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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

  For the fiscal year ended December 31, 2003

OR

  For the transition period from                      to                     

Commission File Number 0-25996

TRANSWITCH CORPORATION

(Exact name of Registrant as Specified in its Charter)

Three Enterprise Drive Shelton, Connecticut 06484

(Address of principal executive offices, including zip code)

Telephone (203) 929-8810

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

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

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

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

The aggregate market value of the outstanding common stock, other than shares held by persons who may be deemed affiliates of the Registrant, as of the last business day of the Registrant’s most recently completed second fiscal quarter was approximately $122.2 million. At February 25, 2004, as reported on the Nasdaq National Market, there were 91,041,156 shares of common stock, par value $.001 per share, of the Registrant outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Parts of the following document are incorporated by reference in Part III of this Form 10-K Report:

(1) Proxy Statement for the Registrant’s 2004 Annual Meeting of Shareholders—Items 10, 11, 12, 13 and 14.

Item 1. Business.

The following description of our business should be read in conjunction with the information included elsewhere in this document. The description contains certain forward-looking statements that involve risks and uncertainties. When used in this document, the words “intend”, “anticipate”, “believe”, “estimate”, “plan”, and “expect” and similar expressions as they relate to us are included to identify forward-looking statements. Our actual results could differ materially from the results discussed in the forward-looking statements as a result of risk factors set forth elsewhere in this document. See also, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Factors That May Affect Future Results.”

General

TranSwitch is a Delaware corporation incorporated on April 26, 1988. We design, develop and market highly integrated semiconductor devices, also referred to as very large scale integration (VLSI) devices, that provide core functionality in voice and data communications network equipment deployed in the global communications network infrastructure. In addition to their high degree of functionality, our products incorporate digital and mixed-signal (analog and digital) processing capabilities, providing comprehensive system-on-a-chip (SOC) solutions to our customers.

Our products are compliant with relevant communications network standards including Asynchronous/Plesiochronous Digital Hierarchy (Asynchronous/PDH), Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH), Ethernet and Asynchronous Transfer Mode/Internet Protocol (ATM/IP). We offer several products that combine multi-protocol capabilities on a single chip, enabling our customers to develop network equipment for multi-service (voice, data and video) applications. A key attribute of our products is their inherent flexibility. Many of our products incorporate embedded programmable micro-processors, enabling us to rapidly accommodate new customer requirements or evolving network standards by modifying a function of the device via software instruction.

We bring value to our customers through our communications systems expertise, VLSI design skills and commitment to excellence in customer support. Our emphasis on technical innovation and complete reference solutions enables us to define and develop products that permit our customers to achieve faster time-to-market, and to produce communications systems that offer a host of benefits such as greater functionality, improved performance, lower power dissipation, reduced system size and cost and greater reliability for their customers.

Our principal customers are the telecommunications and data communications equipment Original Equipment Manufacturers (OEMs) that serve three market segments:

We have sold our VLSI devices to more than 400 customers worldwide since shipping our first product in 1990. Our products are sold through a worldwide direct sales force and a worldwide network of independent distributors and sales representatives.

Industry Background

State of the Market

After the severe downturn in the global telecommunication market in 2001 and 2002, the market showed signs of stability and mild recovery in the latter part of 2003. Communication service providers, internet service providers, regional Bell operating companies and interexchange carriers continue to closely monitor their capital

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expenditures. Spending on voice-only equipment is still slow while spending on equipment providing the efficient transport of data services on existing infrastructure appears to be slowly recovering. Demand for new, high bandwidth applications such as video conferencing, broadband audio and telephone is placing an increased burden on existing WANs.

We are heavily focused on two means of efficiently transporting data across the existing WAN infrastructure: Digital Subscriber Line (DSL) and Ethernet over SONET/SDH (EoS). Throughout the downturn from 2001 to 2003, the demand for DSL installations was sustained at an average of 6 million lines per quarter on a worldwide basis. With the advent of new technologies such as Asymmetrical Digital Subscriber Line 2+ (ADSL2+) and Very high data rate Digital Subscriber Line (VDSL) that allow greater bandwidth over larger distances, network equipment deployed in the field will need to be upgraded to provide these services.

Ethernet over SONET/SDH is another means of efficiently transporting Ethernet services over existing SONET/SDH networks eliminating the need for massive overlay networks. This is a new growth market for communication service providers and OEMs alike.

The Role of Communications Standards

In an effort to provide interoperability among communication networks and equipment, the communications industry has established numerous standards and protocols that address connectivity issues between networks and network equipment. Communication standards protocols for transmission of information such as voice, high speed data or video over electrical, optical or wireless media have been implemented to ensure that equipment from different manufacturers and the various public and private networks can communicate with each other reliably and efficiently. The VLSI devices supplied by us conform to these standards.

SONET and SDH standards were defined for efficient and reliable transport of information over optical fiber. SONET is primarily a North American standard, while SDH is its international counterpart. Introduced in the late 1980s, SONET and SDH were initially employed primarily for the transport of voice traffic in telephone networks. Prior to the introduction of the SONET/SDH standards, Asynchronous/PDH standards were in use for transmission over metallic cables, radio and optical fiber. ATM is a higher level standard that enables public networks, Internet, WAN and local area network (LAN) systems designers to provide a mix of services to network users. ATM allows communication service providers to reduce the impact of network congestion, assure quality of service and to provide mixed high-speed and high-volume data communications, voice, video and imaging services. This ability allows the communication service providers to generate more revenue by offering more services to their customers.

IP is another standard that allows packets or frames of data to be forwarded, transmitted, and routed between networks. In the access networks, IP packets are carried over ATM, where ATM serves as a transport layer for IP packets (i.e. DSL).

Recently, industry standards have emerged for carrying Ethernet over SONET/SDH. Ethernet is a protocol that is used throughout LANs. Increased requirements for connectivity between corporate LANs and WANs are driving the need for bridging Ethernet protocol over the public network. Communication service providers are beginning to deploy Ethernet services because it represents additional revenue opportunities and it is a relatively efficient way to handle increasing amounts of data moving from the LAN to the WAN and then from the WAN to another LAN.

Communications Semiconductors

In order to deploy new infrastructures and transmission protocols, communication service providers are demanding improved time to market of cost-effective, differentiated products from OEMs. The complexity of the equipment, increasing cost pressures and the need for high reliability and standards compliance mandate the use of VLSI devices incorporating a high degree of functionality. OEMs recognize that, similar to the trend

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experienced in the computer industry, the functionality incorporated into VLSI devices is contributing an increasing share of the intellectual property and the value of network equipment. The design of VLSI devices contained in SONET/SDH, Asynchronous/PDH and ATM/IP equipment requires specialized expertise in mixed-signal semiconductor design and implementation, in-depth knowledge of telecommunications and data communications standards and systems engineering expertise. Expertise in mixed-signal device design is relatively uncommon, and, as a result, OEMs needing these capabilities often seek independent semiconductor vendors. However, many semiconductor vendors lack the communications industry knowledge and experience, as well as familiarity with the standards, to be able to contribute significant value to the OEMs’ systems designs. Consequently, OEMs require a semiconductor vendor that understands their markets and the applicable standards and is able to provide a broad range of cost-effective semiconductor devices. One of our core competencies is our understanding of these standards and protocols and our experience in designing these specialized VLSI products.

Our Products and their Applications

We supply high-speed, broadband VLSI semiconductor devices to network systems OEMs that serve three market segments: the worldwide public network infrastructure that supports both voice and data communications, the Internet infrastructure that supports the World Wide Web and other data services and corporate WANs that support voice and data information exchange within medium-sized and large enterprises. As a system-on-a-chip innovation leader, our core competencies include:

Our products comply with all relevant industry standards and provide functionality in three key areas:

We believe that our chip-set approach and broad product coverage in all three product lines position us as a “one-stop source” for broadband communications VLSI products. Network equipment OEMs can mix and match our VLSI devices to optimally configure their specific systems. Our product lines can be combined to provide a cost-effective communication systems solution with increased functional integration and features while providing seamless integration of SONET/SDH, Asynchronous/PDH and ATM/IP for broadband network applications. In 2003, the prices for our products ranged from approximately $10 to $200 per device, depending on technology, volume, complexity and functionality.

Our product portfolio, driven by our customer needs and objectives, continues to expand to accommodate the latest networking and telecommunication standards to enable the efficient transport of data services across the LAN and WAN. In 2003 we extended our product offerings in the EtherMap^® family of products by announcing the EtherMap-12, providing an Ethernet over SONET/SDH product portfolio from STS-3/STM-1 rates to STS-48/STM-16. Additionally, we introduced our Envoy family of products in co-operation with Intel’s^® Network Processors Division and the PacketTrunk-4 product allowing the efficient transport of legacy services (DS1, E1, DS3, E3) over the new data (IP, Multi-Protocol Layer Switching (MPLS), Ethernet) networks.

SONET/SDH Products

In the SONET/SDH area, we offer framer devices that provide a direct interface for fiber optic transmission in North America, Europe and Asia. Our mappers bridge the interconnections between SONET/SDH equipment and Asynchronous/PDH equipment, allowing DS-series and E-series transmission lines to be connected with

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SONET/SDH lines. These mappers transparently transport Asynchronous/PDH signals across the SONET/SDH network.

Our EtherMap family of products constitutes a major extension of our SONET/SDH product line. These products comply with recently introduced industry standards for efficient and flexible transport of Ethernet over SONET/SDH networks. Ethernet is universally deployed in enterprise LANs, while SONET/SDH is equally ubiquitous in optical WANs. Our EtherMap products enable our customers to rapidly enhance their existing systems or to develop new systems that provide Ethernet transport capabilities. This in turn provides value to their customers, the service providers, by enabling service providers to leverage their existing investment in SONET/SDH networks to provide new revenue generating services.

Our SONET/SDH products have traditionally been used to build access equipment, add/drop multiplexers, digital cross connects and other telecommunication and data communications equipment. This equipment is configured for use in both domestic and international fiber-based public networks. Our SONET/SDH products also have applications in customer premise equipment (CPE), such as routers and hubs, and in central offices, adding integrated fiber optic transmission capability to telephone switches.

Our OMNI multi-service switching family of products extends the reach of SONET/SDH products from the access networks into the metro networks. This product family consists of a highly integrated SONET/SDH Transport Processor and a Switch Element device that enable our customers to build highly scalable switch fabrics with improved performance in the areas of switching granularity and versatility which allows simultaneous support of multiple data types.

