources and a lengthy evaluation and product qualification process. Since the decision to purchase our products is made as part of this network planning process, our sales cycle is lengthy, often as long as one year or more. Substantially all of our sales are made on the basis of purchase orders rather than long-term agreements. As a result, we commit resources to the development and production of products without having received advance purchase commitments from customers.

We currently use Fine Pitch, a contract manufacturer and a subsidiary of Solectron Corporation, to manufacture all of our products. This subcontracting arrangement includes material procurement, board level assembly, final assembly, testing and shipment to our customers. If for any reason our contract with Fine Pitch was terminated, we would be required to purchase any excess inventory held by it and we would have to qualify another contract manufacturer for our products. As of December 31, 2002, our inventory purchase commitments were minimal.

In connection with the granting of stock options and restricted stock purchase awards to our employees, we recorded deferred stock compensation totaling approximately $16.9 million from inception through December 31, 2002, net of cancellations. This amount represents the difference between the exercise price and the fair value of our common stock on the date these stock options were granted, adjusted for cancellations of stock options under the intrinsic method. We are amortizing the deferred stock compensation over the vesting periods of the applicable options and the repurchase periods for restricted stock purchases, generally either four years or 18 months. For awards with vesting periods of four years, the service period over which deferred stock compensation is amortized is determined separately for each 25% portion of the total award, in accordance with Financial Accounting Standards Board Interpretation No. 28 (FIN No. 28). The result of this accounting treatment is that approximately 52% of the unearned deferred stock compensation will be amortized in the first year, 27% in the second year, 15% in the third year and 6% in the fourth year following the date of the grant. For service awards with vesting periods of 18 months, the service periods over which deferred stock compensation is amortized is determined separately for each 16.7% portion of the total award, in accordance with FIN No. 28. The result of this accounting treatment is that approximately 41% of the unearned deferred stock compensation will be amortized in the first quarter, 24% in the second quarter, 16% in the third quarter, 10% in the fourth quarter, 6% in the fifth quarter, and 3% in the sixth quarter following the date of the grant. We recorded $291,000 of related deferred stock compensation amortization expense during the three months ended December 31, 2002 and $2.0 million of such expense during the year ended December 31, 2002. As of December 31, 2002, we had an aggregate of $425,000 of related deferred stock compensation to be amortized. The amortization of this amount will result in additional charges to operations through 2004. The amortization of deferred stock compensation is presented as a separate component of operating expenses in our statements of operations.

Critical Accounting Policies

The 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 our reported assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventory, income taxes, and lease losses. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

The methods, estimates, and judgments we use in applying our most critical accounting policies have a significant impact on the results that we report in our consolidated financial statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a

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company’s financial condition and results of operations, and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain at the time of estimation. We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue Recognition

We recognize revenues from product sales in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, based upon shipment of products pursuant to customer purchase orders, assuming that the price to the customer is fixed or determinable and that collectibility of the resulting receivable is reasonably assured. When the arrangement with the customer includes future obligations for which fair value does not exist or when customer acceptance is required, we recognize revenues when those obligations have been met or customer acceptance has been received. When an arrangement with the customer includes obligations to deliver unspecified additional products in the future, we recognize revenues ratably over the obligation period. When collectibility of the resulting receivable is not reasonably assured based on the company’s assessment of the customer’s financial condition, we recognize revenues upon customer payment. Our policy generally does not allow for product returns. We maintain a reserve for estimated potential returns based on our historical minimal level of returns. We defer revenues from services and support provided under our maintenance programs based upon the fair value of the program and recognize those revenues on a straight-line basis over the period of the contract. We generally provide a twelve-month warranty for hardware products not covered under hardware maintenance programs. We estimate costs associated with the warranty program based on historical warranty program costs and accrue for those costs at the time of product shipment. We defer revenues from consulting and training based on the fair value of the services, and recognize those revenues when such services are completed.

Allowance for doubtful accounts

Accounts receivable are recorded net of allowance for doubtful accounts totaling $5,000 and $998,000 as of December 31, 2002 and 2001, respectively. We regularly review the adequacy of our accounts receivable allowance after considering the age of each invoice, each customer’s expected ability to pay and our collection history with each customer. Using these criteria, we establish an allowance for specific invoices deemed uncollectible. In addition, we maintain a minimal unallocated reserve for invoices not specifically reserved. The allowance for doubtful accounts represents our best current estimate of the portion of all outstanding invoices deemed uncollectible. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required, increasing our operating expenses.

