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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Commission File Number: 000-25291

TUT SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (925) 490-3900

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  ¨

As of April 23, 2003, 19,805,041 shares of the Registrant’s common stock, par value $0.001 per share, were issued and outstanding.

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TUT SYSTEMS, INC.

FORM 10-Q

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

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

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TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

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

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TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)

NOTE 1—DESCRIPTION OF BUSINESS:

Tut Systems, Inc. (the “Company”) was founded in 1983 and began operations in August 1991. The Company designs, develops, markets and sells video content processing systems optimized for the provisioning of public broadcast digital TV services across telephone company and cable company facilities, digital video trunking systems for applications across TV broadcast, government and education facilities, and broadband data transmission systems for application over existing private campus or building facilities. Historically, most of the Company’s sales were derived from its broadband data transmission systems. With the Company’s November 2002 acquisition of VideoTele.com (VTC), formerly a subsidiary of Tektronix, Inc., the Company extended its product offerings to include video content processing and video trunking systems.

The Company has incurred substantial losses and negative cashflows from operations since inception. For the three months ended March 31, 2003, the Company incurred a net loss of $2,231 and negative cashflows from operating activities of $4,355, and has an accumulated deficit of $278,767 at March 31, 2003. To the extent the Company’s business continues to be affected by poor economic conditions impacting the telecommunications industry, it will continue to require cash to fund operations. The Company will seek additional funding for operations from alternative debt and equity sources, if necessary, to maintain reasonable operating levels. The Company cannot assure that such funding efforts will be successful. Failure to generate positive cashflow in the future could have a material impact on the Company’s ability to achieve its intended business objectives.

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Basis of presentation

The accompanying condensed consolidated financial statements as of March 31, 2003 and December 31, 2002 and for the three months ended March 31, 2003 and 2002 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of March 31, 2003 and December 31, 2002, their results of operations for the three months ended March 31, 2003 and 2002 and their cash flows for the three months ended March 31, 2003 and 2002. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 2003. The balance sheet as of December 31, 2002 was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. The results for the three months ended March 31, 2003 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2003.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, expect per share amounts)

Revenue recognition

The Company generates revenue primarily from the sale of hardware products, including third-party products, through professional services, the licensing of its HomeRun technology and the sale of its software products. The Company sells products through direct sales channels and through distributors.

Product revenues

The Company recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the fee is fixed or determinable, and collection is probable. Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition until evidence of sell-through occurs and cash is received. Revenue from service obligations included in product revenues is deferred and recognized ratably over the period of the obligation. The Company also maintains accruals and allowances for all cooperative marketing and other programs. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized. The Company’s products generally carry a one year warranty from the date of purchase.

During the three months ended March 31, 2003, the Company made no adjustments to its warranty accrual.

Turnkey solution revenues

Revenue on turnkey solution sales, which typically include the design, manufacture, test, integration and installation of the Company’s equipment to its customers’ specifications, or equipment acquired from third parties to be integrated with the Company’s products, is generally recognized using the percentage-of-completion method. Under the percentage-of-completion method, revenue recognized reflects the portion of the anticipated contract revenue that has been earned, equal to the ratio of labor costs expended to date to anticipated final labor costs, based on current estimates of labor costs to complete the project. If the estimated costs to complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized immediately. Generally, the terms of turnkey solution sales provide for billing for products at the time of delivery and for services at the time of substantial completion of the project.

License and royalty revenues

The Company has entered into non-exclusive technology agreements with various licensees. These agreements provide the licensees the right to use the Company’s proprietary technology to manufacture or have products manufactured using the proprietary technology and to receive customer support for specified periods and any changes or improvements to the technology over the term of the agreement.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, expect per share amounts)

Contract fees for the services provided under these licensing agreements are generally comprised of license fees and non-refundable, prepaid royalties that are recognized when the proprietary technology is delivered if there are no significant vendor obligations. If the licensing agreements contain post-contract customer support, the Company recognizes the contract fees ratably over the period during which the post-contract customer support is expected to be provided. This period represents the estimated life of the technology. The Company begins to recognize revenue under the contract once it has delivered the implementation package that contains all information needed to use the Company’s proprietary technology in the licensee’s process. The remaining obligations are primarily to provide the licensee with any changes or improvements to the technology and technical advice on specifications, testing, debugging and enhancements.

The Company recognizes royalties upon notification of sale by its licensees. The terms of the royalty agreements generally require licensees to notify the Company and pay royalties within 60 days of the end of the quarter during which the sales occur.

Software license and post-contract support revenues

Currently, the Company’s software revenue is derived from two separate sources, software license fees and post-contract maintenance and support fees. The software license fee typically grants a perpetual license to the customer. The Company generally recognizes revenue from the sale of the software license when all criteria for revenue recognition that are similarly applicable to the Company’s hardware product sales have been met. The revenue for maintenance and support fees is recognized ratably over the term of the separate support contract.

Revenue recognition in each period is dependent on the application of these accounting policies. If the Company believes that any of the conditions to recognize revenue have not been met, it will defer revenue recognition. For example, if collectiblitiy is not reasonably assured the Company will defer revenue recognition until subsequent cash receipt. The Company’s application of percentage-of-completion accounting is subject to its estimates of labor cost to complete each turnkey solution project. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, its operating results for a particular period could be adversely affected. Unearned revenue that has been billed but not collected at the end of the period, is deferred as a reduction against the related accounts receivable balance. Unearned revenue deferred as a reduction against the related accounts receivable was $2,400 and $900 at March 31, 2003 and December 31, 2002, respectively.

Inventories

Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than estimated, additional inventory provisions may be required.

Allowance for doubtful accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make payments. These estimated allowances are periodically reviewed, analyzing customers’ payment history and information regarding customers’ creditworthiness that is known to the Company. If the financial condition of any of its customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.

Accounting for long-lived assets

The Company assesses the impairment of long-lived assets and related goodwill periodically. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period, and the market capitalization of the Company relative to its net book value.

When the Company determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Company’s current business model.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, expect per share amounts)

During the first quarter of 2003, the Company determined that no such impairment had occurred. Future events could cause the Company to conclude that impairment indicators exist. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

Legal contingencies

The Company is currently involved in certain legal proceedings as discussed in Note 6. Because of uncertainties related to both the potential amount and range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there were an unfavorable outcome in any of these legal proceedings. As additional information becomes available, the Company will re-assess the potential liability related to this pending litigation and revise its estimates accordingly. Revisions of the Company’s estimates of such potential liability could materially impact its results of operations, financial condition or cashflows.

Accounting for stock based compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, and “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25,” and complies with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 148 and the Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.”