Asynchronous/PDH Products

Our Asynchronous/PDH products are used to configure transmission equipment to increase the capacity of the radio and copper-based public network. Our Asynchronous/PDH VLSI products also enable customer premise equipment to access the public network for voice and data communications.

Our Asynchronous/PDH products provide high levels of integration, as well as cost, power and performance benefits relative to discrete and competing integrated circuit solutions. Our Asynchronous/PDH VLSI products include devices that provide solutions for DS-0 through DS-3 and E-1 through E-3 transmission lines. This product line includes line interfaces, multiplexers, which combine multiple low-speed lines to form a higher speed line, as well as demultiplexers, which perform the reverse function. In addition, we offer framers, which are devices that identify the starting points of defined bit streams and enable systems to recognize the remaining bits.

ATM/IP Products

Our ATM/IP products provide the key functions of ATM/IP-based multi-service access multiplexer systems. CellBus^® is a patented system architecture invented by us for implementing ATM/IP access multiplexers and ATM/IP switching systems. The products incorporating our CellBus technology include the CUBIT^® and ASPEN^® families of VLSI devices. Our CellBus technology provides single-chip ATM/IP switching capability in access equipment. These products have been designed into many network system OEMs’ solutions since late 1995, establishing CellBus as a significant technology in the global broadband network access market. Our ATM/IP products also include VLSI semiconductor devices for line interfacing and service adaptation functions, including the mapping of these data protocols into SONET/SDH.

Our recently introduced Envoy family of products provides valuable bridging functions for LAN/WAN interconnection. In conjunction with network processor devices, these devices provide Ethernet services to LAN/WAN routers and switches.

With the introduction of the PacketTrunk-4 device, we extended our reach from the Access portion of the communications network to the Edge portion of the communications network allowing customers to efficiently

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transport legacy time division multiplexing (TDM) services over IP/MPLS/Ethernet equipment. While communication service providers continue to deploy new data services, predominantly based on Ethernet (EoS) technology, the need to carry TDM legacy services continues.

The following tables summarize our net product revenue mix by product line for the fiscal years ended December 31, 2003, 2002 and 2001 (dollar amounts in thousands), respectively:

Applications of our Products in the Network

The following briefly describes our view of the Metro and Access areas of the network infrastructure and some typical equipment that may include our VLSI products.

The Access Network

This section of the network infrastructure interconnects end user locations (residences or businesses) to the nearest service provider location (usually the telephone company central office). The primary functions performed by equipment in the access network are aggregation and distribution of traffic and interconnection to the switching or transmission equipment that connects to the WAN. The access network may consist of electrical, optical or wireless transmission equipment. Our VLSI products are used in a variety of equipment in the access network. For example, members of our ASPEN and CUBIT product families are used in Digital Subscriber Line Access Multiplexers (DSLAMs) that are used to provide DSL services. These products are also used in Base Station equipment for cellular phone service. Our SONET/SDH and Asynchronous/PDH products are used in add-drop multiplexers that serve as a primary vehicle for aggregation and distribution of traffic in the access network.

The Metro Network

The Metro network infrastructure is principally an optical-fiber based network that provides high-speed communications and data transfer covering an area larger than a campus area network and smaller than a WAN, interconnects two or more LANs, and usually covers an entire metropolitan area, such as a large city and its suburbs. In addition to interconnecting locations within the metropolitan area, the metro network connects to the access portion of the network and the long-haul or core network which interconnects different metropolitan networks across a region, a country or internationally. Equipment in the Metro network perform functions such as switching or routing of traffic, processing of data in various protocols, and further aggregation and distribution of traffic. Our OMNI family of multi-service switching products is designed specifically for next generation metro switching equipment that provides extremely high speed switching capability for signals in either TDM, ATM or IP formats. Our SONET/SDH framer and mapper products are used in digital cross-connect systems, add-drop multiplexers and voice equipment that switches high-speed analog signals to digital signals, and also in equipment that splits or combines various transmission signals.

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Technology

We believe that one of our core competencies is our knowledge of the telecommunications and data communications landscape. Specifically, our systems engineering personnel possess substantial telecommunications and data communications design experience, as well as extensive knowledge of the relevant standards. This includes not only a thorough understanding of the actual written standards, but also an awareness of and appreciation for the nuances associated with the standards necessary for assuring that device designs are fully compliant.

Complementing our communications industry expertise is our VLSI design competence. Our VLSI design personnel have extensive experience in designing high-speed digital and mixed-signal devices for communications applications. These designs require a sophisticated understanding of complex technology, as well as the specifics of the deep sub-micron manufacturing processes and their resulting impact on device performance. We have developed a large number of VLSI blocks and intellectual property cores that operate under the demanding requirements of the telecommunications and data communications industries. These blocks and intellectual property cores have been designed using standard VLSI-oriented programming languages such as Visic Hardware Descriptive Language (VHDL) and Verilog and have been verified with standard verification tools.

We have developed proprietary tool sets, called “Test Benches”, that facilitate rapid development of VLSI products and help assure that our products are standards compliant and meet customer requirements. These Test Benches consist of behavioral models of all applicable functions in a high-level design environment and also include test signal generators and analyzers such as models of SONET/SDH signals. Systems engineers use Test Benches to test new architectural concepts, while VLSI designers use Test Benches to ensure that the device conforms to product specifications.

In addition to the extensive hardware functionality, many of our products utilize embedded processors that are software programmable. This approach enables us to develop products with higher levels of functionality and flexibility than are possible with purely hardware based solutions.

The newly announced EtherMap-12, Envoy and PacketTrunk-4 devices are multi-million gate devices, which will be implemented in 0.18 and 0.13 micron complementary metal oxide semiconductor (CMOS) silicon technologies. They incorporate high speed mixed signal circuitry, and many of them are equipped with embedded processors that provide added functionality through software.

Other products that incorporate programmability are the ASPEN family of ATM processors, and the PHAST series of products that target simultaneous mapping and transport of ATM/point-to-point protocol (PPP) and TDM services over fiber optic networks. In addition, we have introduced a family of devices, which provide a high degree of granularity for access networks. The T3BwP and TEPro VLSI devices support both data and management planes with an on-chip Reduced Instruction Set Computing (RISC) processor supporting full standards based management and performance monitoring.

We have enhanced our internal chip layout capabilities through standard hiring practices and enhanced our design for test capability through the acquisition of Horizon Semiconductors, Inc. in 2001, both of which have resulted in significant improvements in silicon efficiency, silicon testability and time-to-market. Our system-on-a-chip definition, architecture, verification expertise and design methodology ensure that hardware and software architectural trade-offs yield desired performance testing from our VLSI solutions. The system-on-a-chip performance simulation, emulation, verification and stress testing, using Test Benches and test equipment, ensures that our products meet carrier class quality, performance and reliability requirements.

The expertise of our personnel, our rigorous design methodology and our investment in state-of-the-art electronic design automation tools enable us to develop the complex and innovative products our customers demand.

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Strategy

Our goal is to be the leading supplier of innovative, complete VLSI solutions to telecommunications and data communications OEMs worldwide. The key elements of our business strategy include the following:

Provide Complete Solutions Within Target Markets

We offer network equipment OEMs chip sets that represent complete solutions for SONET/SDH, Asynchronous/PDH and ATM/IP applications. In addition to providing our families of VLSI devices, we offer OEM customers the following:

Our “chip-set” approach allows OEMs to optimally configure their products while maintaining product compatibility over multiple generations. This approach allows equipment vendors to selectively upgrade their products with next-generation higher functionality VLSI devices. We have extended this approach to provide seamless integration of SONET/SDH, Asynchronous/PDH and ATM/IP applications.

Continue to Promote the Deployment of Programmable Devices

We intend to continue to develop and promote programmable system-level building blocks that we call Connectivity Engines. By providing core functionality in the form of dense, high-speed, programmable packages, we believe these new devices offer greater power, flexibility and functionality at a lower cost than the single-function, hard-wired devices they are designed to replace. We believe that our Connectivity Engines represent a new and more versatile approach to designing communications systems and that these new devices have the potential to play a significant role as product-building platforms in the development of new generations of equipment by networking OEMs.

Seek Early Market Penetration Through Customer Sponsorship

We seek to develop close sponsoring relationships with strategic OEMs during product development in order to secure early adoption of our solutions. We believe that OEMs recognize the value of their early involvement through sponsorship of our products, as they can design their system products in parallel with our product development, thereby accelerating their time to market. In addition, we believe that our sponsoring relationships with leading OEMs helps us to obtain early design wins and help reduce risks of market acceptance for our new products.

Focus on Mixed-Signal Applications

We seek to identify applications requiring our mixed-signal VLSI device design capabilities. By leveraging both our industry knowledge and the special design skills required for mixed-signal devices, we believe that we are able to identify and implement optimal combinations of design elements for desired analog and digital functionality targeted toward the specific needs of network equipment OEMs. We believe that our experience and expertise provides our customers accelerated time to market, better performance and lower costs than combinations of separate digital and analog solutions.

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Partner With Selected Foundries

We work with select third-party foundries to obtain our semiconductor devices. This approach allows us to avoid substantial capital spending, obtain competitive pricing and technologies, and retain the ability to migrate our products to new process technologies to reduce costs and optimize performance. Our design methodology enables the production of our devices at multiple foundries using well-established and proven processes. We engage foundries that are ISO 9001:2000 certified for quality and which use only semiconductor processes and packages that are qualified under industry-standard requirements.

Marketing and Sales

Our marketing strategy focuses on key customer relationships to promote early adoption of our VLSI devices in the products of market-leading communications equipment OEMs. Through our customer sponsorship program, OEMs collaborate on product specifications and applications while participating in product testing in parallel with our own certification process. This approach accelerates our customers’ time-to-market delivery while enabling us to achieve early design wins for our products and volume forecasts for specific products from these sponsors.

Our sales strategy primarily focuses on worldwide suppliers of high-speed communications and communications-oriented equipment. These customers include telecommunications, data communications, internet, customer premise, computing, process control and defense equipment vendors. In addition, we target emerging technology leaders in the communications equipment market that are developing next generation solutions for the telecommunications and data communications markets. We identify and address sales opportunities through our worldwide direct sales force and our worldwide network of independent distributors and sales representatives.

