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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended March 31, 2004.

or

For the transition period from              to              .

Commission File Number 000-30928

PATH 1 NETWORK TECHNOLOGIES INC.

(Exact name of registrant as specified in its charter)

6215 FERRIS SQUARE, SUITE 140, SAN DIEGO, CALIFORNIA 92121

(858) 450-4220

(Address, including zip code, and telephone number, including area code, of principal executive offices)

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 whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes  ¨    No  x

As of April 30, 2004, 6,692,317 shares of the registrant’s common stock were outstanding.

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PATH 1 NETWORK TECHNOLOGIES INC.

Quarterly Report on Form 10-Q

For the Quarterly Period Ended March 31, 2004

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Path 1 Network Technologies Inc.

Condensed Consolidated Balance Sheets

(in thousands, except shares data)

See accompanying notes to these condensed consolidated financial statements.

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Path 1 Network Technologies Inc.

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)

See accompanying notes to these condensed consolidated financial statements.

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Path 1 Network Technologies Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

See accompanying notes to these condensed consolidated financial statements.

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Path 1 Network Technologies Inc.

Notes to the Unaudited Condensed Consolidated Financial Statements

Note 1 – Basis of Presentation

The accompanying condensed consolidated balance sheet at March 31, 2004, the condensed consolidated statements of operations for the three-month periods ended March 31, 2004 and 2003, and the condensed consolidated statements of cash flows for the three-month periods ended March 31, 2004 and 2003, have been prepared by Path 1 Network Technologies Inc. (the “Company”) and have not been audited. The condensed consolidated balance sheet at December 31, 2003 has been audited. These condensed consolidated quarterly financial statements, in the opinion of management, include all adjustments, consisting only of normal and recurring adjustments, necessary to state fairly the financial information set forth therein, in accordance with accounting principles generally accepted in the United States. These condensed quarterly condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2003 included in the Company’s Form 10-K/A filed May 4, 2004. The interim consolidated financial information contained in this filing is not necessarily indicative of the results to be expected for any other interim period or for the full year ending December 31, 2004.

The Annual Report on Form 10-K/A for the year ended December 31, 2003, includes restated consolidated financial information for the first three quarters of 2003 from our previously reported unaudited financial results. Financial statement information and related disclosures included in the Form 10-K/A reflect, as noted, changes as a result of the restatement.

This restatement related to the recording of the embedded beneficial conversion feature related to convertible promissory notes we issued in 2002 and 2003. The related debt discount resulted from the conversion price of the notes being less than the fair value of our common stock on the date the notes were issued, which resulted in the embedded beneficial conversion feature. We had initially determined fair value based on a discount to the market price of the underlying common stock which was then trading on the over-the-counter market. This discount was determined based on independent valuations of our common stock. This accounting treatment was formulated in 2000 in connection with the filing of our Form 10 and had been consistently applied.

This restatement resulted from our revision of this accounting methodology in favor of determining fair value of our common stock by reference primarily to the market trading price. This is in line with the terms of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Rates.” EITF 98-5 states generally that the trading price on an active market is the best evidence of fair value. Our previous accounting methodology was based on the view that an active trading market for our common stock did not exist at the time the promissory notes were issued and that reliance solely on the over-the-counter trading price would not yield fair value. The financial restatement described in the Form 10-K/A resulted from a change in our accounting methodology towards reliance on the market trading prices as quoted on the OTC Bulletin Board to determine fair value.

The effects of this restatement were non-cash and non-operating, and only required adjustments to interest expense, notes payable and stockholders’ equity. The significant effects of the restatement on the quarter ended March 31, 2003, were as follows (in thousands):

On July 23, 2003, the Company effected a one-for-six reverse stock split in anticipation of its public offering and listing on the American Stock Exchange. All per share figures herein reflect such reverse stock split.

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Reclassifications

Certain reclassifications have been made to prior periods financial statements to conform to current year presentation.

Recently Issued Accounting Standards

In April 2002, the FASB issued SFAS No. 145 (“SFAS No. 145”) Rescission of SFAS No. 4, 44 and 64, Amendment of SFAS No. 13, and Technical Corrections. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 requires, among other things, (i) that the modification of a lease that results in a change of the classification of the lease from capital to operating under the provisions of SFAS No. 13 be accounted for as a sale-leaseback transaction, and (ii) the reporting of gains or losses from the early extinguishment of debt as extraordinary items only if they met the criteria of Accounting Principles Board Opinion No. 30, Reporting the Results of Operations. The amendment of SFAS No. 13 is effective for transactions occurring on or after May 15, 2002. Although the rescission of SFAS No. 4 is effective January 1, 2003, the FASB has encouraged early application of the provisions of SFAS No. 145. On August 6, 2003, the Company repurchased $1,180,000 principal amount, plus accrued unpaid interest totaling $25,427, of its 7% convertible notes payable for an aggregate amount of $1,382,427. The Company recognized a $262,000 ordinary loss on the early extinguishment of these notes. See Note 10.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. This statement amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

The following table summarizes the impact on the Company’s net loss had compensation cost been determined based upon the fair value at the grant date for awards under the stock option plans consistent with the methodology prescribed under SFAS No. 123 (in thousands, except per share data):

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities. This interpretation clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. It further clarifies whether an entity shall be subject to consolidation according to the provisions of this interpretation, if by design, certain conditions exist. Management is assessing the impact of this interpretation.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities. This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. Management has assessed the impact of this statement and believes that it has no material impact.

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Note 2 – Public Offering

On July 30, 2003, the Company raised $13.5 million in a public offering of 1,250,000 units consisting of three shares of the Company’s common stock and two publicly traded redeemable warrants. The Company’s common stock, units and public warrants commenced trading on the American Stock Exchange on July 31, 2003. On August 29, 2003, the Company raised approximately $2.0 million from the issuance of an additional 187,500 units consisting of three shares of the Company’s common stock and two publicly traded redeemable warrants. In total, the Company raised approximately $15.5 million and issued 1,437,500 units representing 4,312,500 common shares and 2,875,000 warrants to purchase common stock of the Company. On August 30, 2003, in accordance with the units’ terms, the units separated and the 4,312,500 common shares and 2,875,000 warrants became outstanding as such rather than as components of units.

Net proceeds, after expenses, from the public offering was approximately $13.1 million. Expenses included $1,164,375 of underwriting discounts, a managing underwriter’s non-accountable expense allowance of $349,313, other expenses paid for underwriters of $45,500, and approximately $911,000 of legal, accounting, printing and other expenses. None of these payments went directly or indirectly to our directors, officers, general partners, affiliates, 10% owners, or any of their associates.

Note 3 – Management Estimates And Assumptions

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and reported amounts of expenses during the reporting period. Actual results could differ from those estimates.

Note 4 – Inventory

The Company records inventory, which consists primarily of raw materials used in the production of video gateways and related products, at the lower of cost or market. Cost is determined principally on the average cost method. Provisions for potentially obsolete or slow-moving inventory are made based on an analysis of inventory levels and future sales forecasts.

