Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004.

or

For the transition period from              to            .

Commission File Number (000-25865)

Copper Mountain Networks, Inc.

(Exact name of registrant as specified in its charter)

1850 Embarcadero Road, Palo Alto, California 94303

(650) 687-3300

(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 Rule 12b-2 of the Exchange Act).     YES  ¨    NO  x

The number of shares outstanding of the issuer’s common stock, $.001 par value, as of October 29, 2004 was 7,995,901

Table of Contents

COPPER MOUNTAIN NETWORKS, INC.

INDEX

2

Table of Contents

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

COPPER MOUNTAIN NETWORKS, INC.

CONDENSED BALANCE SHEETS

(in thousands)

See accompanying notes to condensed financial statements

3

Table of Contents

COPPER MOUNTAIN NETWORKS, INC.

CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

See accompanying notes to the financial statements

4

Table of Contents

COPPER MOUNTAIN NETWORKS, INC.

CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands)

(unaudited)

See accompanying notes to condensed financial statements

5

Table of Contents

COPPER MOUNTAIN NETWORKS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to condensed financial statements

6

Table of Contents

NOTE 1 - General

In management’s opinion, the accompanying unaudited financial statements for Copper Mountain Networks, Inc. (the “Company”) for the three and nine months ended September 30, 2004 and 2003 have been prepared in accordance with generally accepted accounting principles for interim financial statements and include all adjustments that the Company considers necessary for a fair presentation of its financial position, results of operations, and cash flows for such periods. However, the accompanying financial statements do not contain all of the information and footnotes required by generally accepted accounting principles for complete financial statements. This quarterly report and the accompanying financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto presented in its Annual Report on Form 10-K for the year ended December 31, 2003 (the “2003 Annual Report”). Footnotes which would substantially duplicate the disclosures in the Company’s audited financial statements for the year ended December 31, 2003 contained in the 2003 Annual Report have been omitted. The interim financial information contained in this quarterly report is not necessarily indicative of the results to be expected for any other interim period or for the full year ending December 31, 2004.

Management Plans

As shown in the financial statements, the Company incurred significant losses of $3.6 million and $15.0 million for the three and nine months ended September 30, 2004, respectively. We currently fund our operations with our cash, cash equivalents and marketable investments. During the three and nine months ended September 30, 2004 we used approximately $4.9 million and $16.5 million, respectively, in cash to fund our operations. At September 30, 2004, we had cash, cash equivalents, and short-term marketable investments of $17.1 million. We currently require approximately $5 million to $7 million in cash per quarter to fund our operations, and we presently expect this rate of quarterly cash use to continue through 2004.

We anticipate that we may have to seek additional equity or debt financing in the private or public capital markets to obtain the funds we need to continue operations beyond the first quarter of 2005 and to demonstrate our future viability as a going concern to potential and existing customers. Additional financing may not be available when needed on terms and conditions favorable to us or at all. If adequate funds are not available or are not available on acceptable terms and conditions, we may be unable to fund our ongoing operations. Such capital raising may be made more difficult if we are no longer listed on the NASDAQ stock market as a result of our failure to continue to meet the listing requirements required by NASDAQ, which is a risk we face.

The Company has made significant investments in the development of the VantEdge Broadband Remote Access Server (BRAS) product and believes it has significant promise; however it is unclear whether it will be commercially successful and generate sufficient revenue to offset the decline of sales of current products. Presently, current and prospective customers are evaluating and/or trialing the VantEdge, and it is uncertain as to whether it will meet these carriers’ current and/or future overall requirements; whether it will meet these carriers’ performance and cost expectations; and whether it will require substantial further development. As a result, carriers’ acceptance of the VantEdge may be delayed or may not occur at all; the enhancement and commercialization of the VantEdge product might be delayed, perhaps indefinitely; or might require the expenditure of significantly more funds than currently anticipated, in which case liquidity and capital resources would be adversely affected.

On August 31, 2004 the Company announced that it had retained Raymond James & Associates, Inc. as its advisor to explore strategic options, including a possible sale of the company. In the event that the Company is not successful in these efforts, and in the absence of increased sales of CopperEdge products or significant sales of the VantEdge product, the Company may be unable to continue as a going concern. We may seek additional equity or debt financing in the private or public capital markets to obtain the funds needed to continue operations and to demonstrate the Company’s future viability as a going concern to potential and existing customers. If the Company is unable to obtain sufficient financing, the Company may have to further reduce expenses through workforce reductions and other cost cutting measures. Management believes that such expense reduction, if appropriate, would need to occur during 2004 or early 2005 in order for the cost savings to be meaningful to us. Even if such expense reduction occurs during 2004 or early 2005, it may not be sufficient to generate enough cost savings to sufficiently improve our liquidity and/or capital resources to enable the Company to remain viable as a going concern.

7

Table of Contents

Investments In Marketable Securities

At September 30, 2004, the Company held investments in investment grade debt and money market securities with various maturities through January 2005. Management determines the appropriate classification of the Company’s investments in debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. The Company’s total investments in these securities as of September 30, 2004 totaled $8.0 million. These debt securities have been classified as short-term marketable investments as they have original maturities of more than 90 days. The fair value of the Company’s total investments in marketable securities based upon the closing market prices of such securities on September 30, 2004 approximated the carrying value. The Company has designated all of its investments held on September 30, 2004 as held-to-maturity.

Concentration of Credit Risk

A relatively small number of customers account for a significant percentage of the Company’s revenues. The Company expects that the sale of its products to a limited number of customers may continue to account for a high percentage of revenues for the foreseeable future. The Company’s revenues for the three months ended September 30, 2004 include revenue recognized from three significant customers totaling $0.4 million, or 24%; $0.5 million, or 28%; and $0.2 million, or 10% of net revenue. The Company’s revenues for the three months ended September 30, 2003 include revenue recognized from three significant customers totaling $1.0 million, or 28%; $1.0 million, or 27% (international customer); and $0.9 million, or 23% of net revenue. The Company’s revenues for the nine months ended September 30, 2004 include revenue recognized from four significant customers totaling $0.8 million, or 14%; $0.8 million, or 13%; $0.7 million, or 11% (international customer); and $0.6 million, or 10% (from a reseller) of net revenue. The Company’s revenues for the nine months ended September 30, 2003 include revenue recognized from two significant customers totaling $4.3 million, or 40% (international customer); and $1.5 million, or 14% of net revenue.

The Company performs ongoing credit evaluations of its customers as it deems appropriate, and generally requires no collateral. The Company had significant accounts receivable balances due from five customers individually representing 29%, 14%, 14%, 11%, and 10% of total accounts receivable at September 30, 2004.

The Company from time to time maintains a substantial portion of its cash and cash equivalents in money market accounts with one financial institution. The Company invests its excess cash in debt instruments of the U.S. Treasury, governmental agencies and corporations with strong credit ratings. The Company has established guidelines relative to diversification and maturities that attempt to maintain safety and liquidity.

Inventory

Inventory is stated at the lower of cost, principally standard costs, which approximates actual costs on a first-in, first-out basis, or market. During the three and nine months ended September 30, 2004 the Company recognized inventory obsolescence expenses of $0.9 million and $1.2 million related to excess and obsolete inventory. During the three and nine months ended September 30, 2004 the Company sold CE200 access concentrators and related line cards that had been previously written down by $0.4 million and $0.8 million, respectively. During the three and nine months ended September 30, 2003 the Company sold CE200 access concentrators and related line cards that had been previously written down by $0.4 million and $9.6 million, respectively.

