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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2003

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

For the transition period from                      to                     

Commission File Number: 0-30757

Sunrise Telecom Incorporated

(Exact name of Registrant as specified in its charter)

302 Enzo Drive, San Jose, California 95138

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (408) 363-8000

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

None

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

Common Stock, par value $0.001 per share

(Title of class)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

    Yes x     No ¨

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12B-2).

    Yes ¨     No x

As of June 30, 2003, the aggregate market value of the Common Stock of the Registrant held by non-affiliates was $34,703,436.

As of February 27, 2004, there were 50,253,134 shares of the Registrant’s Common Stock outstanding, par value $0.001 per share.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the 2004 Annual Meeting of Stockholders are incorporated by reference in Part III.

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SUNRISE TELECOM INCORPORATED

Index to Annual Report on Form 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

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Forward-Looking Statements

This report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding possible growth in the market for telecommunications test equipment and new product development. Except for historical information, the matters discussed in this report on Form 10-K are forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected due to certain factors, including those discussed below in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results” and elsewhere in this report. You should not rely solely on any forward-looking statements in this report to support an investment decision. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report on Form 10-K.

PART I.

ITEM 1.    BUSINESS

OVERVIEW

We manufacture and market service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, and internet networks. Our products offer broad functionality, leading edge technology, and compact size to test broadband services; these include wireline access services (including DSL), fiber optics, cable broadband networks, and signaling networks. We design our products to maximize technicians’ effectiveness in the field and to provide realistic network simulations for equipment manufacturers to test their products. Our customers include incumbent local exchange carriers, cable companies, competitive local exchange carriers, and other service providers, network infrastructure suppliers, and installers throughout North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region.

In October 1991, we were incorporated in California as Sunrise Telecom, Inc. In July 2000, we reincorporated in Delaware and changed our name to Sunrise Telecom Incorporated (“Sunrise”). “Sunrise Telecom,” “SunSet,” and “SunLite” are trademarks of Sunrise Telecom Incorporated. This report on Form 10-K also includes references to registered service marks and trademarks of other entities.

INDUSTRY BACKGROUND

High-Speed Data Access

Data traffic in the United States and Canada has surpassed the amount of voice traffic carried on the existing telephone network. Consumers are seeking higher-speed access to bandwidth intensive content and services, such as highly graphical Web sites and audio, video, and software downloads. As an increasing number of Internet users access more and different content, the ability to connect to and receive data from the Internet at high speeds has become and will continue to become more important.

One primary investment area is the redesign of the access network to support broadband access to end users. This portion of the network between the customer’s premise and the service provider’s central office is also known as the “last-mile.” The last mile typically consists of copper wires that operate at substantially lower transmission speeds than those offered in the long-haul segment of a network or by some available broadband alternatives. These copper wires were originally intended to carry only analog circuit-switched, low-speed voice signals and, as a result, have become a bottleneck that limits high-speed data transmission. Several access technologies are being deployed to support higher-

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speed Internet access in the networks, including digital subscriber lines, digital cable broadband, fiber optics, and broadband wireless. In addition, the signaling portion of the network is essential to the integration of new broadband services into the existing telecommunications network. We summarize some of these technologies below.

Wireline Access Technology.    Wireline access technology includes such technologies as “Plain Old Telephone Service” (“POTS”), T-carrier, E-carrier, ISDN, and digital subscriber line technology. Digital subscriber line technology, commonly known as DSL, today transmits data up to 50 times faster than a conventional dial-up modem over a POTS line using the existing copper telephone wires. Various implementations of DSL are being developed and deployed, including asymmetric DSL, known as ADSL, symmetric DSL, know as SDSL, high bit-rate DSL, known as HDSL, and integrated services digital network DSL, known as IDSL. Service providers deploying DSL technology include incumbent local exchange carriers, such as SBC Communications Inc., Verizon Communications Inc., and Sprint Corporation.

Cable Broadband Networks.    Cable broadband operators use two-way cable, cable modems installed in the home, cable modem termination systems installed at major cable concentration points, and network headend equipment designed to connect their cable broadband networks to video feeds and other networks. Several cable companies are currently offering broadband access services across two-way cable, including Comcast, Charter Communications, Cox, and TimeWarner Cable.

Fiber Optics.    Fiber optic cables use pulses of light to transmit digital information. Because fiber optic cables support thousands of high-speed, local digital connections onto a single higher-speed connection to the central office or the central side of the cable broadband network where the video signals emanate, they offer virtually unlimited bandwidth capacity. Due to their high capacity, fiber optic cables are being used increasingly in the access network in both telecommunications and cable broadband applications. Today, fiber optic cables carry higher bandwidths by increasing the wavelength modulation speed from 2.5 Gbps or by carrying multiple wavelengths on a single fiber. Common wavelength multiplexing schemes include Coarse Wavelength Division Multiplexing (CWDM) and Dense Wavelength Division Multiplexing (DWDM).

Signaling.    Telephone systems require a signaling mechanism to set up and tear down phone calls. These signals serve functions such as supervising or monitoring the status of a line or circuit to see if it is busy, idle, or requesting service; alerting or indicating the arrival of an incoming call; and addressing or transmitting routing and destination signals over the network. Signaling System 7, or SS7, is the standard signaling system used by telecom networks worldwide. Signaling networks must support new access technologies to ensure interoperability with the existing telephone network.

The Need for Service Verification Equipment

In order to successfully deploy and maintain broadband networks, service providers rely on sophisticated service verification equipment. This equipment allows service providers to pre-qualify facilities for services, verify proper operation of newly installed services, and diagnose problems. In addition, equipment manufacturers use service verification equipment to test simulated networks during equipment development and verify the successful production of equipment. Service verification equipment can be grouped into the following three types: field verification, remote testing, and alarm and surveillance.

Field Verification Equipment.    Field verification equipment is used by service providers to probe the actual wires, cables, or airwaves to verify that a service works. In the case of a service malfunction, a field technician can use the equipment to locate the exact fault so that repairs can be made. Research and development labs, manufacturing departments, and central office technicians also use field verification equipment in their day-to-day operations. Of the three types of service verification equipment, field verification equipment delivers the most detailed service information. Service providers have found field verification to be an effective method to help to ensure that the lines operate properly.

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Remote Test Equipment.    Remote test equipment can help verify services and identify certain types of service malfunctions from a centralized location. The equipment is typically controlled by a centralized test system that automates much of the remote testing process. It is commonly used to determine which section within a 3,000 mile circuit has malfunctioned and to diagnose quickly the nature of a customer’s complaint. Due to its centralized and automated nature, remote test equipment is an efficient way to complement field test equipment in the deployment and maintenance of broadband networks.

Alarm and Surveillance Equipment.    Alarm and surveillance equipment constantly monitors the telephone network, searching for facility or service degradations, including outages. When a problem is noticed, a report may be sent immediately to an automated trouble diagnostic system or to a human operator who interprets the message and decides what further action is required. Corrective action typically involves field verification or remote test equipment to identify and correct specific problems.

Because the competition is intense for subscribers for high-speed bandwidth access, the quality and reliability of network service has become critical to service providers who may lose customers and revenue and be subject to negative publicity as a result of providing poor service. Field technicians who use service verification equipment allow service providers to verify and repair service problems effectively and, thus, increase the quality and reliability of the network.

THE SUNRISE SOLUTION

We design and manufacture service verification equipment, physical layer diagnostic equipment, and monitoring systems that enable service providers to pre-qualify facilities for services, verify newly installed services, monitor the performance of video and signaling networks, and diagnose problems relating to copper twisted pair, coaxial cable, and optical fibers. Our products also enable equipment manufacturers to test simulated networks during equipment development and verify the successful production of equipment. Our field products offer the following features:

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PRODUCTS

Our major products, grouped by product category, are as follows:

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The percentage of our total revenue contributed by each class of products were as follows:

These product categories comprise our sole operating segment, telecommunications, cable broadband, and internet network testing equipment.

CUSTOMERS

Our customers include telecommunications service providers, cable network operators, network infrastructure suppliers and installers, technicians, and engineers in North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region. The following is a list of certain of our customers to which we made significant amounts of sales during 2003:

As of December 31, 2003, we had sold versions of our products to over 2,000 customers in over 60 countries. SBC Communications Inc. accounted for 13% of our net sales in 2003. No other individual customer accounted for 10% or more of our net sales in 2003, and no individual customer accounted for 10% or more of our net sales in 2002 and 2001. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Customer Concentration.”

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SALES, MARKETING AND CUSTOMER SERVICE

Sales.    We sell our products to telecommunications service providers, cable network operators, network infrastructure suppliers and installers, technicians, and engineers through manufacturers’ representatives, independent distributor organizations, and our direct sales force.

In the United States, we sell our products through manufacturers’ representatives who are supported by our in-house direct sales force. Manufacturers’ representatives are paid on a commission basis and have exclusive rights in their respective regions. Our manufacturers’ representatives or direct salesmen solicit orders from the customer, and we ship our products directly to the customer. We pay commissions once we have received payment from the customer. Our direct sales force includes a team of regional sales managers who direct the efforts of our manufacturers’ representatives and regional account managers who focus on specific accounts within a region.

Outside the United States, we sell our products through a mix of our own sales offices and independent distributor organizations, which are directed by our regional directors of marketing and sales. In general, we sell our products to the distributor at a discount from the end user price, and the distributor or sales office then resells the products to the end user. International sales, including North American sales to Canada, were $21.3 million or 39% of total net sales in 2003, $16.1 million or 30% in 2002, and $29.7 million or 38% in 2001. We expect that international sales will continue to account for a significant portion of our net sales in future periods. In addition to our network of international distributors, we have sales offices based in Anjou, Canada; Beijing, China; Tokyo, Japan; Seoul, Korea; Modena, Italy; Geneva, Switzerland; and Stuttgart, Germany. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Risks of International Operations.”

We sell our products predominantly to large telecommunications and cable service providers. These types of customers generally commit significant resources to an evaluation of our and our competitors’ products and require each vendor to expend substantial time, effort, and money educating them about the value of the vendor’s solutions. Consequently, sales to this type of customer generally require an extensive sales effort throughout the prospective customer’s organization and final acceptance of our products by an executive officer or other senior level employee. The result is lengthy sales and implementation cycles, which make sales forecasting difficult. In addition, even after a large service provider has approved our product for purchase, their future purchases are uncertain because we generally do not enter into long-term supply agreements or requirements contracts with those parties. Delays associated with a customers’ internal approval and contracting procedures, procurement practices, and testing and acceptance processes are common and may cause potential sales to be delayed or foregone. As a result of these and related factors, the sales cycle of new products for large customers typically ranges from six to twenty-four months.