Note 5 – Revenue Recognition

We generate revenue primarily from the sale of our video gateway products. We sell our products through direct sales channels and through distributors or resellers. Generally, product revenue is generated from the sale of video gateway products. We also derive revenue from contract services and license fees.

Product Revenue

We recognize product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured. Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, we may recognize revenue when the products are shipped or defer recognition until evidence of sell-through occurs and cash is received. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized. Our products generally carry a one-year warranty from the date of purchase.

Contract Service Revenue

Revenue from support or maintenance contracts, including extended warranty programs, is recognized ratably over the contractual period. Amounts invoiced to customers in excess of revenue recognized on support or maintenance contracts are recorded as deferred revenue until the revenue recognition criteria are met. Revenue on engineering design contracts, including technology development agreements, is recognized on a percentage-of-completion method, based on costs incurred to date compared to total estimated costs, subject to acceptance criteria. Billings on uncompleted contracts in excess of incurred costs and accrued profits are classified as deferred revenue.

License Revenue

Revenues from license fees are recognized when persuasive evidence of a sales arrangement exists, delivery and acceptance have occurred, the price is fixed or determinable, and collectability is reasonably assured.

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Allowances for Doubtful Accounts, Returns and Discounts

We establish allowances for doubtful accounts, returns and discounts based on credit profiles of our customers, current economic trends, contractual terms and conditions and historical payment, return and discount experience, as well as for known or expected events. If there were to be a deterioration of a major customer’s creditworthiness, or if actual defaults, returns or discounts were higher than our historical experience, our operating results and financial position could be adversely affected.

Note 6 – Warranty Reserves, Indemnification Arrangements and Guarantees

In connection with the Company’s adoption of FASB Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others, the following disclosures are made with respect to the Company’s product warranties.

We provide a limited warranty for our products. A provision for the estimated warranty cost is recorded at the time revenue is recognized. Liabilities for the estimated future costs of repair or replacement are established and charged to cost of sales at the time the related revenue is recognized. The amount of liability to be recorded is based on management’s best estimates of future warranty costs after considering historical and projected product failure rates and product repair costs. The Company’s standard product warranties are for one year, although in some agreements, it may warrant products for periods in excess of one year. The Company had $126,000 in warranty reserves at March 31, 2003. The following table summarizes the activity in the liability accrual related to product warranty during the three months ended March 31, 2004:

The Company also undertakes indemnification obligations in the ordinary course of business related to its products, the licensing of its software, and the issuance of securities. Under these arrangements, the Company may indemnify other parties such as business partners, customers, and underwriters, for certain losses suffered, claims of intellectual property infringement, negligence and intentional acts in the performance of services, and violations of laws including certain violations of securities laws. The Company’s obligation to provide such indemnification in such circumstances would arise if, for example, a third party sued a customer for intellectual property infringement and the Company agreed to indemnify the customer against such claims. The Company is unable to estimate with any reasonable accuracy the liability that may be incurred pursuant to its indemnification obligations. Some of the factors that would affect this assessment include, but are not limited to, the nature of the claim asserted, the relative merits of the claim, the financial ability of the parties, the nature and amount of damages claimed, insurance coverage that the Company may have to cover such claims, and the willingness of the parties to reach settlement, if any. Because of the uncertainty surrounding these circumstances, the Company’s indemnification obligations could range from immaterial to having a material adverse impact on its financial position and its ability to continue in the ordinary course of business.

Note 7 – Off Balance Sheet Arrangements

We do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as special purpose entities (“SPEs”).

Note 8 – Reportable Operating Segments

The Company is a network communications technology company enabling simultaneous delivery of broadcast quality and interactive video transmissions and other real-time data streams over Internet Protocol (IP) networks. For the purpose of applying SFAS No. 131, management determined that, subsequent to the discontinuance of the Silicon Systems business unit (“Sistolic”) in April 2002, it has one operating segment.

Note 9 – Stock Options

The Company accounts for stock-based compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (“APB”) 25, Accounting for Stock Issued to Employees, Statement of Financial Accounting Standards (SFAS), Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or

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Award Plans, and SFAS Interpretation No 38, Determining the Measurement Date for Stock Option, Purchase, and Award Plans involving Junior Stock. The Company also complies with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation.

The Company accounts for equity instruments issued to non-employees using the fair value method in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. This statement amends FASB Statement No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has made the required disclosure under SFAS No. 148. See Note 1.

Equity instruments issued to non-employees that are fully vested and non-forfeitable are measured at fair value at the issuance date and expensed in the period over which the benefit is expected to be received. Equity instruments issued to non-employees which are either unvested or forfeitable, for which counter-party performance is required for the equity instrument to be earned, are measured initially at the fair value and subsequently adjusted for changes in fair value until the earlier of: 1) the date at which a commitment for performance by the counter-party to earn the equity instrument is reached; or, 2) the date on which the counter-party’s performance is complete.

During the three-month period ended March 31, 2004, the Company recorded no stock-based compensation expense related to the amortization of options outstanding to employees and consultants. For the same three-month period in 2003, the Company recognized expense of $25,000 related to the amortization of stock-based compensation.

Note 10 – Notes Payable

In 2002 and 2003, the Company closed private placements of aggregate $4.4 million in face value of convertible notes payable and warrants and received cash proceeds, net of issuance costs, of approximately $3.7 million from accredited investors.

During the three months ended March 31, 2004, approximately $331,000 of note principal along with accrued interest was converted into the Company’s common stock. The carrying value of the Company’s remaining convertible notes payable, excluding our line of credit, at March 31, 2004, is as follows:

On February 14, 2003, the Company entered into a $1 million revolving line of credit with Laurus. This revolving line of credit (“the LOC”) is secured by the Company’s accounts receivables and other assets, and the Company has the ability to draw down advances under the LOC subject to limits. Under the terms of the LOC, Laurus can convert advances made to the Company into common stock at a fixed conversion price of $6.78 per share. In connection with the LOC, the Company issued warrants to purchase 12,500 shares of the Company’s Common Stock at $6.78 per share. On February 14, 2003, the Company borrowed a $300,000 advance under the LOC. The Company recorded a non-cash debt discount of $23,000 in its quarter ended March 31, 2003. The carrying value of the LOC at March 31, 2004, is zero.

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The maturities of the Company’s notes payable at March 31, 2004, are as follows (in thousands):

Long-term notes payable consist of the following at March 31, 2004:

At March 31, 2004, the maturities of long-term debt, net of discount, are as follows:

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

Forward Looking Statements

This document may contain forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. Except to the extent required by federal law, we disclaim any duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

You are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made in this Item 2 or in our annual report on Form 10-K and other reports and filings made with the Securities and Exchange Commission.

OVERVIEW

The most important challenge that we, as an emerging company, now face is to execute efficiently and effectively in the key areas of our operations as we commercialize our technology products. We are making important changes in our senior management as part of our effort to demand and achieve better focus and results in our operations. We continue to believe that our technology is attractive to the marketplace and in particular we see good short-term opportunities with our long-haul products and with a strategy of augmenting our indirect selling channels with more direct sales and marketing efforts.