The Company amortizes stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and earnings per share is presented and has been determined as if the Company had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, expect per share amounts)

The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation:

The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

Prior to the Company’s initial public offering, the fair value of each option grant was estimated using the minimum value method. Volatility and dividend yields were not factors in the Company’s minimum value calculation. Subsequent to the offering, the fair value of each stock option grant has been estimated on the date of the grant using the Black-Scholes option pricing model. The Company has also estimated the fair value of the purchase rights issued from its employee stock purchase plan using the Black-Scholes option pricing model. The Company first issued purchase rights from the 1998 Purchase Plan in fiscal 1999.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, expect per share amounts)

Recent accounting pronouncements

In July 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS 146 eliminates the definition and requirement for recognition of exit costs in 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),” where a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company does not believe that the adoption of this statement will have a material impact on its results of operations, financial position or cash flows.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002, and have been implemented in the Company’s financial statements.

In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently evaluating this Issue and its impact on the Company’s financial statements.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The interim disclosure requirements of SFAS No. 148 have been implemented in the Company’s financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company believes that the adoption of this standard will not have a material impact on its financial statements.

Reclassifications

Certain reclassifications have been made to prior year balances in order to conform to the current year presentation.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 3—NET LOSS PER SHARE:

Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding. Options were not included in the computation of diluted net loss per share because the effect would be antidilutive.

The calculation of net loss per share follows:

NOTE 4—COMPREHENSIVE LOSS:

Comprehensive loss includes net loss, unrealized gains and losses on other assets, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders’ equity. The following table sets forth the calculation of comprehensive loss:

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 5—BALANCE SHEET COMPONENTS:

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

Intangibles and other assets:

The aggregate amortization expense for the three months ended March 31, 2003 and 2002 was $459 and $300, respectively.

Minimum future amortization expense at March 31, 2003 are as follows:

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 6—COMMITMENTS AND CONTINGENCIES:

Lease obligations

The Company leases office, manufacturing and warehouse space under noncancelable operating leases that expire in 2003 and 2005. In connection with the acquisition of VideoTele.com (“VTC”) in 2002, the Company assumed an operating lease that expires in July 2005.

In August 2002, the Company entered into an agreement to terminate its lease for engineering facilities in Bridgewater Township, New Jersey for $257, which consisted of forfeiture of a $116 letter of credit and a cash payment of $141. As part of its November 2002 restructuring program, the Company entered into an agreement to terminate its lease for its headquarters facility in Pleasanton, California for $2,409, which consisted of forfeiture of a $1,350 letter of credit and a cash payment of $1,059. The Company also incurred $327 in legal costs and other professional fees related to this lease termination. These amounts have been paid as of March 31, 2003. In December 2002, the Company entered into a lease agreement for a facility in Pleasanton, California that expires in December 2003.

Minimum future lease payments under operating leases at March 31, 2003 are as follows:

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

Purchase commitments

The Company had noncancelable commitments to purchase finished goods inventory totaling $375 and $421 in aggregate at March 31, 2003 and December 31, 2002, respectively.

Contingencies

Beginning July 12, 2001, six putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against Tut Systems, Inc. and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about its business during the putative class period. Specifically, the complaints allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, the plaintiffs filed an amended complaint. Defendants filed a motion to dismiss portions of the amended complaint. The Court has not ruled on that motion. The Company believes the allegations against it are without merit and intends to defend the action vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition, or cashflows.

On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. There has not been a response filed to the complaint, discovery has not commenced, and no trial date has been established.

On August 3, 2001, a complaint, Arrow Electronics, Inc. v. Tut Systems, Inc., Case No. CV 800433, was filed in the Superior Court of the State of California for the County of Santa Clara against the Company. The complaint was filed by one of the Company’s suppliers and alleges causes of action for breach of contract and for money on common counts. The complaint sought damages in the amount of $10,469. The Company settled this case on December 20, 2002 and the related costs have been recorded in the consolidated financial statements

On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended (the “1933 Act”) and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for the Company’s initial public offering and secondary offering. The Court has denied the Company’s motion to dismiss and the case will now proceed to discovery. The Company believes the allegations against it are without merit and intends to defend the action vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition, or cash flows.

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Company’s management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

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NOTE 7—SEGMENT INFORMATION:

Revenue

The Company currently targets its sales and marketing efforts to both public and private service providers and users across two related markets. The Company currently operates in a single business segment as there is only one measurement of profitability for its operations. Revenues are attributed to the following countries based on the location of customers:

It is impracticable for the Company to compute product revenues by product type for three months ended March 31, 2003 and 2002.

Two customers, Atlantic Telephone Membership Corporation and Home Telephone Company accounted for 12% and 11%, respectively, of the Company’s revenue for the three months ended March 31, 2003. Four customers, Capital Planeado SA de SV, Kanematsu Computer System. Ltd., RIKEI Corporation and BTN Internetworking, accounted for 17%, 13%, 11% and 10% respectively, of the Company’s revenue for the three months ended March 31, 2002.

NOTE 8-PRO FORMA INFORMATION

In accordance with SFAS 141, the following unaudited pro forma information is provided. The total revenues include the consolidated revenues of the Company as reported and the net revenues of VTC as if it had been acquired as of the beginning of the period ended March 31, 2002. The pro forma net loss and net loss per share have been adjusted to include the additional costs of amortization of intangibles and depreciation based on the actual purchase price of VTC. The unaudited pro forma information is not necessarily indicative of what actual results would have been had the acquisition been completed by the Company at the beginning of the period.

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

The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below 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. These forward-looking statements include, but are not limited to, statements about (1) our ability to generate income in the digital TV head-end, video trucking and private broadband network markets, (2) our ability to generate income through increases in sales volume and reductions in our manufacturing costs, (3) our expectation that our U.S. sales will continue to represent most of our aggregate sales and that international sales will continue to account for a significant portion of our revenue, (4) our expectation that we will derive material benefits from sales of product lines that we acquired in our acquisitions of third parties, (5) our expectation that we will be able to introduce new products and product enhancements that our customers demand, (6) our expectation that our suppliers and manufacturers would be able to meet such demand from our customers in a timely manner, (7) our expectation that our foreign sales will continue to be denominated primarily in U.S. dollars, (8) our expectation that we will continue to make significant expenditures on research and development activities as a percentage of overall operating expenses (9) our expectation that our research and development activities will continue to represent a significant percentage of our overall operating expenses during the remainder of 2003, (10) our expectation of how in-process research and development will impact our future results of operations or cash flows, (11) our anticipation that, the amount of cash used to fund operations will decrease throughout the remainder of 2003 (12) our working capital expenditures will decrease, (13) our expectation that our cash and cash equivalents will be sufficient to satisfy our cash requirements for the next 12 months, (14) our expectation that our cash flows from operating activities will increase in 2003, (15) our expectations about future license revenue, (16) our expectation that we will not incur restructuring costs in 2003, (17) our revenue sources our cash flow and cash position, our expense trends, products and standards development, and our plans, objectives, expectations and intentions and other statements contained herein that are not historical facts. When used herein, the words “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “seeks,” “should,” “will” or the negative of these terms or similar expressions are generally intended to identify forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. These forward-looking statements reflect current views of our management with respect to future events and are subject to these and other risks, uncertainties and assumptions. As a result, actual results may differ materially from the forward-looking statements contained herein. Such risks and uncertainties include those set forth below in “Additional Risk Factors that Could Affect our Operating Results and the Market Price of our Stock.” In particular, see “Additional Risk Factors that Could Affect our Operating Results and the Market Price of our Stock—We have a history of losses and expect to continue to incur losses in the future,” “—Our operating results may fluctuate significantly, which could cause our stock price to decline,” and “—We are and continue to be affected by poor general economic conditions that have resulted in significantly reduced sales levels and, if such adverse economic conditions continue or worsen, our business, operating results and financial condition will continue to be negatively impacted.” All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this paragraph.