Our worldwide direct sales force, technical support personnel and key engineers work together in teams to support our customers. We have technical support capabilities located in key geographical locations throughout the world as well as a technical support team at our headquarters as a backup to the field applications engineers.

We have established foreign distributors and sales representative relationships in Australia, Belgium, Brazil, Canada, China, Germany, India, Ireland, Israel, Italy, Japan, Korea, Luxemburg, Mexico, Scandinavian countries, Spain, Switzerland, Taiwan, Turkey and the United Kingdom. We also sell our products through domestic distributors and a network of domestic sales representatives. We have regional sales and technical support capabilities in Boston, Massachusetts; San Jose, California; Raleigh/Durham, North Carolina; Stockholm, Sweden; Paris, France; Rome, Italy; Berkshire, England; Hilversum, Netherlands; Brussels, Belgium; New Delhi, India; and Taipei, Taiwan, as well as at our headquarters facility in Shelton, Connecticut.

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Customers

We have sold our products and services to over 400 customers since shipping our first product in 1990. Our customers include public network systems OEMs that incorporate our products into telecommunications systems, WAN and LAN equipment OEMs, Internet-oriented OEMs, communications test and performance measurement equipment OEMs and government, university and private laboratories that use our products in advanced public network and WAN and LAN developments. A small number of our customers have historically accounted for a substantial portion of our net revenues. The following table sets forth the percentage of net revenues attributable to our major distributors as well as the significant customers that had total purchases (either direct or through distributors) of greater than 10% of net revenues for the fiscal years ended December 31, 2003, 2002 and 2001, respectively:

Information on reportable operating segments for each of the last three years is located in Note 8 of the Notes to Consolidated Financial Statements in Item 8 of this report.

Research and Development

We believe that the continued introduction of new products in our target markets is essential to our growth. As of December 31, 2003, we had 195 full-time employees engaged in research and product development efforts. We employ designers who have the necessary engineering and systems qualifications and who are experienced in software, mixed-signal, high-speed digital, telecommunications and data communications technologies.

Research and development expenditures for the fiscal years ended December 31, 2003, 2002 and 2001 were $42.0 million, $53.5 million, and $49.3 million, respectively. In the fiscal years ended December 31, 2003, 2002 and 2001, we also expensed $0.5 million, $2.0 million and $22.0 million, respectively, of purchased in-process research and development related to the acquisitions of ASIC Design Services, Inc., Systems On Silicon, Inc. and Opal Acquisition Corporation (formerly known as Onex Communications Corporation), respectively.

All development efforts are carried out using ISO 9001:2000 certified design processes and our design tools and environment are continuously updated to improve design, fabrication and verification of products. From time to time, we subcontract design services and acquire products from third parties to enhance our product lines. Our internal research and development organization thoroughly reviews the external development processes and the design of these products as part of our quality assurance process.

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Patents and Licenses

Through the end of 2003, we have been issued or became an assignee of one hundred thirty-five (135) patents worldwide with an additional one hundred twenty-six (126) patents pending worldwide. We have been assigned forty-eight (48) United States patents of which two are co-assigned (one with Siemens Telecommunications Systems, Ltd. and one with ECI Telecom Ltd.). One of the United States patents has been abandoned and is no longer in force. In addition there were thirty-three (33) United States patents pending. Many of the United States issued and pending patents were filed internationally. As a result, we have been issued eighty-seven (87) international patents, which are active and, which include the co-assigned patents with Siemens Telecommunications Systems, Ltd. and ECI Telecom Ltd., as of December 31, 2003. For one or more of our United States patents, we have coverage in Canada, China, Taiwan, Israel, Japan, Korea, France, Germany, United Kingdom, Belgium, Italy, Sweden, Spain, Ireland, Denmark, The Netherlands, Portugal, Switzerland, Luxembourg and Liechtenstein. Internationally, there are fifty-six (56) patents pending in specific countries with an additional thirty-five (35) filed in the European Patent Office (EPO) or under the Patent Cooperative Treaty (PCT).

We cannot guarantee that our patents will not be challenged or circumvented by our competitors, and we cannot be sure that pending patent applications will ultimately be issued as patents. Under current law, patent applications in the United States filed before November 29, 2000 are maintained in secrecy until they are issued but applications filed after November 29, 2000 (and foreign applications) are generally published 18 months after their priority date, which is generally the filing date. The right to a patent in the United States is attributable to the first to invent, while in most jurisdictions the right to a patent is obtained by the first to file the patent application. We cannot be sure that our products or technologies do not infringe patents that may be granted in the future based upon currently pending non-published patent applications or that our products do not infringe any patents or proprietary rights of third parties. From time to time, we receive communications from third parties alleging patent infringement. If any relevant claims of third-party patents are upheld as valid and enforceable, we could be prevented from selling our products or could be required to obtain licenses from the owners of such patents or be required to redesign our products to avoid infringement. We cannot be assured that such licenses would be available or, if available, would be on terms acceptable to us or that we would be successful in any attempts to redesign our products or processes to avoid infringement. Our failure to obtain these licenses or to redesign our products would have a material adverse effect on our business.

We also have been granted registration of seventeen trade or service marks in the United States, and we have four more U.S. applications for trademarks awaiting approval. We have also obtained four trademark registrations under the European Community Trademark (ECT) procedure with two awaiting approval in the ECT and two awaiting approval in Canada.

Our ability to compete depends upon our ability to protect our proprietary information through various means, including ownership of patents, copyrights, mask work registrations and trademarks. While no intellectual property right of ours has been invalidated or declared unenforceable, we cannot assure that such rights will be upheld in the future. We believe that, in view of the rapid pace of technological change in the communication semiconductor industry, the technical experience and creative skills of our engineers and other personnel are the most important factors in determining our future technological success.

We have entered into various license agreements for product or technology exchange. The purpose of these licenses has, in general, been to obtain second sources for standard products or to convey or receive rights to certain proprietary or patented cores, cells or other technology.

We sell our products for applications in the telecommunications and data communications industries, which require our products to conform to various standards that are agreed upon by recognized industry standards committees. Where applicable, we design our products to be in conformity with these standards. We have received and expect to continue to receive, in the normal course of business, communications from third parties stating that if certain of our products meet a particular standard, these products may infringe one or more patents

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of that third party. We review the circumstances of each communication, and, in our discretion and upon the advice of legal counsel, have taken or may take in the future one of the following courses of action: we may negotiate payment for a license under the patent or patents that may be infringed, we may use our technology and/or patents to negotiate a cross-license with the third party or we may decline to obtain a license on the basis that we do not infringe the claimant’s patent or patents, or that such patents are not valid, or other basis. We cannot assure that licenses for any of these patents will be available to us on reasonable terms or that we would prevail in any litigation seeking damages or expenses from us or to enjoin us from selling our products on the bases of any of the alleged infringements.

Manufacturing and Quality

Our manufacturing objective is to produce reliable, high-quality devices on a cost effective basis. To this end, we seek to differentiate ourselves by:

Established independent foundries manufacture all of our VLSI devices. This approach permits us to focus on our design strengths, minimize fixed costs and capital expenditures and access diverse manufacturing technologies. Currently, we utilize five foundries to process our wafers, of which four of these relationships are governed by foundry agreements: Texas Instruments Incorporated (TI), LSI Logic Corporation, IBM Microelectronics (a division of IBM) and Taiwan Semiconductor Manufacturing Company Limited (TSMC). Foundries are required to have qualified and reliable processes. The selection of a foundry for a specific device is based on availability of the required process technology and the foundry’s capability to support the particular set of tools used by us for that device. Currently, TI manufactures all of our Bipolar Complementary Metal Oxide Semiconductor (BiCMOS) devices.

Various independent subcontractors and foundry suppliers perform assembly and testing functions. Additionally, certain testing and inspection functions are performed at our facility in Shelton, Connecticut.

TUV Rheinland of North America, Inc. registers us as complying with the requirements of ISO 9001:2000.

Acquisitions

While some of the next generation products we introduce are based on technologies that we develop ourselves, we have filled some of our technology and skills needs through acquisitions. The following is a table that summarizes technology and skills we obtained through acquisitions of stand-alone companies during the fiscal years ended December 31, 2003, 2002 and 2001, respectively.

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Investments in Non-Publicly Traded Companies

We will, from time-to-time, make investments (which include convertible debt investments) in early stage venture-backed, start-up companies that develop technologies that are complementary to our product roadmap. In all cases, when investing in other semiconductor companies, we have also entered into commercial agreements giving us the rights to resell products developed by these companies. A summary of each of these businesses including their locations follows. When determining the accounting method for these investments, we consider both direct (TranSwitch) ownership and indirect ownership, which is comprised of employees and directors of TranSwitch. We also consider other factors, such as our influence over the financial, technology and operating policies of these companies.

OptiX Networks Inc. is a Delaware corporation with a development center in Kfar Saba, Israel. OptiX Networks is developing VLSI devices in advanced technologies for the broadband optical backbone, interoffice and metro area communications. We account for this investment under the equity method and made our initial investment in February 2000.

TeraOp (USA), Inc. is a Delaware corporation with a research and development center in Kfar Saba, Israel. TeraOp designs micro electro mechanical systems (MEMS) based optical crossbars and variable optical attenuators for next generation core and metro storage switches and routers. We consolidate the assets and liabilities of this investment under FIN 46 and made our initial investment in May 2001.

Accordion Networks, Inc. is a California corporation with offices in Milpitas, California. Accordion designs and supplies broadband services platforms designed to allow service providers to remotely activate, personalize and manage bandwidth-intensive applications. Accordion’s target market is metro area telecommunications and data communications providers. We account for this investment under the cost method and made our initial investment in December 2001.

Opulan Technologies Corporation is a Cayman Islands corporation with offices in Milpitas, California, and a design center in the People’s Republic of China. Opulan Technologies provides high performance, cost-effective, IP convergence Application Specific Standard Product (ASSP)/SoC technologies for use in developing broadband multiservice access platforms such as DSLAM, wireless base station/Radio Network Controller (RNC), and Fiber to the Location (FTTx) for its target markets in China, East Asia and North America. We account for this investment under the cost method and made our initial investment in April 2003.