We are an industry leader in developing and supplying video router or gateway products that enable the transportation and distribution of real-time, high-quality video over Internet Protocol (IP) networks, such as the networks that comprise the Internet. Our products are currently used in two different segments of the video market. Our products are used by a variety of providers to transmit high-quality, real-time video to one or more locations throughout the United States or the world (which we refer to as “long-haul transmission”). Our products are also used by cable companies to supply video-on-demand services. We do not sell our products to individual consumers. Our customers include cable, broadcast and satellite companies, movie studios, carriers, and government and educational institutions and system integrators that supply them. We refer to these customers as communication service providers, or simply as providers.

Long Haul & Broadcast Service

Broadcasters and news organizations need to move high quality video over long distances. In the broadcast industry, video is both distributed (for example, a video program that a broadcaster broadcasts to its viewers) as well as contributed (for instance, the video clips from multiple sources that are transported between and among broadcast studios or affiliates to be assembled into a video segment such as a news report or feature story that is, in turn, distributed for broadcast to viewers). For the distribution and contribution of broadcast quality video, broadcasters have traditionally used satellite links or procured dedicated bandwidth on fiber lines, both of which are very expensive and usually require multi-year contracts. Our products now allow the same video to be moved over existing IP networks at significantly reduced cost. In 2003, roughly 50% of our product revenues were derived from the long haul broadcast market.

Our Cx1000 product is currently being used by dedicated bandwidth providers to deliver broadcast video in key US and international cities. Customers using our products for long-haul transmission include the Vyvx division of WilTel Communications which recently used our Cx1000 to carry both the live primary and backup high definition (“HD”) broadcasts of Super Bowl XXXVIII^® over Vyvx’s HD VenueNet at 40.5 Mpbs and 270 Mbps, respectively. Vyvx accounted for 17% of our product revenue in 2003. C-SPAN uses our products to televise real-time, interactive classrooms between Washington, D.C. and the University of Denver. RTVI, a Russian television network, runs live broadcast-quality Russian language programming between Moscow and New York using our long haul product, and is expanding its network internationally. Currently, Level (3) offers full and part-time video services using our Cx1000 product to deliver broadcast video in key US and European cities.

Cable Companies

The versions of our Chameleon vidX^™ product line designed for cable companies allows them to use existing digital set-top boxes already in consumer homes to provide video-on-demand services, a significant competitive advantage over satellite providers. The more efficient use of existing bandwidth (both into the home and within the network) allows cable companies to increase the volume of content (whether movies, television or live events) available for delivery whenever requested by the cable subscriber, or to increase the number of subscribers served with existing content volume.

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Today, consumers who desire to have personalized video recording in the home, must purchase the necessary digital video recorder (“DVR”) and subscribe to a service. We believe that the drawbacks to DVRs are requiring the purchase of additional equipment in the home or the swapping out of the existing in-home set top box for a new set top box with local storage. Using our products, cable companies could in the future offer network-based (with our equipment sitting at the edge of the network) personalized video recorder capabilities to their subscribers to compete with in-home DVR service providers. Cable company subscribers in this case would not require a DVR in the home to enjoy on-demand viewing.

We believe that the desire for video-on-demand—indeed, all content-on-demand—will continue to rise as consumers become increasingly aware of its availability and benefits, and as IP networks enabled by our products provide access to significant amounts of interactive programming previously unavailable. Cable companies currently using our products include companies such as Time-Warner and Cablevision.

Additionally, our products enable cable companies to deliver HD television that can potentially overwhelm the bandwidth capacity of current delivery technologies. HD television requires at least five times the bandwidth currently required for standard television transmissions. Using our products, providers can avoid incurring significant capital expenditures to increase the capacity of existing infrastructure, and can avoid significant recurring costs to maintain and support the expanded networks resulting from HD television and increased numbers of channels. Should these providers use existing methods of transmission, they might eventually be forced to decrease programming or other services to conserve bandwidth.

Satellite Providers

Satellite providers broadcast signals to earth from satellites 22,000 miles above sea level. Because of the coverage area (or “footprint”) from that altitude, satellite broadcasts are capable of reaching vast areas. Uplinking content to the satellite for subsequent broadcast back to Earth, however, must be done at earth stations located in areas with characteristics favorable for uplinking. Currently, many satellite providers collect content at these uplink earth stations. As a result, information often “hops” from its source to and from the Earth via interim earth stations and satellites until its reaches the uplink earth station positioned to deliver the content to the end-user. Satellites have a maximum 15-year useful life, requiring satellite providers to periodically revisit the extreme expense of launching and maintaining a satellite in orbit.

Our Cx1000 product line allows satellite providers to gather content at uplink earth stations without the need to hop the content through interim satellites, reducing the strain on, and cost of, satellite networks and their maintenance. In addition to the cost-savings, collecting information at uplink earth stations via IP networks, as opposed to satellite hops, increases the speed by which information moves from source to consumer. Use of our products enables satellite providers to avoid the delay associated with “live” satellite feeds. Each satellite hop introduces a half-second delay whereas an existing terrestrial fiber international circuit has less than a quarter-second delay. PanAmSat is an example of a satellite provider using our Cx1000 product over terrestrial fiber to interconnect earth stations for video routing with the least delay.

Movie Studios and Government Agencies

Certain industries require delivery of exceptionally high resolution, real-time video. Military and other government units require a unique level of sound and picture quality upon which they can make critical, high-consequence decisions. Movie studios demand similar standards upon which to make artistic or editorial decisions regarding their multi-million dollar productions.

To attain the level of resolution required by studios and for government applications requires data to be delivered uncompressed. Compression, a common means for transporting high-resolution data, is designed to eliminate what would typically be redundant or unnecessary information, or to allow data to fit on satellites’ limited bandwidth. Because of the unerring detail required by these industries, what is generally acceptable TV-quality degradation becomes unacceptable. The opposing requirements of exceptionally high resolution and high bit-rate make most delivery methods (such as satellite) unusable. Our Cx1000 enables the delivery of exceptionally high resolution, high bit-rate, and real-time video. Our products are currently in limited use by DreamWorks SKG for domestic and international creative collaborations using high-definition video cameras. DreamWorks SKG accounted for 5% of our 2003 revenues. Additionally, C-SPAN, which accounted for 3% of our 2002 sales, has used our Cx1000 product to televise real-time, interactive classrooms between Washington, D.C. and the University of Denver.

