TUT SYSTEMS INC - 10-Q Quarterly Report

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

	December 31, 2003			September 30, 2004
				(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	14,370		$	9,253
Accounts receivable, net of allowance for doubtful accounts of $47 and $37 in 2003 and 2004, respectively	7,062			5,122
Insurance settlement receivable	10,725			—
Inventories, net	4,181			4,447
Prepaid expenses and other	1,026			1,611
Total current assets	37,364			20,433
Property and equipment, net	1,722			1,893
Intangibles and other assets	3,685			2,293
Total assets	$	42,771		$	24,619

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Line of credit	$	—		$	2,562
Accounts payable	3,055			3,102
Accrued liabilities	1,516			1,952
Legal settlement liability	10,725			—
Deferred revenue	253			161
Total current liabilities	15,549			7,777
Note payable	3,523			3,743
Other liabilities	44			4
Total liabilities	19,116			11,524
Commitments and contingencies (Note 7)
Stockholders’ equity:
Preferred stock, $0.001 par value, 5,000 shares authorized, no shares issued and outstanding in 2003 and 2004, respectively	—			—
Common stock, $0.001 par value, 100,000 shares authorized, 20,274 and 20,469 shares issued and outstanding in 2003 and 2004, respectively	20			20
Additional paid-in capital	305,777			306,106
Accumulated other comprehensive loss	(89		)	(150		)
Accumulated deficit	(282,053		)	(292,881		)
Total stockholders’ equity	23,655			13,095
Total liabilities and stockholders’ equity	$	42,771		$	24,619

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

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2004			2003			2004
Revenue:
Product	$	8,283		$	6,668		$	22,384		$	17,932
License and royalty	239			4			604			40
Total revenue	8,522			6,672			22,988			17,972
Cost of goods sold	3,751			4,102			11,025			12,678
Gross margin	4,771			2,570			11,963			5,294
Operating expenses:
Sales and marketing	1,848			2,001			5,702			5,838
Research and development	1,887			1,844			6,221			5,526
General and administrative	1,018			1,044			3,325			3,260
Restructuring costs	292			—			292			—
Impairment of intangible assets	—			—			128			202
Amortization of intangible assets	442			376			1,360			1,148
Total operating expenses	5,487			5,265			17,028			15,974

Loss from operations	(716		)	(2,695		)	(5,065		)	(10,680		)
Interest and other (expense) income, net	(26		)	(48		)	67			(148		)

Net loss	$	(742	)	$	(2,743	)	$	(4,998	)	$	(10,828	)

Net loss per share, basic and diluted (Note 3)	$	(0.04	)	$	(0.13	)	$	(0.25	)	$	(0.53	)

Shares used in computing net loss per share, basic and diluted (Note 3)	20,040			20,453			19,912			20,361

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

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Nine Months Ended September 30,
	2003			2004
Cash flows from operating activities:
Net loss	$	(4,998	)	$	(10,828	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation	796			972
Provision (recovery) for doubtful accounts	30			5
Provision for (reduction of) excess and obsolete inventory and abandoned products	(775		)	1,397
Impairment of intangibles	128			202
Amortization of intangibles	1,360			1,148
Deferred interest on note payable	193			220
Change in operating assets and liabilities, net of businesses acquired:
Accounts receivable	(5,246		)	1,935
Inventories	841			(1,663		)
Prepaid expenses and other assets	(447		)	(605		)
Accounts payable and accrued liabilities	(2,649		)	444
Deferred revenue	(786		)	(92		)
Net cash used in operating activities	(11,553		)	(6,865		)
Cash flows from investing activities:
Purchase of property and equipment	(745		)	(1,143		)
Net cash used in investing activities	(745		)	(1,143		)
Cash flows from financing activities:
Proceeds from line of credit	¾			2,562
Proceeds from issuances of common stock, net	683			329
Net cash provided by financing activities	683			2,891
Net decrease in cash and cash equivalents	(11,615		)	(5,117		)
Cash and cash equivalents, beginning of period	25,571			14,370
Cash and cash equivalents, end of period	$	13,956		$	9,253

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

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)

NOTE 1—DESCRIPTION OF BUSINESS:

The Company designs, develops, and sells digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals over their networks. The Company also offers digital video processing systems that enable private enterprise and government entities to transport video signals over satellite, fiber, radio, or copper facilities for surveillance, distance learning, and TV production applications. The Company also offers broadband transport and service management products that enable the provisioning of high-speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

Historically, the Company derived most of its sales from its broadband transport and service management products. In November 2002, the Company acquired VideoTele.com, or VTC, from Tektronix, Inc. to extend its product offerings to include digital video processing systems. These video-based products now represent a majority of the Company’s sales.

The Company has incurred substantial losses and negative cash flows from operations since inception. For the nine months ended September 30, 2004, the Company incurred a net loss of $10,828 and negative cash flows from operating activities of $6,865, and has an accumulated deficit of $292,881 at September 30, 2004. Management believes that the cash and cash equivalents as of September 30, 2004 are sufficient to fund its operating activities and capital expenditure needs for the next twelve months. However, in the event that general economic conditions worsen, the Company may require additional cash to fund its operations. In October 2004, the Company completed the sale of 4,600 shares of its common stock at a price of $2.25 per share for gross proceeds of $10,350. Net proceeds from the offering were approximately $8,700. Failure to generate positive cash flow 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 December 31, 2003 and September 30, 2004 and for the three and nine months ended September 30, 2003 and 2004 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 December 31, 2003 and September 30, 2004, its results of operations for the three and nine months ended September 30, 2003 and 2004 and its cash flows for the nine months ended September 30, 2003 and 2004. 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/A, filed with the Securities and Exchange Commission on September 2, 2004. The balance sheet as of December 31, 2003 was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. The results for the three and nine months ended September 30, 2004 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2004.

Revenue recognition

The Company generates revenue primarily from the sale of hardware products, including third-party products, through professional services, and through the sale of its software products. The Company sells products through direct sales channels and through distributors. Generally, product revenue is generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.

Product revenue

Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.

Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. The Company sells these products through its own direct sales channels and also through distributors.

The Company’s revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2, and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

In the case of software arrangements which require significant production, modification or customization of software, which encompasses all of the Company’s turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The Company recognizes revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the post contract support (“PCS”) element, for which the Company has established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value of the arrangement prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

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 of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, the Company must also make a judgment regarding collectibility of the arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to the Company’s credit review policy. The Company sells to customers for which there is a history of successful collection and to new customers for which no similar history may exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are increased only after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon the Company’s credit review process, no credit is extended and revenue is recognized on a cash-collected basis, after shipment has occurred or the revenue has been earned under the percentage-of-completion method.

The Company also maintains accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. The Company’s products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

License and Royalty Revenue

License and royalty revenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by the Company for products sold by its licensees. Currently, the majority of the Company’s license and royalty revenue is comprised of non-refundable license fees paid in advance. Such revenue is recognized ratably over the period during which post-contract customer support is expected to be provided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by the Company for products sold by its licensees.

Should changes in conditions cause the Company to determine that the criteria for revenue recognition are not met for certain

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:

	Three Months Ended September 30,							Nine Months Ended September 30,
	2003				2004			2003			2004
Net loss – as reported	$	(742		)	$	(2,743	)	$	(4,998	)	$	(10,828	)
Adjustment:
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects	(816			)	(497		)	(2,853		)	(1,902		)
Net loss – pro forma	$		(1,558	)	$	(3,240	)	$	(7,851	)	$	(12,730	)
Basic and diluted net loss per share – as reported	$		(0.04	)	$	(0.13	)	$	(0.25	)	$	(0.53	)
Basic and diluted net loss per share – pro forma	$		(0.08	)	$	(0.16	)	$	(0.39	)	$	(0.63	)

The fair value of options 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. 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 net loss/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.

Recent accounting pronouncements

In January 2003, the Financial Accounting Standards Board, the (“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” which was subsequently revised in December 2003 with the issuance of FIN46-R. This interpretation 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. Application of this Interpretation is required in financial statements for periods ending after March 15, 2004. The adoption of this Interpretation in the nine months ended September 30, 2004 did not have a material impact on the Company’s results of operations, financial position or cash flows.