We generally do not sell our products with rights of return; on the few occasions when we have agreed to provide customers with rights of return, we have deferred recognition of sales revenue until the rights of return have lapsed. We also generate a relatively small amount of revenue from the sale of extended warranties on our products. We defer this revenue and recognize it evenly over the term of the extended warranties. We generally do not provide extended payment terms to our customers.

Marketing.    We market and promote sales of our products by the following activities:

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Customer Service.    We believe that customer service following the sale of our products is a critical ingredient to our success. We provide customer service in numerous ways, including the following:

SEASONALITY

Our sales have been seasonal in nature and tied to the buying patterns of our customers. Prior to 2000, the largest volume of quarterly sales had usually been during the last calendar quarter of the year, as customers spent the unused portions of their annual budgets. In 2001 and 2000, there was a change in this fourth quarter seasonality as our customers had fewer remaining unused budget dollars available to generate an increase in the fourth quarter seasonal sales. In 2002, however, we saw a return to the pre-2000 pattern, with increased sales in the fourth quarter. Also in 2003, our fourth quarter was our largest quarter of the 2003 fiscal year with sales of $20.4 million. However, our 2004 fiscal year visibility is limited, and we expect that our quarterly operating results may fluctuate significantly and will be difficult to predict due to the lengthy and unpredictable buying patterns of our customers, the degree to which our customers allocate and spend their yearly budgets, and the timing of our customers’ budget processes. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Quarterly Fluctuations.”

BACKLOG

Our backlog of customer orders at December 31, 2003 was approximately $6.4 million compared to approximately $4.4 million at December 31, 2002. Prior to the time of shipment, customers may cancel orders that they have placed with us, but they must reimburse us for any production costs incurred prior to the cancellation. Order cancellations have historically not been significant in relation to our order backlog. Variations in the size and delivery schedules of purchase orders that we receive, as well as changes in customers’ delivery requirements may result in substantial fluctuations in the amount of backlog orders for our products from quarter to quarter.

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RESEARCH AND DEVELOPMENT

Our engineering personnel have expertise in a number of fields, including interfacing test equipment with digital loop carriers, voice and data switching technology, local loop equipment, and operations support systems. We spent approximately $16.1 million on research and development in 2003, $16.7 million in 2002, and $17.8 million in 2001. Research and development represents our largest direct employment expense. At December 31, 2003, we had a total of 110 employees engaged in research and development in San Jose, California; Norcross, Georgia; Anjou, Canada; Modena, Italy; Taipei, Taiwan; and Geneva, Switzerland.

We believe that our continued success depends on our ability to anticipate and respond to changes in the telecommunications industry and anticipate and satisfy our customers’ preferences and requirements. Accordingly, we continually review and evaluate technological and regulatory changes affecting the telecommunications industry and seek to offer products and capabilities that solve customers’ operational challenges and improve their efficiency. In general, we spend from two months to four years developing a new product.

REGULATIONS AND INDUSTRY STANDARDS

Our products are designed to comply with a significant number of industry standards and regulations, some of which are evolving as new technologies are deployed. In the United States, our products must comply with various regulations defined by the Federal Communications Commission and Underwriters Laboratories as well as industry standards established by Telcordia Technologies, Inc., formerly Bellcore, and the American National Standards Institute. Internationally, our products must comply with standards established by the European Committee for Electrotechnical Standardization, the European Committee for Standardization, the European Telecommunications Standards Institute, telecommunications authorities in various countries, and with recommendations of the International Telecommunications Union. The failure of our products to comply, or delays in compliance, with the various existing and evolving standards could negatively impact our ability to sell our products.

MANUFACTURING AND SOURCES OF SUPPLY

Our production process consists of planning, procurement, fabrication, rework, system assembly, system final test, software option customization, and shipping. We purchase substantially all parts, including resistors, integrated circuit boards, LCDs, and printed circuit boards, from distributors and manufacturers worldwide. We package these parts into kits and either send them to local contract manufacturers to assemble them into printed circuit boards or assemble them ourselves at our Taipei, Taiwan facility. We perform substantially all remaining manufacturing operations. We maintain sourcing and manufacturing operations in San Jose, California; Norcross, Georgia; Anjou, Canada; Taipei, Taiwan; and Modena, Italy. In 2001 and 2002, we performed the majority of sourcing, contract manufacturing, and final assembly in San Jose, California and Taipei, Taiwan. Our San Jose, Taiwan, and Modena, Italy operations are ISO 9001 certified. In 2003, we increased our manufacturing capacity in Taiwan, while reducing capacity in San Jose to reduce overall production costs. Our Taiwan subsidiary, Taiwan Sunrise Telecom Company Limited, is a turn-key manufacturer and local procurement operation. We intend to continue increasing the use of our Taiwan subsidiary for complete turn-key manufacturing to help lower our manufacturing costs.

In our manufacturing process, we purchase many key products, such as microprocessors, bus interface chips, optical components, and oscillators, from a single source or from that source’s sole supplier. We rely exclusively on third-party subcontractors to manufacture certain sub-assemblies, and we have retained, from time to time, third party design services in the development of our products. We do not have long-term supply agreements with these vendors. In general, we make advance purchases of some products and components to help to ensure an adequate supply. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Dependence on Sole and Single Source Suppliers.”

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For sales information regarding operations in different geographic regions, see Note 16 to our consolidated financial statements. A total of $24.4 million of our net property and equipment is located in the United States and $2.5 million is located in other countries. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Risks of International Operations.”

COMPETITION

The market for field verification test equipment is fragmented and intensely competitive, both inside and outside the United States, and is subject to rapid technological change, evolving industry standards, regulatory developments, and varied and changing customer preferences and requirements. We compete with a number of United States and international suppliers that vary in size and in the scope and breadth of the products and services offered. The following table sets forth our principal competitors in each of our product categories:

We expect that as our industry and market evolve, new competitors or alliances among competitors could emerge and acquire significant market share. We anticipate that competition in our markets will increase with the result that we will face greater threats to our market share, price pressure on our products, and the possibility that, over time, our profitability may decrease.

We believe that the principal competitive factors in our market include the following:

We believe that we compete favorably on the basis of these factors.

INTELLECTUAL PROPERTY AND PROPRIETARY TECHNOLOGY

Our intellectual property, including our proprietary technology, processes and know-how, trade secrets, patents, trademarks, and copyrights, is important to our business and to our continued success. We have six patents relating to communications testers that expire between 2007 and 2012, and we have filed several applications for additional patents with the U.S. Patent and Trademark Office and with foreign patent offices. Our research and development and

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manufacturing process typically involves the use and development of a variety of forms of intellectual property and proprietary technology, although no one particular form of this intellectual property and proprietary technology is material to our business. In addition, we incorporate software, some of which we may license from third party sources. These licenses generally renew automatically on an annual basis. We believe that alternative technologies for this licensed software are available both domestically and internationally.

We protect our proprietary technology by the following means:

EMPLOYEES

At December 31, 2003, we had a total of 377 full-time employees, consisting of 180 in the United States, 91 in Taiwan, 29 in Italy, 57 in Canada, 5 in Korea, 4 in Switzerland, 7 in China, 3 in Japan, and 1 in Germany. We also had 5 temporary employees at December 31, 2003. Of the total full-time employees, 110 were engaged in research and development, 94 were engaged in sales, marketing and customer support, 126 were engaged in operations, and 47 were engaged in administration and finance. None of our employees is subject to a collective bargaining agreement. The employees of our Pro.Tel subsidiary are protected by certain provisions of Italian law. We believe that our relations with our employees are good. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Dependence on Key Employees.”

EXECUTIVE OFFICERS

The names and ages of our executive officers as of December 31, 2003 are as follows:

Paul Ker-Chin Chang co-founded Sunrise in October 1991 and has served as Chairman, Chief Executive Officer, and President since that time. From 1984 to 1991, Mr. Chang was employed as Engineering Supervisor for the Wiltron division of Anritsu Corporation, a manufacturer of communications test equipment. Mr. Chang holds an M.S. in Electrical Engineering from the University of Kansas at Lawrence and a B.S. in Physics from Tunghai University in Taiwan.

Paul A. Marshall co-founded Sunrise in October 1991 and has served as Chief Operating Officer since December 1999, as Vice President of Marketing since March 1992, Acting Chief Financial Officer since October 2002, and as a director since October 1991. Mr. Marshall also served as Chief Financial Officer of Sunrise from March 1992 until December 1999. From 1980 to 1992, Mr. Marshall held various positions with the Wiltron division of Anritsu

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Corporation. Mr. Marshall holds an M.B.A. from the Harvard Business School and a B.S. in Mechanical Engineering from the University of California at Davis.

Raffaele Gerbasi joined Sunrise in January 2001 and has served as Vice President and General Manager Cable Broadband Division since September 1, 2001. Mr. Gerbasi formed Avantron Technologies in 1989 as a wholly-owned division of Dynastie Electronics and held the position of President prior to its acquisition by Sunrise in January 2001. A graduate of the Radio Electronic Television School, Mr. Gerbasi started his career in the cable broadband industry in 1979. From 1979 to 1984, Mr. Gerbasi was employed as Technical Services Manager for Incospec Electronics, a Canadian cable broadband equipment company. In 1984, Mr. Gerbasi joined Dynastie, a cable broadband service and engineering company and became President and sole owner in 1987.

Scott E. Green joined Sunrise in February 2000 and has served as Corporate Controller since October 2002. Mr. Green also served as Assistant Controller from March 2001 to October 2002 and Accounting Manager from February 2000 to March 2001. Before joining Sunrise, Mr. Green was an Accounting Manager with ITT Industries from May 1997 to February 2000. Prior to 1997, Mr. Green held senior accountant positions with the public accounting firms Deloitte & Touche LLP and KPMG LLP. Mr. Green is a Certified Public Accountant and a Certified Management Accountant and is a member of the American Institute of Certified Public Accountants and the Institute of Management Accountants. Mr. Green holds an M.B.A. from the University of California at Irvine and a B.A. in Economics from the University of California at Berkeley.

Jeong E. Joo joined Sunrise in March 1994 and has served as Chief Technology Officer since July 2001. Mr. Joo served as Director of Engineering—New Technologies from December 2000 to July 2001. Since joining Sunrise in 1994, Mr. Joo has held lead engineering development and management positions in the Engineering Department, contributing most recently to our fiber optics products. Mr. Joo held engineering management positions with Taihan Electric Wire, Co. Ltd., a telecom electronics company in Korea, from 1988 to March 1994. Mr. Joo holds a BSEE from Chungang University, Seoul, Korea.