Accrued Compensation

During the third quarter of 2004 the Company reversed $0.6 million of accrued incentive compensation that was accrued during the six months ended June 30, 2004, which resulted in credits to various line items in the Company’s income statement, including cost of goods sold ($0.1 million), research and development

8

Table of Contents

($0.1 million), sales and marketing ($0.1million) and general and administrative expenses ($0.3 million). The accrual was reversed because in management’s opinion it became unlikely that the Company would achieve certain financial milestones that would trigger the payment of this incentive compensation.

Deferred Stock Compensation

The deferred stock compensation expense line item in the Company’s income statement includes the amortization of deferred stock compensation from grants of restricted stock and from re-priced stock options. The compensation expense for the restricted stock awards is fixed at the time of grant. The deferred stock compensation expense related to the re-priced options is re-measured at the end of each reporting period and may fluctuate depending on the price of the Company’s common stock. The re-measurement of the compensation expense during the three months ended September 30, 2004, resulted in a credit of $2.4 million as a result of the decline in the Company’s stock price during the quarter. The re-measurement credit was offset by deferred compensation expense associated with restricted stock grants.

Restricted Common Stock

During the third quarter of 2004, the Company granted 239,000 shares of restricted common stock, all to non-executive employees. The related net compensation expense of approximately $2.0 million will be amortized on an accelerated basis over the vesting period of two years. The Company recognized compensation expense of $0.2 million related to this grant of restricted common stock for the three months ended September 30, 2004. These shares begin to vest in July of 2005.

Stock-Based Compensation

Had compensation cost for the Company’s stock-based compensation plans been determined consistent with SFAS No. 123, the Company’s pro forma amounts would have been as indicated below (in thousands, except per share data):

The weighted-average estimated fair value of stock options granted during the three months ended September 30, 2004 and 2003 was $3.89 and $4.97 per share, respectively. The weighted-average estimated fair value of stock options granted during the nine months ended September 30, 2004 and 2003 was $4.08 and $4.76 per share, respectively. For purposes of pro forma disclosures, the estimated fair value of options is amortized to expense over the vesting period.

9

Table of Contents

Warranty Reserves

The Company provides limited warranties on certain of its products for periods of up to one year. The Company recognizes warranty reserves when products are shipped based upon an estimate of total warranty costs, and such reserves are included in accrued liabilities. The estimate of such costs is based upon historical and anticipated requirements (in thousands).

Revenue Recognition

Revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is fixed or determinable and; (iv) collectibility is reasonably assured. Sales returns are estimated based on historical experience and management’s expectations and are recorded at the time product revenue is recognized.

Annual service and support arrangements can be purchased by customers for products no longer under warranty and are generally billed quarterly. Revenue from service and support arrangements is recognized ratably over the respective service period or as services are performed.

The Company may extend limited stock rotation, product return and price protection rights to certain distributors and resellers. The Company may not be able to estimate product returns if the relationship with the distributor is new or if there is limited historical basis to determine product returns.

NOTE 2 - Management Estimates and Assumptions

The preparation of financial statements in conformity with generally accepted accounting principles 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 revenues and expenses during the reporting period. Some examples include provisions for returns; bad debts; excess inventory and adverse purchase commitments; restructuring; and the ultimate outcome of litigation. Actual results could differ from those estimates.

NOTE 3 – Sale of Common Stock

On May 6, 2004, we completed the sale of 1,250,000 shares of common stock at $9.00 per share, together with related warrants to purchase 312,500 shares of common stock in a private placement to new and current stockholders. The warrants issued have an exercise price of $10.00 per share and expire on May 5, 2009

NOTE 4 – Net Loss Per Share

Basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during the period including any dilutive common stock equivalents. Common stock equivalents of 0.8 million and 1.0 million for the three month periods ending September 30, 2004 and 2003, respectively, were excluded from the calculation because of their anti-dilutive effect. Common stock equivalents of 1.1 million and 0.4 million for the nine month periods ending September 30, 2004 and 2003, respectively, were excluded from the calculation because of their anti-dilutive effect.

10

Table of Contents

NOTE 5 - Composition of Certain Balance Sheet Captions (in thousands)

NOTE 6 – Restructuring

The Company has had three restructurings since March 2001. These restructurings resulted in the Company adopting business plans to re-size its business to reflect current and expected business conditions. As a result of the adoption of these plans, the Company recorded total charges of approximately $21.7 million. These charges primarily relate to: consolidation of the Company’s continuing operations resulting in impairment of assets; anticipated losses on disposition of assets and excess lease costs; and the elimination of job responsibilities, resulting in costs incurred for employee severance.

The remaining balance of the accrued restructuring charges are as follows (in thousands):

NOTE 7 – Litigation and Claims

On October 20, 2000, a Copper Mountain stockholder, Ariel Hernandez, on behalf of himself and purportedly on behalf of a class of Company stockholders, filed a complaint in the United States District Court for the Northern District of California (the “Northern District”) against the Company and two officers of the Company, alleging violations of the federal securities laws arising out of recent declines in the Company’s stock price. Thereafter, approximately twenty-three similar complaints were filed in the Northern District, along with related derivative actions against certain of the Company’s current and former officers and directors in California Superior Court (Aaron v. Gilbert, et. al. ) and Delaware (collectively, the “Complaints”). The Complaints allege claims in connection with various alleged statements and omissions to the public and to the securities markets. The twenty-three Northern District Complaints have been consolidated into a single action identified as In re Copper Mountain Networks Securities Litigation, case number C-00-3894-VRW. On June 23, 2004, the Northern District action was dismissed with prejudice at the plaintiffs’ request. Plaintiffs informed the Court that, after additional investigation, they were unable to identify facts necessary to support their allegations.

11

Table of Contents

On November 15, 2000, a derivative complaint alleging securities fraud against certain current and former Copper Mountain officers and directors, titled Glassman v. Gilbert et. al, Civil Action No. 18491-NC, was filed in the Delaware Chancery Court based upon the same facts as those alleged In re Copper Mountain Securities Litigation. On August 26, 2004, plaintiff voluntarily dismissed that action.

On November 22, 2002, a derivative complaint alleging securities fraud against certain current and former Copper Mountain officers and directors, titled Aaron v. Gilbert, et. al., No. 812877, was filed in Santa Clara Superior Court based upon the same facts as those alleged in In re Copper Mountain Securities Litigation. On January 31, 2003, the plaintiffs stipulated to consolidate the case with another derivative complaint pending in Santa Clara Superior Court, Czajowski v. Gilbert et. al, No. 797885. On June 28, 2004 and July 2, 2004, the Santa Clara Superior Court granted plaintiffs’ voluntary dismissal of these two derivative actions.