Investments in Venture Capital Funds

We have also invested in Neurone Ventures II (Neurone), which is a venture capital fund organized as a partnership in the business of making, supervising and disposing of privately negotiated equity and equity-related investments, principally in early-stage Israeli and Israeli-related high-technology companies. We have a 1% ownership interest in this partnership and we account for it under the cost method.

Competition

The communication semiconductor industry is intensely competitive and is characterized by the following:

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The telecommunications and data communications industries, which are our primary target markets, are also intensely competitive due to deregulation and heightened international competition.

The global telecommunications market, which experienced a severe downturn in 2001 and continued decline through 2002, began to recover slightly during the latter part of 2003. The adverse market conditions have impacted the entire supply chain including communication service providers, internet service providers, regional Bell operating companies and interexchange carriers, OEMs such as Alcatel, Cisco, Lucent and Nortel, and communication VLSI product vendors such as TranSwitch. During the last three years there has been excess bandwidth capacity in communication service provider infrastructures, excess inventory levels in the supply chain and a slowing global economy, which resulted in reduced demand for our customers’ equipment and therefore a reduced demand for our products.

We recognized this industry shift and have focused our product strategy on supporting the current needs of our customers. Recently, we have introduced new product lines that meet our customers evolving data communications requirements. Our Ethernet over SONET/SDH (EoS) product line enables telecommunication carriers and internet service providers the ability to offer new revenue-generating services, such as the high-speed transport of information over IP networks, based on their current network infrastructure. By utilizing the current network infrastructure, telecommunication carriers can realize revenue growth with only a modest increase in their costs.

We believe that our competitive position in the telecommunications semiconductor industry has remained relatively unchanged during the recent decline in these markets during the past three years. Although our net product revenues have declined significantly during this time period, our competitors’ telecommunications product revenues have also declined on a consistent basis. In addition, the overall market for our products has also dropped on a relative basis, leaving us in a similar market position as prior to the significant decline experienced in the telecommunications market during the past three years. Some of our competitors are more diversified than we are and accordingly, their other shipments, such as LAN, wireless, and digital signal processing, have helped them to offset the declines in their telecommunications revenues. Their overall revenues, therefore, may not have declined on a similar basis to ours because we have focused extensively on telecommunications related products.

Our competition consists of specialized semiconductor companies from the United States as well as other countries and semiconductor divisions of vertically integrated companies, such as IBM Corporation, Lucent Technologies, Inc., NEC Corporation and Siemens Corporation. New entrants are also likely to attempt to obtain a share of the market for our current and future products.

Our principal competitors in the Asynchronous/PDH and SONET/SDH areas are Applied Micro Circuits Corporation, Conexant Systems, Inc., Cirrus Logic, Inc., Infineon Technologies, Exar Corporation, Agere Systems, PMC-Sierra Inc., TriQuint Semiconductor, Inc., Vitesse Semiconductor Corporation and Broadcom Corporation. In addition, there are a number of Applications Specific Integrated Circuit (ASIC) vendors, including AMI Semiconductor, LSI Logic Corporation and STM Microelectronics Group, which compete with us by supplying customer-specific products to OEMs. In the ATM market, the principal competitors include all the vendors mentioned above and, in addition, Intel Corporation. Other domestic and international vendors have announced plans to enter into this market.

Backlog

As of December 31, 2003, our backlog was $7.1 million, as compared to $2.2 million as of December 31, 2002. Backlog represents firm orders anticipated to be shipped within the next 12 months. Our business and, to a

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large extent, that of the entire communication semiconductor industry, is characterized by short-term order and shipment schedules. Since orders constituting our current backlog are subject to changes in delivery schedules or to cancellation at the option of the purchaser without significant penalty, backlog is not necessarily an indication of future revenues. During 2003, there was a slight increase in demand as compared to 2002, when many of our customers experienced decreased demand, order cancellations or postponements.

Employees

At December 31, 2003, we employed 278 full time employees, which included 195 in research and development, 51 in marketing and sales, 17 in operations and quality assurance, and 15 in administration. We have not entered into any collective bargaining agreements. We have never experienced any work stoppage, and we believe our employee relations are good.

On January 15, 2003, we announced a restructuring action and through the implementation of such restructuring action, we reduced our operating cost structure. This resulted in terminations of approximately 24% of our workforce. Refer to Note 13—Restructuring and Asset Impairment Charges in our Consolidated Financial Statements.

Available Information

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are made available free of charge through the Investor Relations section of our Internet website (http://www.transwitch.com) as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Our executive offices are located at Three Enterprise Drive, Shelton, CT 06484.

Item 2. Properties

Our headquarters are located in a suburban office park in Shelton, Connecticut. We have additional sales offices and design centers located throughout the world. The following is a summary of our offices and locations for which we have lease commitments:

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Notes

Refer to Note 14—Commitments and Contingencies of our Consolidated Financial Statements for additional disclosures regarding our commitments under lease obligations. Also, refer to Note 13—Restructuring and Asset Impairment Charges of our Consolidated Financial Statements regarding our restructuring charges during fiscal years 2001 through 2003 as we have recorded charges for future rent payments relating to excess office space.

Item 3. Legal Proceedings

We are not party to any material litigation proceedings. However, we are currently prosecuting civil action number 03-10228NG in U.S. District Court in Massachusetts, entitled TranSwitch Corp. v. Galazar Networks, Inc., and are responsible for litigation costs therefrom. We initially asserted that Galazar Networks, Inc. (Galazar) infringed three of our United States patents, and Galazar has alleged that those three patents are not infringed, are invalid and are unenforceable. Currently we are seeking to replace the patent infringement counts with a count for false advertising and unfair competition, and Galazar is seeking to add a counterclaim for antitrust law violation. There can be no assurances that we will be successful in our suit against Galazar or that Galazar will be unsuccessful in its allegations and counterclaims.

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

We did not submit any matters to a vote of our security-holders during the three months ended December 31, 2003.

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PART II

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

Our common stock is traded under the symbol “TXCC” on the Nasdaq National Market. TranSwitch’s common stock was listed on the NASDAQ SmallCap market from October 14, 2002 until July 10, 2003, at which time we resumed trading on the Nasdaq National Market. The following table sets forth, for the periods indicated, the range of high and low closing prices for our common stock. The prices set forth below reflect a 3-for-2 stock split in the form of a dividend effected on June 8, 1999, a 3-for-2 stock split in the form of a dividend effected on January 11, 2000, and 2-for-1 stock split in the form of a dividend effected on August 10, 2000.

As of February 25, 2004 there were approximately 598 holders of record and approximately 30,500 beneficial shareholders of our common stock.

We have never paid cash dividends on our common stock. We currently do not anticipate paying any cash dividend in the foreseeable future. Any future declaration and payment of dividends will be subject to the discretion of our Board of Directors, will be subject to applicable law and will depend upon our results of operations, earnings, financial condition, contractual limitations, cash requirements, future prospects and any other factors deemed relevant by our Board of Directors.

We also have securities authorized for issuance under equity compensation plans. The following table provides information as of December 31, 2003 with respect to shares of our common stock that may be issued under our existing equity compensation plans, including our 1995 Third Amended and Restated Stock Plan (the “1995 Plan”), our 2000 Stock Option Plan (the “2000 Plan”), the 1995 Non-Employee Director Stock Option Plan (the “Non-Employee Director Plan), and the 1995 Employee Stock Purchase Plan (the “Purchase Plan”) as well as the 1995 Stock Plan of Alacrity Communications, Inc. and the 1999 Stock Incentive Plan of Onex Communications Corporation.

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Item 6. Selected Financial Data

The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Item 7 of this Form 10-K. The selected statements of operations data as well as the selected balance sheet data presented below are derived from our consolidated financial statements. Historical periods have been restated to reflect the share-for-share exchange accounted for as a pooling of interests with Easics N.V. in May 2000 and to reflect the change in reporting entity from the cost to the equity method for our investment in OptiX Networks, Inc, and reclassified to reflect the gain on debt extinguishment previously classified as extraordinary to continuing operations in accordance with SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (SFAS 145).

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

Management’s Discussion and Analysis of Financial Conditions and Results of Operations (MD&A) is provided as a supplement to the accompanying consolidated financial statements and footnotes in Item 8 to help provide an understanding of our financial condition, changes in our financial condition and results of operations. The MD&A is organized as follows:

Caution concerning forward-looking statements. This section discusses how certain forward-looking statements made by us throughout the MD&A are based on management’s present expectations about future events and are inherently susceptible to uncertainty and changes in circumstances.

Overview. This section provides a general description of our business.

Critical accounting policies and use of estimates. This section discusses those accounting policies that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application.

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Restatements of prior period results. During fiscal 2002, we restated 2001 results due to a change in reporting entity related to an investment in a non-publicly traded company. This restatement is further described in this section.

Results of operations. This section provides an analysis of our results of operations for the fiscal years ended December 31, 2003, 2002 and 2001. In addition, a brief description is provided of transactions and events that impact the comparability of the results being analyzed.

Liquidity and capital resources. This section provides an analysis of our cash position and cash flows, as well as a discussion of our financing arrangements. In this section, we also summarize related party transactions and recent accounting pronouncements not yet adopted by us.

Factors that may affect future results. In this section, we detail risk factors that affect our quarterly and annual results, but which are difficult to predict.

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that involve risks and uncertainties. When used in this report, the words, “intend”, “anticipate”, “believe”, “estimate”, “plan”, “expect” and similar expressions as they relate to us are included to identify forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of factors, including those set forth under “FACTORS THAT MAY AFFECT FUTURE RESULTS” and elsewhere in this report. You should read this discussion in conjunction with the consolidated financial statements and the notes thereto included in this report.

Overview

We are a Delaware corporation incorporated on April 26, 1988. We design, develop and market highly integrated semiconductor devices that provide core functionality in voice and data communications network equipment deployed in the global network infrastructure. In addition to their high degree of functionality, our products incorporate digital and mixed-signal (analog and digital) processing capabilities, providing comprehensive system-on-a-chip (SOC) solutions to our customers.

Our products are compliant with relevant communications network standards including Asynchronous/Plesiochronous Digital Hierarchy (Asynchronous/PDH), Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH) and Asynchronous Transfer Mode/Internet Protocol (ATM/IP). We offer several products that combine multi-protocol capabilities on a single chip, enabling our customers to develop network equipment for multi-service (voice, data and video) applications. A key attribute of our products is their inherent flexibility. Many of our products incorporate embedded programmable processors, enabling us to rapidly accommodate new customer requirements or evolving network standards.