Kirk O. Williams joined Sunrise in December 2002 and has served as General Counsel and Secretary since January 2003. Mr. Williams is the Company’s chief legal, compliance, and ethics officer and is responsible for our corporate governance initiatives and the protection of the Company’s legal interests and operations worldwide. Prior to joining Sunrise, Mr. Williams served as Vice President, Legal and Corporate Affairs, Assistant General Counsel at Exodus Communications, Inc., where he oversaw the company’s global reorganization and sale to Cable & Wireless. While at Exodus, Mr. Williams also served as Associate General Counsel, Business Development, Finance and Strategy and as Senior Corporate Counsel, responsible for, among other things, overseeing the company’s merger and acquisition, joint venture, and corporate finance activities and securities compliance. Prior to joining Exodus, Mr. Williams practiced corporate and securities law with the law firm Gray Cary Ware & Freidenrich LLP in Palo Alto, California. Mr. Williams holds a J.D. from New York University School of Law and a dual B.A. in Economics and Political Science from Stanford University.

AVAILABLE INFORMATION

Our Web site can be found at www.sunrisetelecom.com. We make available free of charge, on or through our Web site, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the Securities and Exchange Commission. Information contained on our Web site is not part of this report.

ITEM 2.    PROPERTIES

Our owned headquarters and manufacturing and research and development facility, which we built during 2001 on property that we acquired that year, occupies 91,700 square feet in San Jose, California. As of December 31, 2003, we

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also leased 10,000 square feet of office and manufacturing space in Montreal, Canada; 16,500 square feet of office and manufacturing space in Norcross, Georgia; 10,000 square feet of office and manufacturing space in Modena, Italy; 26,290 square feet of manufacturing and office space in Taipei, Taiwan; 6,742 square feet of office space in Santa Rosa, California; 7,000 square feet of office and manufacturing space in Mannheim, Germany; and 2,000 square feet of office space in Geneva, Switzerland. We lease sales offices in Beijing, China; Seoul, Korea; Tokyo, Japan; and Stuttgart, Germany.

ITEM 3.    LEGAL PROCEEDINGS

From time to time, we may be involved in litigation relating to claims arising out of our day-to-day operations. As of December 31, 2003, we were not engaged in any legal proceedings that were expected, individually or in the aggregate, to have a material adverse effect on our business, financial condition, results of operations or cash flow.

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

During the quarter ended December 31, 2003, there were no matters submitted to a vote of the security holders.

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Part II.

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

INFORMATION ABOUT OUR COMMON STOCK

Our common stock has been traded on the Nasdaq National Market under the symbol “SRTI” since our initial public offering on July 13, 2000. The following table sets forth, for the periods indicated, the highest and lowest closing sale prices for our common stock, as reported by the Nasdaq National Market.

As of December 31, 2003, we had approximately 86 stockholders of record of our common stock. We estimate that as of March 1, 2004, there were approximately 2,750 beneficial owners of our common stock.

In July 2003, we declared and paid a cash dividend in the aggregate amount of approximately $2.0 million. We did not declare or pay any cash dividend on our common stock in 2002 or 2001. In January 2004, our board of directors instituted an annual dividend for the Company and declared a cash dividend for 2004 in the aggregate amount of approximately $2.5 million. We paid this dividend in February 2004. Our board of directors will determine the amount of future dividends based on our future financial condition and results of operations.

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ITEM 6.     SELECTED FINANCIAL DATA

The table below sets forth summary consolidated financial information for the periods indicated. It is important that you read this information together with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K.

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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In addition to the other information in this report, certain statements in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) are forward-looking statements. Words such as “expects,” “anticipates,” “estimates,” “intends”, “plans”, “believes”, and similar words and expressions are intended to identify forward-looking statements. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties are set forth below under “Risk Factors Affecting Future Operating Results.” The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included elsewhere in this report.

OVERVIEW

We manufacture and market service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, and internet networks. Our products offer broad functionality, leading edge technology, and compact size to test broadband services; these include wireline access services (including DSL), fiber optics, cable broadband networks, and signaling networks. We design our products to maximize technicians’ effectiveness in the field and to provide realistic network simulations for equipment manufacturers to test their products. Our customers include incumbent local exchange carriers, cable companies, competitive local exchange carriers, and other service providers, network infrastructure suppliers, and installers throughout North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region.

For the past three years, many companies in the telecommunications industry throughout the world have been experiencing decreased profitability resulting from many factors. The most significant of these factors are overbuilding of certain portions of the telecommunications infrastructure during the late 1990s and increased overlap between the previously separate businesses of wireless, local telephone services, and cable TV service, which has lead to increased competition. We have been affected by this downturn, and after nine consecutive years of profitability, we were unprofitable during each of the years ended December 31, 2002 and 2003. However, through conservative financial management, we continued to generate positive cash flows from operating activities during those two years, and we ended the year 2003 with a strong cash position and very low debt levels. We compete in the challenging telecommunications equipment market by pursuing a strategy of offering products that address the needs of a diverse group of telecommunications service providers and by investing heavily in research and development to create high-quality products that address evolving telecommunications technologies in innovative ways. We also continuously work to minimize operating costs while executing this strategy.

We assess the overall performance of our business primarily through the use of financial metrics. Management considers several factors to be particularly important when assessing past business success and projecting future performance. The first such factor is our maintenance of high levels of working capital and low levels of debt. See “Liquidity and Capital Resources”. This first factor is enabled by the second factor: The generation of cash flows from our operating activities. Ultimately, our ability to consistently generate substantial positive cash flows is the primary indicator of our business’s success and is imperative for our business’s survival. See “Liquidity and Capital Resources”. The third factor is profitability. In general, profitability provides an indication of our ability to generate present and future cash flows from our operating activities. The key components of our profitability are net sales, cost of sales, and operating expenses. See the discussion directly below and “Comparison of Years Ended December 31, 2003 and 2002” and “Comparison of the Years Ended December 31, 2002 and 2001.”

Sources of Net Sales

We generate our cash flows primarily from selling telecommunications network testing equipment, and our future cash flows are largely dependent on our continuing ability to sell our products and collect cash from our customers for

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those sales. We consider investment in research and development and selling and marketing activities and the continued development of new products to be critical to our ability to generate strong sales volume in the future, and we continually seek to offer new products to meet our customer’s needs. Notably, in 2003 we introduced modules for our hand-held SunSet MTT product line, which tests a variety of types of network, and for our SunSet STT, which is primarily a fiber optics testing product, and the realWORX cable broadband testing product. During the three years ended December 31, 2003, our research and development efforts have not generated the sales volumes to which we had previously been accustomed.

We sell our products predominantly to large telecommunications service providers. These types of customers generally commit significant resources to the evaluation of our and our competitors’ products and require each vendor to expend substantial time, effort, and money educating them about the value of the proposed solutions before the customer agrees to purchase any amount of product. As a result of these and related factors, the sales cycle of new products for large customers typically ranges from six to twenty-four months. During the past three years, we have observed a significant decline in capital spending in the telecommunications industry, which may lengthen the sales cycle further. Substantially all of our sales are made on the basis of purchase orders rather than long-term agreements or requirements contracts. As a result, we commit resources to the development and production of products without having received advance or long-term purchase commitments from customers. We anticipate that our operating results for any given period will continue to be dependent to a significant extent on purchase orders, which can be delayed or cancelled by our customers without penalty.

Historically, a significant portion of our net sales have come from a small number of relatively large orders from a limited number of customers. One customer, SBC Communications Inc., comprised $7.2 million, or 13%, of our sales in 2003. No customers comprised more than 10% of our sales in 2002 and 2001. Overall, we anticipate that our operating results for a given period will be dependent on a small number of customers.

Our sales have been seasonal in nature and tied to the buying patterns of our customers. Prior to 2000, the largest volume of quarterly sales had usually been during the last calendar quarter of the year, as customers spent the unused portions of their annual budgets. In 2001 and 2000, there was a change in this fourth quarter seasonality as our customers had fewer remaining unused budget dollars available to generate an increase in the fourth quarter seasonal sales. In 2003 and 2002, however, we saw a return to the pre-2000 pattern, with increased sales in the fourth quarter. Market conditions in our industry are currently too uncertain for us to predict whether or not this pattern will continue. We expect that our quarterly operating results may fluctuate significantly and will be difficult to predict due to the length and unpredictable buying patterns of our customers, the degree to which our customers allocate and spend their yearly budgets, and the timing of our customers’ budget processes.

Currently, competition in the telecommunications equipment market is intense and is characterized by declining prices. Because of these market conditions and potential pricing pressures from large customers in the future, we expect that the average selling price for our products will decline over time. If we fail to reduce our production costs accordingly or fail to introduce higher margin new products, there will be a corresponding decline in our gross margin percentage. See “Risk Factors Affecting Future Operating Results—Competition” and “—Risks of the Telecommunications Industry.”

A substantial portion of our net sales have come from customers located outside of the United States, and we believe that future growth may depend on growth of our sales in international markets. These sales are primarily dollar denominated, which limits our financial exposure to currency exchange rate fluctuations. Currently, we maintain a manufacturing facility in Taipei, Taiwan; manufacturing, research, development, and sales facilities in Modena, Italy; manufacturing, research, development, and sales facilities in Anjou, Canada; and research and development facilities in Geneva, Switzerland and Mannheim, Germany. We also have a representative liaison office in Beijing, China, and sales offices in Tokyo, Japan; Seoul, Korea; Stuttgart, Germany; and Barbados.

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We have a small amount of sales denominated in Euros and the Canadian dollar and have, in prior years used derivative financial instruments to hedge our foreign exchange risks. As of December 31, 2003, we had no derivative financial instruments. To date, foreign exchange exposure from sales has not been material to our operations. We have also been exposed to fluctuations in non-U.S. currency exchange rates related to our manufacturing activities in Taiwan. In the future, we expect that a growing portion of international sales may be denominated in currencies other than U.S. dollars, thereby exposing us to gains and losses on non-U.S. currency transactions. See “Risk Factors Affecting Future Operating Results—Risks of International Operations.”

Cost of Sales

Our cost of sales consists primarily of the following:

We recognize direct cost of sales, wages, taxes, benefits, and allocated overhead costs at the same time we recognize revenue for products sold. We expense scrapped materials as incurred.

If we underestimate our requirements, we may have inadequate inventory, resulting in additional product costs for expediting delivery of long lead time components. An increase in the cost of components could result in lower margins. Additionally, these long lead times have in the past, and may in the future, cause us to purchase larger quantities of some parts, increasing our investment in inventory and the risk of the parts’ obsolescence. Any subsequent write-off of inventory could result in lower margins. See “Risk Factors Affecting Future Operating Results—Dependence on Sole and Single Source Suppliers”.