LIQUIDITY AND CAPITAL RESOURCES

Since our inception on January 30, 1998 through July 2003 we financed our operations primarily through the sale of common equity securities to investors and strategic partners, as well as from the issuance of convertible notes. On July 31, 2003, we successfully completed a $13,500,000 public offering of 1.25 million units and the listing of our common stock and units on the American Stock Exchange. A unit consisted of three shares of common stock and two warrants, each warrant to purchase a share of common stock at $5.40 per share. On August 29, 2003, our underwriters exercised their over-allotment option and we raised

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additional proceeds of $2,025,000 from the sale of 187,500 units, bringing total gross proceeds from the public offering (the “IPO”) to $15.5 million. On August 30, 2003, the units separated in accordance with their terms, and the IPO’s common stock (4,312,500 shares) and warrants (2,875,000 warrants) now trade on the American Stock Exchange directly rather than as components of units.

From January 30, 1998 through March 31, 2004, we incurred losses totaling $41.2 million. We have not yet achieved profitability, and we remain a risky enterprise. We believe that our existing capital resources will enable us to fund operations for at least the next twelve months. At March 31, 2004, we had working capital of $5.4 million. Cash and cash equivalents at March 31, 2004 totaled $5.5 million.

In February 2003, we entered into a $1 million revolving line of credit with Laurus. This revolving line of credit (“the LOC”) is secured by our accounts receivables and other assets, and we have the ability to draw down advances under the LOC subject to limits. Under the terms of the LOC, Laurus can convert advances made to us into our common stock at a fixed conversion price of $6.78 per share. The balance outstanding on our LOC was nil at March 31, 2004.

We are not yet profitable and unless we increase our sales substantially we cannot be profitable. For the foreseeable future, we expect to incur substantial additional expenditures associated with cost of sales, marketing, and research and development, in addition to increased costs associated with staffing for management. Additional capital may be required to implement our business strategies and fund our plan for future growth and business development.

At March 31, 2004, we had no material commitments other than our operating leases and convertible notes with a face amount of $228,000 which are due in 2005. Our future capital requirements will depend upon many factors, including the timing of research and product development efforts, the possible need to acquire new technology, the expansion of our sales and marketing efforts, and our expansion internationally. We expect to continue to expend significant amounts in all areas of our operations.

Cash used in operations was approximately $2.4 million for the three months ended March 31, 2004, compared to $877,000 for the same period in 2003. The increase in cash used in operations for the three months ended March 31, 2004, compared to the same period in the prior year, was due primarily to our net loss.

Cash used in investing activities for the three months ended March 31, 2004, was $111,000, compared to $5,000 for the same period ended March 31, 2003. In the 2004 quarter, we purchased $120,000 of equipment for use in our engineering lab and for sales and marketing display.

Cash provided by financing activities for the three-month period ended March 31, 2004, was $235,000, compared to cash provided of $910,000 for the same period ended March 31, 2003. The cash provided by financing activities in 2004 resulted primarily from the exercise of warrants issued in 2003 in our 7% convertible notes offering.

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RESULTS OF OPERATIONS

Three Months Ended March 31, 2004 vs. Three Months Ended March 31, 2003

For the quarter ended March 31, 2004, net revenue decreased $272,000, or 41%, to $389,000, compared to $661,000 during the three-month period ended March 31, 2003. Revenues from sales of products in the first quarter ended March 31, 2004, decreased to $351,000, or approximately 41%, from $598,000 in the first quarter ended March 31, 2003. The decrease in product revenues in the quarter ended March 31, 2004, versus the same period in the prior year was principally caused by the timing of orders from our resellers that resulted in production delays, market competition that reduced the selling price of our products within the cable space, and the deferral of revenue recognition on units shipped during the 2004 quarter to our reseller in Japan that had not been sold-through to end users by March 31, 2004. More than half our shipments in the first quarter of 2004 went to one customer in the cable industry at prices that were heavily discounted reflecting the prevalent pricing pressure. The mix of our product sales and the prices at which we sell them may fluctuate from period to period. Contract revenues in the first quarter ended March 31, 2004 were nil, down from $63,000 in the same quarter last year. In the first quarter ended March 31, 2004, revenue from license fees was $20,000. There was no license revenue in the same quarter last year. First quarter 2004 license revenues resulted from a final-stage license fee from an agreement entered into between us and Visionary Solutions in 2002. Under the agreement, which, in part, granted the licensee the right to incorporate our TrueCircuit technology into their products, Visionary Solutions was required to pay $20,000 to us at the time that the licensee first produced their products for sale.

Cost of revenues increased by $18,000, or 5%, to $374,000 in the quarter ended March 31, 2004, from $356,000 in the same quarter last year. The increase in cost of sales reflects higher material costs incurred in the manufacturing of our products, in part caused by parts supply problems and several key parts vendors that resulted in expedite charges. Cost of products sold consists primarily of raw material costs, warranty costs and labor associated with manufacturing, which we now outsource on a turn-key basis.

Gross profit totaled $15,000 for the quarter ended March 31, 2004, compared to gross profit of $305,000 in the same quarter last year. The decrease in gross profit for the current year period versus the prior year period is mainly attributable to a large contract for sales of products, at highly discounted prices, into the cable space, diseconomies of scale due to failure to expand product sales volumes, and the higher material costs in the quarter Our margins on products sold in the cable market may continue to suffer from intense price pressure.

Engineering, research and development expenses for the quarter ended March 31, 2004, increased 19% to $480,000 from $404,000 in the quarter ended March 31, 2003. The increase is due primarily to higher levels of staffing of engineering personnel. We continue to invest in engineering personnel and the tools required for new product development and sustaining engineering efforts; therefore, we anticipate further increases in engineering, research and development costs going forward.

Sales and marketing expenses for the quarter ended March 31, 2004, increased 312% to $1.2 million from $291,000 for the quarter ended March 31, 2003. The $900,000 increase in sales and marketing expenses is primarily due to the repurchase from Aurora Networks (“Aurora”) of certain exclusive marketing rights, including the right to market our products to certain enterprises operating within the North American cable market and the rights to the integrated QAM product we had developed for them. As part of this transaction, we also repurchased the most-favored-nation pricing rights for all our products which Aurora had been granted as a reseller of our products. The remainder of the increase consisted principally of costs associated with developing our channel partners sales network ($313,000) and sales and marketing personnel costs ($101,000). We are making substantial changes in our sales and marketing operations and personnel and expect our quarterly sales and marketing expenses for the rest of 2004 to be lower than those in the 2004 first quarter.

General and administrative expenses for the quarter ended March 31, 2004, increased 71% to $1.1 million from $666,000 in the same quarter of the prior year. The $473,000 increase results principally from a one-time charge for Mr. Cary’s severance pay as provided in his employment agreement ($260,000), greater spending on investor relations ($87,000), and higher outside legal fees ($69,000) and accounting fees ($55,000) related to our recent Form S-3 securities registration filings. We expect to return to more normal levels of general and administrative expenses in the remaining three quarters of 2004.

Stock-based compensation expense is a non-cash expense item that is recognized as a result of stock options having exercise prices below estimated fair value. Stock-based compensation expense is calculated as the difference between exercise prices and estimated fair market value on the date of grant. We have historically recorded compensation expense related to the outstanding options to consultants and some employees for the amount of options that vest in that period. In the quarter ended March 31, 2004, we did not have a charge for stock-based compensation, versus a $25,000 non-cash compensation charge in the same quarter ended March 31, 2003.