In December 2001, the Company and certain of its officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation, Case No. 01-CV-10943. In the amended complaint, the plaintiffs allege that the Company, certain of its officers and directors and the underwriters of its initial public offering (“IPO”) violated section 11 of the Securities Act of 1933 based on allegations that the Company’s IPO registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The amended complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted deceit on investors. The plaintiffs seek unspecified monetary damages and other relief. Similar complaints collectively referred to here as the “IPO Lawsuits,” were filed in the same court against hundreds of other public companies (“Issuers”) who conducted IPOs between 1998 and 2000.

On August 8, 2001, the IPO Lawsuits were consolidated for pretrial purposes before United States Judge Shira Scheindlin of the Southern District of New York. On July 15, 2002, the Company joined in a global motion to dismiss the IPO Lawsuits filed by all of the Issuers (among others). On October 9, 2002, the Court entered an order dismissing our named officers and directors from the IPO Lawsuits without prejudice, pursuant to an agreement tolling the statute of limitations with respect to these officers and directors until September 30, 2003. On February 19, 2003, the court issued a decision denying the motion to dismiss the claims against the Company and almost all of the Issuers, and denying the motion to dismiss the Section 10(b) claims against the Company and many of the other issuers.

In June 2003, the Issuers reached a tentative settlement agreement with the plantiffs that would, among other things, result in the dismissal with prejudice of all claims against the issuers and their officers and directors in the IPO Lawsuits. In addition, the tentative settlement guarantees that, in the event that the Plaintiffs recover less than $1 billion in settlement or judgment against the Underwriter defendants in the IPO Lawsuits, the Plaintiffs will be entitled to recover the difference between the actual recovery and $1 billion from the insurers for the Issuers. In September 2003, in connection with the tentative settlement, those officers and directors who had entered tolling agreements (described above) agreed to extend those agreements so that they would not expire prior to any settlement being finalized. In June 2004, we executed a final settlement agreement with the plaintiffs. The settlement is still subject to a number of conditions, including action by the Court certifying a class action for settlement purposes and formally approving the settlement. The Underwriter defendants have opposed both the certification of a settlement class action and judicial approval of the settlement.

No assurances can be made that we will be successful in our defense of such claims. If we are not successful in our defense of such claims, we could be forced to make significant payments to our stockholders and their lawyers, and such payments could have a material adverse effect on our business, financial condition and results of operations if not covered by our insurance carrier. Even if such claims are not successful, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our business, results of operations and financial position.

12

Table of Contents

The Company is party to other legal proceedings and claims in the ordinary course of business. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. Consequently, management is unable to ascertain the ultimate aggregate amount of monetary liability, amounts which may be covered by insurance, or the financial impact with respect to these matters as of September 30, 2004. However, management believes that the final resolution of these matters, individually and in the aggregate, will not have a material adverse impact upon the Company’s financial position, results of operations or cash flows.

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

Forward Looking Statements

This document contains 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. We are under no 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.

Readers 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 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and under the caption “Risk Factors” included herein and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and other reports and filings made with the Securities and Exchange Commission.

Overview

As shown in the financial statements, the Company incurred significant losses of $3.6 million and $15.0 million for the three months and nine months ended September 30, 2004. We currently fund our operations with our cash, cash equivalents and marketable investments. During the three and nine months ended September 30, 2004, we used approximately $4.9 million and $16.5 million in cash to fund our operations. At September 30, 2004, we had cash, cash equivalents, and short-term marketable investments of $17.1 million. We currently require approximately $5 million to $7 million in cash per quarter to fund our operations, and we presently expect that this rate of quarterly cash use to continue through 2004.

We anticipate that we may have to seek additional equity or debt financing in the private or public capital markets to obtain the funds we need to continue operations beyond the first quarter of 2005 and to demonstrate our future viability as a going concern to potential and existing customers. Additional financing may not be available when needed on terms and conditions favorable to us or at all. If adequate funds are not available or are not available on acceptable terms and conditions, we may be unable to fund our ongoing operations. Such capital raising may be made more difficult if we are no longer listed on the NASDAQ stock market as a result of our failure to continue to meet the listing requirements required by NASDAQ, which is a risk we face.

The Company has made significant investments in the development of the VantEdge Broadband Remote Access Server (BRAS) product and believes it has significant promise; however it is unclear whether it will be commercially successful and generate sufficient revenue to offset the decline of sales of current products. Presently, current and prospective customers are evaluating and/or trialing the VantEdge, and it is uncertain as to whether it will meet these carriers’ current and/or future overall requirements;

13

Table of Contents

whether it will meet these carriers’ performance and cost expectations; and whether it will require substantial further development. As a result, carriers’ acceptance of the VantEdge may be delayed or may not occur at all; the enhancement and commercialization of the VantEdge product might be delayed, perhaps indefinitely; or might require the expenditure of significantly more funds than currently anticipated, in which case liquidity and capital resources would be adversely affected.

On August 31, 2004 the Company announced that it had retained Raymond James & Associates, Inc. as its advisor to explore strategic options, including a possible sale of the company. In the event that the Company is not successful in these efforts, and in the absence of increased sales of CopperEdge products or significant sales of the VantEdge product, the Company may seek additional equity or debt financing in the private or public capital markets to obtain the funds needed to continue operations and to demonstrate the Company’s future viability as a going concern to potential and existing customers. If the Company is unable to obtain sufficient financing, the Company may have to further reduce expenses through workforce reductions and other cost cutting measures. Management believes that such expense reduction, if appropriate, would need to occur during 2004 or early 2005 in order for the cost savings to be meaningful to us. Even if such expense reduction occurs during 2004 or early 2005, it may not be sufficient to generate enough cost savings to sufficiently improve our liquidity and/or capital resources to enable the Company to remain viable as a going concern.

Our current operating activities include developing, building and testing the VantEdge product line and establishing relationships with our target customers. In the future, we expect that revenue growth, if any, will be substantially dependent on sales of the VantEdge product. The VantEdge product is generally available for sale, however, we have yet to generate material revenues from the sale of the VantEdge product line.

Currently, our revenue is generated primarily from sales of and service on our CopperEdge 200 DSL concentrators, or CE200, and the related wide area network (WAN) modules and line modules, as well as from CE200 system software upgrade licenses. Additionally, we license network management software, which provides monitoring and management capabilities for the CE200, revenues from which have not been material to date.

For the three months ended September 30, 2004, revenue recognized from our three largest customers, Mpower, Florida Digital, and LDMI accounted for approximately 28%, 24%, and 10% of our revenue, respectively. While the level of sales to any specific customer is anticipated to vary from period to period, we expect that we will continue to have significant customer concentration for the foreseeable future. Our customers’ buying patterns are unpredictable. Future sales, if any, to the significant customers mentioned above may be substantially less than historical sales. The loss of any one of our major customers or the delay of significant orders from such customers, even if only temporary, could among other things reduce or delay our net revenue, adversely impact our ability to sustain or achieve annual or quarterly profitability and adversely impact our ability to generate positive cash flow, and, as a consequence, could materially adversely affect our business, financial condition and results of operations.

We market and sell our products directly to telecommunications service providers and through distributors. We generally recognize revenue from product sales upon shipment if collection of the resulting receivable is probable and product returns are reasonably estimated. No revenue is recognized on products shipped on a trial basis. Estimated sales returns, based on historical experience by product, are recorded at the time the product revenue is recognized. To date, significant revenues generated from international sources are entirely comprised of sales to Versatel.