Operating Costs

We classify our operating expenses into three general operational categories: research and development, selling and marketing, and general and administrative. Our operating expenses include stock-based compensation expense and amortization of certain intangible assets. We classify charges to the research and development, selling and marketing, and general and administrative expense categories based on the nature of these expenditures. Although each of these three categories includes expenses that are unique to the category type, each category also includes commonly recurring expenditures that typically relate to all of these categories, such as salaries, amortization of stock-based compensation, employee benefits, travel and entertainment costs, communications costs, rent and facilities costs, and third party professional service fees. The selling and marketing category of operating expenses also includes expenditures specific to the selling and marketing group, such as commissions, public relations and advertising, trade shows, and marketing materials. The research and development category of operating expenses includes expenditures specific to the research and development group, such as design and prototyping costs. The general and administrative category of operating expenses includes expenditures specific to the general and administrative group, such as legal and professional fees and amortization of identifiable intangible assets.

We allocate the total cost of overhead and facilities to each of the functional areas that use overhead and facilities based upon the square footage of facilities used or the headcount in each of these areas. These allocated charges

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include facility rent, utilities, communications charges, and depreciation expenses for our building, equipment, and office furniture.

In 2003 and 2002, we recorded amortization of deferred stock-based compensation expense of $1.8 million and $1.9 million, respectively, related to the grant of pre-IPO options to purchase our common stock at exercise prices subsequently deemed to be below fair market value. Total compensation expense related to these options, which were granted in 1999 and the first quarter of 2000, is amortized on a straight-line basis, over the respective four-year vesting periods of the options, to the departments of the employees who received these below-market option grants. The 1999 options were fully amortized by the end of 2003. During 2003 and 2002, we allocated amortization of deferred stock-based compensation expense of $0.3 million to cost of sales, $0.7 million to research and development expense, $0.5 million and $0.6 million, respectively, to selling and marketing expense, and $0.4 million and $0.3 million, respectively, to general and administrative expense. At December 31, 2003, $0.3 million of deferred stock-based compensation expense remained to be amortized and will be amortized during 2004.

Also, during 2003 and 2002, we charged $3.3 million to general and administrative expense for amortization of intangible assets obtained in business acquisitions.

Acquisitions and Consolidation of Wireless Operations

On January 8, 2001, we acquired Avantron Technologies, Inc. (“Avantron”), a Canadian company that specializes in the design and manufacture of cable broadband spectrum analyzers and performance monitoring systems, for $11.9 million in cash, acquisition costs, and short-term notes payable. We accounted for this acquisition using the purchase method of accounting, and, accordingly, recorded goodwill and other intangible assets of $10.4 million, to be amortized on a straight-line basis over their original estimated useful lives of five years. At December 31, 2001, we had $5.2 million in unamortized goodwill remaining from the Avantron acquisition. In accordance with SFAS No. 142, we ceased amortizing this goodwill as of January 1, 2002. We review goodwill for impairment annually as required by SFAS No. 142.

On February 28, 2002, we acquired the CaLan Cable TV test business from Agilent Technologies for $7.2 million in cash and acquisition costs. We recorded acquired identifiable intangible assets of $3.5 million, to be amortized on a straight-line basis over their original estimated useful lives of two-and-a-half to five years, and goodwill of $2.6 million, which we review for impairment annually.

On June 19, 2002, we acquired the ADSL Tester business from Integrated Telecom Express, Inc. (“ITeX”) for $100,000 in cash. We recorded goodwill of $68,000, which we review for impairment annually.

On September 4, 2002, we acquired Luciol Instruments SA (“Luciol”), a Swiss corporation specializing in fiber optic measurement and instrumentation, for $1.2 million in cash and acquisition costs. We recorded acquired intangible assets of $0.1 million, to be amortized on a straight-line basis over their original estimated useful lives of five years, and goodwill of $1.3 million, which we review for impairment annually. Concurrent with this acquisition and as amended in February 2004, we entered into non-compete agreements with certain former owners of Luciol that will result in payments to the former owners totaling approximately $116,000 over four years, provided that they perform as stipulated under the agreements. We are amortizing the corresponding non-compete assets on a straight-line basis over their four-year estimated useful lives. We also entered into, and amended in February 2004, employment agreements with these same former owners that will result in bonus payments to the former owners totaling approximately $349,000 over four years, in addition to their regular salaries and subject to certain conditions, primarily related to their continued employment by us.

On February 28, 2003, we acquired substantially all of the assets of GIE GmbH (“GIE”), a German corporation located in Mannheim and specializing in wireless and RF measurement instrumentation, for $0.6 million in cash and

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acquisition costs. We recorded acquired intangible assets of $89,000, of which $37,000 was assigned to in-process research and development assets that were written off at the date of the acquisition. The remaining $52,000 of acquired intangible assets is developed technology. We did not record any goodwill on this acquisition. Concurrent with this acquisition, we entered into a non-compete agreement with certain former owners of GIE obligating us to make payments to the former owners totaling approximately $100,000 over four years, provided that they perform as stipulated under the agreements. We are amortizing the corresponding non-compete assets on a straight-line basis over their four-year estimated useful lives. We also entered into employment agreements with these same former owners obligating us to make bonus payments to the former owners totaling approximately $200,000 over four years, in addition to their regular salaries and subject to certain conditions, primarily related to their continued employment by us. As of August 2003, two of the three former owners of GIE were no longer employed by us. Based on this fact and other actions by the former owners that we believe breech the terms of their agreements with us, we might not be required to pay these former owners the bonus or non-compete payments specified under the acquisition-related agreements. As our wireless product development process proceeded, we determined that we would not make significant use in our wireless product designs of the developed technology that we capitalized at the time of the GIE acquisition, so we wrote off the remaining unamortized balance of $48,000 during the fourth quarter of 2003.

During the three month period ended September 30, 2003, we initiated a plan to move our wireless product research and development operations from Mannheim, Germany to our existing facility in Santa Rosa, California, and we modified this plan during March 2004 to move these operations to our corporate headquarters in San Jose, California. We expect that this consolidation will allow us to make the best use of our engineering talent and to closely control the wireless product development operations. We expect that the wireless operations in San Jose will be conducted by existing staff from the San Jose and Santa Rosa facilities, augmented by additional hires, as needed. Except for the research and development activities of one employee, which we expect will be completed in March 2004, all operating activities in our Mannheim location had ceased by December 31, 2003. As a result of closing the Mannheim office, we wrote off the book value of the remaining fixed assets and recorded a provision for the remaining future payments under the facility lease, both of which we included as charges against other income, net on our consolidated statement of operations. We have not identified any additional material future costs to be incurred as a result of closing the Mannheim facility. Additional costs, including lease termination costs and employee related costs, may become apparent during 2004 as a result of negotiating the termination of the Mannheim office lease and if terminated employees claim and are allowed additional, unanticipated severance benefits, but we do not expect that any such additional costs would be material to our financial position or results of operations.

We believe that acquisitions and joint ventures may be an important part of our growth and competitive strategy. See “Risk Factors Affecting Future Operating Results—Acquisitions.”

Subsequent Events

On January 9, 2004, we, with our subsidiary Luciol and a former owner of Luciol, settled an intellectual property dispute over certain technology for testing fiber optic communication networks. In the settlement, we agreed to pay $500,000 to certain other parties in order to settle all their claims to the intellectual property. Under the terms of our acquisition of Luciol, we are entitled to indemnification of this amount from the three former owners of Luciol, who are all now our employees. During January 2004, we agreed with these former owners to accept $300,000 as payment in full of the reimbursement to which we are entitled. In February 2004, we amended the terms of the employment agreements with these former owners of Luciol to reduce the bonus and non-compete payments to be paid to them by approximately $300,000 as the means to provide the reimbursement due to us. The remaining $200,000 of the settlement amount is covered by a provision for litigation in this same amount that was established by us at the time of the Luciol acquisition.

On January 28, 2004, our Board of Directors declared a $2.5 million dividend, to be paid on February 20, 2004 to stockholders of record as of February 10, 2004.

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RESULTS OF OPERATIONS

The following table sets forth certain operating data as a percentage of net sales for the periods indicated:

COMPARISON OF YEARS ENDED DECEMBER 31, 2003 AND 2002

Net Sales.    Net sales increased 1%, to $54.9 million in 2003 from $54.3 million in 2002. During 2003, sales of our wireline access products increased by $1.4 million or 6%, sales of our fiber optics products increased by $2.2 million or 20%, and sales of our signaling products increased by $0.5 million or 19% over sales in the prior year. These sales increases were generally due to increased demand for our products resulting from our continuing penetration of diverse geographic markets with product lines that we continue to enhance in terms of breadth, functionality, and performance. In particular, the introduction of a number of new modules for our MTT and STT platforms drove sales in our wireline and fiber optics product lines. Our overall sales increase was limited by a $3.5 million or 19% decrease in sales of our cable broadband products. This decrease resulted primarily from a decline in sales to our North American cable broadband customers, who restricted capital expenditures during 2003 after a period of significant expansion of their networks through 2002, and increasing competition in the hand-held installation and field testing part of the business.

During 2003, sales decreased $3.9 million or 10% in North America, increased $1.7 million or 27% in Europe/Africa/Middle East, and increased $2.8 million or 35% in Asia/Pacific compared to 2002. Sales were essentially unchanged in Latin America. The decrease in North American sales is primarily the result of decreased sales of cable broadband products. Our growth in Asia reflects the results of our ongoing development of distribution channels in these regions, and our growth in Europe is a rebound from a particularly weak year 2002. International sales, including North American sales in Canada, increased to $21.3 million, or 39% of net sales, in 2003, from $16.1 million, or 30% of net sales, in 2002.

Cost of Sales.    Cost of sales increased 4%, to $19.3 million in 2003 from $18.6 million in 2002. This increase is primarily due to the shift in sales from North America to the international market, where our margins are lower. Cost of sales represented 35% and 34% of net sales in 2003 and 2002, respectively. Although cost of sales was almost the

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same as a percentage of sales in 2003 and 2002, this percentage is susceptible to change from variations in our product mix, changes in the proportion of our sales going to international customers, and pricing pressures.

Research and Development.    Research and development expenses decreased 4%, to $16.1 million in 2003 from $16.7 million in 2002. This decrease is primarily due to reduced parts and prototype and design service costs. Research and development expenses represented 29% of net sales in 2003 and 31% of net sales in 2002. Research and development expenses tend to fluctuate from period to period, depending on requirements at the various stages of our product development cycles. Through our research and development activities, we are attempting to balance two conflicting strategic priorities. The first is to tightly control costs in response to sales volume that has significantly decreased over the last three years. The second is to continue to develop products that address customer needs in a rapidly changing and very competitive market. In any given time period, research and development expenses may increase in absolute dollars and/or as a percentage of sales as we continue to invest in product development and expand our product lines.