Depreciation and amortization expense for the quarter ended March 31, 2004, was $108,000, compared to $68,000 for the same quarter last year. The increase in depreciation and amortization expense resulted principally from accelerated amortization of debt issuance costs resulting from the early conversion of convertible debt. Almost all of our convertible debt has now been repaid or converted.

Net interest expense for the quarter ended March 31, 2004 was $30,000 versus $245,000 of expense in the same quarter ended March 31, 2003. The decrease in interest expense predominantly results from the early retirement of debt.

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RISK FACTORS

Investment in our common stock involves a high degree of risk. The risks and uncertainties described below are not the only ones we face. If any of the following risks actually occurs, our business, financial condition or results of operations could suffer.

OUR LIMITED SALES HISTORY AND LIMITED REVENUES TO DATE MAKE IT DIFFICULT TO EVALUATE OUR PROSPECTS.

We were founded in January 1998 and have only been selling our products commercially since 2002, which makes an evaluation of our prospects difficult. Because of our limited sales history, we have limited insight into trends that may emerge and affect our business. In addition, we have generated only limited revenues to date from sales of our products and the income potential of our business and market are unproven. An investor in our securities must consider the challenges, expenses and difficulties we face as our sales and marketing efforts mature.

PRICING PRESSURE ON OUR PRODUCTS HAS PLACED US AT A COMPETITIVE DISADVANTAGE.

We have recently experienced significant pricing pressure in some of the markets for our products. Due to competitive factors, cable customers have been willing to pay only reduced amounts for our products. This has placed us at a competitive disadvantage with our competitors who have the financial strength to withstand pricing pressures. If we are unable to regain larger margins on our product sales, we may be forced to exit certain market segments and our results of operations and profitability will be negatively affected.

WE RECENTLY LAUNCHED OUR INITIAL COMMERCIAL PRODUCTS AND SERVICES AND THEY MAY NOT GAIN CUSTOMER ACCEPTANCE.

In 2002, we launched our two primary commercial products into the long haul video transport market and announced the deployment of our Chameleon vidX^™ product line in our first quarter of 2003. These products are in the early stages of commercial deployment. We may not be able to gain customer acceptance of any of our products due to our lack of an established track record, our financial condition, competition, price or a variety of other factors. If our products and services are not accepted by potential customers, or if these customers do not purchase our products and services at the levels we anticipate, our operating results may be materially adversely affected.

WE HAVE INCURRED LOSSES SINCE INCEPTION AND WILL LIKELY NOT BE PROFITABLE AT LEAST FOR THE NEXT SEVERAL QUARTERS.

We have incurred operating losses since our inception in January 1998, and we expect to incur losses and negative cash flow for at least the next several quarters. As of March 31, 2004, our accumulated deficit was approximately $41.4 million. We expect to continue to incur significant operating, sales, marketing, research and development and general and administrative expenses and, as a result, we will need to generate significant revenues to achieve profitability. Even if we do achieve profitability, we cannot assure you that we can sustain or increase profitability on a quarterly or annual basis in the future.

OUR RECENT CHANGE IN SENIOR MANAGEMENT MAY RESULT IN DIFFICULTIES

On March 29, 2004, Frederick Cary resigned as our chief executive officer and president and was replaced by John Zavoli. On April 26, 2004, Patrick Bohana accepted early retirement from his position as Vice President, Sales and General Manager. Changes in senior management of small companies are inherently disruptive, and efforts to implement any new strategic or operating goals may also prove to be disruptive. In addition, until we hire new senior executives to assist him, there is a risk that due to his many responsibilities (he is also our chief financial officer, general counsel and secretary), Mr. Zavoli may not be able to devote sufficient attention to one or more of his important roles.

OUR QUARTERLY FINANCIAL RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY.

Our quarterly operating results are difficult to predict and may fluctuate significantly from period to period, particularly because our sales prospects are uncertain and our sales are made on a purchase order basis. In addition, we have not proven our ability to execute our business strategy with respect to establishing and expanding sales and distribution channels. Fluctuations may result from:

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As a result, we may experience significant, unanticipated quarterly losses.

WE FACE COMPETITION FROM ESTABLISHED AND DEVELOPING COMPANIES, MANY OF WHICH HAVE SIGNIFICANTLY GREATER RESOURCES, AND WE EXPECT SUCH COMPETITION TO GROW.

The markets for our products, future products and services are competitive. We face direct and indirect competition from a number of established companies, including Scientific-Atlanta, as well as development stage companies, and we anticipate that we will face increased competition in the future as existing competitors seek to enhance their product offerings and new competitors emerge. Many of our competitors have greater resources, higher name recognition, more established reputations within the industry and stronger manufacturing, distribution, sales and customer service capabilities than we do.

The technologies that our competitors and we offer are expensive to design, develop, manufacture and distribute. Competitive technologies may be owned and distributed by established companies that possess substantially greater financial, technical and other resources than we do and, as a result, such companies may be able to develop their products more rapidly and market their products more extensively than we can.

Competitive technologies that offer a similar or superior capacity to converge and transmit audio, video and telephonic data on a real-time basis over existing networks may currently exist or may be developed in the future. We cannot assure you that any technology currently being developed by us is not being developed by others or that our technology development efforts will result in products that are competitive in terms of price or performance. If our competitors develop products or services that offer significant price or performance advantages as compared to our current and proposed products and services, or if we are unable to improve our technology or develop or acquire more competitive technology, we may find ourselves at a competitive disadvantage and our business could be adversely affected. In addition, competitors with greater financial, marketing, distribution and other resources than we have may be able to leverage such resources to gain wide acceptance of products inferior to ours.

OUR CUSTOMER BASE IS CONCENTRATED AND THE LOSS OF ONE OR MORE OF OUR KEY CUSTOMERS WOULD HARM OUR BUSINESS.

Historically, a significant majority of our sales have been to relatively few customers, including Scientific-Atlanta. We expect that sales to relatively few customers will continue to account for a significant percentage of our net sales for the foreseeable future. Almost all of our sales are made on a purchase order basis, and none of our customers has entered into a long-term agreement requiring it to purchase our products. The loss of, or any reduction in orders from, a significant customer would harm our business.

THE INCREASED COMPETITIVE NATURE OF OUR RELATIONSHIP WITH SCIENTIFIC-ATLANTA MAY JEOPARDIZE OUR SUCCESS.

In 2002, approximately 66% of our total revenues were from sales to Scientific-Atlanta and its subsidiary, BarcoNet N.V. Our revenues from Scientific-Atlanta, as a percentage of our total revenues, were 14% in 2003 and declined further for the three months ended March 31, 2004. We anticipate that our 2004 revenues from Scientific-Atlanta will, as a percentage of our total revenues, be lower than in previous periods resulting in part from increased revenues from the long haul broadcast market.