Inventory valuation

Inventory is stated at the lower of cost or market. If we determine that the utility of our inventory has been impaired, as measured by our estimate of net realizable value when selling the inventory to customers or other third parties, we reflect this impairment by recording a charge to cost of revenues in the current period. We recorded $5.6 million and $37.7 million to cost of revenues for the years ended December 31, 2002 and 2001, respectively. Decreases in the net realizable value of our finished goods and raw material inventories, including provisions for purchase commitments, were attributable to decreases in our forecasts of future demand. Such

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determinations require the use of management’s judgment to estimate future demand and the recoverable cost for inventories in excess of foreseeable demand. As of December 31, 2002, inventory has been written down in its entirety.

Accounting for income taxes

We have recorded a deferred tax asset valuation allowance of $47.6 million and $33.8 million as of December 31, 2002 and 2001, respectively, for the portion of the deferred tax asset that more likely than not will not be realized. We review the adequacy and need for the deferred tax asset valuation allowance on a quarterly basis, based on current and estimated future financial information. The allowance represents our best current estimate, but if demand from our customers or the current market conditions were to improve such that we are profitable, the valuation allowance may be reduced or may not be required.

Lease losses

During fiscal 2001, we recorded a $2.7 million provision for estimated losses on an operating lease. The provision related to the portion of our leased headquarters facility that we intend to sublease at prevailing market rates, which are less than the rates that we are obligated to pay under our contractual lease commitment. The decision to sublease a portion of our facilities was made as a result of reductions in operations and workforce during 2001, which has resulted in excess facilities. We evaluate facilities requirements on an ongoing basis. The provision for loss on operating lease was determined based on our best estimate of future facilities requirements and current market conditions. If business conditions and the real estate market were to deteriorate such that we were unable to sublease the unused portion of our headquarters facility as estimated, additional provisions may be required.

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Results of Operations

The following table sets forth certain statements of operations data as a percentage of net revenues for the periods indicated. The data has been derived from the consolidated financial statements contained in this report. This information should be read in conjunction with these consolidated financial statements.

Fiscal Years Ended December 31, 2002, 2001 and 2000

Net Revenues

Net revenues consist of product revenue and service revenue. Product revenue for the periods presented consists primarily of sales of our CX100 loop management products and, to a lesser extent, our MX500 Copper CrossConnect^® and SX Smart Splitter^® products and our Crossworks^™ and ONYX automation software licenses. Service revenue is derived primarily from our product maintenance programs.

Product revenue was $2.4 million for the year ended December 31, 2002, $10.1 million for the comparable period in 2001 and $143.1 million for the comparable period in 2000, representing a 76.7% decrease in fiscal 2002 from fiscal 2001 and a 93.0% decrease in fiscal 2001 from fiscal 2000. Service revenue was $1.4 million for the year ended December 31, 2002, $3.4 million for the comparable period in 2001 and $6.3 million for the comparable period in 2000, representing a 57.2% decrease in fiscal 2002 from fiscal 2001 and a 46.9% decrease in fiscal 2001 from fiscal 2000. The decreases in product revenue and service revenue were attributable to reduced demand from competitive local exchange carrier customers.

Our revenue to date has been recognized from a small number of customers. We expect that the majority of our revenue will continue to depend on sales of our products to a small number of customers. For the year ended

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December 31, 2002, three customers each contributed greater than 10% of total revenues, for a combined total of 52% of total revenues. For the year ended December 31, 2001, three customers each contributed greater than 10% of total revenues, for a combined total of 53% of total revenues. For the year ended December 31, 2000, one customer contributed greater than 10% of total revenue, for a total of 19% or total revenues. Revenue from international customers totaled 46.9% of our net revenues for the year ended December 31, 2002, 21.0% for the comparable period in 2001 and 12.3% for the comparable period in 2000.

While a limited supply of our products remain available for sale, we have generally ceased all direct sales efforts related to them, and do not expect to generate material revenues from them for the foreseeable future.

Cost of Revenues

Cost of product revenue includes amounts paid to our third party contract manufacturer and related overhead expenses, consisting primarily of salary and other expenses for personnel engaged in procurement, vendor management and quality assurance. Cost of service revenue includes costs to maintain our customer support group, consisting primarily of salaries for customer support personnel and costs associated with technical support and training activities.

Cost of product revenue was $1.3 million for the year ended December 31, 2002, $5.9 million for the comparable period in 2001 and $59.4 million for the comparable period in 2000, representing a 78.3% decrease in fiscal 2002 from fiscal 2001 and a 90.0% decrease in fiscal 2001 from fiscal 2000. These decreases were attributable to decreases in CX100 product sales to competitive local exchange carriers.