Overview

We design, develop, and sell video content processing systems optimized for the provisioning of public broadcast digital TV services across telephone company and cable company facilities, digital video trunking systems for applications across TV broadcast, government and education facilities, and broadband data transmission systems for application over existing private campus or building facilities.

Historically, most of our sales were derived from our broadband data transmission systems. With our November 2002 acquisition of Video Tele.com (“VTC”), formerly a subsidiary of Tektronix, Inc., we extended our product offerings to include video content processing and video trunking systems. The acquisition of VTC has resulted in a significant change in the structure, organization and priorities of Tut, including: (1) changes in our organizational structure and employee staffing; (2) establishment of significant operations in Lake Oswego, Oregon, at the prior headquarters location of VTC; (3) an expansion of sales and marketing efforts to include VTC products; and (4) a reprioritization of Tut Systems’ research and development budget to include the research and development of products acquired by Tut in its acquisition of VTC.

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Sales to customers outside of the United States accounted for approximately 13.2% and 67.1% of revenue for the three months ended March 31, 2003 and 2002, respectively. With the inclusion of the products associated with the acquisition of VTC our geographic sales breakdown has shifted significantly towards the United States. We expect this trend to continue for the remainder of 2003. However, actual results, both geographically and in absolute dollars, may vary from quarter to quarter depending on the timing of orders placed by customers. To date, all international sales have been primarily denominated in U.S. dollars.

We expect to continue to evaluate product line expansion and new product opportunities, engage in research, development and engineering activities and focus on cost-effective design of our products. Accordingly, we will continue to make significant expenditures on research and development activities as a percentage of overall operating expenses.

In February 2000, we acquired FreeGate Corporation (“FreeGate”) for approximately $25.5 million, consisting of 510,931 shares of our common stock, 19,707 options to acquire shares of our common stock, and acquisition related expenses consisting primarily of investment advisory, legal and other professional service fees and other assumed liabilities. This transaction was treated as a purchase for accounting purposes. FreeGate was located in Sunnyvale, California. FreeGate designed, developed and marketed Internet server appliances combining the functions of IP routing, firewall security, network address translation, secure remote access via VPN networking, and email and web servers on a compact, PC-based platform.

In April 2000, we acquired certain assets of OneWorld Systems, Inc. (“OneWorld”) for approximately $2.4 million in cash. This transaction was treated as a purchase for accounting purposes. The acquired assets consisted of $1.0 million for acquired workforce, $1.1 million for goodwill and $0.3 million for property and equipment.

In May 2000, we acquired Xstreamis Limited (“Xstreamis”), formerly Xstreamis, PLC, for $19.6 million, consisting of 439,137 shares of our common stock, 10,863 options to acquire shares of our common stock, $0.1 million in cash and $0.6 million in acquisition related expenses consisting primarily of legal and other professional fees. This transaction was treated as a purchase for accounting purposes. Xstreamis was located in the United Kingdom. Xstreamis provided policy-driven traffic management for high-performance, multimedia networking solutions including routing, switching and bridging functions.

In January 2001, we acquired ActiveTelco, Inc. (“ActiveTelco”) for approximately $4.9 million, consisting of an aggregate of 321,343 shares of our common stock and 18,657 options to purchase shares of our common stock and acquisition related expenses consisting primarily of legal and other professional fees, assumed ActiveTelco convertible notes in the amount of $0.7 million plus accrued interest and other assumed liabilities of approximately $1.1 million. This transaction was treated as a purchase for accounting purposes. ActiveTelco was located in Fremont, California. ActiveTelco provided an Internet telephony platform that enabled Internet and telecommunications service providers to integrate and deliver Web-based telephony applications such as unified messaging, long-distance service, voicemail and fax delivery, call forwarding, call conferencing and callback services.

In September 2001, we acquired certain assets, including some intellectual property rights, from ViaGate Technologies, Inc. (“ViaGate”) for approximately $0.6 million in cash. This transaction was treated as a purchase of assets for accounting purposes. The acquired patents and technology of ViaGate provide a highly scalable, carrier-class, full service gateway built on standards-based asynchronous transfer mode, or ATM, IP and VDSL technology.

In November 2002, we acquired VTC from Tektronix, Inc. (Tektronix) for approximately $7.2 million, consisting of an aggregate of 3.3 million shares of our common stock valued at $3.6 million, acquisition related expenses consisting primarily of legal and other professional fees of $0.3 million, and a note payable to Tektronix in the amount of $3.3 million. This transaction was treated as a purchase for accounting purposes. VTC offers digital head-end solutions enabling home entertainment delivery via the broadband Internet.

In connection with our acquisition of VTC, we are contractually obligated to use our commercially reasonable efforts to register on a Form S-3 pursuant to Rule 415(a)(1)(i) under the Securities Act of 1933, as amended, on a continuous or delayed offering the 3.3 million shares of common stock issued to Tektronix no later than May 30, 2003, in order that Tektronix may sell such shares on or after December 1, 2003.

As of March 31, 2003, our net intangible assets remaining to be amortized were $4.9 million, related to the acquisitions of the ViaGate assets, Xstreamis and VideoTele.com.

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Results of Operations

The following table sets forth items from our statements of operations as a percentage of total revenues for the periods indicated:

Three Months Ended March 31, 2003 and 2002

Revenue. We generate revenue primarily from the sale of hardware products, including third-party products, professional services through the licensing of our HomeRun technology, and from the sale of software products. Following our acquisition of VTC in November 2002, we also generate revenues from turnkey solutions, which are comprised of the sale of digital head-end and video trunking equipment. Our total revenue increased to $6.6 million for the three months ended March 31, 2003, from $2.4 million for the three months ended March 31, 2002. Using a year-over-year comparison, the increase in 2003 compared to 2002 of $4.2 million, or 179.9%, was due to sale of products acquired with the acquisition of VTC.

License and royalty revenue was flat at $0.2 million for each of the three months ended March 31, 2003 and 2002, respectively. We did not enter into any new license or royalty agreements during the first three months of 2003 or 2002.

Cost of Goods Sold/Gross Margin. Cost of goods sold consists of raw materials, contract manufacturing, personnel costs, overhead, test and quality assurance for products, and the cost of licensed technology included in the products. Our cost of goods sold increased to $3.3 million for the three months ended March 31, 2003, from $1.6 million during the same period in 2002. The increase of $1.7 million or 114% was primarily due to increased product sales and, consequently, increased product costs, related to the additional products we acquired with the acquisition of VTC. As a percentage of revenue, however, the VTC products have lower costs of sales than our other products. During the first quarter of 2002, we recorded additional reserves of $0.3 million for excess and obsolete inventory as a part of our normal business operations and product inventory assessments. This inventory adjustment was included in cost of goods sold. We did not have a similar charge in the first quarter of 2003.