We expect our gross margin could be affected by many factors including competitive pricing pressures, charges for excess and obsolete inventory, fluctuations in manufacturing volumes, costs of components and sub-assemblies, costs from our contract manufacturers, the mix of products or system configurations sold and the volume and timing of sales of follow-on line cards for systems shipped in prior periods. As of September 30, 2004, we had a substantial amount of fully reserved finished goods and component inventory for the CE200 and VantEdge product lines. Our reserve had been established based on our projection, which indicated certain inventories would not be used or would be sold below their original cost. In the future, we could utilize fully reserved components to complete products, which could result in higher gross

14

Table of Contents

margins. The gross margin realized will be highly dependent upon our cost to complete the units and our ability to sustain pricing at current levels which may prove to be difficult given the severe pricing pressures that we are currently experiencing. In addition, our overall gross margin realized on sales of our products may fluctuate widely and will be highly dependent upon sales mix, utilization of fully reserved inventory, if any, and the prices at which our customers are willing to purchase our products.

We outsource most of our manufacturing and supply chain management operations, and we conduct manufacturing engineering, quality assurance, program management, documentation control and product repairs at our facility in San Diego, California. Accordingly, a significant portion of our cost of revenue during the periods presented consists of payments to our contract manufacturers, which in 2004 was principally with Plexus Corporation. We selected our manufacturing partner with the goal of ensuring a reliable supply of high quality finished products and of lowering per unit product costs as a result of manufacturing economies of scale. However, we cannot assure you that we will achieve or maintain the volumes required to realize these economies of scale or when or if such cost reductions will occur. The failure to obtain such cost reductions could materially adversely affect our gross margins and operating results.

Research and development expenses consist primarily of salaries and related personnel expenses, consultant fees and prototype expenses related to the design, development and testing of our products and enhancement of our network management software. We believe that continued investment in research and development is critical to attaining our strategic product objectives.

Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing, sales and field service support functions, as well as trade shows and promotional expenses.

General and administrative expenses consist primarily of salaries and related expenses for executive, finance, human resources, management information systems and administrative personnel, recruiting expenses, professional fees, bad debt expenses and other general corporate expenses.

We have had three restructurings since March 2001. These restructurings resulted in our adoption of business plans to re-size our business to reflect current and expected business conditions. As a result of the adoption of these plans, we recorded total charges of approximately $21.7 million. These charges primarily relate to: consolidation of our continuing operations resulting in impairment of assets; anticipated losses on disposition of assets and excess lease costs; and the elimination of job responsibilities, resulting in costs incurred for employee severance.

The remaining balances of the accrued restructuring charges are as follows (in 000s):

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which are prepared in accordance with generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with generally accepted accounting principles 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 revenues and expenses during the reporting period. Examples include estimated restructuring costs, excess inventory and adverse purchase commitments, provisions for returns, bad debts, warranty costs, and the ultimate realizability of investments and the ultimate outcome of litigation. Actual results could differ from those estimates.

15

Table of Contents

We have several critical accounting policies that are both important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments. Typically, the circumstances that make these judgments complex and difficult have to do with making estimates about the effect of matters that are inherently uncertain. Our critical accounting policies are as follows:

Revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is fixed or determinable and; (iv) collectibility is reasonably assured. Sales returns are estimated based on historical experience and management’s expectations and are recorded at the time product revenue is recognized. Annual service and support arrangements can be purchased by customers for products no longer under warranty and are generally billed quarterly. Revenue from service and support arrangements is recognized ratably as services are performed. We may extend limited stock rotation, product return and price protection rights to certain distributors and resellers.

Inventory is stated at the lower of cost, principally standard costs, which approximates actual costs on a first-in, first-out basis, or market. We estimate the market value of our inventory based upon anticipated future demand for our products.

We provide limited warranties on certain of our products, typically for periods of up to one year. We recognize warranty reserves when products are shipped based upon an estimate of total warranty costs, and such reserves are included in accrued liabilities. The estimate of such costs is based upon historical and anticipated requirements.

Results of Operations

The following table sets forth, as a percentage of net revenue, certain statement of operations data for the periods indicated.

16

Table of Contents

Three Months Ended September 30, 2004 vs. Three Months Ended September 30, 2003

Net Revenue. Net revenue decreased from $3.7 million for the three months ended September 30, 2003 to $1.8 million for the three months ended September 30, 2004. Sales to our three largest customers, Mpower, Florida Digital, and LDMI were $0.5 million, $0.4 million, and $0.2 million, respectively. Sales to our three largest customers for the three months ended September 30, 2003, DSL.Net, Versatel, and Mpower, were $1.0 million, $1.0 million, $0.9 million, respectively. Software and service sales during the three months ended September 30, 2004 and 2003 were approximately $0.6 million and $1.8 million, respectively.

Gross Margin. Our gross margin decreased from $2.5 million for the three months ended September 30, 2003 to $0.3 million for the three months ended September 30, 2004. The decrease in gross margin was primarily the result of the recognition of an inventory obsolescence charge of $0.9 million, which was related to excess and obsolete inventory and to a decrease of $1.2 million in high margin software and service sales during the three months ended September 30, 2004 compared to the same period in the prior year. During the three months ended September 30, 2004 and 2003, the Company sold CE200 access concentrators and related line cards that had been previously written down by $0.4 million and $0.4 million, respectively. The Company expects margins in subsequent periods to fluctuate, perhaps substantially, and margins in future quarters may be lower than in the current period.

Research and Development. Our research and development expenses increased from $3.2 million for the three months ended September 30, 2003 to $3.3 million for the three months ended September 30, 2004. During the three months ended September 30, 2004 depreciation expense related to capital equipment decreased by approximately $0.3 million as a result of lower average purchases of capital equipment. Additionally, compensation costs decreased by $0.3 million over the same period as a result of lower headcount and lower incentive compensation. These decreases were offset by an increase in the purchase of prototype materials of $0.6 million used in product development and by an increase of $0.2 million in consulting services used in the same period.

Sales and Marketing. Our sales and marketing expenses decreased from $1.5 million for the three months ended September 30, 2003 to $1.0 million for the three months ended September 30, 2004. This decrease was primarily the result of a decrease in personnel costs of $0.2 million as a result of lower commission and bonus expenses and due to a $0.2 million decrease in consulting costs.

General and Administrative. Our general and administrative expenses decreased from $1.8 million for the three months ended September 30, 2003 to $1.2 million for the three months ended September 30, 2004. This decrease was primarily the result of a decrease in personnel costs of $0.7 million as a result of lower bonus expenses and a $0.1 million decrease in depreciation. These decreases were offset by an increase in legal and accounting costs of $0.2 million.

Deferred Stock Compensation. Our deferred stock compensation expense decreased from $0.8 million for the three months ended September 30, 2003 to a credit of $1.6 million for the three months ended September 30, 2004. This decrease was primarily the result of the re-measurement of the deferred stock compensation related to unexercised options that were re-priced in 2002. The re-measurement of the compensation expense resulted in a credit of $2.4 million during the current quarter as a result of the significant decline in the Company’s stock price. The re-measurement credit was offset by deferred compensation expense associated with restricted stock grants.