We bring value to our customers through our communications systems expertise, VLSI design skills and commitment to excellence in customer support. Our innovative skills and technical capabilities enable us to define and develop products that permit our customers to achieve faster time-to-market and to produce communications systems that offer a host of benefits such as greater functionality, improved performance, lower power dissipation, reduced system size and cost and greater reliability.

Critical Accounting Policies And Use Of Estimates

Our consolidated financial statements and related disclosures, which are prepared to conform with accounting principles generally accepted in the United States of America (U.S. GAAP), require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the period reported. We are also required to disclose amounts of contingent assets and liabilities at the date of the consolidated financial statements. Our actual results in future periods could differ from those estimates. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.

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We consider the most critical accounting policies and uses of estimates in our consolidated financial statements to be those surrounding:

(1) revenues, cost of revenues and gross profit;

(2) derivative liability associated with our 5.45% Convertible Plus Cash Notes due 2007;

(3) estimated excess inventories;

(4) estimated restructuring reserves; and

(5) valuation of investments in non-publicly traded companies.

These accounting policies, the bases for these estimates and their potential impact to our consolidated financial statements, should any of these estimates change, are further described as follows:

Revenues, Cost of Revenues and Gross Profit. Net revenues are primarily comprised of product shipments, principally to domestic and international telecommunications and data communications OEMs and to distributors. Net revenues from product sales are recognized at the time of product shipment when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) title and risk of loss transfers to the customer; (3) the selling price is fixed or determinable; and (4) collectibility is reasonably assured. Agreements with certain distributors provide price protection and return and allowance rights. With respect to recognizing revenues from our distributors: (1) the prices are fixed at the date of shipment from our facilities; (2) payment is not contractually or otherwise excused until the product is resold; (3) we do not have any obligations for future performance relating to the resale of the product; and (4) the amount of future returns, allowances, refunds and costs to be incurred can be reasonably estimated and are accrued at the time of shipment. Service revenues are recognized when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) we have performed a service in accordance with our contractual obligations; (3) the fee is fixed or determinable, and (4) collectibility is reasonably assured.

At the time of shipment, we record an expense (and related liability) against our gross product revenues for future price protection and sales allowances. This liability is established based on historical experience, contractually agreed to provisions and future shipment forecasts. We had established liabilities totaling $0.7 million and $1.0 million as of December 31, 2003 and 2002, respectively, for price protection and sales allowances related to shipments that were recorded as revenue during the preceding 12 months. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net revenues, cost of revenues and gross profits.

We also record, at the time of shipment, an expense (and related liability) against our gross product revenues and an inventory asset against product cost of revenues in order to establish a provision for the gross margin related to future returns under our distributor stock rotation program. As of December 31, 2003, we had established a liability of $1.0 million and an inventory asset of $0.5 million for a stock rotation reserve for future estimated returns totaling $0.5 million. This compares to a liability of $0.5 million and an inventory asset of $0.25 million for a stock rotation reserve for future estimated returns totaling $0.25 million as of December 31, 2002. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net revenues, cost of revenues and gross profits.

We warranty our products for up to one year from the date of shipment. A liability is recorded for estimated claims to be incurred under product warranties and is based primarily on historical experience. Estimated warranty expense is recorded as cost of product revenues when products are shipped. As of December 31, 2003 and 2002, we had a warranty liability established in the amounts of $0.3 million and $0.2 million, respectively, which is included in accrued expenses on the consolidated balance sheets. We had no material warranty claims during the year ended December 31, 2003. Should future warranty claims differ from our estimated current liability, there could be adjustments (either favorable or unfavorable) to our cost of revenues. Any adjustments to cost of revenues could also impact future gross profits.

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Derivative Liability Associated with our 5.45% Convertible Plus Cash Notes due 2007. In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (SFAS 133), the auto-conversion make whole provision and the holder’s conversion right (collectively, “the features”) contained in the terms governing our 5.45% Convertible Plus Cash Notes^SM due 2007 (the Plus Cash Notes) were not clearly and closely related to the characteristics of the Plus Cash Notes upon issuance. Accordingly, these features qualified as embedded derivative instruments and, because they do not qualify for any scope exception within SFAS 133, they are required by SFAS 133 to be accounted for separately from the debt instrument and recorded as derivative financial instruments.

During the fourth quarter of 2003, we recorded other income of $2.6 million, of which, $0.8 million and $1.8 million related to the auto conversion make-whole provision and holder’s conversion right, to reflect the change in fair value of our derivative liability, which is shown below:

At each balance sheet date, we adjust the derivative financial instruments to their estimated fair value and analyze the instruments to determine their classification as a liability or equity. As of December 31, 2003, the estimated fair value of our derivative liability was $20.7 million, of which $2.2 million and $18.5 million related to the auto conversion make-whole provision and holder’s conversion right, respectively. The estimated fair value of the auto conversion make-whole provision and holder’s conversion right were determined using the Monte Carlo simulation model and the Black-Scholes option pricing model, respectively. These models use several assumptions including: historical stock price volatility, risk-free interest rates, remaining maturity, and the closing price of our common stock to determine estimated fair value of our derivative liability. We believe that the assumption that has the greatest impact on the determination of fair value is the closing price of our common stock during each quarterly period. Accordingly, we have calculated the fair value of the derivative liability as shown in the following different scenarios below. We have included the change in the fair value of the derivative liability below based on all assumed estimates remaining the same except for our common stock price.

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As of December 31, 2003, these embedded derivative financial instruments were recorded and classified as a derivative liability on our consolidated balance sheet because the daily volume weighted price of our common stock determined according to the voluntary conversion provision was below the threshold price of $2.61 as set forth in the terms of the Plus Cash Notes. Thus, if any holders of the Plus Cash Notes voluntarily converted their Plus Cash Notes, we would have to pay the plus cash amount in cash. Assuming the daily volume weighted price of our common stock remains below the threshold price, this embedded derivative related to the holder’s conversion right will continue to be classified as a liability and adjusted quarterly for changes in fair value during the period of time that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income.

In subsequent periods, if the daily volume weighted price of our common stock determined according to the voluntary conversion provision equals or exceeds the threshold price of $2.61, the embedded derivative financial instrument related to the holder’s conversion right will be adjusted to fair value with the corresponding charge or credit to other expense or income and then reclassified from total liabilities to stockholders’ equity. Changes in fair value during the period of time that any such Plus Cash Notes are outstanding and classified within stockholders’ equity, will be made by a corresponding charge or credit to additional paid-in-capital. The auto-conversion make-whole provision will be adjusted quarterly for changes in fair value during the first two years that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income. The auto-conversion make-whole provision can only be settled with cash and, accordingly, will remain classified as a derivative liability in the consolidated balance sheet.

Estimated Excess Inventories. We periodically review our inventory levels to determine if inventory is stated at the lower of cost or net realizable value. The telecommunications and data communications industries have experienced a significant downturn during the past few years and, as a result, we have had to evaluate our inventory position based on known backlog of orders, projected sales and marketing forecasts, shipment activity and inventory held at our significant distributors. During the fiscal years ended December 31, 2003, 2002 and 2001, respectively, as a result of then current and anticipated business conditions, as well as lower than anticipated demand, we recorded a charge for excess inventories of approximately $1.5 million, $4.8 million and $39.2 million, respectively. Most of these products have not been disposed of and remain in our inventory.

During fiscal 2003, 2002 and 2001, we recorded net product revenues of approximately $8.7 million, $4.8 million and zero respectively, on shipments of excess inventory that had previously been written down to their estimated net realizable value of zero. This resulted in 100% gross margin on these product revenues. Had these products been sold at our historical average cost basis, a 56% gross margin would have been recorded. We currently do not anticipate that a significant amount of the excess inventories subject to the write-downs described above will be used in the future based upon our current demand forecast. Should our actual future demand exceed the estimates that we used in writing down our excess inventories, we will recognize a favorable impact to cost of revenues and gross profits. Should demand fall below our current expectations, we may record additional inventory write-downs which will result in a negative impact to cost of revenues and gross profits.

Estimated Restructuring Reserves. During the fiscal years ended December 31, 2003, 2002 and 2001, we recorded restructuring charges and asset impairments totaling $2.5 million, $3.9 million and $32.5 million, respectively, related to employee termination benefits and costs to exit certain facilities, net of sub-lease benefits. At December 31, 2003 and 2002, the restructuring liabilities were $24.1 and $27.5 million, respectively, on the consolidated balance sheets. Certain assumptions are used by us to derive this estimate, including future maintenance costs, price escalation and sublease income derived from these facilities. Should we negotiate additional sublease rental income agreements or reach a settlement with our lessors to be released from our existing obligations, we could realize a favorable benefit to our results of future operations. Should future lease, maintenance or other costs related to these facilities exceed our estimates, we could incur additional expenses in future periods.

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Valuation of Investments in Non-Publicly Traded Companies. Since 1999, we have been making strategic equity investments in non-publicly traded companies that develop technologies that are complementary to our product road map. Depending on our level of ownership and whether or not we have the ability to exercise significant influence, we account for these investments on either the cost or equity method, and review such investments periodically for impairment. The appropriate reductions in carrying values are recorded when, and if, necessary. The process of assessing whether a particular investment’s net realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investee’s cash position, projected cash flows (both short and long-term), financing needs, most recent valuation data, the current investing environment, management / ownership changes, and competition. This evaluation process is based on information that we request from these privately-held companies. This information is not subject to the same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary. Based on our evaluations, we recorded impairment charges related to our investments in non-publicly traded companies of $1.5 million, $8.7 million and zero during the fiscal years ended December 31, 2003, 2002 and 2001, respectively. The total investment in non-public companies was $0.6 million and $2.0 million as of December 31, 2003 and 2002, respectively, on our consolidated balance sheets. We used the modified equity method of accounting to determine the impairment loss for certain investments, as it was determined that no better current evidence of the value of our cost method investments existed and we believe that this gives us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss on a cost method investment equal to the investor’s proportionate share of the investee’s losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investor’s investment.