Reclassifications

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

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:

	Three Months Ended September 30,							Nine Months Ended September 30,
	2003				2004			2003			2004
Net loss per share, basic and diluted:
Net loss	$	(742		)	$	(2,743	)	$	(4,998	)	$	(10,828	)
Net loss per share, basic and diluted	$		(0.04	)	$	(0.13	)	$	(0.25	)	$	(0.53	)
Shares used in computing net loss per share, basic and diluted	20,040				20,453			19,912			20,361
Antidilutive securities not included in net loss per share calculations	3,132				4,320			3,132			4,320

NOTE 4—COMPREHENSIVE LOSS:

Comprehensive loss includes net loss, unrealized gains and losses on investments, 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:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2004			2003			2004
Net loss	$	(742	)	$	(2,743	)	$	(4,998	)	$	(10,828	)
Unrealized losses on other assets	(43		)	12			(41		)
Foreign currency translation adjustments	(12		)	(8		)	(24		)	(20		)
Net change in other comprehensive loss	(12		)	(51		)	(12		)	(61		)
Total comprehensive loss	$	(754	)	$	(2,794	)	$	(5,010	)	$	(10,889	)

NOTE 5—BALANCE SHEET COMPONENTS:

	December 31, 2003			September 30, 2004
Inventories, net:
Finished goods	$	4,015		$	5,485
Raw materials	391			190
Allowance for excess and obsolete inventory and abandoned product	(225		)	(1,228		)
	$	4,181		$	4,447
Property and equipment:
Computers and software	$	1,328		$	1,787
Test equipment	2,277			2,941
Office equipment	41			56
	3,646			4,784
Less: accumulated depreciation	(1,924		)	(2,891		)
	$	1,722		$	1,893
Accrued liabilities:
Professional Services	$	494		$	858
Compensation	652			837
Other	370			257
	$	1,516		$	1,952

The Company recorded a provision for inventory within cost of goods sold totaling $402 in the three months ended September 30, 2004, and $1,397 in the nine months ended September 30, 2004, related to the costs of raw materials and finished goods in excess of what the Company reasonably expected to sell in the foreseeable future as of the third quarter of 2004. The Company also reduced inventory costs to market value.

Intangible and other assets:

	As of December 31, 2003
	Gross Carrying Amount		Accumulated Amortization			Net Intangibles
Intangible and other assets:
Completed technology and patents	$	8,125	$	(5,003	)	$	3,122
Contract backlog	247		(247		)	—
Customer list	86		(14		)	72
Maintenance contract renewals	50		(12		)	38
Trademarks	315		(52		)	263
	$	8,823	$	(5,328	)	3,495

Other non-current assets						190
						$	3,685

	As of September 30, 2004
	Gross Carrying Amount		Accumulated Amortization			Net Intangibles
Amortized intangible assets:
Completed technology and patents	$	7,922	$	(6,101	)	$	1,821
Contract backlog	247		(247		)	—
Customer list	86		(24		)	62
Maintenance contract renewals	50		(19		)	31
Trademarks	315		(86		)	229
	$	8,620	$	(6,477	)	2,143

Other non-current assets						150
						$	2,293

During the nine months ended September 30, 2004, the Company determined that certain of the technology acquired as part of the purchase of the assets of Viagate Technologies, Inc. in September 2001 had become impaired. As a result, the Company incurred a loss of $202 to write-off the technology.

The aggregate amortization expense for the three months ended September 30, 2003 and 2004 was $442 and $376, respectively and $1,360 and $1,148 for the nine months ended September 30, 2003 and 2004.

Minimum future amortization expense as of September 30, 2004 is as follows:

Remainder of 2004	$	376
2005	875
2006	424
2007	363
Thereafter	105
	$	2,143

NOTE 6 – LINE OF CREDIT

On September 23, 2004, the Company entered into a revolving asset based credit facility (“credit facility”), with Silicon Valley Bank (“the Bank”). This facility has a term of two years and expires on September 23, 2006. All borrowings under this facility are classified as current liabilities. Borrowings under the credit facility are formula based and limited to the lesser of $7.0 million or an amount based on a percentage of eligible accounts receivable and eligible inventories. Based on the maximum percentages of eligible accounts receivable and eligible inventory levels, borrowings under this facility were $2,562 million as of September 30, 2004. The annual interest rate as of September 30, 2004 was 5.25%. The interest rate is equal to the bank’s base rate, or prime rate, currently at 4.75%, plus 0.5%. The rate may increase by 1.0% if the Company does not meet certain financial covenants. The credit facility is secured by all of the Company’s assets, and contains various covenants. For further discussion of the credit facility, please see the discussion of the facility under “Liquidity and Capital Resources” in Item 2. The Company repaid the borrowings under this facility in October 2004.

NOTE 7–COMMITMENTS AND CONTINGENCIES:

Lease obligations

The Company leases equipment and office, assembly and warehouse space under non-cancelable operating leases that expire from 2004 through 2007.

Minimum future lease payments under operating leases as of September 30, 2004 are as follows:

Remainder of 2004	$	233
2005	731
2006	52
Thereafter		27
	$	1,043

Purchase commitments

The Company had non-cancelable commitments to purchase finished goods inventory totaling $1,009 and $479 in aggregate at December 31, 2003 and September 30, 2004, respectively.

In re Tut Systems, Inc. Securities Litigation, Civil Action No. C-01-2659-JCS (the “Securities Litigation Action”).

Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of investors 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 the Company’s business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints were 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 were 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, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, defendants answered the remaining allegations of the amended complaint. Defendants reached a settlement of the Securities Litigation Action in December 2003. Subject to preliminary and final approval by the Court, the Company’s insurance carriers agreed to pay $10 million, on behalf of the Company, to settle the suit. The settlement includes a release of all defendants. The insurance carriers paid the settlement amount to plaintiffs’ escrow agent in January 2004. The Court preliminarily approved the settlement on February 24, 2004 and finally approved the settlement on May 14, 2004. In the second quarter of 2004, the amounts were paid by the Company’s insurance carriers and the $10 million was removed from the insurance settlement receivable and the legal settlement liability.The settlement became final on September 15, 2004, the date when the appeals period ended.

Lefkowitz v. D’Auria, et al

On March 19, 2003, Chesky Lefkowitz, a stockholder 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. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The Company and the individual defendants reached a settlement of the derivative action in December 2003. The settlement involves the Company’s adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $722,000 and an incentive award to the derivative plaintiff in the amount of $3,000. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carrier involved in this suit agreed to pay the entire $725,000 settlement amount and, therefore, recovery from the insurance carrier was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The settlement was approved by the Court on January 12, 2004, and, shortly thereafter, the insurance carrier paid the settlement amount to the derivative plaintiff’s counsel. Therefore, in the first quarter of 2004, the $725,000 was removed from the insurance settlement receivable and the legal settlement liability. The settlement includes a release of the Company and the individual defendants.

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.

NOTE 8—SEGMENT INFORMATION:

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. Revenue is attributed to the following countries based on the location of customers:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2004		2003		2004
United States	$	6,999	$	4,971	$	18,839	$	14,125
International:
Ireland	—		472		545		1,201
Canada	911		465		1,619		1,279
China	181		390		512		421
Korea	—		162		—		162
All other countries	431		212		1,473		784
	$	8,522	$	6,672	$	22,988	$	17,972

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. 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. We have based these forward-looking statements on our current expectations and projections about future events. Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The forward-looking statements contained in this quarterly report include statements about the following: (1) our belief that there is and will continue to be growing demand for video services in the future (2) our belief that video products will provide most of our growth opportunities for the foreseeable future, (3) our belief that the number of telco video subscribers will grow significantly between 2004 and 2008 and that this market space will continue to become more competitive,(4) our expectation that we will see growing demand for our products in the future, (5) our expectation that we will compete with larger public companies as we begin to target larger telco customers, (6) our expectation that emerging advancements in video compression technology will allow more efficient transport of video streams, (7) our expectation that digital subscriber line or DSL technology will continue to dominate telco broadband networks for the foreseeable future, (8) our belief that new controls and procedures have addressed the conditions identified by our auditors as material weaknesses, (9) our expectation that we will maintain our sales and marketing expenses at levels consistent with our future revenue expectations, (10) our expectation that capital expenditures for research and development in 2004 will remain comparable to capital expenditures in 2003 (11) our expectation that our research and development expenses will increase throughout the remainder of 2004, (12) our expectation that capital expenditures in 2004 will be comparable to 2003 and that these capital expenditures will be funded from operations,(13) our expectation that negative cash flows from operating activities will decrease over the next several quarters, (14) our anticipation that we will continue to be able to borrow money under our line of credit with Silicon Valley Bank (15) our expectation that we will pay accrued interest on the note issued to Tektronix beginning January 31, 2006,(16) our belief that our cash and cash equivalents as of September 30, 2004 are sufficient to fund our operating activities and capital expenditure needs for the next twelve months, (17) our expectation that revenue from broadband transport and service management products will decline slightly for the remainder of 2004, (18) our expectation that future license and royalty revenue will be minimal in future periods, (9) our anticipation that our sales and operating margins will continue to fluctuate, (20) our expectation that revenue for the fourth quarter of 2004 will exceed $7.0 million, (21) our anticipation that we will generally continue to invoice foreign sales in U.S. dollars, (22) our intention to continue to evaluate new acquisition candidates, divesture and diversification strategies, and (23) our expectation that customers outside of the United States will represent a significant and growing portion of our revenue.