Gross margin as a percentage of revenue increased to 50.6% of revenue for the three months ended March 31, 2003 from 35.4% of revenue for the three months ended March 31, 2002. The increase in gross margin is the result of the higher gross margins associated with the VTC product line and higher sales volumes.

Sales and Marketing. Sales and marketing expense primarily consists of personnel costs, including commissions and costs related to customer support facilities, travel, trade shows, promotions and outside services. As a result of our continued focus on cost saving measures, our sales and marketing expenses decreased to $1.9 million for the three months ended March 31, 2003 from $2.3 million for the three months ended March 31, 2002. The decrease for the three months ended March 31, 2003 when compared to the same period in 2002 of $0.4 million (or 16.8%), was primarily due to our restructurings.

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Research and Development. Research and development expense consists primarily of personnel and facility costs related to engineering and technical support, contract consultants, outside testing services, equipment and supplies associated with enhancing existing products and developing new products. Research and development costs are expensed as incurred. Our research and development expenses decreased to $2.1 million for the three months ended March 31, 2003, from $3.3 million for the three months ended March 31, 2002. The decrease for the three months ended March 31, 2003, when compared to the same period in 2002 of $1.2 million (or 36.5%), was primarily a result of our continued focus on cost saving measures and prior year restructurings, including the reduction, postponement or abandonment of research and development efforts on certain of our product lines. These cost saving measures resulted in year-over -year decreases of $0.6 million in personnel costs, $0.4 in facilities costs and another $0.2 million in travel and other discretionary expenses. Even though research and development expenses decreased in total for the first quarter of 2003 compared to the first quarter of 2002, we expect research and development activities to represent a significant percentage of our overall operating expenses during the remainder of fiscal 2003.

General and Administrative. General and administrative expense primarily consists of personnel costs for administrative officers and support personnel, legal, accounting, insurance and consulting fees. Our general and administrative expenses decreased to $1.2 million for the three months ended March 31, 2003 from $2.0 million for the three months ended March 31, 2002. This decrease for the three months ended March 31, 2003, when compared to the same period in 2002 of $0.8 million (or 38.6%), was primarily due to our continued focus on cost saving measures and our restructurings in 2002 which resulted in year-over-year decreases of $0.3 million in insurance and professional fees, $0.2 million in depreciation and $0.2 million in facilities and overhead.

Amortization of Intangibles. Amortization of intangibles is comprised of completed technology and patents related to acquisitions and are amortized over their estimated useful lives of five years. Amortization of intangibles increased to $0.5 million for the three months ended March 31, 2003, from $0.3 million for the three months ended March 31, 2002. The increase for the three months ended March 31, 2003, when compared to the same period in 2002 of $0.2 million (or 52.7%), was primarily due to the intangibles acquired when we purchased VTC in November 2002. As of March 31, 2003, net intangible assets were $5.0 million, which consist primarily of completed technology and patents and are being amortized over their remaining useful lives.

Interest and Other Income, Net. Interest and other income, net consisted primarily of interest income and expense and a foreign currency exchange gain. Our interest and other income, net decreased to $0.1 million for the three months ended March 31, 2003 from $0.2 million for the three months ended March 31, 2002. The decrease for the three months ended March 31, 2003, when compared to the same period in 2002, was due to lower interest rates on lower average cash balances and to increased interest expense associated with the long-term note payable to Tektronix as part of the acquisition of VTC. These reductions in interest and other income, net were partially offset by a foreign currency exchange gain.

Liquidity and Capital Resources

Historically, our principal source of liquidity has been through equity funding. From our inception through January 1999, we financed our operations primarily through the sale of preferred equity securities for an aggregate of $46.2 million, net of offering costs. In January 1999, we completed our initial public offering and issued 2,875,000 shares of our common stock at a price of $18.00 per share. From that January 1999 offering, we received approximately $46.9 million in cash, net of underwriting discounts, commissions and other offering costs. We also received approximately $6.7 million as a result of the exercise of a warrant to purchase 666,836 shares of Series G convertible preferred stock at a price of $10.00 per share. In March 2000, we completed our secondary offering and issued 2,500,000 shares of our common stock at a price of $60.00 per share, and we received approximately $141.7 million in cash, net of underwriting discounts, commissions and other offering costs, from that offering. In the future, we cannot be certain that similar equity funding will be available to us. If we are unable to obtain additional equity financing on terms acceptable to us, our business, operating results and financial condition could be negatively impacted.

Cash and cash equivalents totaled $21.0 million at March 31, 2003, a decrease of $4.6 million, or 18.0%, from cash and cash equivalents of $25.6 million at December 31, 2002.

The net decrease in cash and cash equivalents of $4.6 million during the three months ended March 31, 2003 resulted primarily from our use of $ 4.4 million in cash for operating activities. Included in cash used for operating activities was the payment of $1.85 million representing the first of two equal installments totaling $3.7 million towards the remaining purchase commitments of raw material components. The second and final payment was paid in the second quarter of 2003. Also included in cash used for operating activities during the first quarter of 2003 were cash payments of $0.5 million associated with our restructuring activities that we had previously reserved for.

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In future periods, we generally anticipate a decrease in working capital expenditures on a period-to-period basis primarily as a result of completing a substantial portion of payments for purchase commitments for inventory and decreases in our operational costs due to our restructurings and workforce reductions.

We have entered into certain contractual obligations and other purchase commitments that could result in cash outflows.

Our future minimum lease payments under operating leases at March 31, 2003 are as follows:

We have incurred substantial losses and negative cash flows from operating activities since inception. For the quarter ended March 31, 2003, we incurred a net loss of $ 2.2 million, negative cash flows from operating activities of $4.4 million, and have an accumulated deficit of $279 million. Management believes that the cash and cash equivalents as of March 31, 2003 are sufficient to fund our operating activities and capital expenditure requirements for the next twelve months. Management expects the amount of cash used to fund operations to decrease throughout the remainder of 2003. However, to the extent our business continues to be affected by poor economic conditions impacting the telecommunications industry, we will continue to require cash to fund operations. We will seek additional funding for operations from alternative debt and equity sources, if necessary, to maintain reasonable operating levels. We cannot assure that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material adverse effect on our ability to achieve our intended business objectives.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our unaudited condensed 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 management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, investments, intangible assets and income taxes. Our estimates are based on historical experience and on various other assumptions we believe are reasonable under the circumstances. Actual results may differ from these estimates.

The accounting policies described below are those that most frequently require us to make estimates and judgments, and are therefore critical to understanding our results of operations.

Revenue recognition

We generate revenue primarily from the sale of hardware products including third-party products, through professional services, the licensing of our HomeRun technology and the sale of our software products. We sell products through direct sales channels and through distributors.