RESTATEMENTS OF PRIOR PERIOD RESULTS

Accounting principles generally accepted in the United States of America (U.S. GAAP) requires retroactive restatement where an equity investment previously accounted for under the cost method of accounting qualifies for use of the equity method. We have restated prior period results to reflect the change from the cost to the equity method of accounting for our investment in OptiX Networks, Inc. (OptiX) as we obtained the ability to significantly influence the operating and financial policies of OptiX during the third quarter of fiscal 2002 through our investments in convertible preferred stock and convertible debt. This restatement reduced the investment balance in OptiX (included in investments in non-publicly traded companies on the consolidated balance sheets), as if accounted for on the equity method since inception and we reflected our pro-rata share of equity in net losses of OptiX. The amounts reflecting equity in net losses of affiliates were recorded on the consolidated statement of operations for the prior periods reported. Refer also to Note 5—Investments in Non-Publicly Traded Companies in our Consolidated Financial Statements.

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RESULTS OF OPERATIONS

The results of operations that follow should be read in conjunction with our critical accounting policies and estimates summarized above as well as our consolidated financial statements and notes thereto contained in Item 8 of this report. The following table sets forth certain consolidated statements of operations data as a percentage of net revenues for the periods indicated.

Comparison of Fiscal Years 2003 and 2002

Net Revenues. The following tables summarizes our net product revenue mix by product line for the years ended December 31, 2003 and 2002 (dollar amounts in thousands), respectively:

The increase in revenues for 2003 compared to 2002 is primarily due to increased volume shipments in our SONET/SDH and ATM/IP product lines. The increase in volume in our SONET/SDH product line can be attributed to overall increased demand as well as inventory depletion in the distribution channel. As inventory is being consumed, customers are placing new orders to meet their end demand. The increase in our ATM/IP product line can be attributed primarily to an increase in the volume of shipments of our ASPEN product, which serves the DSLAM market, where there has been an increase in equipment deployments in 2003.

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Given the limited visibility in the current market, we cannot predict when, and to what extent, historical revenue levels or product mix percentages will return, if at all. Included in total net revenues is service revenues consisting of design services performed for third parties on a short-term contract basis. Service revenues are not our primary strategic focus and, as such, will fluctuate up or down from period to period, depending on business priorities.

International net revenues represent approximately 72% of net revenues compared with approximately 59% of net revenues for the years ended December 31, 2003 and 2002, respectively. The increase is attributed to increased volume shipments into Europe and China as customer demand for our products increased and excess inventory decreased. Refer also to Note 8—Segment Information and Major Customers in our Consolidated Financial Statements, which summarizes revenue by country.

Gross Profit. The following table presents the impact to gross profit of the excess inventory charges and benefits for the years ended December 31, 2003 and 2002, respectively:

The increase in gross margins is due in part to lower charges for excess inventory in 2003 of $1.5 million versus $4.8 million in the prior year, as well as an increase in the shipments of previously written down inventory. Excluding the charges for excess inventories as well as the benefit from sales of previously written down inventory in fiscal 2003, gross profit for 2003 increased by $4.9 million, or 58%. The increase in gross profit dollars for the year ended December 31, 2003 is the result of higher total net revenues which in turn resulted from a more favorable product mix over the prior year.

We anticipate that gross profit will continue to be impacted by fluctuations in the volume and mix of our product shipments as well as material costs, yield and the fixed cost absorption of our production operations.

Research and Development. Research and development expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, costs related to electronic design automation tools, subcontracting and fabrication costs, depreciation and amortization and facilities expenses. The decrease in research and development expense for 2003 compared to 2002 is primarily attributable to payroll and related benefits, depreciation and amortization, and facilities expenses. This decrease is a result of streamlining and prioritizing our product development efforts and the effects of our workforce reductions. We believe that continued investment in the design and development of future products is vital to maintain a competitive edge. We have monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001, one during fiscal 2002 and one during fiscal 2003. We will continue to closely monitor both our costs and our revenue expectations in future periods. We will continue to balance our spending in this area with meeting our customer requirements and will take actions as market conditions dictate.

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Marketing and Sales. Marketing and sales expenses consist primarily of personnel-related expenses, trade show expenses, travel expenses and facilities expenses. The decrease in marketing and sales expenses for 2003 compared to 2002 is primarily attributable to headcount reductions, which decreased payroll, commissions and related benefit expenses. There is also a decrease in travel related expenses as we continued to reduce our discretionary spending during 2003. We have monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001, one during fiscal 2002 and one during fiscal 2003. We will continue to closely monitor both our costs and our revenue expectations in future periods. We will continue to balance our spending in this area with meeting our customer requirements and will take actions as market conditions dictate.

General and Administrative. General and administrative expenses consist primarily of personnel-related expenses, professional and legal fees and facilities expenses. The decrease in general and administrative expenses for 2003 compared to 2002 is primarily due to lower professional fees and savings on facility and other related charges realized from our restructuring actions. We have monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001, one during fiscal 2002 and one during fiscal 2003. We will continue to closely monitor both our costs and our revenue expectations in future periods. We will continue to balance our spending in this area with meeting our customer requirements and will take actions as market conditions dictate.

Impairment of Goodwill. During 2002, we performed our impairment test for the goodwill related to our one reporting unit as required by SFAS 142. We determined that all of our goodwill was impaired during 2002 because of the significant decline in our common stock price and our related market capitalization, which was used to determine the fair value of our one reporting unit. Accordingly, we recorded a charge of $59.9 million during 2002 and wrote off all of our goodwill. During 2003, we did not record any additional goodwill.

Restructuring Charges and Asset Impairments. In January 2003, we announced a restructuring plan in order to lower our operating expense run-rate due to then current and anticipated business conditions. This plan resulted in a work-force reduction of approximately 24% of existing personnel. Also, we announced the closing of our South Brunswick, New Jersey (SOSi) design center, and the reduction of staff in Bedford, Massachusetts and Shelton, Connecticut. This workforce reduction also impacted our Switzerland and Belgium locations. In addition, we have postponed the completion of the IAD product line and archived the related intellectual property until that market returns, if ever. During the year ended December 31, 2003, we incurred approximately $3.4 million in restructuring expenses related to employee termination benefits and $0.5 million related to excess facility costs. In addition, we recorded a charge for fixed assets that were impaired with a net book value totaling $0.3 and a patent on our IAD product line with a net book value of $0.2 million. This resulted in a total restructuring and asset impairment charge for the year ended December 31, 2003 totaling $4.4 million. This restructuring charge is partially off set by a benefit of $1.9 million realized, as we were able to sub-lease portions of our excess facilities, for a net restructuring expense for the year ended December 31, 2003 of $2.5 million. We do not anticipate any significant additional charges related to employee termination benefits. We estimate that there will be future adjustments to our liability for future lease payments as market conditions change. We estimate future operating expense savings related to this plan to be approximately $8.3 million of personnel costs and $0.3 million of facility costs for total annual savings of approximately $8.6 million. However, there can be no assurances that future events will not cause the actual savings to rise or fall in future periods.

During the year ended December 31, 2002, we announced a restructuring plan due to then current and anticipated business conditions. As a result of this plan, we eliminated fifty-six positions and announced the closing of our design centers in Milpitas, California and Raleigh, North Carolina. In conjunction with this restructuring, we discontinued the AsTriX and Sertopia product lines and strategically refocused our research and development efforts. This plan resulted in employee termination benefits of $2.4 million and costs to exit facilities of $3.1 million for a total restructuring expense of approximately $5.5 million recorded on the consolidated statement of operations. Restructuring charges for the year ended December 31, 2002 were $3.9 million as we recognized a restructuring benefit of approximately $1.6 million related to the sublease of a portion of our unused excess facilities.

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We will continue to closely monitor both our costs and our revenue expectations in future periods and will take actions as market conditions dictate.

In-Process Research and Development. During the year ended December 31, 2003, we recorded a charge for In-Process Research and Development (IPR&D) of $0.5 million related to the purchase of ASIC Design, Inc. (ADS).

At the time of acquisition, ADS had one project that qualified for IPR&D activities, which is referred to as the VTXP chip. The project was started concurrently with ADS’s inception in 2002 and is scheduled for its first release during 2004.

The $0.5 million allocated to IPR&D in fiscal 2003 was determined through an independent valuation using established valuation techniques in the telecommunications and data communications industries. The value allocated to IPR&D was based upon the forecasted operating after-tax cash flows from the technology acquired, giving effect to the stage of completion at the acquisition date. Future cash flows were adjusted for the value contributed by any core technology and development efforts expected to be completed post acquisition. These forecasted cash flows were then discounted at rates commensurate with the risks involved in completing the acquired technologies, taking into consideration the characteristics and applications of each product, the inherent uncertainties in achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. A project’s risk is the highest at its inception. As the project progresses, the risk of a project generally decreases. As of the acquisition date, the VTXP chip was still in its initial stages of development. After considering these factors, the risk-adjusted discount rates for the VTXP chip product was determined to be 50%. As this acquired technology had not yet reached technological feasibility and for which no alternative future uses existed, it was expensed upon acquisition in accordance with FASB issued Statement No. 2, “Accounting for Research and Development Costs.”

During the year ended December 31, 2002, we recorded a charge for IPR&D of $2.0 million related to our purchase of Systems On Silicon, Inc. (SOSi) on March 27, 2002. This transaction was recorded in the first quarter of fiscal 2002.

Impairment of Investments in Non-Publicly Traded Companies. During 2003 and 2002, we reduced the carrying value of our investments (including bridge loans) in non-publicly traded companies as follows (in thousands):

During the year ended December 31, 2003, we impaired our remaining convertible bridge loan investment in Intellectual Capital for Integrated Circuits, Inc. (IC4IC) totaling $0.05 million as this company ceased all operations. In addition, we impaired our remaining investments in convertible preferred stock and convertible debt in Accordion based on review of impairment indicators listed below.

During the years ended December 31, 2003 and 2002, as a result of industry conditions, we determined that there were indicators of impairment to the carrying value of our investments in non-publicly traded companies.

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The process of assessing whether a particular investment’s net realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investee’s cash position, projected cash flows (both short and long-term), financing needs, most recent valuation data, the current investing environment, management/ownership changes, and competition. This evaluation process is based on information that we request from these privately held companies. This information is not subject to the same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary.

During the years ended December 31, 2003 and 2002, we used the modified equity method of accounting to measure the impairment loss for our investments in non-publicly traded companies as we determined that no better current evidence of the value of our cost method investments existed. We believe that this measurement process gives us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss on a cost method investment equal to the investor’s proportionate share of the investee’s losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investor’s investment.