The cautionary statements contained under the caption “Additional Risk Factors that Could Affect Our Operating Results and the Market Price of Our Stock” and other similar statements contained elsewhere in this report, identify important factors with respect to such forward-looking statements, including certain risks and uncertainties that could cause our actual results, performance or achievements expressed or implied by such forward-looking statements.

Although we believe that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. We disclaim any obligation or undertaking to disseminate any updates or revision to any forward-looking statement contained herein or reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

Overview

Our Business

We design, develop, and sell digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals across their networks. We refer to these systems as digital TV headends or video content processing systems. We also offer digital video processing systems that enable private enterprise and government entities to transport video signals across satellite, fiber, radio, or copper facilities for surveillance, distance learning, and TV production applications.

We also offer broadband transport and service management products that enable the provisioning of high speed Internet access and other broadband data services over a single pair of copper wire for broadband internet applications across multi-tenant complexes such as hotels, apartments and private campus facilities.

Our History

Prior to November 2002, most of our sales were derived from our broadband transport and service management products. In 2000 and 2001, we acquired three companies (FreeGate Corporation, Xstreamis Limited and ActiveTelco, Inc.) and the assets from two other companies (OneWorld Systems, Inc. and ViaGate Technologies, Inc.) in order to expand our sales of broadband transport and service management products. However, the significant downturn in the world economy in general, and the telecommunications market in particular, beginning in late 2000 had a severe and sustained adverse effect on our business, financial condition and results

of operations. Our sales of broadband transport and service management products decreased substantially beginning in 2001, which required us to take a number of restructuring efforts and incur significant impairment and other charges in order to realign our cost structure in light of the economic environment. For the period January 1, 2001 through December 31, 2002, we incurred an aggregate of $32.6 million in intangible asset impairment charges and $11.5 million in restructuring charges. In 2003, sales from our broadband transport and service management products stabilized, as we began to experience an improvement in sales of broadband transport and service management products to the hospitality industry.

With our November 2002 acquisition of Tektronix’s subsidiary VTC, we extended our product offerings to add video processing systems for digital TV headends and for the transmission of video signals over private and government networks. The acquisition of VTC resulted in significant changes in our business, including: (1) changes in our organizational structure and employee staffing; (2) relocation of our administrative offices, executive offices (as of January 2004) and a significant portion of our operations from Pleasanton, California to Lake Oswego, Oregon, the prior headquarters of VTC; (3) an expansion of our sales and marketing efforts to include VTC products; and (4) a reprioritization of our research and development efforts to focus on products that we acquired in our acquisition of VTC. With our acquisition of VTC, sales of video processing systems now represent a majority of our total revenue and will provide most of our growth opportunities for the foreseeable future.

We earn revenue primarily by selling video content processing systems both directly and through resellers to telecommunications service providers. We also earn revenue by selling video transmission systems to TV broadcasters, government agencies and educational institutions, and by selling broadband transport and service management products directly and through distributors to the hospitality industry and to owners of private multi-tenant campus facilities.

Prior to our acquisition of VTC, international sales represented 56.3% and 43.0% of our total sales in 2001 and 2002, respectively. Since our acquisition of VTC, international sales have represented a smaller percentage of our overall business relative to prior years, though international sales are still a material portion of our total sales. In 2003, international sales represented 18.4% of our total sales and for the three and nine months ended September 30, 2004, international sales represented 25.5% and 21.4%, respectively, of our total sales.

Material Trends and Uncertainties

We pay close attention to and monitor various trends and uncertainties emerging in the markets we serve. There is a growing demand by independent operating telephone companies to offer video services to their customer base. According to a report released by InStat/MDR in May 2004, the number of telco video subscribers worldwide will increase from 755,000 at the end of 2003 to over 14.0 million by the end of 2008. While this growing market presents opportunities to serve a larger customer base, we are also seeing the emergence of intense competition as more companies compete to sell digital TV headend products. We expect this market space will continue to become more competitive in the future. As we begin to target larger telco customers, we expect to compete with larger public companies, including Harmonic, Motorola and Tandberg Television. Our immediate competitors in the digital TV headend markets are primarily small private companies that are focused on a more narrow product line than ours and thereby may be able to devote substantially more targeted resources to developing, marketing and selling new products than we are able to. In addition, these companies may become targets for acquisition by larger companies, in which case we would face competitors with substantially greater name recognition, and technical, financial and marketing resources than we have.

The emergence of new technologies to serve the digital TV headend market means that we must continue to invest in these new technologies to maintain our market position. Digital subscriber line (“DSL”) technologies use sophisticated modulation schemes to pack data onto copper wires. DSL technologies are sometimes referred to as “last mile” technologies because they are used only for connections from a telephone switching station to a home or office, not between switching stations. The limitations on the amount of data that can be transmitted in a fixed amount of time (“bandwidth”) and distance limitations of the copper based last mile constrain both the number of video channels that may be delivered simultaneously over a DSL network and the number of customers that are reachable from a telco central office. Emerging advancements in video compression technology will soon enable high quality video streams to be transported at lower data transfer rates or “bit rates” than currently deployed. These emerging compression advancements also introduce the possibility of delivering high-definition television over bandwidth constrained asymmetric DSL, or ADSL, lines for the first time. ADSL is a new technology that allows more data to be sent over existing copper telephone lines. Additionally, there are DSL advancements emerging that expand the available bandwidth from the telco to the subscriber thereby supporting higher DSL bit rates over longer distances. As our products continue to incorporate these new technological advancements we expect demand for our products will increase since they will enable more telcos to reach a higher percentage of their customers with a larger number of video channels.

While DSL technologies will continue to dominate telco broadband networks for the foreseeable future, telephone companies are beginning to construct fiber optic networks to their customers’ homes. Though fiber-to-the-home will eliminate bandwidth limitations on delivering higher speed data services and high-quality video offerings, telephone companies deploying fiber-to-the-home will require advanced video processing systems, such as our Astria Product line, to convert signals between multiple protocols used in their networks.

The digital media industry continues to be intensely competitive. We are continuing to focus on developing technologies and introducing new products and we expect that our research and development expenses will increase throughout the remainder of 2004. We continue to aggressively market our new and existing products and to expand our marketing efforts domestically and internationally. Nevertheless, our operations have been subject, and will continue to be subject, to pressure from weakness in the overall technology sector as well as the digital media industry. During the first three quarters of 2004, our sales cycle generally increased and customers delayed purchasing decisions. The deferral of customer orders reduced our expected revenue in the first three quarters of 2004 compared with prior periods and compared with what we had expected for those quarters. We believe the lengthening of the purchase decision by prospective customers is the result of several factors affecting the overall digital TV headend market. In discussions with our customers, certain of those customers have indicated to us that factors causing these delays include, but are not limited to, their anticipation of the introduction of advanced compression technologies later this year and early next year, customers’ decisions to use more efficient data transmission technologies (decisions that some of our customers wish to make before they commit to purchasing headends) and customers’ decisions about using emerging video signal encryption technologies (decisions that some of our customers wish to make before they commit to purchasing headends). Therefore, given the opportunities offered by the growing number of telcos deploying video services and the lengthening of the sales cycle, we expect to maintain our sales and marketing expenses at levels consistent with our future revenue expectations.

We have been operating at a loss since inception and, based on expected revenue, we will continue to operate at a loss for the remainder of 2004. As we announced on September 20, 2004, we expect revenue during the fourth quarter of 2004 will be approximately $7.0 million. However, the deferral of customer orders we experienced during the first three quarters of 2004 may continue, which may result in reduced revenue in the future.

Internal Controls and Disclosure Controls and Procedures

Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of September 30, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to ensure that our disclosure controls and procedures are designed to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely discussions regarding required disclosure. This evaluation also included consideration of our internal controls and procedures for the preparation of our financial statements. As of September 30, 2004, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure control and procedures are effective.

In January 2004 in connection with the completion of its audit of our financial statements for the year ended December 31, 2003, PricewaterhouseCoopers LLP, the Company’s independent registered public accounting firm, advised management and the audit committee of the Board of Directors that it had identified deficiencies in our internal controls and processes relating to inventory management and reporting that it considers to be material weaknesses, as defined by Statement on Auditing Standards No. 60, “Communication of Internal Control Related Matters Noted in an Audit.” The material weaknesses that PricewaterhouseCoopers LLP identified related to inventory controls and the accounts payable process for the Company’s VideoTele.com business, which the Company acquired in November 2002. Specifically:

1. Our internal controls are inadequate to properly record our inventory quantities in an accurate and timely manner; and

2. Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.