Cost of service revenue was $365,000 for the year ended December 31, 2002, $1.3 million for the comparable period in 2001, and $1.6 million in the comparable period of 2000. These decreases were primarily attributable to headcount reductions in our customer support organization that were made in response to the decreased demand for our product maintenance services.

Write-down of inventory represents a charge to write down the value of finished goods and raw materials inventory on hand to net realizable value. Provision for purchase commitments represents charges to accrue a liability for minimum purchase commitments made for future delivery of raw materials in excess of forecast requirements. In the aggregate, write-down of inventory and provision for purchase commitments was $5.6 million for the year ended December 31, 2002, $37.7 million for the comparable period of 2001 and $11.4 million for the comparable period in 2000. Decreases in the net realizable value of our finished goods and raw material inventories, including provisions for purchase commitments, were attributable to decreases in our forecasts of future demand. As of December 31, 2002, inventory was written down in its entirety and purchase commitments were minimal.

If we are successful in selling our loop management family and UNE management family products in future periods, we expect cost of product revenue as a percentage of product revenue to temporarily decrease as a percentage of sales. This decrease would be primarily attributable to our existing quantities of finished goods and raw materials inventories that have been written down in their entirety, but that would be available to partially fulfill future customer demand.

Research and Development

Research and development expenses, net of non-cash compensation expense of $879,000 for the year ended December 31, 2002, $1.9 million for the comparable period in 2001, and $3.8 million for the comparable period in 2000, consist primarily of salaries and related personnel expenses, fees paid to consultants and outside service providers, and material costs related to the design, development, testing and enhancement of our products.

Research and development expenses, net of non-cash compensation, were $15.0 million for the year ended December 31, 2002, $22.0 million for the comparable period in 2001 and $18.7 million for the comparable

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period in 2000, representing a decrease of 31.8% in fiscal 2002 from fiscal 2001 and an increase of 17.4% in fiscal 2001 from 2000. The decrease in fiscal 2002 was primarily attributable to the discontinuation of our research and development operations in New Zealand and overall headcount reductions resulting from our restructuring in September 2001. The increase in fiscal 2001 from fiscal 2000 was primarily due to increases in the number of personnel engaged in research and development activities, including the addition of research and development personnel associated with our acquisition of Paragon Solutions Limited.

Going forward, our research and development activities will be focused primarily on in-process research and development related to our next generation copper automation products for incumbent local exchange carriers. We expect that research and development expenses will remain a substantial percentage of total operating expenses in future periods.

Sales and Marketing

Sales and marketing expenses, net of non-cash compensation expense of $468,000 for the year ended December 31, 2002, $938,000 for the comparable period in 2001, and $1.9 million for the comparable period in 2000, consist primarily of salaries, commissions and related expenses for personnel engaged in marketing, sales and customer support functions, as well as trade shows and promotional expenses.

Sales and marketing expenses, net of non-cash compensation expense, were $8.0 million for the year ended December 31, 2002, $15.6 million for the comparable period in 2001 and $13.3 million for the comparable period in 2000, representing a decrease of 48.7% in fiscal 2002 from fiscal 2001 and an increase of 17.3% in fiscal 2001 from fiscal 2000. The decrease in fiscal 2002 was primarily attributable to a decrease in the number of sales and sales support personnel domestically and internationally from fiscal 2001, as well as reduced tradeshow and other customer marketing activities. The increase in fiscal 2001 was primarily due to an increase in the number of sales and sales support personnel domestically and internationally, costs associated with the addition of sales offices in Brazil, Hong Kong and Singapore, and increased tradeshow activities.

Currently, we are focusing our sales and marketing activities on engaging North American incumbent local exchange carriers in testing and purchasing our UNE management and next generation frame automation product families. If we are successful in engaging them, we will incur substantial sales and marketing costs related to their trials of our products.

General and Administrative

General and administrative expenses, net of non-cash compensation expense of $654,000 for the year ended December 31, 2002, $1.1 million for the comparable period in 2001, and $1.4 million for the comparable period in 2000, consist primarily of salaries and related expenses for executive, finance and administrative personnel, professional fees and other general corporate expenses.