In addition, we also evaluated all outstanding bridge loans pursuant to SFAS 114, “Accounting by Creditors for Impairment of a Loan” (SFAS 114) that we had not already impaired under the modified equity method of accounting. Under SFAS 114, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.

The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.

We will continue to periodically review all of our investments in non-publicly traded companies for impairment in future periods. There can be no assurances that future impairment charges will not be necessary.

Equity in Net Losses of Affiliates. The decrease in equity losses in 2003 is due to lower overall net losses at OptiX in fiscal 2003 compared to the same period in 2002. In addition, during the year ended 2003, we terminated our investment relationship with GTV and received, as a return of capital, the remaining balance of our investment in GTV of approximately $0.9 million. As a result, equity losses in GTV ceased after the first quarter of 2003.

Prior to June 30, 2002, we had been accounting for our investment in OptiX under the cost method. However, during the third quarter of fiscal 2002, in connection with a bridge loan of $4.0 million that is convertible to convertible preferred stock upon OptiX closing its next round of financing, we obtained the ability to exercise significant influence over the financial and operating policies of OptiX, and as a result, switched to the equity method of accounting for our investment in Optix. All prior period financial information has been retroactively restated to reflect this change (refer also to Note 1—Summary of Significant Accounting Policies of our Consolidated Financial Statements for additional disclosure). During 2003, we continued to account for OptiX under the equity method of accounting.

Equity in net losses of affiliates will continue to be a component of our other (expense) income in future periods and amounts will fluctuate depending primarily on the business results of OptiX.

Change in Fair Value of the Derivative Liability. For the year ended December 31, 2003 we recorded other income of approximately $2.6 million to reflect the change in the fair value of the derivative liability resulting from issuance of the 5.45% Convertible Plus Cash Notes due 2007 (refer to Note 12—Convertible Notes of our Consolidated Financial Statements).

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Gain from the Exchange and Repurchase of our 4.50% Convertible Notes due 2005. During the year ended December 31, 2003, we did not repurchase any 4.50% Convertible Notes due 2005 (4.50% Notes). However, on September 30, 2003, we completed the exchange offer with and new money offering to the holders of our 4.50% Notes. We issued $98.0 million aggregate principal amount of 5.45% Convertible Plus Cash Notes_SM due September 30, 2007 (Plus Cash Notes), which represented $74.0 million of Plus Cash Notes issued in exchange for $89.7 million in principal amount of our 4.50% Notes tendered in the exchange offer and $24.0 million of Plus Cash Notes sold for cash. We recorded a gain on the exchange of approximately $14.5 million, which is calculated as follows:

During the year ended December 31, 2002, we repurchased, through a tender offer, approximately $199.9 million face value of our outstanding 4.50% Notes for a cash payment of $139.9 million. This resulted in a gain of $52.0 million, net of transaction costs, $4.8 million in deferred financing fees related to these notes and approximately $19.5 million recorded as income tax expense. Prior to fiscal year 2003, this gain had been classified as extraordinary on the consolidated statement of operations. However, we adopted SFAS No. 145 “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” effective January 1, 2003, which requires gains from the extinguishment of debt to be included in results from continuing operations. Accordingly, we have reclassified the gains related to the early extinguishment of some of the 4.50% Notes and the related deferred financing fees and income taxes that were previously recorded in the consolidated statements of operations as an extraordinary item to other (expense) income and income tax expense, respectively.

Interest (Expense) Income, net. At December 31, 2003 and 2002, the effective interest rates on our interest-bearing securities were approximately 1.37% and 2.15%, respectively. Therefore, the increase in interest expense in fiscal 2003, net is due to lower interest income as a result of a lower average cash balance and lower interest rates during fiscal 2003 compared to fiscal 2002.

Income Tax Expense. The decrease in income tax expense in fiscal 2003 was due to the recording of an additional valuation allowance of $61.4 million during fiscal 2002 to reduce the carrying value of deferred tax assets. During fiscal 2003 and 2002, we evaluated our deferred tax assets as to whether it is “more likely than not” that the deferred tax assets will be realized. In our evaluation of the realizability of deferred tax assets, we considered projections of future taxable income, the reversal of temporary differences and tax planning strategies. We have evaluated and determined that it is not “more likely than not” that all of the deferred tax assets will be realized. Accordingly, a valuation reserve was recorded in 2002 against all of our net deferred tax assets, which we increased during 2003 primarily for our 2003 net operating loss. In future periods, we will not recognize a deferred tax benefit and will maintain a deferred tax valuation allowance until we achieve sustained taxable income. Additionally, in the future, we expect our current income tax expense to be related to taxable income generated by our foreign subsidiaries.

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The following table summarizes the differences between the U.S. federal statutory rate and our effective income tax rate on continuing operations for financial statement purposes for the years ended December 31, 2003 and 2002, respectively:

Extraordinary Loss Upon Consolidation of TeraOp (USA), Inc. In January 2003, FIN No. 46 “Consolidation of Variable Interest Entities “ (FIN 46) was issued. The interpretation provides guidance on consolidating variable interest entities and applies to all variable interests in variable interest entities created after January 31, 2003. The interpretation requires variable interest entities to be consolidated if the equity investment at risk is not sufficient to permit an entity to finance its activities without support from other parties or if the equity investors lack certain specified characteristics. We applied the provisions of FIN 46 to our investment in TeraOp (USA), Inc. (TeraOp) as of February 1, 2003, which required us to consolidate the results of TeraOp.

During the first quarter of 2003, we loaned TeraOp $0.5 million under a new convertible loan agreement, which provides us with additional contractual rights over existing debt or equity investors. In addition, we are also in a position, as a result of the loan, to negotiate a more favorable conversion price of the equity securities of TeraOp and have the ability to control the operations of TeraOp. None of the existing debt or equity investors, other than us, is expected to, or is obligated to, absorb any additional losses from their investment given that the equity in TeraOp was negative as of January 31, 2003. As a result, the convertible loan has been determined to be a variable interest and TeraOp is now considered a variable interest entity, as defined by FIN 46. We have calculated the effect of the initial measurement as of January 31, 2003. As a result of this measurement and consolidation of TeraOp, we recognized an extraordinary loss of approximately $0.1 million, as the fair value of TeraOp’s liabilities exceeded its assets by this amount. All significant intercompany balances, including our investments in TeraOp, have been eliminated upon consolidation.

Cumulative Effect on Prior Years of Retroactive Application of New Depreciation Method. Effective January 1, 2003, we changed the method of depreciating property and equipment to the straight-line method. Depreciation of property and equipment in prior years was computed using the half-year convention method. We evaluated the use and related consumption of all classes of acquired property and equipment. We have determined that many of our assets are used and consumed on a consistent level over their estimated economic lives. Under the half-year convention method, property and equipment placed in service during the first year of acquisition was subject to six months of depreciation expense regardless of when the asset was acquired, placed in service and consumed. We believe that the straight-line method results in a better approximation of the underlying consumption of the asset over its estimated useful life and provides a better matching of revenues and expenses. The effect of the change in depreciation method as of January 1, 2003 was applied retroactively to property and equipment acquisitions of prior years. The cumulative effect of the change with respect to the retroactive application of the straight-line method is approximately a $0.8 million charge and has been recorded as such on the consolidated statement of operations for the year ended December 31, 2003. This charge has not been presented net of income taxes as we continue to maintain a full valuation allowance against our net deferred income tax assets.

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Comparison of Fiscal Years 2002 and 2001

Net Revenues. The following table summarizes our net product revenue mix by product line for the years ended December 31, 2002 and 2001 (dollar amounts in thousands):

The decrease in our revenue in 2002 compared to 2001 was primarily related to a decline in volumes shipped over the prior comparable period resulting from an overall economic downturn and significant excess capacity in the telecommunications and data communications industries.

Included in total net revenues were service revenues consisting of design services performed for third parties on a short-term contract basis. Service revenues are not our primary strategic focus and, as such, will fluctuate up or down from period to period, depending on business priorities. Approximately 33% of service revenues during fiscal 2002 were from OptiX Networks, Inc. (OptiX), a related party. We obtained significant influence over the financial and operating policies of OptiX during the year ended December 31, 2002. As a result we switched to the equity method of accounting for this investment and did not recognize revenue on any services performed for OptiX after March 30, 2002. Refer also to Note 5—Investments in Non-Publicly Traded Companies of our Consolidated Financial Statements.

International net revenues represented approximately 59% of net revenues for the year ended December 31, 2002 compared with approximately 69% of net revenues for the year ended December 31, 2001. The decrease in international revenues as a percent of total revenues in fiscal 2002 was due to a greater marketing focus on domestic customers than international during the fiscal year. Refer also to Note 8—Segment Information and Major Customers in our Consolidated Financial Statements, which summarizes revenue by country.

Gross Profit. The following table presents the impact to gross profit (loss) of the excess inventory charges and benefits for the years ended December 31, 2002 and 2001, respectfully:

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The increase in gross profit in fiscal 2002 was due in large part to charges that we took against cost of revenues in fiscal 2001 for excess inventories ($39.2 million) versus much lower charges taken during fiscal 2002 ($4.8 million). Gross profit percentage (excluding excess inventory charges and benefits) for the year ended December 31, 2002 was 51% compared to 64% for the year ended December 31, 2001. This decrease in gross profit percentage was due to the change in product mix over the prior year and the excess capacity absorption due to lower product volumes causing our average inventory cost to increase compared to the prior year.

Research and Development. The increase in research and development expenses in fiscal 2002 was the result of acquisitions during the first quarter of 2002 and the second half of 2001 and continued investment in personnel, electronic design automation software tools and intellectual property cores, as well as fabrication costs and depreciation expense in connection with developing next generation telecommunication and data communication products. As a percentage of total net revenues, our research and development costs increased as we continued investing in the design and development of future products notwithstanding the fact that product shipments declined due to adverse industry conditions. We monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001 and one during fiscal 2002.

Marketing and Sales. The decrease in marketing and sales expenses for the year ended December 31, 2002 was primarily attributed to a decrease in commissions due to the decrease in revenues over the same period in 2001. Also contributing to this decrease was a reduction in our allowance for doubtful customer accounts by approximately $1.1 million for the year ended December 31, 2002. During fiscal 2002, we experienced improved collections on certain customer accounts receivable that we had previously reserved. We monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001 and one during fiscal 2002.