Selling and marketing.    Selling and marketing expenses increased 1%, to $17.0 million in 2003 from $16.8 million in 2002. Selling and marketing expenses represented 31% of net sales in 2003 and 2002. During 2002 and 2003, we reached a level of selling and marketing effort that allowed us to actively promote our products to potential customers, but that simultaneously recognized the cost constraints that we face during a period of economic difficulty in the telecommunications industry. However, in the future, selling and marketing expense may increase in absolute dollars and/or as a percentage of sales as we continue to develop our selling and marketing capabilities. In addition, the commission expenses included in selling and marketing can fluctuate both with changes in sales volume and with changes in the channels through which the sales flow. We use different distribution methods to supply our products to different geographical regions and different customers, and the commission rates we incur can vary among these channels.

General and Administrative.    General and administrative expenses decreased 14%, to $9.8 million in 2003 from $11.4 million in 2002. The main reason for this decrease was a reduction in bad debt expenses related to uncollectible accounts receivable. Since 2001, we have experienced a trend of decreasing uncollectible accounts receivable. We believe that the reason for this trend is that many of our customers with questionable financial resources have gone out of business or have reduced the scope of their operations as a result of the telecommunications downturn and that those customers that continue to buy from us are those with the most financial resources to pay for their purchases. General and administrative expenses represented 18% of net sales in 2003 and 21% of net sales in 2002. We try to carefully control our general and administrative expenses. However, general and administrative expenses may increase in absolute dollars if we experience growth in our business, expand our infrastructure, or pursue additional acquisitions. General and administrative expenses could increase as a percentage of sales if we experience increased costs related to our collection of receivables, if unforeseen legal matters arise, and if regulatory or public company compliance costs, including costs related to complying with the Sarbanes-Oxley Act of 2002 and its associated regulations, increase.

Other Income, Net.    Other income, net primarily represents interest earned on cash and investment balances and gains and losses on assets, liabilities, and transactions denominated in foreign currencies. Other income, net remained unchanged at $0.9 million in 2003 and 2002.

Income Tax Expense (Benefit).    Income tax expense (benefit) consists primarily of federal and state income taxes. We recorded an income tax benefit associated with our operating losses of $2.5 million in 2003 and $3.3 million in 2002. Our effective income tax rates were 39% in 2003 and 40% in 2002.

COMPARISON OF YEARS ENDED DECEMBER 31, 2002 AND 2001

Net Sales.    Net sales decreased 31%, to $54.3 million in 2002 from $79.1 million in 2001. During 2002, sales of our wireline access products decreased by $25.7 million or 53%, sales of our fiber optics products decreased by $4.0

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million or 26%, and sales of our signaling products decreased by $1.8 million or 42% from sales in the prior year. These sales decreases were generally due to reductions in capital spending by our customers in the telecommunications industry. These sales decreases were partially offset by a $6.7 million or 59% increase in sales of our cable broadband products. Of the increase in cable broadband product sales, $3.6 million was attributable to the CaLan acquisition. The remaining $3.1 million increase was from our existing product lines, primarily the CM1000, and the increasing acceptance of these products within the cable broadband industry.

During 2002, sales decreased $13.6 million or 26% in North America, $5.0 million or 45% in Europe/Africa/Middle East, $3.7 million or 32% in Asia/Pacific, and $2.4 million or 65% in Latin America compared to 2001. The decrease in North American sales during 2002 was due to decreased sales of our wireline access, fiber optics, and signaling products. These decreases were partially offset by an increase in the sales of our cable broadband products. Of the growth in our North American cable broadband product sales, 45% of the increase in 2002 over 2001 relates to products from the CaLan business acquired during the first quarter of 2002. The decreases in our North American sales were primarily the result of decreased capital spending by our telecommunications customers. In addition, beginning largely in 2002, some DSL providers encouraged customer self-installation and reported that up to 90% of their customers perform self-installation successfully. The self-installation procedure reduces the need for technicians to test for DSL service, reducing the demand for our DSL wireline access products; under the self-installation model, our customers use our equipment primarily for troubleshooting and not for routine installations.

International sales, including North American sales in Canada, decreased to $16.1 million, or 30% of net sales, in 2002, from $29.7 million, or 38% of net sales, in 2001. The decrease in international sales is primarily due to decreased sales of our wireline access product lines and our fiber optics products.

Cost of Sales.    Cost of sales decreased 29%, to $18.6 million in 2002 from $26.2 million in 2001. This decrease is primarily due to the decrease in net sales volumes. Cost of sales represented 34% and 33% of net sales in 2002 and 2001, respectively.

Research and Development.    Research and development expenses decreased 6%, to $16.7 million in 2002 from $17.8 million in 2001. This decrease is primarily due to decreased payroll dedicated to research and development activities. Research and development expenses represented 31% of net sales in 2002 and 23% of net sales in 2001. The increase as a percentage of net sales is primarily due to product sales decreasing more rapidly than research and development expenditures, as we continued to invest in product development and expansion of our product lines.

Selling and marketing.    Selling and marketing expenses decreased 17%, to $16.8 million in 2002 from $20.3 million in 2001. This decrease is primarily due to reductions in advertising and printing expenses, headcount reductions among selling and marketing personnel, and reduced commission expenses. Commission expenses decreased primarily due to the decrease in our sales, particularly North American sales, on which we make the preponderance of our commission payments. Selling and marketing expenses represented 31% of net sales in 2002 and 26% of net sales in 2001. The increase as a percentage of net sales in 2002 is primarily due to product sales decreasing more rapidly than selling and marketing expenditures and our efforts to continue to develop markets for and sell our products.

General and Administrative.    General and administrative expenses decreased 17%, to $11.4 million in 2002 from $13.7 million in 2001. This decrease is primarily due to a $1.8 million decrease in amortization of purchased intangible assets resulting from the cessation of amortization of goodwill related to acquisitions beginning on January 1, 2002. The remaining $0.5 million of the decrease is primarily due to cost reduction measures. General and administrative expenses represented 21% of net sales in 2002 and 17% of net sales in 2001.

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Other Income, Net.    Other income, net decreased to $0.9 million in 2002 from $2.5 million in 2001. This decrease resulted primarily from a decrease in interest income as our cash, cash equivalents, and investments in marketable securities balances declined and interest rates fell.

Income Tax Expense (Benefit).    We recorded an income tax benefit of $3.3 million in 2002 and income tax expense of $0.7 million in 2001. Our effective income tax rates were 40% in 2002 and 20% in 2001. Our effective tax rate was lower during 2001 than 2002 because during 2001 our research and development tax credit, foreign sales corporation (FSC) tax benefit, and tax exempt interest were larger in proportion to our statutory taxes than they were during 2002.

LIQUIDITY AND CAPITAL RESOURCES

Cash Requirements and Capital Resources

As of December 31, 2003 and 2002, we had working capital of $54.7 million and $52.8 million, respectively, and cash and cash equivalents of $39.9 million and $36.4 million, respectively. At December 31, 2002, we also had $1.0 million in investments in marketable securities that were classified as current assets on our balance sheet. These investments have matured, and as explained in the notes to our December 31, 2003 consolidated financial statements, our $2.1 million investment in marketable securities at December 31, 2003 consisted entirely of equity securities of Top Union Electronics Corp., a Taiwan R.O.C. Company. At December 31, 2002, these securities were reported at historical cost and classified with other assets on our balance sheet. During the quarter ended June 30, 2003, these securities became listed on the GreTai Securities Market, Taiwan’s over-the-counter exchange. As a result, we reclassified them to marketable securities and revalued them to their fair value, as required for available-for-sale securities. We do not consider this to be a liquid investment, and accordingly classify it as a non-current asset.

We have generated positive cash flows from our operating activities every year since 1992. We believe that current cash balances and future cash flows from operations will be sufficient to meet our anticipated cash needs for our operations, complete needed business projects, achieve our plans and objectives, meet financial commitments, meet working capital requirements, make capital expenditures, and fund other activities well beyond the next 12 months. However, a large acquisition of complementary businesses, products, or technologies, or material joint ventures could require us to obtain additional equity or debt financing. We cannot assure you that such additional financing would be available on acceptable terms, if at all. However, no such activities are anticipated at this time and our present levels of debt and other future commitments are small compared to our present cash balances, so we presently anticipate that our most significant cash requirements during at least the next 12 months will be for our normal research and development, selling and marketing, and production activities. Furthermore, we are unaware of any known material trends or uncertainties that may require us to make cash management decisions that will impair our short or long-term operating capabilities.

Sources and Uses of Cash

In general, we have financed our operations and capital expenditures primarily using cash flows generated by our operating activities. In addition, in July 2000 we received net proceeds of $51.6 million from an initial public offering of our common stock. We have since expended these proceeds, mainly to acquire complementary businesses and to construct our corporate headquarters in San Jose, California. We foresee relying on cash flows from our operating activities and existing cash resources to fund our business activities during at least the next 12 months, and we do not expect to rely on any significant financing activities during that time.

Cash provided by operating activities was $5.8 million in 2003, $0.7 million in 2002, and $19.8 million in 2001. Operating cash flows increased during 2003 compared to 2002 primarily due to changes in non-cash items affecting

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our net income year over year and changes in certain of our current assets and liabilities, including a lower employment retention bonus payment to the vice president and general manager of our cable broadband operation and the collection during 2003 of income taxes receivable. These items were partially offset by a reduction in deferred revenue. Operating cash flows decreased during 2002 compared to 2001 primarily because of our net loss in 2002. Furthermore, although we continued to have net reductions in inventory purchases during 2002, the amount of these net reductions was significantly less than during 2001, and our cash generated from collecting accounts receivable decreased during 2002 compared to 2001. The factors decreasing operating cash flow during 2002 were partially offset by a reduction in payments on our accounts payable and accrued expenses. In general, our ability to continue to generate positive cash flows from operations will depend on our ability to generate and collect the cash from future sales, while maintaining a cost structure lower than those sales amounts. Therefore, sales volume is by far the most significant uncertainty in our ability to generate cash flow from operations. We believe that our business strategies will allow us to generate future sales that, combined with our existing cash and cash equivalents, will be sufficient to fund our business well beyond the next 12 months.

Cash used in investing activities was $1.0 million in 2003, $9.7 million in 2002, and $27.8 million in 2001. The $8.7 million decrease in net cash used in investing activities during 2003 from 2002 is primarily due to a decrease in business acquisition related expenditures and due to a non-recurring event, a loan made to our Chief Executive Officer in 2002 and repaid in 2003. Offsetting these reductions was a decrease in proceeds from the sale of marketable securities. The $18.1 million decrease in net cash used in investing activities during 2002 from 2001 is primarily due to decreased amounts paid for business acquisitions and decreased capital expenditures. Capital expenditures during 2001 included $8.8 million for land and $5.6 million for construction of our facility in San Jose, California, and we also reduced our expenditures on equipment and other capital assets during 2002. Offsetting those reductions in cash flows used in investing activities was the loan made to our Chief Executive Officer in early 2002. As of December 31, 2003, we had no plans for large capital expenditures outside the usual course of those needed for our ongoing production, research and development, and selling and marketing activities.