Interest and Other Income. Our interest and other income decreased from $92,000 for the three months ended September 30, 2003 to $59,000 for the three months ended September 30, 2004. This decrease was primarily the result of lower average cash and short-term investment balances.

Interest Expense. Our interest expense decreased from $41,000 for the three months ended September 30, 2003 to zero for the three months ended September 30, 2004. The amounts outstanding under capital lease and equipment notes payable facilities have been paid in full.

17

Table of Contents

Nine Months Ended September 30, 2004 vs. Nine Months Ended September 30, 2003

Net Revenue. Net revenue decreased from $10.8 million for the nine months ended September 30, 2003 to $5.9 million for the nine months ended September 30, 2004. Sales to our four largest customers for the nine months ended September 30, 2004, MPower, Florida Digital, Versatel and Graybar (reseller), were $0.8 million, $0.8 million, $0.7 million and $0.6 million, respectively. Sales to our two largest customers for the nine months ended September 30, 2003, Versatel and MPower, were $4.3 million and $1.5 million, respectively.

Gross Margin. Our gross margin decreased from $7.2 million for the nine months ended September 30, 2003 to $2.5 million for the nine months ended September 30, 2004. The decrease in gross margin was primarily the result of the decrease in sales during the nine months ended September 30, 2004. Also attributing to the decrease in gross margin was an increase in the charge taken for inventory obsolescence. Inventory obsolescence charges totaled $0.2 million and $1.2 million for the nine months ended September 30, 2003 and 2004, respectively. Additionally, high margin software and service sales decreased from $3.3 million to $2.4 million, during the nine months ended September 30, 2003 and 2004, respectively. During the nine months ended September 30, 2003 and 2004, the Company sold CE200 access concentrators and related line cards that had been previously written down by $9.6 million and $0.8 million, respectively.

Research and Development. Our research and development expenses increased from $9.9 million for the nine months ended September 30, 2003 to $10.0 million for the nine months ended September 30, 2004. The increase in research and development costs were the result of increased spending on prototype materials used in product development and an increase in the use of outside consultants which was partially offset by a decrease in depreciation expense related to capital equipment. During the nine months ended September 30, 2004 prototype material expenditures and outside consulting costs increased by approximately $1.3 million and $0.6 million, respectively when compared to the same period of the prior year. During the nine months ended September 30, 2004 depreciation expense decreased by approximately $1.2 million when compared to the same period of the prior year.

Sales and Marketing. Our sales and marketing expenses decreased from $4.9 million for the nine months ended September 30, 2003 to $3.8 million for the nine months ended September 30, 2004. This decrease was primarily due to a decrease in personnel costs as a result of lower salaries, commission and bonus expenses.

General and Administrative. Our general and administrative expenses decreased from $5.8 million for the nine months ended September 30, 2003 to $4.3 million for the nine months ended September 30, 2004. This decrease was primarily the result of lower employee compensation costs and lower depreciation costs. During the nine months ended September 30, 2004 depreciation expense related to capital equipment decreased by approximately $0.6 million as a result of lower average purchases of capital equipment. In addition our personnel costs, including salaries and bonuses, decreased in the same period by $1.2 million.

Deferred Stock Compensation. Our deferred stock compensation expense decreased from $2.9 million for the nine months ended September 30, 2003 to a credit of $0.1 million for the nine months ended September 30, 2004. This decrease was primarily the result of the re-measurement of the deferred stock compensation related to unexercised options that were re-priced in 2002. The re-measurement of the compensation expense during the third quarter of 2004 resulted in a credit of $2.4 million as a result of the significant decline in the Company’s stock price. The re-measurement credit was offset by deferred compensation expense associated with restricted stock grants.

Interest and Other Income. Our interest and other income decreased from $278,000 for the nine months ended September 30, 2003 to $147,000 for the nine months ended September 30, 2004. This decrease was primarily the result of lower average cash and short-term investment balances and a decrease in average investment yields.

Interest Expense. Our interest expense decreased from $194,000 for the nine months ended September 30, 2003 to $5,000 for the nine months ended September 30, 2004. This decrease was primarily due to a decrease in the amounts outstanding under capital lease and equipment notes payable facilities as a result of payments made under such facilities. The amounts outstanding under capital lease and equipment notes payable facilities have been paid in full.

18

Table of Contents

Liquidity and Capital Resources

Currently, we are not generating sufficient revenue to fund our operations. We expect our operating losses and net operating cash outflows to continue if we are unable to increase sales. On March 7, 2001, August 2, 2001, and July 11, 2002, we announced that we had adopted business plans to re-size our business to reflect current and expected business conditions. We cannot assure you that we will be able to decrease our operating expenses significantly below current levels and still remain viable and competitive. If we are unable to realize sufficient savings from re-sizing our business, and/or sufficiently increase our revenues, and/or raise additional capital, our ability to deploy and service our products, fund our operations or respond to competitive pressures could be significantly impaired.

We currently fund our operations with our cash, cash equivalents and marketable investments. During the three months ended September 30, 2004, we used approximately $4.9 million in cash to fund our operations, and we expect this rate of usage could continue or increase. At September 30, 2004, we had cash, cash equivalents, and short-term marketable investments of $17.1 million.

We estimate that we currently require approximately $5 million to $7 million in cash per quarter to fund our operations, and we presently expect this rate of quarterly cash use to continue through 2004. Based on our current estimates, we believe that we have sufficient cash, cash equivalents and marketable investments to fund our operations for at least six months. These estimates reflect various assumptions, including the assumptions that the sales of our existing products will continue at approximately the same levels as in the first nine months of 2004, that testing, continued development and commercialization of our new VantEdge product proceeds as planned, and that we do not incur significant additional expenses, including but not limited to expenses related to litigation, including any adverse determination in any of the litigation described elsewhere in this Form 10-Q under the heading “Legal Proceedings.” Any of our assumptions may prove to be incorrect. In particular, revenues from sales of our products have decreased in the last two years. In the future, it is unclear whether we will continue to generate revenue from sales of products at the same levels, if at all. Finally, carriers’ acceptance of the VantEdge may be delayed or may not occur at all; the enhancement and commercialization of the VantEdge product might be delayed, perhaps indefinitely; or might require the expenditure of significantly more funds than currently anticipated, in which case liquidity and capital resources would be adversely affected.

We have made significant investments in the development of the VantEdge Broadband Remote Access Server (BRAS) product and we believe it has significant promise; however it is unclear whether it will be commercially successful and generate sufficient revenue to offset the decline of sales of current products. Presently, current and prospective customers are evaluating and/or trialing the VantEdge, and it is uncertain as to whether it will meet these carriers’ current and/or future overall requirements; whether it will meet these carriers’ performance and cost expectations; and whether it will require substantial further development. As a result, carriers’ acceptance of the VantEdge may be delayed or may not occur at all; the enhancement and commercialization of the VantEdge product might be delayed, perhaps indefinitely; or might require the expenditure of significantly more funds than currently anticipated, in which case liquidity and capital resources would be adversely affected. Should sufficient funds not be available to fund the commercialization of VantEdge, our viability as a going concern may be in doubt.

Should any of these or other factors occur, our use of cash may be adversely affected. This may require management to reduce expenses to have sufficient funds for our operations beyond the first quarter of 2005. Management believes that such expense reduction, if appropriate, would need to occur during 2004 or early 2005 in order for the cost savings to be meaningful to us.