Our technology uses non-proprietary industry standard interfaces and designs for video transport (known as IP/gigabit Ethernet). We are aware that Scientific-Atlanta has developed a product line that operates with an alternative to the open industry standard of IP/gigabit Ethernet.

We believe transporting video directly over a proprietary standard eliminates the flexibility offered through open standards such as IP/gigabit Ethernet. Nonetheless, Scientific-Atlanta’s development, marketing and sale of its proprietary standard-based products may compete directly with our development, marketing and sales efforts. Since Scientific-Atlanta has greater financial, marketing, and other resources than we do, Scientific-Atlanta may be able to develop its products more rapidly and market its products more extensively than we can. Because of Scientific-Atlanta’s name recognition, industry-reputation and other reasons, Scientific-Atlanta’s products could become the standard for delivery of real-time, broadcast-quality video, in which case the sale of our products could materially suffer. Scientific-Atlanta’s products may be superior to ours in terms of price or performance, or inferior to ours but backed by superior marketing and support capabilities. As a result, we may not be able to compete successfully with Scientific-Atlanta, and our ability to gain market share for our products could be adversely affected.

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Our relationship with Scientific-Atlanta, as both a significant customer and a significant competitor, may have adverse consequences to our business. While general risks are associated with any competitor and any customer, the conflicting interests of Scientific-Atlanta (as a result of being both) magnifies these risks. Scientific-Atlanta may decide to pursue its proprietary standard based products and downplay or even discontinue its relationship with us, as both a reseller and an outside manufacturer. Loss of sales to Scientific-Atlanta and its distribution network to communication service providers could adversely affect our business.

THE RATE OF MARKET ADOPTION OF OUR TECHNOLOGY IS UNCERTAIN AND WE COULD EXPERIENCE LONG AND UNPREDICTABLE SALES CYCLES, ESPECIALLY IF THE SLOWDOWN IN THE TELECOMMUNICATIONS INDUSTRY PERSISTS.

Our products are based on new technology and, as a result, it is extremely difficult to predict the timing and rate of market adoption of our products, as well the rate of market adoption of applications enhanced by our products such as video-on-demand. Accordingly, we have limited visibility into when we might realize substantial revenue from product sales. This is compounded by our inability to foresee when, if ever, delivery of video over IP networks will be significantly embraced by communication service providers.

We are providing new and highly technical products and services to enable new applications. Thus, the duration of our sales efforts with prospective customers in all market segments is likely to be lengthy as we seek to educate them on the uses and benefits of our products. This sales cycle could be lengthened even further by potential delays related to product implementation as well as delays over which we have little or no control, including:

These uncertainties, combined with the worldwide slowdown in capital spending in the telecommunications business that began in 2001, and the slowdown in corporate spending on technology generally as well as new technologies such as ours, substantially complicate our planning and may reduce prospects for sales of our products. If our prospective customers curtail or eliminate their purchasing programs, decrease their budgets or reduce their purchasing priority, our results of operations could be adversely affected.

THE SUCCESS OF OUR BUSINESS IS DEPENDENT ON ESTABLISHING AND EXPANDING SALES AND DISTRIBUTION CHANNELS FOR OUR PRODUCTS.

Third-Party Collaborations. We intend to partner with the leading suppliers to communication service providers, including Scientific-Atlanta, to promote and distribute our products, both as an outside equipment manufacturer to suppliers and with suppliers acting as resellers of our products. We may not be able to identify adequate partners, and even if identified, we may not be able to enter into agreements with these entities on commercially reasonable terms, or at all. To the extent that we enter into any such agreements with third parties, any revenues we receive from sales of our products in those markets will depend upon the efforts of such third parties, which in most instances will not be within our control. If we are unable to effectively leverage a partner to market our products more broadly than we can through our internal sales force, our business could be adversely affected.

Internal Sales Force. We have limited experience in marketing and selling our products. We intend to expand our direct and indirect sales force and independent channel partners domestically and internationally for the promotion of our product lines and other future products to suppliers and communication service providers of all kinds. Competition for quality sales and marketing personnel and channel partners is intense. In addition, new employees, particularly new sales and marketing employees, will require training and education concerning our products and will also increase our operating expenses. There can be no assurance that we will be successful in attracting or retaining qualified sales and marketing personnel and partners. As a result, there can be no assurance that the sales force we are able to build will be of a sufficient size or quality to effectively market our products.

WE MAY BE UNABLE TO RAISE ADDITIONAL CAPITAL IN THE FUTURE WHEN NEEDED, WHICH COULD PREVENT US FROM GROWING.

While we completed a public offering resulting in gross proceeds of $15.5 million, we have not yet achieved profitability and cannot be certain that such financing will be adequate or sufficient for our future needs. We may be required to raise additional capital, and we cannot ensure that financing would be available to us on acceptable terms, if at all. Our inability to raise capital when needed could seriously harm our business. In addition, additional equity financing may dilute our stockholders’ interest, and debt financing, if available, may involve restrictive covenants and could result in a substantial portion of our operating cash flow being dedicated to the payment of principal and interest on debt. If adequate funds are not available, we may need to curtail our operations significantly.

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WE MAY NOT BE ABLE TO PROFIT FROM GROWTH IF WE ARE UNABLE TO EFFECTIVELY MANAGE THE GROWTH.

We anticipate that we will need to grow in the future. This anticipated growth will place strain on our managerial, financial and personnel resources. The pace of our anticipated expansion, together with the complexity of the technology involved in our products and the level of expertise and technological sophistication incorporated into the provision of our design, engineering, implementation and support services, demands an unusual amount of focus on the operational needs of our future customers for quality and reliability, as well as timely delivery and post-installation and post-consultation field and remote support. In addition, new customers, especially customers that purchase novel and technologically sophisticated products such as ours, generally require significant engineering support. Therefore, adoption of our platforms and products by customers would increase the strain on our resources.

To reach our goals, we will need to hire rapidly, while at the same time investing in our infrastructure. We expect that we will also have to expand our facilities. In addition, we will need to successfully train, motivate and manage new employees; expand our sales and support organization; integrate new management and employees into our overall operations; and establish improved financial and accounting systems. Indeed, even without consideration of future needs imposed by any future growth of our business, we need to upgrade several of these areas even to support our present levels of business, because during the pre-IPO periods of tight cash, we focused our resources on areas other than business infrastructure.

We may not succeed in anticipating all of the changing demands that growth would impose on our systems, procedures and structure. If we fail to effectively manage our expansion, if any, our business may suffer.

WE WILL DEPEND ON BROADCASTING, CABLE AND SATELLITE INDUSTRY SPENDING FOR A SUBSTANTIAL PORTION OF OUR REVENUE AND ANY DECREASE OR DELAY IN SPENDING IN THESE INDUSTRIES WOULD NEGATIVELY IMPACT OUR RESOURCES, OPERATING RESULTS AND FINANCIAL CONDITION.

Demand for our products will depend on the magnitude and timing of spending by cable television operators, broadcasters, satellite operators and carriers for adopting new products for installation with their networks.