While these material weaknesses had an immaterial effect on our reported results, they nevertheless constituted deficiencies in our disclosure controls. In light of these material weaknesses and the requirements enacted by the Sarbanes-Oxley Act of 2002 and the related rules and regulations adopted by the SEC, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2003, our disclosure controls and procedures needed improvement and were not effective. Despite those deficiencies in our disclosure controls, management believed that as of December 31, 2003, and at the time of filing its Annual Report on Form 10-K for the fiscal year ended December 31, 2003, as amended, there were no material inaccuracies, or omissions of material facts necessary to make the statements not misleading in light of the circumstances under which they were made.

At the time of our acquisition of the VideoTele.com business in November 2002, we had in place disclosure controls and procedures and processes for our existing business (i.e., our pre-November 2002 business) that our CEO and CFO at the time believed to be sufficient to record, process, summarize and report information required to be reported within the time periods specified by the SEC. Likewise, we had in place internal controls that our CEO and CFO believed at the time of the VTC acquisition to be sufficient to “provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with generally accepted accounting principles.”

Since December 31, 2002, we have continued to review our disclosure controls and procedures and internal controls periodically in connection with our Form 10-Q filings. Throughout 2003, our CEO and CFO have continued to believe that our disclosure controls and procedures and internal controls have allowed us to provide all material and necessary disclosure in a timely manner, as required by the Exchange Act and the applicable rules thereunder.

In January 2004, during the audit of our financial statements for the fiscal year ended December 31, 2003, PricewaterhouseCoopers LLP discovered the material weaknesses noted above and brought these weaknesses to our attention. Based on discussions with PricewaterhouseCoopers LLP and the audit committee of our Board of Directors, we worked throughout our year-end 2003 accounting close and audit to identify the nature, scope and materiality of these weaknesses in our internal controls and their impact on our fiscal year 2003 financial statements and to determine the extent to which these internal control weaknesses might adversely affect our disclosure controls and procedures. Based on further detailed review of our internal controls as they relate to inventory and accounts payable during the fourth quarter of fiscal 2003, we determined that the accounts payable process had failed to record certain liabilities associated with VTC products that we purchased, principally from our contract manufacturer and certain other suppliers. We quantified this internal control weakness relating to accounts payable recordation by reconciling our records to that of our contract manufacturer and reviewing our liabilities with other vendors. We quantified the inventory process control weakness by taking complete physical inventories at each VTC inventory location and reconciling the results to our records. Upon completion of our analysis and testing, we identified an additional charge of approximately $34,000 to cost of goods sold related to the internal control weaknesses identified above. We recorded this charge prior to issuing our financial statements for the year ended December 31, 2003. In addition to our review of the financial statements for the fiscal year ended December 31, 2003, we re-confirmed that our accounts payable recordation and inventory controls were effective for the year ended December 31, 2002.

During our review of these internal controls weaknesses, we identified the cause of these internal control weaknesses to be the result of prior VTC accounting staff turnover that occurred during the first quarter of 2003. During this quarter, key accounting staff of VTC left the company without sufficient time to transition all of the internal controls and institutional knowledge to our remaining finance and accounting staff.

In addition to identifying the above two internal control weaknesses relating to inventory and the accounts payable process, we also tested our other internal controls to determine whether there were other such material weaknesses aside from the inventory and accounts payable weaknesses mentioned above that affected our financial statements for the fiscal year ended December 31, 2003. In particular, we tested our other internal controls by reviewing processes, analytical reviews and substantive testing that included other third-party confirmations and by reviewing activity subsequent to year-end 2003. Based on these tests, we did not identify any other material weaknesses in internal controls. Therefore, our CEO and CFO believed at the time of the original filing of the Form 10-K on February 2, 2004 that they had reasonable grounds to conclude that the weaknesses in internal controls related solely to those items mentioned above and resulted in an immaterial charge of approximately $34,000.

Based on their review of our internal controls as described above, our CEO and CFO also assessed our disclosure controls and procedures for the fiscal year ended December 31, 2003. Our CEO and CFO believed at the time of the original filing of the Form 10-K that they had reasonable grounds to conclude that, other than the inventory and accounts payable weaknesses that PricewaterhouseCoopers LLP had identified, there were no other material weaknesses in our disclosure controls and procedures and that the information required to be reported in the Form 10-K was recorded, processed, summarized and reported within the time periods specified by the applicable Exchange Act rules.

In order to ensure that we have eliminated the two weaknesses in our internal controls for purposes of future reporting, we have undertaken significant efforts to improve our processes and procedures as they relate to inventory reporting and accounts payable reconciliation. The audit committee is taking an active role in these efforts, including overseeing management’s implementation of corrective measures. With respect to inventory management, since identifying those weaknesses in our internal controls, we have performed and will continue to perform physical inventory counts at least at the end of each quarter in 2004. We have implemented improved inventory systems and accounting controls and have hired an additional full-time staff accountant to account for and control our inventory accounting, given our operations manager company-wide responsibility for inventory management, and have reiterated to key operations and accounting personnel the importance of proper inventory management and control. We will be expanding our inventory receiving process to include remote locations, as appropriate and reconciling inventory to each customer order. Regarding accounts payable reconciliation, we have confirmed and will continue to confirm our key accounts payable balances with our vendors and reconciled the confirmations to our accounting records on a quarterly basis in 2004.

Management believes that the controls and procedures identified above have and will address the conditions identified by PricewaterhouseCoopers LLP as material weaknesses. These changes will become permanent elements of our internal controls. We are now confident that we have and are in the process of implementing the proper level of controls to correct the material weaknesses. We plan to continue to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.

Definitions for Discussion of Results of Operations

Our discussion of our results of operations focuses on the following items from our income statement: Total revenue consists of product sales, and license and royalty fees. Product revenue consists of sales of our video processing systems, which includes both digital TV headend and video transmission systems. Product revenue also consists of revenue from our broadband transport and service management products. License and royalty fees consist of non-refundable license fees and royalties received by us for products sold by our licensees. Since our acquisition of VTC, a large part of our quarterly revenue has been associated with the sale of digital TV headends. Furthermore, each individual headend sale has represented a significant portion of our revenue for each quarter.

If we were to sell even one less system than our forecasted number of headend sales per quarter, our quarterly revenue would be materially impacted. As we have not entered into any new license or royalty agreements since 2000, we expect that our license and royalty revenue will be minimal for the foreseeable future. Cost of goods sold, or COGS, consists of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance for products, and the cost of licensed technology included in our products. Raw materials, contract manufacturing and licensed technology are the principal elements of COGS and vary directly with product sales. Sales and marketing expense consists primarily of selling and marketing personnel costs, including sales commissions, travel, trade shows, promotions and outside services. Research and development expense consists primarily of personnel and facilities costs, contract consultants, outside testing services, and equipment and supplies associated with enhancing existing products and developing new products. General and administrative expense consists primarily of personnel costs for administrative officers and support personnel, professional services and insurance expenses. Amortization of intangible assets consists primarily of expenses associated with the amortization of technology and patents related to prior years’ acquisitions.

Results of Operations

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2004		2003		2004
Total revenue	100.0	%	100.0	%	100.0	%	100.0	%
Total cost of goods sold	44.0		61.5		48.0		70.5
Gross margin	56.0		38.5		52.0		29.5
Operating expenses:
Sales and marketing	21.7		30.0		24.8		32.5
Research and development	22.2		27.6		27.0		30.7
General and administrative	11.9		15.6		14.5		18.1
Restructuring costs	3.4		—		1.3		—
Impairment of intangibles	—		—		0.6		1.1
Amortization of intangibles	5.2		5.6		5.9		6.4
Total operating expenses	64.4		78.9		74.1		88.9
Loss from operations	(8.4	)	(40.4	)	(22.0	)	(59.4	)
Interest and other income, net	(0.3	)	(0.7	)	0.3		(0.8	)
Net loss	(8.7	)%	(41.1	)%	(21.7	)%	(60.2	)%

Three and Nine Months Ended September 30, 2003 and 2004

Total Revenue. Our total revenue decreased to $6.7 million and $18.0 million for the three and nine months ended September 30, 2004, respectively, when compared with total revenue of $8.5 million and $23.0 million for the same periods in 2003. For the three months ended September 30, 2004, our product revenue from video processing systems declined by 24.4% to $5.0 million from $6.6 million for the three months ended September 30, 2003. For the nine months ended September 30, 2004, our product revenue from video processing systems decreased by $4.5 million, or 27.2%, to $12.3 million from $16.8 million for the same period in 2003. The decreases in video processing systems product revenue were due primarily to the adverse effect of several digital TV headend sales not closing during the period as expected. We continue to experience a variety of factors that are causing prospective customers to delay their purchase decisions. Certain prospective customers have indicated to us that factors causing these delays include, but are not limited to, their anticipation of the introduction and general availability of advanced compression technologies later this year and early next year, customers’ decisions to use more efficient data transmission technologies (decisions that some of our customers wish to make before they commit to purchasing headends) and customers’ decisions about using emerging video signal encryption technologies (decisions that some of our customers wish to make before they commit to purchasing headends). Sales of broadband transport and service management products decreased from $2.0 million in the third quarter of 2003 to $1.7 million in the third quarter of 2004 and decreased from $6.1 million for the nine months ended September 30, 2003 to $5.7 million for the nine months ended September 30, 2004. The decrease in broadband transport and service management products revenue was primarily the result of customers choosing competing products that transmit data via wireless data transmission technologies instead of our products (which transmit data over telephone wires). Accordingly, we expect that revenue from our broadband transport and service management products will decline slightly for the remainder of 2004, compared to the three months ended September 30, 2004. For the three months ended September 30, 2004, our license and royalty revenue decreased to $4,000 from $0.2 million for the three months ended September 30, 2003 and decreased to $40,000 for the nine months ended September 30, 2004 from $0.6 million for the nine months ended September 30, 2003. We expect that our license and royalty revenue will be minimal for the foreseeable future.