We anticipate that we may have to seek additional equity or debt financing in the private or public capital markets to obtain the funds we need to continue operations beyond the first quarter of 2005 and to demonstrate our future viability as a going concern to potential and existing customers. Such capital raising may be made more difficult if we are no longer listed on the NASDAQ stock market as a result of our failure to continue to meet the listing requirements required by NASDAQ, which is a risk we face.

If additional funds are raised through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution, or such equity securities may

19

Table of Contents

have rights, preferences or privileges senior to or more favorable than those of the holders of our common stock. If additional funds are raised through the issuance of debt securities, such securities would have rights, preferences and privileges senior to or more favorable than those of the holders of common stock and the terms and conditions relating to such debt could impose restrictions on our operations.

Additional financing may not be available when needed on terms and conditions favorable to us or at all. If adequate funds are not available or are not available on acceptable terms and conditions, we may be unable to fund our ongoing operations. In addition, our inability to obtain additional financing may:

Any or all of these consequences would materially adversely affect our business, financial condition or results of operations.

Cash used in operating activities for the nine months ended September 30, 2004 and 2003 was $15.8 million and $10.1 million, respectively. The relative increase in cash used in operating activities for the nine months ended September 30, 2004 compared to the same period in the prior year was primarily the result of an increase in the net loss which also included lower non-cash depreciation and deferred stock compensation expenses.

Cash provided by/(used in) investing activities for the nine months ended September 30, 2004 and 2003 was $1.2 million and $(2.4) million, respectively. The relative decrease in cash used by investing activities for the nine months ended September 30, 2004 compared to the same period in the prior year was the result of a decrease in net purchases of marketable investments.

Cash provided by/(used in) financing activities for the nine months ended September 30, 2004 and 2003 was $10.6 million and $(2.5) million, respectively. The increase in cash provided by financing activities for the nine months ended September 30, 2004 compared to the same period in the prior year was primarily due to the Company closing the sale of 1,250,000 shares of common stock to new and current shareholders at $9.00 per share in May 2004. The common stock private placement raised net proceeds to the company of approximately $10.6 million net of fees and expenses.

Our future capital requirements will depend upon many factors, including the timing of research and product development efforts and marketing efforts. We expect to continue to expend amounts on property and equipment related to facility infrastructure, computer equipment and for research and development laboratory and test equipment to support on-going research and development operations.

Our capital requirements may vary based upon the timing and the success of implementation of our business plan and as a result of regulatory, technological and competitive developments or if:

20

Table of Contents

We intend to use our cash and other resources for working capital and other general corporate purposes. We may also use a portion of our cash and other resources to acquire complementary businesses or other assets. The amounts actually expended for these purposes will vary significantly depending on a number of factors, including revenue growth, if any, planned capital expenditures, and the extent and timing of our entry into target markets. Our management intends to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.

Risk Factors That May Affect Results of Operations and Financial Condition

You should carefully consider the following risk factors and the other information included before investing in our common stock. Our business and results of operations could be seriously harmed by any of the following risks. The trading price of our common stock could decline due to any of these risks, and you may lose part or all of your investment.

We May Not Be Able to Achieve or Maintain a Scale of Operations, Liquidity or Capital Resources That Is Sufficient In the View of Our Current and/or Prospective Customers.

Many of our current and prospective telecom service provider customers, including but not limited to prospective ILEC, IXC and PTT customers, require telecom equipment vendors to meet certain operational and financial criteria in order for such vendors to be eligible to establish and maintain product supply relationships with the customer. These criteria include, but are not limited to, maintaining a scale of operations, liquidity and capital resources that is sufficient, in the opinion of the customer, to enable the vendor to assure long-term supply of the vendor’s products and demonstrate long-term viability as a going concern. Currently, we may not be able to meet some or all such criteria, especially with respect to prospective ILEC, IXC and PTT customers; in the event that we meet one or more of these criteria today we may not be able to continue to do so in the future. It may not be possible for us to meet such criteria solely by raising additional capital, and the amount of capital necessary to meet our current and prospective customers’ requirements may be significantly greater than the amount of capital available to us. We may be able to meet such criteria if and only if we are acquired by a substantially larger vendor with a scale of operations, liquidity and capital resources significantly greater than ours, which acquisition may not be feasible or may not occur in a timely manner.

The Difficulties Experienced By Many of Our Current Customers and The Challenges Associated With Penetrating New Markets Have Had and Are Expected To Continue To Have an Adverse Effect On Our Business.

To date, we have sold the majority of our products to competitive local exchange carrier (CLEC) customers. Many CLECs have experienced difficulties continuing to finance their businesses. As a result, these CLECs have been forced to scale back their operations, and some, including our historically two largest customers, Northpoint Communications, Inc. and Rhythms Netconnections, Inc., have filed for bankruptcy protection. Our business, financial condition and results of operations have been materially and adversely affected by these difficulties in the CLEC industry. We expect that our business will continue to suffer unless and until we are able to diversify our customer base to derive a substantially greater percentage of our revenues from other types of telecommunication service providers, such as incumbent local exchange carriers (ILECs), who are not experiencing the same level of financial difficulties.

The failure of our CLEC customers to raise sufficient capital to fund their operations and continue to order and pay for our products has impaired and may continue to impair our revenues and profitability. To the extent we ship products to customers who become unable to pay for the products, we may be required to write off significant amounts of our accounts receivable. Similarly, to the extent that our customers order products and then suspend or cancel the orders prior to shipping, we may not generate revenues from the

21

Table of Contents

products we build, our inventories may increase and our expenses will increase. Specifically, we may incur substantially higher inventory carrying costs, as well as be faced with the risk of the excess inventory that could become obsolete over time.

The uncertainties in the CLEC industry in general and among our CLEC customers in particular, and the resulting impact on our business, has made it increasingly difficult for us to reliably forecast our revenues and profitability. We expect that we will continue to be faced with these challenges for as long as the CLEC industry experiences financial difficulties, or until we can successfully shift our business away from reliance on our CLEC customers and add customers with stronger financial positions.

If We Do Not Successfully Introduce and Commercialize the VantEdge Product, Our Business Will Be Materially Adversely Affected

In response to the financial difficulties experienced by our CLEC customers and the resulting reduction in the demand for our products, we have focused our sales and marketing strategy on targeting ILECs, inter-exchange carriers (IXCs), international postal, telephone and telegraphs (PTTs) and independent operating companies (IOCs) as potential customers. The future success of our business will substantially depend on our ability to successfully sell our VantEdge product to such customers. These customers have traditionally been characterized by longer sales cycles and have historically been slow to adopt new products. Accordingly, we anticipate that we may continue to face challenges in connection with our plan to more aggressively pursue this market, and our failure to successfully do so could materially adversely affect our business, financial condition and results of operations.

Sales of our existing products and services, which were primarily aimed at the CLEC market, have decreased substantially over the last two years. Such sales could continue to decrease, if they continue at all. As a result, our future success is substantially dependent upon our ability to successfully market and commercialize our new VantEdge product on a timely basis. We began development of the VantEdge product in 2000, and formally announced the product in 2001. Sales of the VantEdge product may not be sufficient to allow us to continue to operate our business. Our business will be materially adversely impacted if we do not successfully commercialize the VantEdge product.