Cash used in financing activities was $1.7 million in 2003 and $3.7 million in 2002. Cash provided by financing activities was $0.6 million in 2001. The decrease in cash used in financing activities during 2003 from 2002 is primarily due to the completion of a stock repurchase program during 2002. This decrease was partially offset by a $2.0 million dividend paid to our stockholders during 2003, while no dividend was paid during 2002. In January 2004, our Board of Directors announced plans to institute annual dividend payments, with the year 2004 dividend being $2.5 million. This dividend was paid to stockholders in February 2004. The increase in net cash used in financing activities during 2002 from 2001 is primarily due to increased repurchases of our common stock and a reduction in proceeds from common stock issued under our Employee Stock Purchase Plan. During 2002, we completed the repurchases of our stock under a plan approved by the Board of Directors in 2001. Under this plan, a total of 1.7 million shares have been repurchased since 2001 for total cash expended of $5.1 million.

Our outstanding debt at December 31, 2003 consisted primarily of a $1.0 million loan from the Italian government for research and development use that is payable over a period of eight years through semi-annual payments starting in the second half of 2003 and ending in 2011 and nine notes payable related to acquisitions totaling $0.4 million that are being paid in quarterly installments ending in 2006. We have not used off-balance sheet financing arrangements, issued or purchased derivative instruments linked to our stock, or used our stock as a form of liquidity. We do not believe that there are any known or reasonably likely changes in credit ratings or ratings outlook or an inability to achieve such changes which would have any significant impact on our operations. We are not subject to any debt covenants that we believe might have a material impact on our business.

Debt Instruments, Guarantees, and Related Covenants

We have low levels of debt, and our operating, financing, and investing activities are not subject to any significant constraints related to outstanding debt, guarantees, or other contingent obligations. We are not, and during at least the

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next 12 months are not reasonably likely to be, in breach of debt covenants. We are not subject to any significant debt covenants that may limit our ability to borrow additional funds or issue equity securities.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires us to make estimates, assumptions, and judgments that affect the amounts reported in our consolidated financial statements and the accompanying notes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable. Although these estimates are based on our present best knowledge of the future impact on the Company of current events and actions, actual results may differ from these estimates, assumptions, and judgments.

We consider “critical” those accounting policies that require our most subjective or complex judgments, which often result from a need to make estimates about the effect of matters that are inherently uncertain, and that are among the most important of our accounting policies to the portrayal of our financial condition and results of operations. These critical accounting policies are the determination of our allowance for doubtful accounts receivable, valuation of excess and obsolete inventory, valuation of goodwill and other intangible assets, accounting for the liability for product warranties, deferred income tax assets and liabilities, and revenue recognition.

Allowance for Doubtful Accounts Receivable

We determine our allowance for doubtful accounts receivable by making our best estimate considering our historical accounts receivable collection experience and the information that we have about the current status of our accounts receivable balances. If future conditions cause our collection experience to change or if we later obtain different information about the status of any or all of our accounts receivable, additional allowances for doubtful accounts receivable may be required. We charge provisions for doubtful accounts receivable to general and administrative expenses on our statement of operations.

Valuation of Excess and Obsolete Inventory

We determine the valuation of excess and obsolete inventory by making our best estimate considering the current quantities of inventory on hand and our forecast of the need for this inventory to support future sales of our products. We often have limited information on which to base our forecasts, and if future sales differ from these forecasts, the valuation of excess and obsolete inventory may change. We charge provisions for excess and obsolete inventory to cost of sales on our statement of operations.

Valuation of Goodwill and Other Intangible Assets

We evaluate the valuation of goodwill in the manner prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. As required by SFAS No. 142, we test goodwill for impairment annually, during our fourth fiscal quarter. We would also test goodwill for impairment if certain events or changes in circumstances stipulated by SFAS No. 142 were to occur. SFAS No. 142 prescribes a two-step process for the impairment testing of goodwill. The first screens for impairment by comparing the fair value of our reporting unit, which we consider to be the market capitalization of our entire telecommunications testing equipment business, to its carrying value. If the carrying value were to exceed the fair value, the second phase of the process would occur. In the second phase, we would recognize an impairment for the excess of the carrying value, if any, of our goodwill over its implied fair value. The implied fair value of our goodwill is the excess of our reporting unit’s total fair value over the combined net fair values of its individual assets and liabilities. Based on the annual test for impairment performed during our fourth

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fiscal quarter, goodwill was determined not to be impaired, and no subsequent indicators of impairment have been noted.

We evaluate the valuation of intangible assets other than goodwill in the manner prescribed by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. As required by that standard, we monitor events and changes in circumstances that could indicate that the carrying amount of an intangible asset may not be recoverable. These events and circumstances include a significant change in how we use the asset, significant changes in legal factors or the business climate that could affect the asset’s value, and current period operating or cash flow losses combined with a history of such losses or a forecast of continuing losses associated with the use of the asset. If such an event or change in circumstances were to occur, we would assess the recoverability of the intangible asset by determining whether its carrying value would be recovered through undiscounted expected future cash flows. If the carrying value of the asset were to exceed the undiscounted expected future cash flows, we would recognize an impairment for the excess of the carrying value over the asset’s fair value.

Product Warranties

We offer a three-year warranty covering parts and labor on our wireline access products and fiber optic products sold in the United States, and generally offer a one-year warranty covering parts and labor for our products sold in all other countries, with the option to purchase a two-year extended warranty. Our cable broadband and signaling products are covered by a one-year warranty. We are also subject to laws and regulations in the various countries in which we sell regarding vendor obligations to ensure product performance. At the time we recognize revenue from a product’s sale, we determine the reserve for the future cost of meeting our obligations under the standard warranties and product performance laws and regulations by considering our historical experience with the costs of meeting such obligations. If the future costs of meeting these obligations differ from our historical experience, additional reserves for warranty obligations may be required. We charge provisions for future warranty costs to cost of sales on our statement of operations.

Deferred Income Tax Assets and Liabilities

We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for the future tax consequences attributable to operating loss and tax credit carryforwards. In assessing the recoverability of deferred tax assets, we consider whether it is more likely than not that all or some portion of the deferred tax assets will be realized. The ultimate realization of certain deferred tax assets is dependent upon the generation of future taxable income during the periods in which the related temporary differences become deductible. If we obtain information that causes our forecast of future taxable income to change or if taxable income differs from our forecast, we may have to revise the carrying value of our deferred tax assets, which would affect our net income in the period in which the change occurs. The ultimate realization of certain other deferred tax assets is dependent on our ability to carry forward or back operating losses and tax credits. If changes in the tax laws occur that inhibit our ability to carry forward or back operating losses or tax credits, we will recognize the effect on our deferred tax assets in the results of operations of the period that includes the enactment date of the change. Furthermore, we measure our deferred tax assets and liabilities using the enacted tax laws expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. If tax laws change, we will recognize the effect on our deferred tax assets and liabilities in the results of operations of the period that includes the enactment date of the change.

Revenue Recognition

We recognize revenue from a customer order when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectibility is reasonably assured.

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For product sales, we consider delivery to have occurred when title and risk of loss have been transferred to the customer, which is usually at the time that the product has been picked up by a common carrier. For services, we consider delivery to have occurred once the service has been provided. We use objective evidence of fair value to allocate revenue to elements in multiple element arrangements and recognize revenue when the criteria for revenue recognition have been met for each element. In the absence of objective evidence of fair value of a delivered element, we allocate revenue to the fair value of the undelivered elements and the residual revenue to the delivered elements. The price charged when an element is sold separately generally determines fair value.

When the arrangement with the customer includes future obligations or obtaining customer acceptance, we recognize revenue when those obligations have been met or customer acceptance has been received. We defer revenue from services and support provided under our warranty programs and recognizes it on a straight-line basis over the warranty period. Deferred revenue represents amounts received from customers in advance of services and support to be provided and amounts received prior to customer acceptance. Provisions are recorded at the time of sale for estimated product returns, standard warranty obligations, and customer support.

OFF-BALANCE SHEET ARRANGEMENTS

As of December 31, 2003, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our current or future financial condition, revenues or expenses, results of operations, liquidity, or capital resources.

CONTRACTUAL OBLIGATIONS

The following table summarizes, as of December 31, 2003, the timing of future cash payments due under certain contractual obligations (in thousands):

RISK FACTORS AFFECTING FUTURE OPERATING RESULTS

Quarterly Fluctuations—Because our quarterly operating results have fluctuated significantly in the past and are likely to fluctuate significantly in the future, our stock price may be volatile.

In the past, we have experienced significant fluctuations in our quarterly results due to a number of factors. In the future, our quarterly operating results may fluctuate significantly and may be difficult to predict given the nature of our business. Many factors could cause our operating results to fluctuate from quarter to quarter, including the following:

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The factors listed above may affect our business and stock price in several ways. Given our high fixed costs from overhead, research and development, and advertising and marketing, and other activities necessary to run our business, if our net sales are below our expectations in any quarter, we may not be able to adjust spending accordingly. For example, during 2002 our net sales declined 31% from 2001, but our operating expenses only declined 13%, mainly because of the relatively high fixed costs in our operations. Our stock price may decline and may be volatile if our future sales and operating costs continue to reflect historical volatility patterns. Furthermore, the above factors, taken together may make it more difficult for us to issue additional equity in the future or raise debt financing to fund future acquisitions and accelerate growth.

Generally Declining Sales—Our sales have generally decreased over the last three years and we are experiencing increased difficulty predicting future operating results.

Although, due to unfavorable economic and market conditions over the past three years, our sales over the last three-year period have generally declined or been flat, we have shown sequential quarter and year-over-year increases in the last two quarters of 2003. Nonetheless, we believe that it may be too early to predict an upward trend in sales. As a result, we are unable to predict future sales accurately, and we are currently unable to provide long-term guidance for future financial performance. The conditions contributing to this difficulty include the following:

Based on these and other factors, many of our major customers have reduced, modified, cancelled, or rescheduled orders for our products and have expressed uncertainty as to their future requirements.

Economic Downturn—Our operating results and financial condition could continue to be harmed if the telecommunications and cable broadband industries remain over supplied.

The current economic downturn has resulted in reduced purchasing and capital spending in the telecommunications and cable broadband industries, which have been in a downward cycle characterized by diminished product demand, excess manufacturing capacity, and the increasing erosion of average selling prices. The downturn has adversely affected the businesses and cash flows of many of our customers and has even caused some of them to file for bankruptcy. We are uncertain how long the current downturn will last. Continuation of the downturn or any further decline in our customers’ markets or in general economic conditions would likely result in a further reduction in demand for our products and services and also would further limit our customers’ ability to pay for the

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products that they buy from us. All of these circumstances could harm our consolidated financial position, results of operations, cash flows, and stock price and could hinder our ability to reach our goals of restoring long-term profitability and growth.