Cost of Goods Sold. For the three months ended September 30, 2004, our cost of goods sold increased by $0.3 million to $4.1 million from $3.8 million for the three months ended September 30, 2003. This increase in costs of goods sold is due to a year over year net increase of $1.1 million in inventory reserves and an increase in labor costs of $0.2 million. Partially offsetting these increases was a reduction in material costs of $1.0 million Cost of goods sold increased by $1.7 million to $12.7 million during the nine months ended September 30, 2004 from $11.0 million for the nine months ended September 30, 2003. This increase in costs of goods sold is due to a year over year

increase of $2.2 million in inventory reserves. Also included in this increase is $0.5 million in labor costs, $0.2 million in contractors expense, and $0.3 million in freight, travel and other expenses. Partially offsetting these increases was a decrease in material costs of $1.5 million.

Sales and Marketing. For the three months ended September 30, 2004, our sales and marketing expenses increased to $2.0 million from $1.8 million for the three months ended September 30, 2003. The increase was due to higher personnel related costs. For the nine months ended September 30, 2004, our sales and marketing expense increased to $5.8 million from $5.7 million for the nine months ended September 30, 2003. The increase was due to higher expenses for advertising and trade shows.

Research and Development. For the three months ended September 30, 2004, our research and development expense remained the same relative to the same period in 2003. Research and development expense decreased by $0.7 million to $5.5 million for the nine months ended September 30, 2004 from $6.2 million for the nine months ended September 30, 2003. The $0.7 million decrease was due to a decrease in personnel related costs. We expect that our research and development expenses will increase throughout the remainder of 2004. Our capital expenditures for research and development were $27,000 and $45,000 for the three months ended September 30, 2003 and 2004, respectively and $0.3 million and $0.6 million for the nine months ended September 30, 2003 and 2004, respectively. We expect capital expenditures for research and development in 2004 to remain comparable to capital expenditures in 2003.

General and Administrative. For the three and nine months ended September 30, 2003 and 2004, our general and administrative expense remained the same at $1.0 million and $3.3 million, respectively.

Impairment of Intangible Assets. During the first quarter of 2004, we determined that certain of the technology acquired as part of the purchase of the ViaGate Technology assets had become impaired. As a result, we recorded an impairment charge of $0.2 million to write off the book value of the intangible assets associated with this technology. During the second quarter of 2003, we recognized a loss of $0.1 million for the impairment of certain technology acquired as part of the acquisition of the assets of ViaGate.

Amortization of Intangible Assets. Amortization of intangible assets is comprised of intangibles related to the acquisitions of Xstreamis Limited in 2000, and VTC in 2002. The remaining intangible assets subject to amortization from these acquisitions consist primarily of completed technology and patents. For the three months ended September 30, 2003 and 2004, amortization of intangible assets remained consistent at $0.4 million. Amortization of intangible assets decreased to $1.1 million for the nine months ended September 30, 2004 from $1.4 million for the nine months ended September 30, 2003.

Interest and Other Income, Net. Interest and other income, net consists primarily of interest income and expense. For the nine months ended September 30, 2004, our interest and other income, decreased to a net expense of $0.1 million from a net interest and other income of $0.1 million for the nine months ended September 30, 2003. The decrease in the nine months ended September 30, 2004 of $0.2 million compared with the nine months ended September 30, 2003 was primarily the result of lower interest rates on lower average cash balances and increased interest expense associated with the $3.7 million note issued in connection with our purchase of VTC in November 2002.

Liquidity and Capital Resources

Cash and cash equivalents totaled $9.3 million at September 30, 2004, compared with cash and cash equivalents of $14.4 million at December 31, 2003, reflecting a net reduction in cash and cash equivalents of $5.1 million.

Cash used in operating activities was $6.9 million for the nine months ended September 30, 2004, compared with $11.6 million for the nine months ended September 30, 2003. The reduced cash used in operating activities was primarily due to a decrease in accounts receivable due to lower revenue in the third quarter of 2004 and an increased focus on collections and an increase in accounts payable and accrued liabilities due to an increase in end of quarter inventory purchases. We recorded a provision for excess and obsolete inventory within cost of goods sold totaling $1.4 million in the nine months ended September 30, 2004.

Additions to property and equipment were $1.1 million in the nine months ended September 30, 2004, compared with $0.7 million in the nine months ended September 30, 2003, primarily reflecting an increased investment in research and development assets. In total we expect capital expenditures for 2004 to be comparable to 2003. We expect these capital expenditures to be funded from operations.

Cash from financing activities was $2.9 million in the nine months ended September 30, 2004, compared with $0.7 million for the nine months ended September 30, 2003. The increase in cash was due to borrowings under the credit facility.

The following table sets forth our contractual obligations as of September 30, 2004:

	Payments due by period (in thousands)
Contractual Obligations	Total		Remainder of 2004		2005 to 2006		2007 to 2008		Thereafter
Long-Term Debt Obligations	$	3,743	$	—	$	—	$	3,743	$	—
Operating Lease Commitments	1,043		233		731		52		27
Purchase Obligations	479		479		—		—		—
Other Long-Term Liabilities	4		4		—		—		—
Total	$	5,269	$	716	$	731	$	3,795	$	27

We do not have any off balance sheet arrangements.

As part of our acquisition of VTC from Tektronix in November 2002, we issued a note payable to Tektronix for $3.2 million, with repayment in sixty months, or by November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest is added to the principal balance of the note. Thereafter, we will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in full. Principal and accrued interest on the note payable is $3.7 million at September 30, 2004. Accrued interest in the nine months ended September 30, 2004 was $0.2 million.

In connection with the settlements of certain legal matters in December 2003, we recorded a liability and a receivable, each in the amount of $10.7 million, in our December 31, 2003 balance sheet. The settlements were formerly approved by the respective courts and the amounts were paid by our insurance carriers during the nine months ended September 30, 2004. Therefore, we removed the $10.7 million liability and receivable related to the settlements from the balance sheet as of September 30, 2004.

We have seen a recent increase in orders for our products and therefore believe, to the extent that such demand continues, that our negative cash flows from operating activities will decrease to some extent over the next several fiscal quarters. To provide additional assurance of liquidity we entered into a revolving asset based credit facility, or credit facility, with Silicon Valley Bank, or the bank, on September 23, 2004. This facility has a term of two years and expires on September 23, 2006. All borrowings under this facility are classified as current liabilities. Borrowings under the credit facility are formula based and limited to the lesser of $7.0 million or an amount based on a percentage of eligible accounts receivable and eligible inventories. Based on the maximum percentages of eligible accounts receivable and eligible inventory levels, borrowings under this facility were $2.6 million as of September 30, 2004. The annual interest rate as of September 30, 2004 was 5.25%. The interest rate is equal to the bank’s base rate, or prime rate, currently at 4.75%, plus 0.5%. The rate may increase by 1.0% if the Company does not meet certain financial covenants. The credit facility is secured by all of our assets, and contains various covenants.

While we anticipate, based on discussions with the bank, that we will continue to be able to borrow money under the line of credit, the bank enjoys discretion with respect to whether it will continue to make loans to us under the line of credit and there is therefore no guarantee that the bank will necessarily continue to loan to us. Furthermore, while the bank has made no intention to do so, under the terms of the credit facility the bank is able to declare an event of default and accelerate our duty to repay any borrowings based on a wide array of circumstances. These circumstances include, among others, a material adverse change in our business, operations or condition (financial or otherwise).

Subsequent to September 30, 2004, we completed the sale of 4.6 million shares of our common stock at a price of $2.25 per share for gross proceeds of $10.3 million. Net proceeds from the offering were approximately $8.7 million.