Product revenues

We recognize product revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the fee is fixed or determinable, and collection is probable. Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors including specific contract and purchase order terms, completion and timing of delivery to the common carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of our assessment, we may recognize revenue when the products are shipped or defer recognition until evidence of sell-through occurs and cash is received. Revenue from service obligations included in product revenues is deferred and recognized ratably over the period of the obligation. We also maintain accruals and allowances for all cooperative marketing and other programs. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized. Our products generally carry a one year warranty from the date of purchase. During the three months ended March 31, 2003 the Company made no adjustments to its warranty accrual.

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Turnkey solution revenues

Revenue on turnkey solution sales, which typically include the design, manufacture, test, integration and installation of our equipment to our customers’ specifications, or equipment acquired from third parties to be integrated with our products, is generally recognized using the percentage-of-completion method. Under the percentage-of-completion method, revenue recognized reflects the portion of the anticipated contract revenue that has been earned, equal to the ratio of labor costs expended to date to anticipated final labor costs, based on current estimates of labor costs to complete the project. If the estimated costs to complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized immediately. Generally, the terms of turnkey solution sales provide for billing for products at the time of delivery and for services at the time of substantial completion of the project.

License and royalty revenues

We have entered into non-exclusive technology agreements with various licensees. These agreements provide the licensees the right to use our proprietary technology to manufacture or have products manufactured using the proprietary technology and to receive customer support for specified periods and any changes or improvement to the technology over the term of the agreement.

Contract fees for the services provided under these licensing agreements are generally comprised of license fees and non-refundable, prepaid royalties that are recognized when the proprietary technology is delivered if there are no significant vendor obligations. If the licensing agreements contain post-contract customer support, we recognize the contract fees ratably over the period during which the post-contract customer support is expected to be provided. This period represents the estimated life of the technology. We begin to recognize revenue under the contract once it has delivered the implementation package that contains all information needed to use our proprietary technology in the licensee’s process. The remaining obligations are primarily to provide the licensee with any changes or improvements to the technology and technical advice on specifications, testing, debugging and enhancements.

We recognize royalties upon notification of sale by our licensees. The terms of the royalty agreements generally require licensees to notify us and pay royalties within 60 days of the end of the quarter during which the sales occur.

Software license and post contract support revenues

Currently, our software revenue is derived from two separate sources, software license fees and post-contract maintenance and support fees. The software license fee typically grants a perpetual license to the customer. We generally recognize revenue from the sales of software licenses when all criteria for revenue recognition that are similarly applicable to our hardware product sales have been met. The revenue for maintenance and support fees is recognized ratably over the term of the separate support contract.

Revenue recognition in each period is dependant on our application of these accounting policies. If we believe that any of the conditions to recognize revenue have not been met, we will defer revenue recognition. For example, if collectiblitiy is not reasonably assured we will defer revenue recognition until subsequent cash receipt. Our application of percentage-of-completion accounting is subject to our estimates of labor cost to complete each turnkey solution project. In the event that actual results differ from these estimates or we adjust these estimates in future periods, our operating results for a particular period could be adversely affected. Unearned revenue that has been billed but not collected at the end of the period, is deferred as a reduction against the related accounts receivable balance. Unearned revenue deferred as a reduction against the related accounts receivable was $2.4 million and $0.9 million at March 31, 2003 and December 31, 2002, respectively.

Inventories

Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. We record provisions to write down our inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than we estimate, additional inventory provisions may be required.

Allowance for doubtful accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments. These estimated allowances are periodically reviewed, analyzing the customers’ payment history and information regarding the customers’ creditworthiness that is known to us. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.

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Accounting for long-lived assets

We assess the impairment of long-lived assets and related goodwill periodically. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period, and the market capitalization relative to net book value.

When our management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in our current business model.

During the first quarter of 2003, we determined that no such impairment had occurred. Future events could cause us to conclude that impairment indicators exist. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.

Legal contingencies

We are currently involved in certain legal proceedings as discussed in Note 6 of our consolidated financial statements. Because of uncertainties related to both the potential amount and range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there were an unfavorable outcome in any of these legal proceedings. As additional information becomes available, we will re-assess the potential liability related to this pending litigation and revise our estimates accordingly. Revisions of our estimates of such potential liability could materially impact our results of operations, financial condition or cashflows.

Accounting for stock based compensation

We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, and “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”) “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25,” and complies with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of our stock and the exercise price. We accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 148 and the EITF Issue No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.”

We amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and earnings per share is required. This information is required to be determined as if we had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

The following table illustrates the effect on net loss and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation (unaudited, in thousands except per share amounts) :

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The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss and net loss per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

Prior to our initial public offering, the fair value of each option grant was estimated using the minimum value method. Volatility and dividend yields were not factors in our minimum value calculation. Subsequent to the offering, the fair value of each stock option grant has been estimated on the date of the grant using the Black-Scholes option pricing model. We have also estimated the fair value of the purchase rights issued from its employee stock purchase plan using the Black-Scholes option pricing model. We first issued purchase rights from the 1998 Purchase Plan in fiscal 1999.

Recent accounting pronouncements

In July 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force (“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),” where a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. We do not believe that the adoption of this statement will have a material impact on our results of operations, financial position or cash flows.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002, and have been implemented in the Company’s financial statements.

In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We are currently evaluating this Issue and its impact on our financial statements.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The interim disclosure requirements of SFAS No. 148 have been implemented in the Company’s financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We believe that the adoption of this standard will not have a material impact on our financial statements.

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ADDITIONAL RISK FACTORS THAT COULD AFFECT OUR OPERATING RESULTS AND THE MARKET PRICE OF OUR STOCK

We have a history of losses and expect to continue to incur losses in the future.

We have incurred substantial net losses and experienced negative cash flow for each quarter since our inception. We incurred a net loss of $ 2.2 million for the three months ended March 31, 2003 and a net loss of $41.6 million for the year ended December 31, 2002. As of March 31, 2003, we had an accumulated deficit of $279 million. We expect that we will continue to incur losses for the remainder of fiscal year 2003.

We may never achieve profitability and, if we do so, we may not be able to maintain profitability. We have spent substantial amounts of money on the development of our Expresso products, HomeRun and LongRun technology, IntelliPOP products and software products. In November 2002, we acquired VideoTele.com and certain products of VideoTele.com that we anticipate will bring us incremental revenue beyond our Expresso, Home Run, Long Run and IntelliPOP products. During fiscal years 2001 and 2002, we significantly reduced our workforce in an effort to decrease certain of our operating expenditures, including our sales and marketing, research and development and general and administrative expenditures. However, we may not be able to generate a sufficient level of revenue (even with our newly acquired VideoTele.com products) to offset our current level of expenditures. Additionally, we may be unable to adjust our spending in a timely manner to respond to any unanticipated decline in revenue due to the fact that our expenditures for sales and marketing, research and development, and general and administrative functions are relatively fixed in the short term. Our ability to achieve and maintain profitability in the future will primarily depend on our ability to do the following:

Our operating results may fluctuate significantly, which could cause our stock price to decline.