General and administrative expenses, net of non-cash compensation expenses, were $2.8 million for the year ended December 31, 2002, $4.3 million for the comparable period in 2001, and $6.9 million for the comparable period in 2000, representing a decrease of 35.6% in fiscal 2002 from fiscal 2001 and a decrease of 37.4% in fiscal 2001 from fiscal 2000. The decrease in fiscal 2002 was primarily due to a decrease in the number of finance and administrative personnel as a result of restructuring programs, and decreased professional fees. The decrease in fiscal 2001 was primarily due to a $2.1 million charge taken in the fourth quarter of fiscal 2000 to increase our allowance for bad debt as a result of a severe downturn in many of our customers’ financial position, and due to a decrease in the number of finance and administrative personnel in fiscal 2001 as compared to fiscal 2000.

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We expect to incur significant financial advisory fees, legal fees and other general and administrative expenses associated with exploring various strategic alternatives, which may increase general and administrative expenses in future periods.

Amortization of Deferred Stock Compensation

As of December 31, 2002, deferred stock compensation totaled $425,000. We amortized deferred stock compensation of approximately $2.0 million in the year ended December 31, 2002, $3.9 million for the comparable period in 2001, and $7.0 million for the comparable period in 2000.

Provision for Loss on Operating Lease

During fiscal 2001, we recorded a $2.7 million provision for estimated losses on an operating lease. The provision relates to the portion of our leased headquarters facility that we intend to sublease at prevailing market rates, which are less than the rates that we are obligated to pay under our contractual lease commitment. The decision to sublease a portion of our facilities was made as a result of reductions in operations and workforce during 2001, which has resulted in excess facilities.

Interest Income and Other, Net

Interest income and other, net consists primarily of income from our cash investments, and to a lesser extent the net gain or loss from foreign currency translation gains and losses, net gains or losses on disposal of property and equipment, and expenses related to our lease financing obligations. We had interest income and other, net of $5.8 million for the year ended December 31, 2002, $11.4 million for the comparable period in 2001, and $8.0 million for the comparable period in 2000. The decrease in interest income and other, net in fiscal 2002 from fiscal 2001 is primarily due to lower average rate of returns on our investments as well as lower total cash and investment balances. The increase in fiscal 2001 from fiscal 2000 is primarily attributable to increased cash and investment balances in fiscal 2001 as compared to fiscal 2000. In future periods, we expect interest income and other, net to vary depending upon changes in interest rates and the amount and mix of interest-bearing investments and any future short and long-term debt outstanding during each period.

Income Tax Expense

Income tax expense decreased to $125,000 for the year ended December 31, 2002 from $3.7 million in the comparable period in 2001. This decrease is primarily due to a $3.6 million valuation allowance recorded in 2001 for that portion of the deferred tax asset that more likely than not will not be realized. Income tax expense for the year ended December 31, 2002 consisted primarily of minimum state taxes and foreign income taxes related to our international subsidiaries. As a result of the decrease in product revenue due to decreased demand from our existing customer base, current market conditions, and the expected impact of these factors on our future profitability, management has established a $47.6 million allowance for that portion of the deferred tax asset that more likely than not will not be realized. Income tax expense for the year ended December 31, 2000 was $16.0 million and consisted primarily of federal and minimum state taxes at an effective tax rate of 41.7%.

Liquidity and Capital Resources

Our principal source of liquidity as of December 31, 2002 consisted of $103.4 million in cash and cash equivalents, $61.0 million in short-term investments and $47.3 million in long-term investments. Additional capital resources as of December 31, 2002 included restricted cash of $3.6 million.

During the year ended December 31, 2002, we used $16.6 million in operating activities, primarily from our net loss of $25.5 million, which was partially offset by the effect of non-cash charges included in net loss. Non-cash charges consisted principally of amortization of deferred stock compensation of $2.0 million and

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depreciation expense of $1.8 million. Inventory decreased $6.2 million, primarily the result of inventory write-downs of $5.6 million.

Net cash provided by investing activities for the year ended December 31, 2002 was $33.1 million primarily due to proceeds from sales and maturities of available-for-sale investments of $232.1 million, net of purchases of similar investments in the amount of $198.7 million.

In May 2000, we entered into an operating lease agreement for corporate facilities. Upon execution of the lease agreement in May 2000 and extending through the duration of the lease term, we are required to maintain a standby letter of credit in the amount of $3.6 million. This letter of credit requires us to hold funds in the form of a certificate of deposit with a financial institution, and is classified as restricted cash on our consolidated balance sheet. The lease term commenced July 1, 2000 and extends through June 30, 2010. Lease payments will be made on an escalating basis for total minimum lease payments of $42.7 million over the lease term.