These spending patterns are dependent on a variety of factors, including:

Recent developments in capital markets have reduced access to funding for potential and existing customers causing delays in the timing and scale of deployments of our equipment, as well as the postponement of certain projects by our customers. The timing of deployment of our equipment can be subject to a number of other risks, including the availability of skilled engineering and technical personnel.

WE NEED TO DEVELOP AND INTRODUCE NEW AND ENHANCED PRODUCTS IN A TIMELY MANNER TO REMAIN COMPETITIVE.

Broadband communications markets are characterized by continuing technological advancement, changes in customer requirements and evolving industry standards. To compete successfully, we must design, develop, manufacture and sell new or enhanced products that provide increasingly higher levels of performance and reliability. However, in addition to the technological and managerial risks inherent in any product development effort, we may not be able to successfully develop or introduce these products if the development effort requires more financial resources than we are able to bring to bear, or if our products:

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In order to successfully develop and market certain of our planned products for digital applications, we may be required to enter into technology development or licensing agreements with third parties. We cannot assure you that we will be able to enter into any necessary technology development or licensing agreement on terms acceptable to us, or at all. The failure to enter into technology development or licensing agreements when necessary could limit our ability to develop and market new products and, accordingly, could materially and adversely affect our business and operating results.

DELIVERY OF REAL-TIME, BROADCAST-QUALITY VIDEO VIA IP NETWORKS IS A NEW MARKET AND SUBJECT TO EVOLVING STANDARDS.

Delivery of real-time, broadcast-quality video over IP networks is novel and evolving and it is possible that communication service providers or their suppliers will adopt alternative architectures and technologies for delivering real-time, broadcast-quality video over IP networks that are in compatible with our current or future products. If we are unable to design, develop, manufacture and sell products that incorporate or are compatible with these new architectures or technologies, our business could suffer.

WE RELY ON SEVERAL KEY SUPPLIERS OF COMPONENTS, SUB-ASSEMBLIES AND MODULES THAT WE USE TO MANUFACTURE OUR PRODUCTS, AND WE ARE SUBJECT TO MANUFACTURING AND PRODUCT SUPPLY CHAIN RISKS.

We purchase components, sub-assemblies and modules from a limited number of vendors and suppliers that we use to manufacture and test our products. Our reliance on these vendors and suppliers involves several risks including, but not limited to, the inability to purchase or obtain delivery of adequate supplies of such components, sub-assemblies or modules, increases in the prices of such items, quality, and overall reliability of our vendors and suppliers. Although in many cases we use standard parts and components for our products, certain components are presently available only from a single source or limited sources. Some of the materials used to produce our products are purchased from foreign suppliers. We do not generally maintain long-term agreements with any of our vendors or suppliers. Thus we may thus be unable to procure necessary components, sub-assemblies or modules in time to manufacture and ship our products, thereby harming our business.

We also recently signed an agreement with a leading parts vendor to provide turnkey outsourced manufacturing services. To reduce manufacturing lead times and to ensure adequate component supply, we may instruct our vendor to procure inventory based on criteria and forecasts as defined by us. If we fail to anticipate customer demand properly, an oversupply of parts, obsolete components or finished goods could result, thereby adversely affecting our gross margins and results of operations.

We may also be subject to disruptions in our manufacturing and product-testing operations that could have a material adverse affect on our operating results.

UNANTICIPATED DELAYS OR PROBLEMS ASSOCIATED WITH OUR PRODUCTS AND IMPROVEMENTS MAY CAUSE CUSTOMER DISSATISFACTION OR DEPRIVE US OF OUR “FIRST TO MARKET” ADVANTAGE.

Delays in developing and releasing products and improvements are not uncommon in the industry in which we compete. In the event of performance problems with our product offerings, delays of more than a few months in releasing improvements could result in decreased demand for a particular product and adverse publicity, which could further reduce demand for particular products or our products generally.

PRODUCT QUALITY PROBLEMS MAY NEGATIVELY AFFECT OUR REVENUES AND RESULTS FROM OPERATIONS.

We produce highly complex products that incorporate leading edge technology including hardware, software and embedded firmware. Our software and other technology may contain “bugs” that can prevent our products from performing as intended. There can be no assurance that our pre-shipment testing programs will be adequate to detect all defects either in individual products or which could affect numerous shipments that, in turn, could create customer dissatisfaction, reduce sales opportunities, or affect gross margins if the cost of remedying the problems exceed our reserves established for this purpose. Our inability to cure a product defect may result in the failure of a product line, serious damage to our reputation, and increased engineering and product re-engineering costs that individually or collectively would have a material adverse impact on our revenues and operating results.

WE MAY NOT BE ABLE TO HIRE AND ASSIMILATE KEY EMPLOYEES.

Our future success will depend, in part, on our ability to attract and retain highly skilled employees, including management, technical and sales personnel. Despite the recent economic slowdown, significant competition exists for employees in our industry and in our geographic region. We may be unable to identify and attract highly qualified employees in the future. In addition, we may not be able to successfully assimilate these employees or hire qualified personnel to replace them. The loss of services of any of our key personnel, the inability to attract or retain key personnel in the future, or delays in hiring required personnel, particularly engineering and sales personnel, could make it difficult to meet key objectives such as timely and effective product introductions.

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WE ARE DEPENDENT ON OUR KEY EMPLOYEES FOR OUR FUTURE SUCCESS.

Our success depends on the efforts and abilities of our senior management, in particular John R. Zavoli, and certain other key personnel. If any of these key employees leaves or is seriously injured and unable to work and we are unable to find a qualified replacement, then our business and results of operations could be materially harmed.

CHANGES IN THE MIX OF OUR PRODUCT SALES, PRODUCT DISTRIBUTION MODEL OR CUSTOMER BASE COULD NEGATIVELY IMPACT OUR SALES AND MARGINS.

We may encounter a shift the mix of the various products that we sell – products that have varying selling prices based in part on the type of product sold, applicable sales discounts, licensed product feature sets, whether we sell our products as an OEM, and whether the sale is a direct sale or an indirect channel sale through our VARs and resellers. Any change in any of these variables could result in a material adverse impact on our gross sales, gross margins and operating results.

WE MAY BE UNABLE TO OBTAIN FULL PATENT PROTECTION FOR OUR CORE TECHNOLOGY AND THERE IS A RISK OF INFRINGEMENT.

Since the beginning of 2001, we have submitted several patent applications and provisional patent applications on topics surrounding our core technologies to supplement our existing patent portfolio. There can be no assurance that these or other patents will be issued to us, or, if additional patents are issued, that they or our three existing patents will be broad enough to prevent significant competition or that third parties will not infringe upon or design around such patents to develop competing products. In addition, we have filed patent applications in several foreign countries. There is no assurance that these or any future patent applications will be granted, or if granted, that they will not be challenged, invalidated or circumvented.

In addition to seeking patent protection for our products, we intend to rely upon a combination of trade secret, copyright and trademark laws and contractual provisions to protect our proprietary rights in our products. There can be no assurance that these protections will be adequate or that competitors have not or will not independently develop technologies that are substantially equivalent or superior to ours.