A number of factors could cause our quarterly and annual financial results to be worse than expected, which could result in a decline in our stock price. Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future as a result of numerous factors, some of which are outside of our control. These factors include:

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We anticipate that average selling prices for our products will continue to decrease in the near future due to increased competitive price pressures in certain geographical regions. In addition, we may also experience substantial period-to-period fluctuations in future operating results and declines in gross margins as a result of the erosion of average selling prices for high-speed data access products and services due to a number of factors, including increased competition and rapid technological change. Decreasing the average selling prices of our products could cause us to experience decreased revenue despite an increase in the number of units sold. We may be unable to sustain our gross margins, even at the anticipated reduced levels, improve our gross margins by offering new products or increased product functionality or offset future price declines with proportionate reductions in our cost structure.

As a result of these and other factors, our operating results for future periods may be below the expectations of securities analysts and investors. In that event, the price of our common stock would further decline.

We are and continue to be affected by poor general economic conditions that have resulted in significantly reduced sales levels and, if such adverse economic conditions continue or worsen, our business, operating results and financial condition will continue to be negatively impacted.

The continued poor economic conditions in the world economy, the continued industry-wide downturn in the telecommunications market and recent events in the Middle East have materially and adversely affected, and continue to materially and adversely affect, our sales. As a result, we have, and will likely continue to, experience a material adverse impact on our business, operating results and financial condition. Comparatively lower sales for each of our fiscal years since 2000 have resulted in operating expenses increasing as a percentage of revenue for 2002 and 2001 compared to 2000. Although we took actions throughout 2001, 2002 and the first quarter of 2003 to create revenue opportunities and reduce operating expenses, including our acquisition of VideoTele.com, a prolonged continuation or worsening of sales trends that we faced in 2001 and 2002 would force us to take additional actions and charges in order to reduce our operating expenses further. If we are unable to reduce operating expenses at a rate and level consistent with anticipated future adverse sales trends or if we continue to incur significant special charges associated with such expense reductions that are disproportionate to our sales, our business, operating results and financial condition will be even further negatively impacted.

We depend on a limited number of large customers for a substantial portion of our revenue during any given period, and the loss of a key customer or loss or delay of a key order could substantially reduce our revenue in a given period.

We derive a significant portion of our revenue in each period from a limited number of customers. Two customers, Atlantic Telephone Membership Corporation and Home Telephone Company accounted for 12% and 11%, respectively, of the Company’s revenue for the three months ended March 31, 2003. Four customers, Capital Planeado SA de SV, Kanematsu Computer System Ltd., RIKEI Corporation and BTN Internetworking, accounted for 17%, 13%, 11% and 10% respectively, of the Company’s revenue for the three months ended March 31, 2002. Many of our customers have limited or, in some cases, no access to capital and continue to experience significant financial difficulties, including bankruptcy. In order to meet our revenue targets, we must continue to acquire new customers and increase sales to our existing customers. In addition, our strategy of targeting larger, more established customers may result in longer sales cycles and delayed revenue. Sales to larger accounts could also result in increased competition from larger and more established competitors. If sales to our largest customers decrease materially below current levels or if we are unable to establish a new base of customers, such decreases or failures would materially and adversely affect our business, results of operations and financial condition.

We have in the past and may in the future acquire companies, technologies or products, and, if we fail to integrate these acquisitions, our business, results of operations and financial condition could be harmed.

In fiscal years 2002, 2001 and 2000, we completed four acquisitions. As a part of our business strategy, we expect to make additional acquisitions of, or significant investments in, complementary companies, products or technologies. We may need to overcome significant issues in order to realize any benefits from our past transactions, and any future acquisitions would be accompanied by similar risks. These risks include, but are not limited to:

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On November 7, 2002, we completed our acquisition of VTC, a leading provider of video content processing and video trunking, and we are in the process of integrating VTC into our company. We evaluate and enter into other acquisition and alliance transactions on an ongoing basis. The size and scope of the acquisition of VTC relative to our overall size increases both the scope and consequence of ongoing integration risks. We may not successfully address the integration challenges in a timely manner, or at all, and we may not fully realize all of the anticipated benefits or synergies of the VTC acquisition (which are principally associated with restructurings, including workforce reductions, procurement synergies and other operational efficiencies) or of any other transaction to the extent, or in the timeframe, anticipated. Moreover, the timeframe for achieving benefits may depend partially on the actions of employees, suppliers or other third parties.

Even if an acquisition or alliance is successfully integrated, we may not receive the expected benefits of the transaction. Managing acquisitions and alliances requires varying levels of management resources, which may divert our attention from other business operations. The VTC acquisition also has resulted, and may in the future result, in significant costs and expenses and charges to earnings. These costs and expenses could include those related to severance pay, asset impairment charges, charges from the elimination of duplicative facilities and contracts, in-process research and development charges, inventory adjustments, legal, accounting and financial advisory fees, and required payments to executive officers and key employees under retention plans adopted in connection with the transaction. Also, any prior or future downgrades in our credit rating associated with an acquisition could adversely affect our ability to borrow and result in more restrictive borrowing terms, including increased borrowing costs, more restrictive covenants and the extension of less open credit. This in turn could materially and adversely affect our internal cost of capital estimates and, therefore, our operational decisions. As a result of the foregoing, any completed, pending or future transactions may contribute to financial results that differ from the investment community’s expectations in a given quarter.

If we are not successful in integrating VTC into our operations in a timely manner, our business, operating results and financial condition will be materially and adversely impacted.

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We are currently engaged in three securities lawsuits, two of which are class action lawsuits, any of which, if they were to result in an unfavorable resolution, could adversely affect our business, results of operations or financial condition.

Beginning July 12, 2001, six putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against us and certain of our current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased our stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that we and certain of our current and former officers and directors made false and misleading statements about our business during the putative class period. Specifically, the complaints allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, the plaintiffs filed an amended complaint. Defendants filed a motion to dismiss portions of the amended complaint. The Court has not ruled on that motion. We believe the allegations against us are without merit and intend to defend the action vigorously. An unfavorable resolution of this litigation could have a material adverse effect on our business, results of operations, financial condition, or cash flows.

On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorney’s fees. There has not been a response filed to the compliant, discovery has not commenced, and no trial date has been established.

On October 30, 2001, we and certain of our current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from our January 29, 1999 initial public offering and our March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against us and certain of our current and former officers and directors under Section 11 of the 1933 Act and under Section 10(b) and Rule 10b-5 of the Securities and Exchange Act of 1934, as amended, and alleges claims against certain of our current and former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for our initial public offering and secondary offering. The Court has denied the Company’s motion to dismiss, and the case will now proceed to discovery. We believe the allegations against us are without merit and intend to defend the action vigorously. An unfavorable resolution of this litigation could have a material adverse effect on our business, results of operations, financial condition, or cash flows.

If we do not reduce our inventory, we may be forced to incur additional charges, which would further materially and adversely impact our business, results of operations and financial condition.