General and Administrative. The decrease in general and administrative expenses for the year ended December 31, 2002 was primarily due to lower professional fees and savings realized from restructuring actions. As a percentage of total net revenues, our general and administrative costs increased in fiscal 2002 since the fixed components of these costs do not fluctuate with total net revenues. We monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001 and one during fiscal 2002.

Amortization of Goodwill. The decrease in amortization of goodwill expense was related to our adoption of SFAS 141 on July 1, 2001 and SFAS 142 on January 1, 2002, at which time all future amortization of goodwill ceased.

Impairment of Goodwill. As required by SFAS 142, we performed an initial impairment review of our goodwill balance as of January 1, 2002 upon the adoption of SFAS 142. Under SFAS 142, goodwill impairment is deemed to exist if the net asset value of a reporting unit exceeds its estimated fair value. Through this impairment analysis, we determined that as of January 1, 2002, there was no impairment to the carrying value of goodwill. We operate within a single reporting unit and therefore no goodwill is allocated.

We were also required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. We determined that there were indicators of impairment to the carrying value of goodwill during the quarter ended September 30, 2002 as a result of industry conditions. Accordingly, we performed an impairment review of our goodwill in accordance with SFAS 142 and, as a result, recorded a goodwill impairment charge of $59.9 million during the quarter ended September 30, 2002 to reduce the carrying value of goodwill to zero. The amount of goodwill impairment primarily reflected the decline in our stock price during 2002 and related market capitalization. There were no impairments of goodwill in the prior year.

Restructuring Charges and Asset Impairments. During the year ended December 31, 2002, we announced a restructuring plan due to current and anticipated business conditions. As a result of this plan, we eliminated

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fifty-six positions and announced the closing of our design centers in Milpitas, California and Raleigh, North Carolina. In conjunction with this restructuring, we discontinued the AsTriX and Sertopia product lines and strategically refocused our research and development efforts. This plan resulted in employee termination benefits of $2.4 million and costs to exit facilities of $3.1 million for a total restructuring expense of approximately $5.5 million recorded on the consolidated statement of operations. Restructuring charges for the year ended December 31, 2002 were $3.9 million as we recognized a restructuring benefit of approximately $1.6 million related to the sublease of a portion of our unused excess facilities.

During the year ended December 31, 2001 we announced two restructuring plans due to current and anticipated business conditions. As a result of these plans, we eliminated seventy-seven positions and announced the closing of our design centers and certain facilities in Connecticut and Massachusetts. These plans resulted in employee termination benefits of $3.3 million, costs to exit facilities of $28.6 million and asset impairments of $0.6 million for a total restructuring and asset impairment expense of approximately $32.5 million.

In-Process Research and Development. During the year ended December 31, 2002, we recorded a charge for In-Process Research and Development (IPR&D) of $2.0 million related to our purchase of Systems On Silicon, Inc. (SOSi) on March 27, 2002.

At the time of acquisition, SOSi was in the process of developing the Intelligent Integrated Access Device (IAD) chip. The project was started concurrently with SOSi’s inception in 1999 and was scheduled to be released in the first quarter of 2003. The IAD chip was intended to be the enabling solution to service the last mile in voice and data access. The IAD chip provides a system on a chip (SoC) solution. The IAD chip was intended to serve the need for existing incumbent local exchange carrier (ILEC) legacy networks. Its telephone features would have included voice activity detection, silence suppression and comfort noise generation. Subsequent to December 31, 2002, we announced a restructuring plan that included a workforce reduction and facility closings. Included in this plan was the closing of the SOSi design center. In addition, we postponed the completion of the IAD product line and archived the intellectual property until the market returns, if ever.

The $2.0 million allocated to IPR&D was determined using established valuation techniques in the telecommunications and data communications industries. The value allocated to IPR&D was based upon the forecasted operating after-tax cash flows from the technology acquired, giving effect to the stage of completion at the acquisition date. Future cash flows were adjusted for the value contributed by any core technology and development efforts expected to be completed post acquisition. These forecasted cash flows were then discounted at rates commensurate with the risks involved in completing the acquired technologies, taking into consideration the characteristics and applications of each product, the inherent uncertainties in achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. A project’s risk is the highest at its inception. As the project progresses, the risk of a project generally decreases. As of the acquisition date, the IAD chip was still in the initial stages of development. After considering these factors, the risk adjusted discount rate for the IAD chip product was determined to be 65%. The acquired technology that had not yet reached technological feasibility and had no alternative future uses was expensed upon acquisition in accordance with SFAS No. 2, “Accounting for Research and Development Costs”.

During the third quarter of fiscal 2001, we recorded a charge for in-process research and development of $22.0 million related to our purchase of Onex Communications Corporation in September 2001.

Impairment of Investments in Non-Publicly Traded Companies. As a result of industry conditions, we determined that there were indicators of impairment to the carrying value of our investments in OptiX Networks, Inc. (OptiX), TeraOp (USA), Inc. (TeraOp), Intellectual Capital for Integrated Circuits, Inc. (IC4IC), and Accordion Networks (Accordion) during the year ended December 31, 2002. The process of assessing whether a particular investment’s net realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully considered the investee’s cash position, projected cash flows

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(both short and long-term), financing needs, most recent valuation data, the current investing environment, management/ownership changes, and competition. This evaluation process was based on information that we requested from these privately held companies. This information is not subject to the same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary. During fiscal 2002, we used the modified equity method of accounting to measure the impairment loss for TeraOp, IC4IC and Accordion as we determined that no better current evidence of the value of our cost method investments existed and we believed that this would gives us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss on a cost method investment equal to the investor’s proportionate share of the investee’s losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investor’s investment.

In addition, we also evaluated all outstanding bridge loans under SFAS 114, “Accounting by Creditors for Impairment of a Loan” (SFAS 114) that we had not already impaired under the modified equity method of accounting. Under SFAS 114, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.

The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.

During 2002, we reduced the carrying value of our investments (including bridge loans) in non-publicly traded companies as follows (in thousands):

There were no impairments of investments in non-publicly traded companies during the year ended December 31, 2001.

Equity in Net Losses of Affiliates. We account for our investments in GTV Capital, L.P. (GTV) and OptiX under the equity method of accounting. Under the equity method, our pro-rata share of the net income or losses from the investee companies are recorded on the consolidated statement of operations and, accordingly, the investment’s carrying value is adjusted on the consolidated balance sheet.

Prior to June 30, 2002, we had been accounting for our investment in OptiX under the cost method. However, during the third quarter of fiscal 2002, in connection with a bridge loan of $4.0 million that is convertible to convertible preferred stock upon OptiX closing its anticipated round of financing, we obtained the ability to exercise significant influence over the financial and operating policies of OptiX, and as a result, switched to the equity method of accounting for our investment in Optix. Approximately $3.5 million of this $4.0 million bridge loan was drawn upon as of December 31, 2002. All prior period financial information was retroactively restated to reflect this change in reporting entity (refer also to Note 1—Summary of Significant Accounting Policies of our Consolidated Financial Statements for additional disclosure).

Our pro-rata share of equity losses in GTV and OptiX were $3.4 million for the year ended December 31, 2002, collectively, compared with $2.0 million for year ended December 31, 2001. The increase in equity losses was due to our increased investment in OptiX coupled with an increase in OptiX net losses in fiscal 2002.

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Interest (Expense) Income, net. Interest (expense) income, net for the year ended December 31, 2002 decreased by $4.4 million, or 167%, compared to the year ended December 31, 2001. The decrease in interest (expense) income, net was due to a lower average cash balance and lower interest rates during fiscal 2002 compared to fiscal 2001. The decrease in interest income was partially offset by lower interest expense because we repurchased approximately $200 million face value of our 4.50% Convertible Notes due 2005 during the first quarter of 2002. At December 31, 2002 and 2001, the effective interest rates on our interest-bearing securities were approximately 2.15% and 3.52%, respectively.

Income Tax Expense (Benefit). The increase in income tax expense for the year ended December 31, 2002 was due to the recording of an additional valuation allowance of $61.4 million during the year ended December 31, 2002 to reduce the carrying value of our deferred tax assets. We continually evaluate our deferred tax assets as to whether it was “more likely than not” that the deferred tax assets would be realized. In the evaluation of the realizability of deferred tax assets, we consider projections of future taxable income, the reversal of temporary differences and tax planning strategies. We evaluated and determined that it was not “more likely than not” that all of the deferred tax assets would be realized. Accordingly, a valuation reserve was recorded against substantially all of our net deferred tax assets. In future periods, we will not recognize a deferred tax benefit and will maintain deferred tax valuation allowance until we achieve sustained taxable income.

The following table summarizes the differences between the U.S. federal statutory rate and our effective income tax rate on continuing operations for financial statement purposes for the years ended December 31, 2002 and 2001, respectively:

Gain on Repurchase of our 4.50% Convertible Notes due 2005. For the year ended December 31, 2002, we recognized a gain of $52.0 million and approximately $19.5 million recorded as income tax expense compared to a gain of $35.3 million and approximately $13.2 million recorded as income tax expense for the year ended December 31, 2001. This increase was due to repurchasing a higher face value of convertible notes ($199.9 million) during 2002 than the face value of convertible notes ($145.9 million) repurchased during 2001.

Prior to fiscal year 2002, this gain had been classified as extraordinary on the consolidated statement of operations. However, we adopted SFAS No. 145 “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” effective January 1, 2003, which requires gains from the extinguishment of debt to be included in results from continuing operations. Accordingly, we reclassified the gains on the early extinguishment of debt and the related deferred financing fees and income taxes that were previously recorded in the consolidated statements of operations as an extraordinary item to other (expense) income and income tax expense, respectively.

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LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2003, we had total cash, cash equivalents and investments (marketable securities) of approximately $179.4 million. This is our primary source of liquidity, as we are not currently generating positive cash flow from our operations. Details of our cash inflows and outflows for the year ended December 31, 2003 as well as a summary of our cash, cash equivalents and investments and future commitments are detailed as follows:

Cash Inflows and Outflows

During the year ended December 31, 2003, the net decrease in cash and cash equivalents was $7.6 million compared to a net decrease of $219.7 million during the year ended December 31, 2002. As reported on our consolidated statements of cash flows, our decrease in cash and cash equivalents during the years ended December 31, 2003 and 2002 is summarized as follows (in thousands):