If we are unable to continue to borrow under the credit facility, or if the recent increase in orders for our products does not continue and our current expectations concerning future revenue therefore do not turn out to be accurate, we might be required to take measures to reduce our operating expenses and we might require additional sources of funds in order to continue operations over the next twelve months. We cannot be assured that such funding would be available on commercially reasonable terms or at all. We believe that our cash and cash equivalents are sufficient to fund our operating activities and capital expenditure needs for the next twelve months.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We have identified the policies below as critical to our business operations and the understanding of our results of operations.

Revenue recognition. We generate revenue primarily from the sale of hardware products, including third-party products,

through professional services, and through the sale of our software products. We sell products through direct sales channels and through distributors. Generally, product revenue is generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.

Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. We sell these products through our own direct sales channels and also through distributors. Our revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2 and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

In the case of software arrangements that require significant production, modification or customization of software, which encompasses all of our turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We recognize revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element of the multi-element arrangement, for which we have established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

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 the assessment, we may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, we must also make a judgment regarding collectibility of the arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to our credit review policy. We sell to customers for which there is a history of successful collection and to new customers for which such history may not exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are only increased after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, no credit is extended and revenue is recognized on a cash-collected basis after shipment has occurred or the revenue has been earned under the percentage-of-completion method.

We also maintain accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. Our products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

License and royalty revenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by us for products sold by our licensees. Currently, the majority of our license and royalty revenue is comprised of non-refundable license fees paid in advance. Such revenue is recognized ratably over the period during which post-contract customer support is expected to be provided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by us for products sold by our licensees. We expect that such license and royalty revenue will not constitute a substantial portion of our revenue in future periods.

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 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.

Accounting for long-lived assets. We are required to periodically assess the impairment of long-lived assets. 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 our 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 measured 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 nine months ended September 30, 2003, we determined that certain intangible long-lived assets were impaired and recorded a loss of $0.1 million under SFAS No. 144 During the nine month ended September 30, 2004, we determined that certain intangible long-lived assets were impaired and recorded a loss of $0.2 million under SFAS No. 144. Future events could cause us to conclude that impairment indicators once again 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 our consolidated financial statements. Because of uncertainties related to 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 is an unfavorable outcome in these legal proceedings. We recorded a liability for the In re Tut Systems, Inc. Securities Litigation and the Lefkowitz matters, as well as an equal and corresponding receivable (which we subsequently removed from the balance sheet as of June 30, 2004). We have not recorded a liability for the Whalen matter as a consequence of several uncertainties. As additional information becomes available, we will assess the potential liability related to these pending litigation matters and may revise our estimates accordingly. Revisions of our estimates of such potential liability could materially impact our results of operations, financial condition or cashflows.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board, the (“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” and subsequently revised in December 2003 with the issuance of FIN 46-R. This interpretation 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. Application of this Interpretation is required in financial statements for periods ending after March 15, 2004. The adoption of this Interpretation in the nine months ended September 30, 2004 did not have a material impact on our results of operations, financial position or cash flows.

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

We have a history of significant losses, and we may never achieve profitability.

We have incurred substantial net losses and experienced negative cash flow for each quarter since our inception. As of September 30, 2004, we had an accumulated deficit of $292.9 million. We expect to incur losses in the near future. Moreover, we may never achieve profitability and, if we do so, we may not be able to maintain profitability. We may not be able to generate a sufficient level of revenue to offset our current level of expenditures. Moreover, because our expenditures for sales and marketing, research and development, and general and administrative functions are relatively fixed in the short term, we may be unable to adjust our spending in a timely manner to respond to any unanticipated decline in revenue. If we fail to achieve profitability within the timeframe expected by securities analysts or investors, then the market price of our common stock will likely decline.

Each sale of our headend systems represents a significant portion of our revenue for any given quarter. Our failure to meet our quarterly forecast of sales of headend systems in any given quarter could have a material adverse impact on our financial results for a given quarter.

Since we acquired VTC in November 2002, a large part of our quarterly revenue is associated with the sale of headend systems. Each sale represents a significant portion of our revenue for each quarter. We base our operating forecast on our historical sales. Because of the high cost per unit of our headend systems, if we were to sell even one less system than our forecasted number of headend sales per quarter, such a decrease in sales would have a material and adverse impact on our revenue for that quarter, and we may fail to meet investor expectations.

We operate in an intensely competitive marketplace, and many of our competitors have better resources than we do.

Our primary competitors in the digital TV headend market are small private companies that are focused on a more narrow product line than ours, thereby allowing these competitors to devote substantially more targeted resources to developing and marketing new products than we can. As we begin to target larger telco customers for our video content processing systems, we expect more competition from large public companies like Harmonic, Inc., Tandberg Television ASA, and Motorola, Inc., all of which have substantially greater financial, technical and other resources than we do. These competitors have achieved success in providing headend components for cable multiple system operators and satellite TV providers and, we expect these competitors to market some of their products for use in TV over DSL applications. For example, in the past, Harmonic provided video content processing systems to SaskTel, a large Canadian telephone service provider. Harmonic also recently announced that it will provide video content processing systems to Video Networks Limited, a video-over-DSL provider in the United Kingdom.

Our competition in the market for video transmission processing products primarily comes from small private companies such as SkyStream Networks and public companies such as Optibase Inc. and Tandberg Television that together offer a wide array of products with special features and functions. Our broadband transport and service management business tends to compete against public, private and foreign network equipment companies.

To the extent that any of these current or potential future competitors enter or expand further into our markets, develop superior technology and products or offer superior prices or performance features relative to our products, such competition could result in lost sales and severe downward pressure on our pricing, either of which would adversely affect our revenue and profitability.

Commercial acceptance of any technological solution that competes with technology based on communication over copper telephone wire could materially and adversely impact demand for our products, our revenue and growth strategy.

The markets for video content processing, transmission and high-speed data access systems and services are characterized by several competing communication technologies, including fiber optic cables, coaxial cables, satellites and other wireless facilities. Many of our products are based on communication over 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. Our customer base is concentrated on telephone service providers that have a large investment in copper wire technology. If these customers lose market share to their competitors who use competing technologies that are not as constrained by physical limitations as copper telephone wire, and that are able to provide faster access, greater reliability, increased cost-effectiveness or other advantages, demand for our products will decrease. Moreover, to the extent that our customers choose to install fiber optic cable or other transmission media as part of their infrastructure, or to the extent that homes and businesses install other transmission media within buildings, demand for our products may decline. The occurrence of any one or more of these events would harm demand for our products, which would thereby adversely affect our revenue and growth strategy.

If the projected growth in demand for video services from telephone service providers does not materialize or if our customers find alternative methods of delivering video services, future sales of our video content processing systems will suffer.

We manufacture video content processing systems that enable telephone service providers to offer video services to their customers. Our customers, the telephone service providers, face competition from cable companies, satellite service providers and

wireless companies. For some users, these competing solutions provide fast access, high reliability and cost-effective solutions for delivering data, including video services. Telephone service providers hope to maintain their market share in their core business of voice telephony as well as increase their revenue per customer by offering their customers more services, including video services and high-speed data services. However, if the telephone service providers find alternative ways of maintaining and growing their market share in their core business that do not require that they offer video services, demand for our products will decrease substantially. Moreover, if technological advancements are developed that allow our customers to provide video services without upgrading their current system infrastructure, or that offer our customers a more cost-effective method of delivering video services, sales of our video content processing systems will suffer. Alternatively, even if the telephone service providers choose our video content processing systems, the service providers may not be successful in marketing video services to their customers, in which case our sales would decrease substantially.

Our operating results fluctuate significantly from quarter to quarter, and this may cause the price of our stock to decline.

Over the last 12 quarters, our sales per quarter have fluctuated between $9.2 million and $2.0 million. Over the same periods, our loss from operations as a percentage of revenue has fluctuated between approximately 5.2% and 1,274% of revenue. We anticipate that our sales and operating margins will continue to fluctuate. We expect this fluctuation to continue for a variety of reasons, including:

• the timing of customers’ purchase decisions, acceptance of our new products and possible cancellations;

• competitive pressures, including pricing pressures from our partners and competitors;

• delays or problems in the introduction of our new products;

• announcements of new products, services or technological innovations by us or our competitors; and

• management of inventory levels.

The sales cycle for video content processing systems is long and unpredictable, which requires us to incur high sales and marketing expenses with no assurance that a sale will result.

The sales cycle for our headend systems can be as long as 12-18 months. Additionally, with respect to the sale of our products to U.S. and foreign government organizations, we may experience long sales cycles as a result of government procurement processes. As a result, while we continue to incur costs associated with a particular sale prior to payment from the customer, we may not recognize revenue from efforts to sell particular products for extended periods of time.

As a result, our quarter-to-quarter comparisons of our revenue and operating results may not be meaningful and may not provide an accurate indicator of our future performance. Our operating results in one or more future quarters may fail to meet the expectations of investment research analysts or investors, which could cause an immediate and significant decline in the trading price of our common stock.