Net cash used in financing activities for the year ended December 31, 2002 was $6.0 million primarily due to purchases of treasury stock totaling $6.3 million, partially offset by proceeds from stock option exercises and employee stock purchases. Our purchases of treasury stock were made pursuant to a stock repurchase program approved by the board of directors in October 2001. This program approved the purchase of up to $15.0 million of our common stock over the proceeding twelve-month period. In October 2002, the stock repurchase program was extended for an additional twelve-month period. As of December 31, 2002, we were authorized under the program to purchase up to an additional $5.1 million of our common stock.

We expect to devote capital and operating resources to continue our research and development efforts, to repurchase our common stock and for other general corporate activities. Although we believe that current cash and investment balances will be sufficient to fund operations for at least the next 12 months, there can be no assurance that we will not require additional financing within this time frame or that such additional funding, if needed, will be available on acceptable terms. Any additional issuance of equity or equity-related securities will be dilutive to our stockholders.

Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143, which is effective for fiscal years beginning after June 15, 2002, applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and the normal operation of a long-lived asset, except for certain obligations of lessees. Adoption of SFAS No. 143 is not expected to have a material impact on our financial position, results of operations or cash flows.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The principal difference between SFAS 146 and EITF 94-3 relates to SFAS 146’s timing for recognition of a liability for a cost associated with an exit or disposal activity. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost as generally defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. Management does not expect that the adoption of SFAS No. 146 will have a material impact on our financial position, results of operations, and cash flows, except that it may impact the timing of recognition of exit costs.

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which

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clarifies disclosure and recognition/measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition/ measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. We adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and such adoption did not have a material impact on our consolidated financial statements. We are currently evaluating the recognition provisions of FIN 45 but expect that they will not have a material impact on our financial position, results of operations, and cash flows upon adoption.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. The adoption of SFAS No. 148 is not expected to have a material impact on our financial position, results of operations, and cash flows.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, which addresses consolidation by a business of variable interest entities in which it is the primary beneficiary. FIN 46 is effective immediately for certain disclosure requirements and variable interest entities created after January 31, 2003, and in the first interim or annual period beginning after June 15, 2003 for all other variable interest entities entered into prior to January 31, 2003. We are reviewing the provisions of FIN 46 and comply with the disclosure requirements, but do not expect FIN 46 to have a material impact on our financial position, results of operations, and cash flows.

In January 2003, the EITF published EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying this EITF Issue 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. This issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We are currently evaluating the impact the adoption of this issue will have on our financial position, results of operations, and cash flows.

Item 7a.    Quantitative And Qualitative Disclosures About Market Risk

Foreign Currency Risk

We develop our products in the United States and have marketed our products in the United States, Canada, Europe, Asia and Asia Pacific. Substantially all of our sales and expenses are denominated in United States dollars. Foreign currency translation gains and losses are included in interest income and other, net. A strengthening of the dollar could make our products less competitive in foreign markets. We have not engaged in any foreign exchange hedging activities to date. We may conduct transactions in foreign currencies in the future if we expand our international activities and may engage in foreign exchange hedging activities at that time.

Interest Rate Risk

The primary objective of our investment activities is to preserve principal. We attempt to maximize the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause

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the value of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the value of the investment will probably decline. To mitigate this risk, we maintain our portfolio of cash equivalents and investments in a variety of securities, including money market funds, commercial paper and government and non-government debt securities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate. In addition, we invest in relatively short-term securities.

The following table presents the amounts of cash equivalents, short-term investments and long-term investments that are subject to market risk by range of expected maturity and weighted-average interest rates as of December 31, 2002 and 2001. This table does not include money market funds because those funds are subject to minimal market risk.

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Item 8.    Financial Statements And Supplementary Data

The following consolidated financial statements, and the related notes thereto, of Turnstone Systems, Inc. and subsidiaries, and the Report of Independent Auditors, and unaudited supplemental data are filed as a part of this Form 10-K.

The following financial statement schedule for the years ended December 31, 2002, 2001 and 2000 should be read in conjunction with the consolidated financial statements of Turnstone Systems, Inc. and subsidiaries filed as part of this Annual Report on Form 10-K.

Schedules other than that listed above have been omitted since they are either not required, not applicable, or because the information required is included in the consolidated financial statements of the notes thereto.

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors and Stockholders

Turnstone Systems, Inc.:

We have audited the accompanying consolidated balance sheets of Turnstone Systems, Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2002. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule, as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the related financial statement schedule based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Turnstone Systems, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/    KPMG LLP

Mountain View, California

January 17, 2003

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TURNSTONE SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)