We May Not Be Able to Obtain Additional Capital to Fund Our Operations When Needed, and Without Additional Capital We May Not Be Able to Sustain Our Operations

During the last four quarters we required approximately $4.6 to $5.9 million in cash per quarter to fund our operations, and this rate of quarterly cash use could continue or increase. Based upon our recent quarterly cash use, we believe that we have sufficient cash and cash equivalents to fund our operations for at least the next six months. These estimates reflect various assumptions, including the assumption that sales of our existing products will continue at approximately the same levels as in the third quarter of 2004, that testing, continued development and commercialization of our new VantEdge product proceeds as planned, that we do not incur significant additional expenses, including but not limited to expenses related to litigation, including any adverse determination in the litigation described elsewhere in this Form 10-Q under the heading “Legal Proceedings.” Any of our assumptions may prove to be incorrect.

It is unclear whether we will continue to generate revenue from sales of our current products at the same level of such revenues in the past, if at all. Also, carriers’ acceptance of the VantEdge may be delayed or may not occur at all; the enhancement and commercialization of the VantEdge product might be delayed, perhaps indefinitely; or might require the expenditure of significantly more funds than currently anticipated, in which case liquidity and capital resources would be adversely affected.

We currently fund our operations with our cash, cash equivalents and marketable investments. In order to fund our operations significantly beyond the first quarter of 2005, we expect that we may have to further reduce our expenses and / or raise additional funds. Moreover, we may require such financing sooner than anticipated. We anticipate that we may have to seek equity or debt financing in the private or public capital markets to obtain the funds we need to continue operations and to demonstrate our future viability as a going concern to potential and existing customers. Such capital raising may be made more difficult if we are no longer listed on the NASDAQ stock market as a result of our failure to continue to meet the listing requirements required by NASDAQ, which is a risk we face.

22

Table of Contents

If additional funds are raised through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution, or such equity securities may have rights, preferences or privileges senior to or more favorable than those of the holders of our common stock. If additional funds are raised through the issuance of debt securities, such securities would have rights, preferences and privileges senior to or more favorable than those of the holders of common stock and the terms and conditions relating to such debt could impose restrictions on our operations.

Additional financing may not be available when needed on terms and conditions favorable to us or at all. If adequate funds are not available or are not available on acceptable terms and conditions, we may be unable to fund our ongoing operations. In addition, our inability to obtain additional financing may:

Any or all of these consequences would materially adversely affect our business, financial condition or results of operations.

We May Not Achieve Quarterly or Annual Profitability

We expect to continue incurring significant sales and marketing, research and development and general and administrative expenses and, as a result, we may have difficulty achieving profitability, given our current level of revenue. We cannot be certain that we will realize sufficient revenues in the future to achieve profitability on an annual or quarterly basis.

We Derive Almost All of Our Revenues From a Small Number of Customers and Our Revenues May Decline Significantly if Any Major Customer Cancels or Delays a Purchase of Our Products

We sell our products predominantly to CLECs and IOCs. Sales to our largest three customers accounted for approximately 61% of our net revenue for the three months ended September 30, 2004. Unless and until we diversify and expand our customer base, our future success will significantly depend upon the timing and size of future purchase orders, if any, from our CLEC and IOC customers and, in particular:

In light of the market dynamics of the telecommunication service provider industry, it has become extremely difficult for us to forecast our revenues. Future sales, if any, to our historically significant customers may be substantially less than historical sales. The loss of another major customer or the delay of significant orders from any significant customer, even if only temporary, could among other things reduce or delay our net revenue, adversely impact our ability to achieve annual or quarterly profitability and adversely impact our ability to generate positive cash flow, and, as a consequence, could materially adversely affect our business, financial condition and results of operations.

23

Table of Contents

Historically, our backlog at the beginning of each quarter has not been equal to expected revenue for that quarter. Accordingly, we are dependent upon obtaining orders in a quarter for shipment in that quarter to achieve our revenue objectives. In addition, due in part to factors such as the timing of product release dates, purchase orders and product availability, significant volume shipments of product could occur at the end of any given quarter. Failure to ship products by the end of a quarter may adversely affect our operating results. Furthermore, our customers may delay delivery schedules, cancel their orders without notice or be unable to pay for delivered product. Due to these and other factors, quarterly revenue, expenses and results of operations could vary significantly in the future, and period-to-period comparisons should not be relied upon as indications of future performance.

Failure to Effectively Manage Operations in Light of Our Changing Revenue Base Will Adversely Affect Our Business

In the past, we have rapidly and significantly expanded and contracted our operations and we anticipate that in the future, expansion or contraction in certain areas of our business may be required to address potential changes in our client base and market opportunities. In particular, we expect to face numerous challenges in the execution of our new business strategy to focus more on the domestic ILEC and IXC market and the international PTT market. In connection with this endeavor, we may not be able to implement management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations. If we are unable to manage growth or reduction in growth effectively, our business, financial condition and results of operations will be materially adversely affected.

We have excess facilities in Fremont, California, San Diego, California, and Palo Alto, California, most of which are subleased. We are obligated to continue making payments on the leases associated with each of these excess facilities. Rent associated with these excess facilities has adversely affected our financial condition. If we are unable to sublease all of these properties to financially viable sub-lessees at rates comparable to those we are obligated to pay, it could further adversely impact our financial condition. We cannot assure you that our current subtenants will continue to sublease our excess facilities.

We cannot assure you that we will be able to sufficiently decrease our operating expenses. If we are unable to realize sufficient savings from re-sizing our business, and/or sufficiently increase our revenues, our ability to deploy and service our products, fund our operations or respond to competitive pressures could be significantly impaired.

We Have a Limited Operating History

We have a limited operating history as we were incorporated in March 1996. Due to our limited operating history, it is difficult or impossible for us to predict future results of operations. You should not expect future revenue to be comparable to our historic revenue, and our recent quarterly revenues are not a reliable indicator of future quarterly revenues. In addition, we believe that comparing different periods of our operating results is not meaningful, and you should not rely on the results for any period as an indication of our future performance. Investors in our common stock must consider our business and prospects in light of the risks and difficulties typically encountered by companies in their early stages of development, particularly those in rapidly evolving markets such as the telecommunications equipment industry and particularly within our volatile market segment. Some of the specific risks include whether we are able:

24

Table of Contents

We discuss these and other risks in more detail below.

A Number of Factors Could Cause Our Operating Results to Fluctuate Significantly and Cause Our Stock Price to be Volatile

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, many of which are outside of our control. If our quarterly or annual operating results do not meet the expectations of securities analysts or investors, the trading price of our common stock could significantly decline. Some of the factors that could affect our quarterly or annual operating results include:

25

Table of Contents

We Sell the Majority of Our Products to Telecommunications Service Providers That May Reduce or Discontinue Their Purchase of Our Products At Any Time

The purchasers of our products to date have predominantly been the emerging telecommunications service providers known as CLECs, and have included IOCs. These telecommunications service providers and most other telecommunications service providers require substantial capital for the development, construction and expansion of their networks and the introduction of their services. Financing may not be available to such telecommunications service providers on favorable terms, if at all. The inability of our current or potential customers to acquire and keep customers, to successfully raise needed funds, or to respond to any other trends such as price reductions for their services or diminished demand for telecommunications services generally, has adversely affected their operating results and/or caused them to reduce their capital spending programs. If our current and prospective customers are unable to raise sufficient capital or forced to defer or curtail their capital spending programs, our sales to those telecommunication service providers may be adversely affected, which could have a material adverse effect on our business, financial condition and results of operations. In addition, many of our telecommunications service provider customers have recently experienced consolidation, reduced or eliminated access to the capital markets and in some cases bankruptcy. The loss of one or more of our telecommunications service provider customers due to the aforementioned factors could have a material adverse effect on our business, financial condition and results of operations.