If we fail to accurately forecast demand for our products, revenue, profitability and reputation could be harmed.

We rely on contract manufacturers and third-party equipment manufacturers, or OEMs, to manufacture, assemble, test and package our products. We also depend on third-party suppliers for the materials and parts that constitute our products. Our reliance on contract manufacturers, OEMs and third-party suppliers requires us to accurately forecast the demand for our products and coordinate our efforts with those of our contract manufacturers, OEMs and suppliers. We often make significant up-front financial commitments with our contract manufacturers, OEMs and suppliers in order to procure the raw materials and begin manufacturing and assembly of the products. If we fail to accurately forecast demand or coordinate our efforts with our suppliers, OEMs and contract manufacturers, we may face supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products, which could lead to the loss of existing or potential customers and could thereby result in lost sales and damage to our reputation, which would adversely affect our revenue and profitability. 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 profitability.

If we fail to develop and introduce new products in response to the rapid technological changes in the markets in which we compete, we will not remain competitive.

The markets for video content processing, transmission and high-speed data access systems 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. For example, advancements in compression technology are leading the video content processing industry to

begin the transition to next generation compression standards. These advances will allow for further reductions in the bandwidth required to deliver standard definition video channels and introduce the possibility of delivering high-definition television over asymmetric digital subscriber lines, or ADSL, for the first time. ADSL is a new technology that allows more data to be transmitted over copper telephone lines than standard DSL. Further advances in compression technology, or the emergence of new industry standards would require that we further redesign our products to incorporate, and remain compatible with, emerging technologies and industry standards.

We cannot assure you that we will be able to respond quickly and effectively to technological change. We may have only limited time to enter certain markets, and we cannot assure you that we will be successful in achieving widespread acceptance of our products before competitors can offer products and services similar or superior to our products. If we fail to introduce new products that address technological changes or if we experience delays in our product introductions, our ability to compete would be adversely affected, thereby harming our revenue, profitability and growth strategy.

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 revenue, profitability and share price could be materially and adversely affected.

Sales to customers outside of the United States accounted for approximately 56.3%, 43.0% and 18.4% of revenue for the years ended December 31, 2001, 2002 and 2003, respectively and 18.0% and 21.4% for the nine months ended September 30, 2003 and 2004, respectively. Sales and operating activities outside of the United States are subject to inherent risks, including fluctuations in the value of the United States dollar relative to foreign currencies; tariffs, quotas, taxes and other market barriers; political and economic instability; restrictions on the export or import of technology; potentially limited intellectual property protection; difficulties in staffing and managing international operations and potentially adverse tax consequences. Any of these factors may have a material adverse effect on our ability to grow or maintain international revenue.

We expect sales to customers outside of the United States to represent a significant and growing portion of our revenue. However, we cannot assure you that foreign markets for our products will develop at the rate or to the extent that we anticipate. If we fail to generate significant international sales, our revenue, profitability and share price could be materially and adversely affected.

Fluctuations in interest and currency exchange rates may decrease demand for our products.

Substantially all of our foreign sales are invoiced in U.S. dollars. As a result, fluctuations in currency exchange rates could cause our products to become relatively more expensive for international customers, thereby reducing demand for our products. We anticipate that we will generally continue to invoice foreign sales in U.S. dollars. We do not currently engage in foreign currency hedging transactions. However, as we expand our current international operations, we may allow payment in foreign currencies and, as a result, our exposure to foreign currency transaction losses may increase. To reduce this exposure, we may purchase forward foreign exchange contracts or use other hedging strategies. However, we cannot assure you that any currency hedging strategy would be successful in avoiding exchange-related losses. Any such losses would adversely impact our profitability.

If our contract manufacturers, third-party OEMs and third-party suppliers fail to produce quality products or parts in a timely manner, we may not be able to meet our customers’ demands.

We do not manufacture our products. We rely on contract manufacturers and OEMs to manufacture, assemble, package and test substantially all of our products and to purchase most of the raw materials and components used in our products. Additionally, we depend on third-party suppliers to provide quality parts and materials to our contract manufacturers and OEMs, and we obtain some of the key components and sub-assemblies used in our products from a single supplier or a limited group of suppliers. Neither we nor our contract manufacturers or OEMs have any guaranteed supply arrangements with the suppliers. If our suppliers fail to provide a sufficient supply of key components, we could experience difficulties in obtaining alternative sources at reasonable prices, if at all, or in altering product designs to use alternative components. Moreover, if our contract manufacturers or OEMs fail to deliver quality products in a timely manner, such failure would harm our ability to meet our scheduled product deliveries to customers. Delays and reductions in product shipments could increase our production costs, damage customer relationships and harm our revenue and profitability. In addition, if our contract manufacturers and OEMs fail to perform adequate quality control and testing of our products, we would experience increased production costs for product repair and replacement, and our profitability would be harmed. 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 revenue, profitability and reputation.

Design defects in our products could harm our reputation and our revenue, profitability and reputation.

Any defect or deficiency in our products could reduce the functionality, effectiveness or marketability of our products. These defects or deficiencies could cause customers to cancel or delay their orders for our products, reducing revenue or profitability. In any of these events, we would be required to devote substantial financial and other resources for a significant period of time to develop new product designs. We cannot assure you that we would be successful in addressing any design defects in our products or in developing new product designs in a timely manner, if at all. Any of these events, individually or in the aggregate, could harm our

revenue, profitability and reputation.

Our business depends on the integrity of our intellectual property rights. If we fail to adequately protect our intellectual property, our revenue, profitability, reputation and growth strategy could be adversely affected.

We attempt to protect our intellectual property and proprietary technology through patents, trademarks and copyrights, by generally entering into confidentiality or license agreements with our employees, consultants, vendors, strategic partners and customers as needed, and by generally limiting access to and distribution of our trade secret technology and proprietary information. However, any of our pending or future patent or trademark applications may not ultimately be issued as patents or trademarks of the scope that we sought, if at all, and any of our patents, trademarks or copyrights may be invalidated, deemed unenforceable, or otherwise challenged. In addition, other parties may circumvent or design around our patents and other intellectual property rights, may misappropriate our proprietary technology, or may otherwise develop similar, duplicate or superior products. Further, the intellectual property laws and our agreements may not adequately protect our intellectual property rights and effective intellectual property protection may be unavailable or limited in certain foreign countries in which we do business or may do business in the future.

The telecommunications and data communications industries are characterized by the existence of extensive patent portfolios and frequent intellectual property litigation. From time to time, we have received, and may in the future receive, claims that we are infringing third parties’ intellectual property rights. Any present or future claims, with or without merit, could be time-consuming, result in costly litigation, divert management time and attention and other resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us. In addition, any such litigation could force us to cease selling or using certain products or services, or to redesign such products or services. Further, we may in the future initiate claims or litigation against third-parties for infringement of our intellectual property rights or to determine the scope and validity of our intellectual property rights or those of competitors. Such litigation could result in substantial costs and diversion of resources. Any of the foregoing could have an adverse effect upon our revenue, profitability, reputation and growth strategy.

If we fail to provide our customers with adequate and timely customer support, our relationships with our customers could be damaged, which would harm our revenue and profitability.

Our ability to achieve our planned sales growth and retain customers will depend in part on the quality of our customer support operations. Our customers generally require significant support and training with respect to our products, particularly in the initial deployment and implementation stage. As our systems and products become more complex, we believe our ability to provide adequate customer support will be increasingly important to our success. We have limited experience with widespread deployment of our products to a diverse customer base, and we cannot assure you that we will have adequate personnel to provide the levels of support that our customers may require during initial product deployment or on an ongoing basis. Our failure to provide sufficient support to our customers could delay or prevent the successful deployment of our products. Failure to provide adequate support could also have an adverse impact on our reputation and relationship with our customers, could thereby prevent us from gaining new customers and could harm our revenue and profitability.

If we fail to manage our expanding operations, our ability to increase our revenue and improve our results of operations could be harmed.

We anticipate that, in the future, we may need to expand certain areas of our business to grow 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 service providers. 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 revenue, operations and share price could be harmed.

If we are unable to address the material weaknesses in our internal controls that our independent registered public accounting firm identified in the fourth quarter of fiscal 2003, such weaknesses could materially and adversely affect our ability to provide the public with timely and accurate material information about our company, which could harm our reputation and share price.