In fiscal years 2000 and 2001, we accumulated a substantial inventory of finished goods and components due to poor global economic conditions and the reduction in product demand due to capital funding decreases experienced by several key customers. Since that time, we have written off a significant portion of that inventory because we have been largely unsuccessful in monetizing this inventory by selling our existing finished goods inventory and the component inventory resulting from deliveries on already canceled purchase commitments. We expect that competitors will continue to market and sell inexpensive competitive products in the marketplace, thereby continuing to make it difficult for us to reduce our inventory levels further, which may eventually require that we write off our entire remaining $3.8 million inventory. If we are unable to sell a substantial amount of finished goods that we have not yet written off, our expected cash position throughout the remainder of 2003 will be even further materially and adversely impacted, which will harm our business, results of operations and financial condition.

If our Expresso and IntelliPOP products do not gain broader acceptance in the market, our business, financial condition and results of operations will be further harmed.

        We launched our IntelliPOP 5000 product series in the first half of 2001 and have not yet been successful in generating widespread customer interest in this product. Similarly, our sales of Expresso units have been below what we had anticipated. We must devote a substantial amount of human and capital resources in order to broaden commercial acceptance of our Expresso products and to gain commercial acceptance of our IntelliPOP products and expand our offerings of these products in the multi-dwelling unit, or MDU, and the multi-tenant commercial unit, or MCU, markets. However, to date, this commitment of resources to these product lines has not generated the commercial acceptance that we have sought for these products. Historically, the majority of our Expresso products have been sold into the MDU market. Our future success depends on our ability to continue to penetrate this market and to expand our penetration into the MCU market. Our success also depends on our ability to educate existing and potential customers and end-users about the benefits of our Fast Copper and Signature Switch technologies, our LongRun and IntelliPOP products, and about the development of new products to meet changing and expanding demands of service providers, MTU owners and corporate customers, including our new product offerings based on our acquisition of VideoTele.com. The future success of our Expresso and IntelliPOP products will also depend on the ability of our service provider customers to market and sell high-speed data services to end-users. If our IntelliPOP or Expresso products do not achieve broader commercial acceptance within the MDU market, MCU market, or in any other markets we may enter, our business, financial condition and results of operations will be further materially and adversely affected.

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The market in which we operate is highly competitive, and we may not be able to compete effectively.

The market for video and broadband data systems is intensely competitive, and we expect that this market will continue to become more competitive in the future. Our immediate competitors include, or are expected to include, Cisco Systems, Inc., Harmonic Inc., Tandberg Television and a number of other public and private companies. Many of these competitors offer or may in the future offer technologies and services that directly compete with some or all of our high-speed access products and related software products. Also, many of these competitors continue to announce significant changes in their business plans and operations, some of which, such as major write downs of inventory, could result in lower priced products flooding the market, which would have a negative impact on our ability to sustain our current pricing and sell our inventory. In addition, the market in which we compete is characterized by increasing consolidation, and we cannot predict with certainty how industry consolidation will affect us or our competitors.

Our competitors and potential competitors may have substantially greater name recognition and technical, financial and marketing resources than we do, and we can give you no assurance that we will be able to compete effectively in our target markets. These competitors may be able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies and devote substantially more resources to developing new products than we can. In addition, our HomeRun licensees may sell products based on our HomeRun technology to our competitors or potential competitors. This licensing may cause an erosion in the potential market for our Expresso products. We cannot assure you that we will have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully. This competition could result in price reductions, reduced profit margins and loss of market share, which could harm our business, financial condition and results of operations.

Our copper-wire based solutions face severe competition from other technologies, and the commercial acceptance of any competing solutions could harm our ability to compete and thus materially and adversely impact our business, financial condition and results of operations.

The market for high-speed data access products and services is characterized by several competing technologies, including fiber optic cables, coaxial cables, satellites and other wireless facilities. These competing solutions provide fast access, high reliability and cost-effective solutions for some users. Many of our products are based on the use of copper telephone wire. Because there are physical limits to the speed and distance over which data can be transmitted over copper wire, our products may not be a viable solution for customers requiring service at performance levels beyond the current limits of copper telephone wire. To the extent that telecommunications service providers choose to install fiber optic cable or other transmission media in the last mile, or to the extent that homes and businesses install other transmission media within buildings, we expect that demand for our products that are based on copper telephone wires will decline. Commercial acceptance of any one of these competing solutions or any technological advancement or product introduction that provides faster access, greater reliability, increased cost-effectiveness or other advantages over technologies that utilize existing copper telephone wires could decrease the demand for our products and reduce average selling prices and gross margins associated with our products. The occurrence of any one or more of these events could harm our business, financial condition and results of operations.

If we fail to manage our operations in light of our changing revenue base, our ability to increase our revenues and improve our results of operations could be harmed.

Our operations have changed significantly due to volatility in our business. In the past, we rapidly and significantly expanded our operations. However, in fiscal years 2001 and 2002, we reduced our workforce significantly to control overall operating expenses in response to dramatic declines in, and the expectation of continued slowing of, our sales growth. We anticipate that, in the future, expansion in certain areas of our business may be required to expand our customer base and exploit market opportunities. In particular, we expect to face numerous challenges in the implementation of our business strategy to focus on selling our products to the larger, more established customers, such as ILECs and PTTs, in both domestic and international markets.

To exploit the market for our products, we must develop new and enhanced products while implementing and managing effective planning and operating processes. To manage our operations, we must, among other things, continue to implement and improve our operational, financial and management information systems, hire and train additional qualified personnel, continue to expand and upgrade core technologies and effectively manage multiple relationships with various customers, suppliers and other third parties. We cannot assure you that our systems, procedures or controls will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to exploit fully the market for our products or systems. If we are unable to manage our operations effectively, our business, financial condition and results of operations could be harmed.

We depend on international sales for a significant portion of our revenue, which subjects our business to a number of risks; if we are unable to generate significant international sales, our business, financial condition and results of operations could be materially and adversely affected.

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Sales to customers outside of the United States accounted for approximately 13.2%, and 67.1% of revenue for the three months ended March 31, 2003 and 2002, respectively. There are a number of risks arising from our international business, including, but not limited to:

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We expect sales to customers outside of the United States to continue to represent a significant portion of our revenue. However, we cannot assure you that foreign markets for our products will develop at the rate or to the extent currently anticipated. If we fail to generate significant international sales, our business, financial condition and results of operations could be materially and adversely affected.

Our ability to attract and retain our personnel has been and may continue to be materially and adversely affected by our low stock price.

Our continued low stock price means that most of our outstanding employee stock options are “under water” or priced substantially above the current market price of our common stock. Our employees may have felt, and may continue to feel, that they are receiving inadequate compensation. Further, the continued adverse market conditions mean that our stock option offerings and our stock option plans may not offer current and potential future employees sufficient incentive to work for us. If adverse market conditions persist, our stock option offerings and employee stock plans will further diminish our ability to attract and/or retain qualified personnel, which will further materially and adversely impact our business, financial condition, results of operations, or cash flows.