There has been a trend toward litigation regarding patent and other intellectual property rights in the telecommunications industry. Although there are currently no lawsuits pending against us regarding possible infringement claims, there can be no assurance such claims will not be asserted in the future or that such assertions will not materially adversely affect our business, financial conditions and results of operations. Any such suit, whether or not it has merit, would be costly to us in terms of employee time and defense costs and could materially adversely affect our business.

If an infringement or misappropriation claim is successfully asserted against us, we may need to obtain a license from the claimant to use the intellectual property rights. There can be no assurance that such a license will be available on reasonable terms if at all.

WE ARE SUBJECT TO LOCAL, STATE AND FEDERAL REGULATION.

Legislation affecting us (or the markets in which we compete) could adversely impact our ability to implement our business plan on a going-forward basis. The telecommunications industry in which we operate is heavily regulated and these regulations are subject to frequent change. Future changes in local, state, federal or foreign regulations and legislation pertaining to the telecommunications field may adversely affect prospective purchasers of telecommunications equipment, which in turn would adversely affect our business.

THE MARKET PRICE OF OUR COMMON STOCK COULD BE VOLATILE AND YOUR INVESTMENT COULD SUFFER A DECLINE IN VALUE.

The market prices for our common stock is likely to be volatile and could be susceptible to wide price fluctuations due to a number of internal and external factors, many of which are beyond our control, including:

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In addition, stock prices for many technology companies, especially early-stage companies such as us, fluctuate widely for reasons that may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as interest rate increases, recessions or military or political conflicts, may materially and adversely affect the market price of our common stock, thereby causing you to lose some or all of your investment.

In addition, if the average daily trading volume in our common stock is low, the resulting illiquidity could magnify the effect of any of the above factors on our stock price.

OUR OUTSTANDING WARRANTS AND THE STOCK OPTIONS AND BONUS STOCK WE OFFER TO OUR EMPLOYEES, NON-EMPLOYEE DIRECTORS, CONSULTANTS AND ADVISORS COULD RESULT IN ONGOING DILUTION TO ALL STOCKHOLDERS.

We maintain two equity compensation plans: (i) the 2000 Stock Option/Stock Issuance Plan (the “2000 Plan”), pursuant to which we may issue options and common stock to employees, officers, directors, consultants and advisors, and (ii) the 2001 Employee Stock Purchase Plan (the “Purchase Plan”), approved by our stockholders in February 2002, pursuant to which our employees are provided the opportunity to purchase our stock through payroll deductions. As of March 31, 2004, there were options outstanding to purchase 288,881 shares of common stock under our 2000 Plan; 107,872 shares of common stock remain available for issuance under the 2000 Plan. A maximum of 41,667 shares of common stock have been authorized for issuance under the Purchase Plan.

In addition, as of March 31, 2004, there were 89,952 shares of common stock subject to outstanding options granted other than under the 2000 Plan or Purchase Plan. These non-plan options were granted to various employees, directors, consultants and advisors.

We plan to continue to provide our employees opportunities to participate in the Purchase Plan. We also plan to issue options, either under the 2000 Plan or otherwise, to purchase sizable numbers of shares of common stock to new and existing employees, officers, directors, advisors, consultants or other individuals as we deem appropriate and in our best interests. We will seek stockholder approval for a new 2004 equity incentive plan. These ongoing purchases of our common stock (as well as future option grants by us and subsequent exercises of options) could result in substantial dilution to all stockholders and increased control by management.

Currently, there are outstanding warrants to purchase up to 3,140,029 shares of our common stock with a weighted average exercise price of $5.61 per share. The weighted average remaining life for all of the currently outstanding warrants is 4.5 years from March 31, 2004.

WE DO NOT INTEND TO PAY CASH DIVIDENDS.

We have never paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We would be exposed to changes in interest rates primarily from any marketable securities and investments in certain available-for-sale securities. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. At March 31, 2004, we did not have any marketable securities or investments in available-for-sale securities, nor did we have any sales denominated in a currency other than the United States dollar. Our cash equivalents’ principal would not be materially changed by changes in interest rates, but as the short term instruments mature and roll over, we would be able to earn more interest in

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the future if interest rates rise. A one percentage point (100 basis point) increase in interest rates would result in approximately a $90,000 annual increase in our income from cash equivalents, assuming our cash equivalents principal balance remained at its March 31, 2004 level. Our $1 million revolving line of credit from Laurus (which currently has a zero balance outstanding) has a floating interest rate.

ITEM 4. CONTROLS AND PROCEDURES

John Zavoli, who is both our principal executive officer and principal financial officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Securities Exchange Act of 1934 Rule 13a–15(e), concluded that as of March 31, 2004, our disclosure controls and procedures were effective.

ITEM 1. LEGAL PROCEEDINGS

We are not a defendant in any material legal proceedings.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

On July 23, 2003, we effected a one-for-six reverse stock split of our common stock. All of our outstanding derivative securities were correspondingly adjusted.

On July 30, 2003, the SEC declared effective the registration statement (SEC file no. 333-105638) for our initial public offering of units through underwriters led by Paulson Investment Company, Inc.

Through March 31, 2004, we have used the $13,055,136 net proceeds of the offering to pay $1,380,000 in accrued accounts payable, to repurchase $1,180,000 principal amount of our 7% convertible debentures for $1,382,000, to repurchase 27,777 shares of common stock from Ronald Fellman for $92,997, and to fund our continuing negative cash flow, including the payment of cash bonuses to Frederick Cary and John Zavoli totaling $100,000. Except as discussed in the previous sentence, none of these payments went directly or indirectly to our directors, officers, general partners, affiliates, 10% owners, or any of their associates. We have used approximately $4,175,000 to fund negative cash flows from operations and approximately $425,000 to fund negative cash flows from investing activities. Pending use for working capital, research and development efforts and marketing and sales programs, we have invested the remaining $5,500,000 of net proceeds in short-term government obligations.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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

Not applicable.

ITEM 5. OTHER INFORMATION

On March 29, 2004, Frederick Cary resigned as our Chief Executive Officer and President, while retaining his position as Chairman. John Zavoli was elected to the offices of Chief Executive Officer and President that same day, while also retaining his other offices and being added to the Board of Directors. On April 26, 2004, Patrick Bohana accepted early retirement from his positions as Vice President, Sales and General Manager.

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

Exhibits. The following exhibits are included as part of this report. References to “Path 1” or “us” in this Item 6 mean Path 1 Network Technologies Inc., a Delaware corporation.

Reports on Form 8-K.

We furnished, on Form 8-K, Item 12, during this fiscal quarter, a copy of an announcement of historical financial results. Pursuant to SEC staff guidance, such furnished Form 8-K information need not be listed in this Item 6 of Form 10-Q.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: May 17, 2004

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Exhibit List

References to “us” or “Path 1” in this Exhibit List mean Path 1 Network Technologies Inc., a Delaware corporation

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