In January 2004, our independent registered public accounting firm identified deficiencies in our internal controls that they considered to be material weaknesses. Based on these weaknesses, our CEO and CFO determined that, as of December 31, 2003, our disclosure controls and procedures were not sufficient to record, process, summarize and report information required to be reported within the time periods specified by the SEC and accumulated and communicated to our management, including our CEO and CFO, to allow timely discussions regarding required disclosure. These material weaknesses related to our inventory and our accounts payable processes, both of which affect our balance sheet and may also affect our income statement reporting. We have worked to fully address these issues. In order for investors and the equity analyst community to make informed investment decisions and recommendations about our securities, it is important that we provide them with accurate and timely information in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the rules promulgated thereunder. If we cannot do so,

investors will sell our shares and industry analysts will either make incorrect recommendations about our company or else end coverage of our company altogether, any of which results could harm our reputation and adversely impact our share price.

We are currently engaged in a securities class action lawsuit, which, if it were to result in an unfavorable resolution, could adversely affect our reputation, profitability and share price.

We are currently engaged as a defendant in a lawsuit (i.e., Whalen v. Tut Systems, Inc. et al.) that alleges securities law violations against us and certain of our current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended. While we have reached a settlement with the plaintiffs in this lawsuit, the settlement is subject to certain contingencies, including court approval of the terms of settlement. If the court does not approve this settlement, or any other applicable contingencies are not resolved or otherwise addressed, we would be required to resume litigation in this matter. If we were to resume litigation in these matters, there is no assurance that we would prevail and, if the outcome of such litigation were unfavorable to us, our reputation, profitability and share price could be adversely affected.

If our products do not comply with complex government regulations, our product sales will suffer.

We and our customers are subject to varying degrees of federal, state and local as well as foreign governmental regulation. Our products must comply with various regulations and standards defined by the Federal Communications Commission, or FCC. The FCC has issued regulations that set installation and equipment standards for communications systems. Our products are also required to meet certain safety requirements. For example, Underwriters Laboratories must certify certain of our products in order to meet federal safety requirements relating to electrical appliances to be used inside the home. In addition, certain products must be Network Equipment Building Standard certified before certain of our customers may deploy them. Any delay in or failure to obtain these approvals could harm our business, financial condition or results of operations. Outside of the United States, our products are subject to the regulatory requirements of each country in which our products are manufactured or sold. These requirements are likely to vary widely. If we do not obtain timely domestic or foreign regulatory approvals or certificates, we would not be able to sell our products where these regulations apply, which could prevent us from maintaining or growing our revenue or achieving profitability.

In addition, regulation of our customers may adversely impact our business, operating results and financial condition. For example, FCC regulatory policies affecting the availability of data and Internet services and other terms on which telecommunications companies conduct their business may impede our entry into certain markets. In addition, the increasing demand for communications systems has exerted pressure on regulatory bodies worldwide to adopt new standards, generally following extensive investigation of competing technologies. The delays inherent in this governmental approval process may cause the cancellation, postponement or rescheduling of the installation of communications systems by our customers, which in turn may harm our sale of products to these customers.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to manage our business successfully, which could materially and adversely affect our growth strategy, reputation and share price.

We depend on the performance of Salvatore D’Auria, our President, Chief Executive Officer and Chairman of the Board, and on other senior management and technical personnel with experience in the video and data communications, telecommunications and high-speed data access industries. The loss of any one of them could harm our ability to execute our business strategy, which could adversely affect our reputation and share price. Additionally, we do not have employment contracts with any of our executive officers. We believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

We routinely evaluate acquisition candidates and other diversification strategies.

We have completed a number of acquisitions as part of our efforts to expand and diversify our business. For example, we acquired our video content processing and video transmission businesses from Tektronix in November 2002 when we purchased its subsidiary, VTC. We intend to continue to evaluate new acquisition candidates, divestiture and diversification strategies, and if we fail to manage the integration of acquired companies, it could adversely affect our operations and growth strategy. Any acquisition involves numerous risks, including difficulties in the assimilation of the acquired company’s employees, operations and products, uncertainties associated with operating in new markets and working with new customers, and the potential loss of the acquired company’s key employees. Additionally, we may incur unanticipated expenses, difficulties and other adverse consequences relating to the integration of technologies, research and development, and administrative and other functions. Any future acquisitions may also result in potentially dilutive issuances of our equity securities, acquisition or divestiture related write-offs and the assumption of debt and contingent liabilities. Any of the above factors could adversely affect our revenue, profitability, operations or growth strategy.

Our stock price is volatile, and, if you invest in our company, you may suffer a loss of some or all of your investment.

The market price and trading volume of our common stock has been subject to significant volatility, and this trend may continue. In particular, trading volume historically has been low and the market price of our common stock has increased dramatically in recent months. Since the announcement of our acquisition of VTC, the closing price of our common stock, as traded on the Nasdaq

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to changes in interest rates primarily from our investments in certain cash equivalents. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest-sensitive financial instruments at September 30, 2004.

We have no investments, nor are any significant sales, expenses, or other financial items denominated in foreign country currencies. All of our international sales are denominated in U.S. dollars. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, reduce the demand for our products.

ITEM 4. CONTROLS AND PROCEDURES

(a) Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of September 30, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to ensure that our disclosure controls and procedures are designed to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely discussions regarding required disclosure. This evaluation also included consideration of our internal controls and procedures for the preparation of our financial statements. As of September 30, 2004, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure control and procedures are effective.

1. Our internal controls are inadequate to properly record our inventory quantities in an accurate and timely manner; and

2. Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

Exhibit Number			Description

2.1			Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of October 28, 2002.(8)

3.1			Second Amended and Restated Certificate of Incorporation of the Company.

3.2			Bylaws of the Company, as currently in effect.(10)

4.1			Specimen Common Stock Certificate.(1)

10.1*			1992 Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1)

10.2*			1998 Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement thereunder.(1)

10.3*			1998 Employee Stock Purchase Plan, as amended.(2)

10.4*			1998 Stock Plan Inland Revenue Approved Rules for UK Employees.(3)

10.5			American Capital Marketing, Inc. 401(k) Plan.(1)

10.6			Form of Indemnification Agreement entered into between the Company and each director and officer.(1)

10.12*			Executive Retention and Change of Control Plan.(6)

10.13*			Non-Executive Retention and Change of Control Plan and Summary Plan Description.(6)

10.14*			Non-Qualified Stock Option Agreement issued to Mark Carpenter on March 3, 2000.(6)

10.15*			1999 Non-Statutory Stock Option Plan(7)

10.16			Office Lease Agreement between Kruse Way Office Associates Limited Partnership and VideoTele.com dated April 28, 2000.(9)

10.17			Office Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut Systems Inc. dated November 2002.(9)

10.18			Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip Corbishley.(5)

10.19			Loan and Security Agreement

11.1			Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements).

31.1			Certification of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

31.2			Certification of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

32.1			Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2			Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-60419) as declared effective by the Securities and Exchange Commission on January 28, 1999.

(2) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 1999.

(3) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.

INDEX TO EXHIBITS

Exhibit Number				Description

2.1				Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of October 28, 2002.(8)

3.1				Second Amended and Restated Certificate of Incorporation of the Company.

3.2				Bylaws of the Company, as currently in effect.(10)

4.1				Specimen Common Stock Certificate.(1)

10.1*				1992 Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1)

10.2*				1998 Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement thereunder.(1)

10.3*				1998 Employee Stock Purchase Plan, as amended.(2)

10.4*				1998 Stock Plan Inland Revenue Approved Rules for UK Employees.(3)

10.5				American Capital Marketing, Inc. 401(k) Plan.(1)

10.6				Form of Indemnification Agreement entered into between the Company and each director and officer.(1)

10.12*				Executive Retention and Change of Control Plan.(6)

10.13*				Non-Executive Retention and Change of Control Plan and Summary Plan Description.(6)

10.14*				Non-Qualified Stock Option Agreement issued to Mark Carpenter on March 3, 2000.(6)

10.15*				1999 Non-Statutory Stock Option Plan(7)

10.16				Office Lease Agreement between Kruse Way Office Associates Limited Partnership and VideoTele.com dated April 28, 2000.(9)

10.17				Office Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut Systems Inc. dated November 2002.(9)

10.18				Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip Corbishley.(5)

10.19				Loan and Security Agreement

11.1				Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements).

31.1				Certification of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

31.2				Certification of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

32.1				Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2				Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-60419) as declared effective by the Securities and Exchange Commission on January 28, 1999.

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

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

Commission File Number: 000-25291

Delaware		94-2958543
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

6000 SW Meadows Rd, Suite 200 Lake Oswego, Oregon		97035
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (971) 217-0400

PART I.	FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (unaudited):

	Condensed Consolidated Balance Sheets as of December 31, 2003 and September 30, 2004

	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and September 30, 2004

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and September 30, 2004

	Notes to Unaudited Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures about Market Risk

Item 4.	Controls and Procedures

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits and Reports on Form 8-K

Signatures

	TUT SYSTEMS, INC.


	By:	/s/ RANDALL K. GAUSMAN
		Randall K. Gausman Vice-President, Finance and Administration, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer and Duly Authorized Officer)

Date: October 28, 2004