Some of our customers have not been able to meet their financial obligations to us due to changes in the capital markets and these customers’ own precarious financial situations; if more of our customers experience similar financial difficulties, our revenue will decrease further, which would materially and adversely affect our business.

Due to increased volatility in equity markets and tightening of lending in the credit markets, we are exposed to a significant risk that customers will not pay us the amounts that they owe us in order to conserve their capital. This would lead to increases in our outstanding accounts receivable as a percentage of revenue, extended payback periods and increased risk of customer default. For example, during the latter part of the fourth quarter of 2000, several key customers experienced a rapid deterioration in their ability to obtain additional capital to fund their businesses. As a result, these customers declared their inability to make timely payments on their accounts and were unable to demonstrate the ability to pay their existing account balances with us since that time. During fiscal 2001, a significant number of these customers commenced bankruptcy proceedings. As of December 31, 2002, all of these bankruptcies were finalized, and we do not expect that we will collect much, if any, of the amounts owed to us by these customers.

We factor the increased risk of non-payment into our assessment of our customers’ ability to pay, and, in some instances, these considerations will likely result in longer revenue deferrals than we had anticipated at the time that we booked sales to those customers. We also believe that certain of our customers will alter their plans to deploy products to meet the constraints imposed on them by changes in the capital markets. If we are not able to increase sales to other customers, or if our sales are otherwise delayed or revenue written off, our sales will continue to decline, which would further harm our business, operating results and financial condition.

If we inaccurately estimate customer demand, our business, results of operations and financial condition could be harmed.

We plan our expense levels in part based on our expectations about future revenue. These expense levels are relatively fixed in the short-term. However, the number of orders for our products may vary from quarter to quarter. In some circumstances, customers may delay purchasing our current products in favor of next-generation products. In addition, our new products are generally subject to technical evaluations by potential customers that typically last 60 to 90 days. In the case of IntelliPOP, those evaluations may take up to six months. If orders forecasted for a specific customer for a particular quarter are delayed or cancelled, our revenue for that quarter may be less than our forecast. Currently, we have minimal risk of loss associated with long-term customer commitments or penalties for delayed and/or cancelled orders. However, we may be unable to reduce our spending accordingly in the short-term if such a loss occurred, and any such revenue shortfall would have a direct and adverse impact on our results of operations for that quarter. Further, we outsource the manufacturing of our products based on forecasts of sales. If orders for our products exceed our forecasts, we may have difficulty meeting customers’ orders in a timely manner, which could damage our reputation or result in lost sales. Conversely, if our forecasts exceed the orders we actually receive and we are unable to cancel future purchase and manufacturing commitments in a timely manner, our inventory levels would increase. This could expose us to losses related to slow moving and obsolete inventory, which would have a material adverse effect on our business, operating results and financial condition.

We depend on contract manufacturers to manufacture all of our products and rely on them to deliver high-quality products in a timely manner; the failure of these manufacturers to continue to deliver quality products in a timely manner could have a materially adverse effect on our business, results of operations and financial condition.

        We do not manufacture our products. We rely on contract manufacturers to assemble, test and package our products. We cannot assure you that these contract manufacturers and suppliers will be able to meet our future requirements for manufactured products, components and subassemblies. In addition, we believe that current market conditions have placed additional financial strain on our contract manufacturers. Any interruption in the operations of one or more of these contract manufacturers would harm our ability to meet our scheduled product deliveries to customers. We also intend to introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. The inability of our contract manufacturers to provide us with adequate supplies of high-quality products or the loss of a current contract manufacturer would cause a delay in our ability to fulfill customer orders while we obtain a replacement manufacturer and would harm our business, operating results and financial condition. In addition, we have canceled certain finished goods and component orders, which may harm our relationship with certain contract manufacturers. Moreover, if we do not accurately forecast the actual demand for our products, we may face supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products or the loss of existing or potential customers, either of which could harm our business, operating results or financial condition.

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Based on our building specifications, several key components are purchased from single or limited sources, and if our contract manufacturers fail to obtain the raw materials and component products we require in a timely manner we could lose sales; if we lose sales, our business, financial condition and results of operations would be materially and adversely affected.

We currently purchase most of our raw materials and components used in our products through our contract manufacturers. In procuring components for our products, we and our contract manufacturers rely on some suppliers that are the sole source of those components, and we are dependent upon supplies from these sources to meet our needs. We also depend on various sole source offerings from Broadcom, Metalink US and Motorola for certain of our products. Components are purchased pursuant to purchase orders based on forecasts, but neither we nor our contract manufacturers have any guaranteed supply arrangements with these suppliers. The availability of many of these components depends in part on our ability to provide our contract manufacturers and their suppliers with accurate forecasts of our future needs. If we or our manufacturers are unable to obtain a sufficient supply of key components from current sources or if there is any interruption in the supply of any of the key components currently obtained from a single or limited source, we could experience difficulties in obtaining alternative sources at reasonable prices, if at all, or in altering product designs to use alternative components. Resulting delays and reductions in product shipments could damage customer relationships, could disrupt our operations and could harm our business, financial condition or results of operations. In addition, any increases in component costs that are passed on to our customers could reduce demand for our products.

We rely on third parties to test substantially all of our products; and if, for any reason, these third parties were unable to or did not adequately assist us in controlling the quality of our products, this lack of quality control could harm our business, financial condition and results of operations.

Substantially all of our products are assembled and tested by our contract manufacturers. Although we perform random spot testing on manufactured products, we rely on our contract manufacturers for assembly and primary testing of our products. Any quality assurance problems could increase the cost of manufacturing, assembling or testing our products and could harm our business, financial condition and results of operation. Moreover, defects in products that are not discovered in the quality assurance process could damage customer relationships and result in product returns or product liability claims, each of which could harm our business, financial condition and results of operations.

Our business relies on the continued growth of the Internet; any slowdown in or reversal of the growth of Internet use could materially and adversely impact our business.

The market for high-speed data access products depends in large part on the continued use and popularity of the Internet. Issues concerning the use of the Internet, including security, lost or delayed packets, and quality of service may negatively affect the development of the market for our products.

Our industry is characterized by rapid technological change; we must continually introduce new products that achieve broad market acceptance in order to address this change and remain competitive.

The markets for high-speed data access products are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, changes in end-user requirements and evolving industry standards. To remain competitive, we must continually improve the performance, features and reliability of our products, particularly in response to competitive product offerings. We must introduce products that incorporate or are compatible with these new technologies as they emerge and must do so in a timely manner. We cannot assure you that we will be able to respond quickly and effectively to technological change. We may have only limited time to penetrate certain markets, and we cannot assure you that we will be successful in achieving widespread acceptance of our products before competitors offer products and services similar or superior to our products. Any failure to introduce new products addressing technological changes or any delay in our product introductions could adversely affect our ability to compete and cause our operating results to be below our expectations or the expectations of public market analysts or investors. In addition, when we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products. These actions could harm our business, financial condition and operating results by unexpectedly decreasing sales, increasing our inventory levels of older products and exposing us to greater risk of product obsolescence.

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