Long-term Impact of Cost Controls—The actions we have taken and may take in response to the recent slowdown in demand for our products and services could have long-term adverse effects on our business.

Over the past three years, our business generally has experienced lower revenues due to decreased or cancelled customer orders. To scale back our operations and to reduce our expenses in response to this decreased demand for our products and services and lower revenue, we have reduced portions of our workforce, restricted hiring, reduced some employees’ salaries, restricted pay increases, and reduced discretionary spending.

There are several risks inherent in our efforts to transition to a reduced cost structure. These include the risk that we will not be able to reduce expenditures quickly enough and sustain them at a level necessary to restore profitability, and that we may have to undertake further restructuring initiatives that would entail additional charges. In addition, there is the risk that cost-cutting initiatives will impair our future ability to develop and market products effectively, to manage and control our business, and to remain competitive. Each of the above measures could have long-term effects on our business by reducing our pool of technical talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting our ability to increase production quickly if and when the demand for our products increases, and limiting our ability to hire and retain key personnel. These circumstances could cause our earnings to be lower than they otherwise might be.

Dependence on Wireline Access Products—A significant portion of our sales have been from our wireline access products, which makes our future sales and overall business vulnerable to product obsolescence and technological change.

Sales of our DSL and other wireline access products represented approximately 44% of our net sales during 2003 and 42% during 2002. Currently, our DSL products are primarily used by a limited number of incumbent local exchange carriers, including the regional Bell operating companies, and competitive local exchange carriers who offer DSL services. These parties, and other Internet service providers and users, are continuously evaluating alternative high-speed data access technologies, including cable modems, fiber optics, wireless technology, and satellite technologies, and may at any time adopt these competing technologies. These competing technologies may ultimately prove to be superior to DSL services and reduce or eliminate the demand for our DSL products.

Manufacturing Capacity—If demand for our products does not match our manufacturing capacity, our earnings may suffer.

Because we cannot immediately adapt our production capacity and related cost structures to rapidly changing market conditions, when demand does not meet our expectations, our manufacturing capacity exceeds our production requirements, and profitability may decline. Conversely, if during a market upturn we cannot increase our manufacturing capacity to meet product demand, we will not be able to fulfill orders in a timely manner, which in turn may have a negative effect on our earnings and overall business.

Risks of the Telecommunications Industry—We face several risks related to the telecommunications industry, including the possible effects of its unpredictable growth or decline, the possible effects of consolidation among our principal customers, and the risk that deregulation will slow.

After the passage of the Telecommunications Act of 1996, the telecommunications industry experienced rapid growth. The growth led to great innovations in technology, intense competition, short product life cycles, and, to some extent, regulatory uncertainty inside and outside the United States. However, the course of the development of the

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telecommunications industry is difficult to predict. Companies operating in this industry have a difficult time forecasting future trends and developments and forecasting customer acceptance of competing technologies. One possible effect of this uncertainty is that there is, and may continue to be, a delay or a reduction in these companies’ investment in their business and purchase of related equipment, such as our products, and a reduction in their and our access to capital. In addition, deregulation may result in a delay or a reduction in the procurement cycle because of the general uncertainty involved with the transition period of businesses.

The growth that occurred after the passage of the Telecommunications Act of 1996 has slowed dramatically, and it is unknown whether or when it will resume. This slowdown has resulted in reduced investment in the telecommunications industry in general and delayed purchase orders for service verification equipment such as our products in particular. It is not possible to predict whether this slowdown will be temporary or sustained.

In addition, the telecommunications industry has been experiencing consolidation among its primary participants, such as incumbent local exchange carriers and competitive local exchange carriers, several of whom are our primary customers. For example, in recent years, GTE and Bell Atlantic, both of which were customers of ours, merged to create Verizon Communications Inc. Continued consolidation may cause delay or cancellation of orders for our products. The consolidation of our customers will likely provide them with greater negotiating leverage with us and may lead them to pressure us to lower the prices of our products.

Cable Broadband Industry Health—Many of the major companies in the cable broadband industry have debt and profitability problems, which are expected to negatively impact our cable equipment sales.

The cable broadband industry has taken on significant debt as companies aggressively consolidated and built up impressive new digital networks to allow them to provide better picture quality, internet access, and voice telephony. Profits have declined during the last few years within the industry, however. As a result, many cable companies may reduce their capital expenditures and/or hiring, both of which could adversely impact our cable business more than we now expect. During 2003, we saw evidence of such a slowdown, as our sales of cable broadband products decreased 19% or $3.5 million from 2002 levels.

Customer Concentration—A limited number of customers account for a high percentage of our net sales, and any adverse factor affecting these customers or our relationship with these customers could cause our net sales to decrease.

Our customer base is concentrated, and a relatively small number of companies have accounted for a large percentage of our net sales. Net sales from our top five customers represented approximately 36% of total net sales in 2003 and 31% in 2002. In general, our customers are not subject to long-term supply contracts with us and are not obligated to purchase a specific amount of products from us or to provide us with binding forecasts of purchases for any period.

The loss of a major customer or the reduction, delay, or cancellation of orders from one or more of our significant customers could cause our net sales and, therefore, profits to decline. In addition, many of our customers are able to exert substantial negotiating leverage over us. As a result, they may cause us to lower our prices to them, and they may successfully negotiate other terms and provisions that may negatively affect our business and profits.

Goodwill Valuation—Our financial results could be materially and adversely affected if it is determined that the book value of goodwill is higher than fair value.

Our balance sheet at December 31, 2003 includes an amount designated as “goodwill” that represents approximately 11% of assets and 12% of stockholders’ equity. Goodwill arises when an acquirer pays more for a business than the fair value of the acquired tangible and separately measurable intangible net assets. Under accounting

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pronouncement SFAS No. 142, Goodwill and Other Intangible Assets, beginning in January 2002, the amortization of goodwill has been replaced with an “impairment test,” which requires that we compare the fair value of goodwill to its book value at least annually, and more frequently if circumstances indicate a possible impairment.

Our impairment test is based on a market capitalization analysis. Accordingly, if our market capitalization were to diminish significantly, the book value of goodwill could be higher than the fair value, and we would need to record a non-cash impairment charge for the difference, which could materially and adversely affect our net income or loss.

Product Development—If we are unable to develop new products successfully and enhance our existing products, our future success may be threatened.

The market for our products is characterized by rapid technological advances, changes in customer requirements and preferences, evolving industry and customer-specific protocol standards, and frequent new product enhancements and introductions. Our existing products and our products currently under development could be rendered obsolete by the introduction of products involving competing technologies, by the evolution of alternative technologies or new industry protocol standards, or by rival products of our competitors. These market conditions are more complex and challenging because of the high degree to which the telecommunications industry is fragmented.

We believe our future success will depend, in part, upon our ability, on a timely and cost-effective basis, to continue to do the following:

We cannot ensure that we will accomplish these objectives, and our failure to do so could have a material adverse impact on our market share, business, and financial results.

Furthermore, our expenditures devoted to research and development may be considered high for our level of sales. If these efforts do not result in the development of products that generate strong sales for us or if we do not continue to reduce these expenditures, our profit levels will not return to their desired levels. If we reduce this spending, we may not be able to develop needed new products, which could negatively impact our sources of new revenues.

Sales Implementation Cycles—The length and unpredictability of the sales and implementation cycles for our products makes it difficult to forecast revenues.

Sales of our products often entail an extended decision-making process on the part of prospective customers. We frequently experience delays following initial contact with a prospective customer and expend substantial funds and management effort pursuing these sales. Our ability to forecast the timing and amount of specific sales is therefore limited. As a result, the uneven buying patterns of our customers may cause fluctuations in our operating results, which could cause our stock price to decline.

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Other sources of delays that lead to long sales cycles, or even a sales loss, include current and potential customers’ internal budgeting procedures, internal approval and contracting procedures, procurement practices, and testing and acceptance processes. Recently, our customers’ budgeting procedures have lengthened. The sales cycle for larger deployments now typically ranges from six to twenty-four months. The deferral or loss of one or more significant sales could significantly affect our operating results, especially if there are significant selling and marketing expenses associated with the deferred or lost sales.

Managing Growth and Slowdowns—We may have difficulty managing expansions and contractions in our operations, which could reduce our chances of maintaining or restoring our profitability.

We experienced rapid growth in revenues and in our business during 1999 and 2000 followed by significant slowdowns in 2001, 2002, and 2003 that have placed, and may continue to place, a significant strain on our management and operations. For example, our revenues increased to $113.5 million in 2000 from $61.5 million in 1999. Then revenues fell to $79.1 million in 2001 and to $54.3 million in 2002, and then increased slightly to $54.9 million in 2003. As a result of our historical growth and potential future growth or slowdowns, we face several risks, including the following:

We cannot ensure that we will be able to successfully manage growth or slowdowns successfully or profitably.

Acquisitions—We have acquired multiple companies and lines of business, and we may pursue additional acquisitions in the future. These activities involve numerous risks, including the use of cash, acquired intangible assets, and the diversion of management attention.

We have acquired multiple companies and lines of business. As a result of these acquisitions, we face numerous risks, including the following:

The risks stated above are made more difficult because most of the companies we have acquired are located outside of the United States. In addition, if we make future acquisitions, these risks will be exacerbated by the need to integrate additional operations at a time when we may not have fully integrated all of our previous acquisitions.

If we pursue additional acquisitions, we will face similar risks as those outlined above and additional risks, including the following:

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We cannot ensure that we will locate suitable acquisition candidates or that, if we do, we will be able to acquire them and then integrate them effectively, efficiently, and successfully into our business.

Competition—Competition could reduce our market share and decrease our net sales.

The market for our products is fragmented and intensely competitive, both inside and outside the United States, and is subject to rapid technological change, evolving industry standards, regulatory developments, and varied and changing customer preferences and requirements. We compete with a number of United States and international suppliers that vary in size and in the scope and breadth of the products and services offered.

The following table sets forth our principal competitors in each of our product categories.

Many of these competitors have longer operating histories, larger installed customer bases, longer relationships with customers, wider name recognition and product offerings, and greater financial, technical, marketing, customer service, and other resources than we have.

We expect that as our industry and markets evolve new competitors or alliances among competitors with existing and new technologies may emerge and acquire significant market share. We anticipate that competition in our markets will increase, and we will face continued threats to our market share and price pressure on our products. Also, over time, our profitability, if any, may decrease. In addition, it is difficult to assess accurately the market share of our products or of Sunrise overall because of the high degree of fragmentation in the market for service verification equipment. As a result, it may be difficult for us to forecast accurately trends in the market, which of our products will be the most competitive over the longer term, and therefore, what is the best use of our cash and human and other forms of capital.

Dependence on Key Employees—If one or more of our senior managers were to leave, we could experience difficulty in replacing them and our operating results could suffer.

Our success depends to a significant extent upon the continued service and performance of a relatively small number of key senior management, technical, sales, and marketing personnel. In particular, the loss of either of two of our founders, Paul Ker-Chin Chang or Paul A. Marshall, would likely harm our business. Neither of these individuals is bound by an employment agreement with us, and we do not carry key man life insurance. If any of our senior managers were to leave Sunrise, we would need to devote substantial resources and management attention to replace them. As a result, management attention may be diverted from managing our business, and we may need to pay higher compensation to replace these employees.

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Dependence on Sole and Single Source Suppliers—Because we depend on a limited number of suppliers and some sole and single source suppliers that are not bound by long-term contracts, our future supply of parts is uncertain.

We purchase many key parts, such as microprocessors, field programmable gate arrays, bus interface chips, optical components, and oscillators, from single source or sole suppliers, and we license certain software from third parties. We rely exclusively on third-party subcontractors to manufacture some sub-assemblies, and we have retained, from time to time, third party design services in the development of our products. We do not have long-term supply agreements with these vendors. In general, we make advance purchases of some products and components to help to ensure an adequate supply. In the past, we have experienced supply problems as a result of financial or operating difficulties of our suppliers, shortages, and discontinuations resulting from component obsolescence or other shortages or allocations by suppliers. Our reliance on these third parties involves a number of risks, including the following:

In addition, the purchase of these components on a sole source basis subjects us to risks of price increases and potential quality assurance problems. This dependence magnifies the risk that we may not be able to ship our products on a timely basis to satisfy customers’ orders. We cannot ensure that one or more of these factors will not cause delays or reductions in product shipments or increases in product costs, which in turn could have a material adverse effect on our business.

Risks of International Operations—Our plan to expand sales in international markets could lead to higher operating expenses and may subject us to unpredictable regulatory and political systems.

Sales to customers located outside of the United States represented 39% of our net sales in 2003, 30% in 2002, and 38% in 2001, and we expect international revenues to continue to account for a significant percentage of net sales for the foreseeable future. In addition, an important part of our strategy calls for further expansion into international markets. As a result, we will face various risks relating to our international operations, including the following:

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We cannot ensure that one or more of these factors will not materially and adversely affect our ability to expand into international markets or our revenues and profits.

In addition, the Asia/Pacific and Latin America regions have experienced instability in many of their economies and significant devaluations in local currencies. 22% of our sales in 2003, 17% of our sales in 2002, and 19% of our sales in 2001 were from customers located in these regions. These instabilities may continue or worsen, which could have a materially adverse effect on our results of operations. If international revenues are not adequate to offset the additional expense of expanding international operations, our future growth and profitability could suffer.

Operations in Taiwan—We rely on our subsidiary in Taiwan to manufacture a substantial portion of our products, and our reputation and results of operations could be adversely affected if this subsidiary does not perform as we expect.

We produce a substantial portion of our products at our subsidiary in Taiwan and plan to concentrate more of our production there in the future. We depend on our subsidiary to produce a sufficient volume of our products in a timely fashion and at satisfactory quality levels. If we fail to manage our subsidiary so that it produces quality products on time and in sufficient quantities, our reputation and results of operations could suffer. In additions, we rely on our Taiwan subsidiary to place orders with suppliers for the components they need to manufacture our products. If they fail to place timely and sufficient orders with their suppliers, our results of operations could suffer.

The cost, quality, and availability of our Taiwan operation is essential to the successful production and sale of our products. Our increasing reliance on this foreign subsidiary for manufacturing exposes us to risks that are not under our immediate control and which could negatively impact our results of operations. For example, a recurrence of the Severe Acute Respiratory Syndrome (SARS) outbreak that occurred in Asia last year could result in quarantines or closure of our manufacturing operation or its suppliers. In addition, transportation delays and interruptions, political and economic disruptions, the imposition of tariffs, quotas, or other import or export controls, changes in governmental policies and regulations, and natural disasters could also adversely impact our Taiwan operation and negatively impact our results of operations. See “Risk Factors Affecting Future Operating Results—Dependence on Sole and Single Source Suppliers and—Risks of International Operations” for a discussion of risks associated with concentrating production activities at one facility that is outside the United States.

Concentration of Control—Our executive officers and directors retain significant control over us, which allows them to decide the outcome of matters submitted to stockholders for approval. This influence may not be beneficial to all stockholders.

As of December 31, 2003, Paul Ker-Chin Chang, Paul A. Marshall, and Robert C. Pfeiffer beneficially owned approximately 26%, 24%, and 13%, respectively, of our outstanding shares of common stock. Consequently, these three individuals, control approximately 63% of our outstanding shares of common stock and to the extent they act together would be able to control the election of our directors and the approval of significant corporate transactions that must be submitted to a vote of stockholders. In addition, Mr. Chang, Mr. Marshall, and Mr. Pfeiffer constitute three of the six members of the board of directors and have significant influence in directing the actions taken by the board. The interests of these persons may conflict with the interests of other stockholders, and the actions they take or approve may be contrary to those desired by other stockholders. This concentration of ownership and control of the

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management and affairs of our company may also have the effect of delaying or preventing a change in control of our company that other stockholders may consider desirable.

Potential Product Liability—Our products are complex, and our failure to detect errors and defects may subject us to costly repairs and product returns under warranty and product liability litigation.

Our products are complex and may contain undetected defects or errors when first introduced or as enhancements are released. These errors may occur despite our testing and may not be discovered until after a product has been shipped and used by our customers. Many of the products that we ship contain imperfections that we consider to be insignificant at the time of shipment. We may misjudge the seriousness of a product imperfection and allow it to be shipped to our customers. These risks are compounded by the fact that we offer many products with multiple hardware and software modifications, which makes it more difficult to ensure high standards of quality control in our manufacturing process. The existence of these errors or defects could result in costly repairs and/or returns of products under warranty and, more generally, in delayed market acceptance of the product or damage to our reputation and business.

In addition, the terms of our customer agreements and purchase orders which provide us with protection against unwarranted claims of product defects and errors may not protect us adequately from unwarranted claims against us, unfair verdicts if a claim were to go to trial, settlement of these kinds of claims, or future regulation or laws regarding our products. Our defense against such claims in the future, regardless of their merit, could result in substantial expense to us, diversion of management time and attention, and damage to our business reputation and our ability to retain existing customers or attract new customers.

Intellectual Property Risks—Policing any unauthorized use of our intellectual property by third parties and defending any intellectual property infringement claims against us could be expensive and disrupt our business.

Our intellectual property and proprietary technology is an important part of our business, and we depend on the development and use of various forms of intellectual property and proprietary technology. As a result, we are subject to several related risks, including the risks of unauthorized use of our intellectual property and the costs of protecting our intellectual property.

Much of our intellectual property and proprietary technology is not protected by patents. If unauthorized persons were to copy, obtain, or otherwise misappropriate our intellectual property or proprietary technology without our approval, the value of our investment in research and development would decline, our reputation and brand could be diminished, and we would likely suffer a decline in revenue. We believe these risks, which are present in any business in which intellectual property and proprietary technology play an important role, are exacerbated by the difficulty in finding unauthorized use of intellectual property in our business, the increasing incidence of patent infringement in our industry in general, and the difficulty of enforcing intellectual property rights in some foreign countries.

In addition, litigation has in the past been, and may in the future be, necessary to enforce our intellectual property rights. This kind of litigation is time-consuming and expensive to prosecute or resolve, and results in substantial diversion of management resources. We cannot ensure that we will be successful in that litigation, that our intellectual property rights will be held valid and enforceable in any litigation, or that we will otherwise be able to protect our intellectual property and proprietary technology.

In the future, we may receive notices from holders of patents that raise issues as to possible infringement by our products. As the number of telecommunications test, measurement, and network management products increases and the functionality of these products further overlap, we believe that we may become subject to allegations of infringement given the nature of the telecommunications industry and the high incidence of these kinds of claims. Questions of

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infringement and the validity of patents in the field of telecommunications technologies involve highly technical and subjective analyses. These kinds of proceedings are time consuming and expensive to defend or resolve, result in substantial diversion of management resources, cause product shipment delays, and could force us to enter into royalty or license agreements rather than dispute the merits of the proceeding initiated against us.

Anti-takeover Provisions—Anti-takeover provisions in our charter documents could prevent or delay a change of control and, as a result, negatively impact our stockholders.

Some provisions of our certificate of incorporation and bylaws may have the effect of discouraging, delaying, or preventing a change in control of our company or unsolicited acquisition proposals that a stockholder may consider favorable. These provisions provide for the following:

Some provisions of Delaware law and our stock incentive plans may also have the effect of discouraging, delaying, or preventing a change in control of our company or unsolicited acquisition proposals. These provisions also could limit the price that some investors might be willing to pay in the future for shares of our common stock.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We sell our products in North America, Asia, Latin America, Africa, the Middle East, and Europe and maintain operations in several different countries. Changes in currency exchange rates affect the valuation in our financial statements of the assets and liabilities of these operations. We also have a small amount of sales denominated in Euros and the Canadian dollar, which are also affected by changes in currency exchange rates. To hedge these risks, we have at certain times used derivative financial instruments. However, as of December 31, 2003, we had no derivative financial instruments or other foreign exchange risk hedging devices. With or without hedges, our financial results could be affected by changes in foreign currency exchange rates, although foreign exchange risks have not been material to our financial position or results of operations so far.

We are exposed to the impact of interest rate changes and changes in the market values of our investments. Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We have not held derivative financial instruments in our investment portfolio. We invest our excess cash in depository accounts with financial institutions, in debt instruments of United States governmental agencies, and in debt instruments of high-quality corporate issuers, and, by policy, we limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market, and reinvestment risk through portfolio diversification and review of the financial stability of the institutions with which we deposit funds and from whom we purchase debt instruments.

Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating

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rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates. Because our investment policy restricts us to conservative, interest-bearing investments and because our business strategy does not rely on generating material returns from our investment portfolio, we do not expect our market risk exposure on our investment portfolio to be material.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements

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Independent Auditors’ Report

The Board of Directors and Stockholders

Sunrise Telecom Incorporated

We have audited the accompanying consolidated balance sheets of Sunrise Telecom Incorporated and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sunrise Telecom Incorporated and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 6 to the consolidated financial statements, effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.

KPMG LLP

Mountain View, California

January 28, 2004

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SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

Consolidated Balance Sheets

(in thousands, except share data)

See accompanying notes to consolidated financial statements.

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SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

Consolidated Statements of Operations

(in thousands, except per share data)