If DSL Technology and Our DSL-Related Product Offerings Are Not Accepted by Telecommunications Service Providers, We May Not Be Able to Sustain or Grow our Business

Our future success is substantially dependent upon whether DSL technology gains and maintains widespread market acceptance by financially viable telecommunications service providers, of which there are a limited number, and end users of their services. We have invested substantial resources in the development of DSL technology and related technologies, and all of our products are based on DSL technology or depend on the widespread acceptance and continued deployment of DSL technology. Telecommunications service providers are continuously evaluating alternative high-speed data access technologies and may, at any time, adopt technologies other than the DSL technologies offered by us. Even if telecommunications service providers adopt policies favoring full-scale implementation of DSL technology, they may defer purchases of our products or they may not choose to purchase our product offerings. In addition, we have limited ability to influence or control decisions made by telecommunications service providers. In the event that the telecommunications service providers to whom we market our products adopt technologies other than the DSL technologies offered by us or choose not to purchase our DSL product offerings or our other product offerings, we will not be able to sustain or grow our business.

We Have Been Named as a Defendant in Securities Class Action Litigation That Could Result In Substantial Costs and Divert Management’s Attention and Resources

In December 2001, we and certain of our officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation, Case No. 01-CV-10943. In the amended complaint, the plaintiffs allege that we, certain of our officers and directors and the underwriters of our initial public offering (“IPO”) violated section 11 of the Securities Act of 1933 based on allegations that our IPO registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The amended complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted deceit on investors. The plaintiffs

26

Table of Contents

seek unspecified monetary damages and other relief. Similar complaints, collectively referred to here as the “IPO Lawsuits,” were filed in the same court against hundreds of other public companies (“Issuers”) who conducted IPOs between 1998 and 2000.

On August 8, 2001, the IPO Lawsuits were consolidated for pretrial purposes before United States Judge Shira Scheindlin of the Southern District of New York. On July 15, 2002, the we joined in a global motion to dismiss the IPO Lawsuits filed by all of the Issuers (among others). On October 9, 2002, the Court entered an order dismissing our named officers and directors from the IPO Lawsuits without prejudice, pursuant to an agreement tolling the statute of limitations with respect to these officers and directors until September 30, 2003. On February 19, 2003, the Court issued a decision denying the motion to dismiss the Section 11 claims against us and almost all of the Issuers, and denying the motion to dismiss the Section 10(b) claims against us and many of the other issuers.

In June 2003, the Issuers reached a tentative settlement agreement with the plantiffs that would, among other things, result in the dismissal with prejudice of all claims against the Issuers and their officers and directors in the IPO Lawsuits. In addition, the tentative settlement guarantees that, in the event that the Plaintiffs recover less than $1 billion in settlement or judgment against the Underwriter defendants in the IPO Lawsuits, the Plaintiffs will be entitled to recover the difference between the actual recovery and $1 billion from the insurers for the Issuers. In September 2003, in connection with the tentative settlement, those officers and directors who had entered tolling agreements (described above) agreed to extend those agreements so that they would not expire prior to any settlement being finalized. In June 2004, the Company executed a final settlement agreement with the plaintiffs. The settlement is still subject to a number of conditions, including action by the Court certifying a class action for settlement purposes and formally approving the settlement. The Underwriter defendants have opposed both the certification of a settlement class action and judicial approval of the settlement.

No assurances can be made that we will be successful in our defense of such claims. If we are not successful in our defense of such claims, we could be forced to make significant payments to our stockholders and their lawyers, and such payments could have a material adverse effect on our business, financial condition and results of operations if not covered by our insurance carrier. Even if such claims are not successful, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our business, results of operations and financial position.

Unless We are Able to Keep Pace With the Rapidly Changing Product Requirements of Our Customers, We Will Not Be Able to Sustain or Grow Our Business

The telecommunications and data communications markets are characterized by rapid technological advances, evolving industry standards, changes in end-user requirements, frequent new product introductions and evolving offerings by telecommunications service providers. We believe our future success will depend, in part, on our ability to anticipate or adapt to such changes and to offer, on a timely basis, hardware and software products which meet customer demands. Our inability to develop on a timely basis new products or enhancements to existing products, or the failure of such new products or enhancements to achieve market acceptance, could materially adversely affect our business, financial condition and results of operations.

Our Product Cycles Tend to be Short and We May Incur Substantial Non-Recoverable Expenses or Devote Significant Resources to Sales That Occur Later than Anticipated or Not at All

In the rapidly changing technology environment in which we operate, product cycles tend to be short. Therefore, the resources we devote to product sales and marketing may not generate revenues for us and from time to time we may need to write-off excess and obsolete inventory. In the past, we have experienced such write-offs attributed to the obsolescence of certain printed circuit boards and product sub-assemblies and to an excess of raw materials and finished goods on hand and on order. If we incur substantial sales, marketing and inventory expenses in the future that we are not able to recover, it would affect our liquidity and could have a material adverse effect on our business, financial condition and results of operations.

27

Table of Contents

Our Ability to Sustain or Grow Our Business May Be Harmed if We Are Unable to Develop and Maintain Certain Strategic Relationships with Third Parties to Market and Sell Our Products

Our success will depend in part upon our ability to form and maintain distribution partnerships, including agreements under which we agree to sell our products to certain service provider customers through distribution partners. Any such agreements we have entered into in the past may not be successful. The amount and timing of resources which our distribution partners devote to our business, if any, is not within our control and may not be sufficient to generate significant revenue. Our distribution partners may not perform their obligations as expected. Our distribution partners may have entered into distribution partnerships with vendors of products, which compete directly or indirectly with our products, or may enter into such partnerships in the future; either such action could materially adversely affect our ability to generate revenue from such partnerships. In some cases, agreements with our distribution partners may be relatively new, and we cannot be certain that we will be able to achieve expected revenues from such partners or sustain the level of revenue generated in the past under similar arrangements. If any of our distribution partners chooses not to renew, breaches or terminates its agreement, fails to perform its obligations under its agreement, or fails to perform in accordance with our expectations, we may not be able to sustain or grow our business. In the event that such relationships become ineffective or are terminated, we may not be able to continue to maintain or develop similar relationships or to replace distribution partners. In addition, any such agreements we enter into in the future may not be successful.

Intense Competition in the Market for Telecommunications Equipment Could Prevent Us From Increasing or Sustaining Revenue and Prevent Us From Achieving Annual Profitability

The market for telecommunications equipment is highly competitive. We compete directly with the following companies: Cisco Systems, Lucent Technologies, Alcatel S.A., Juniper Networks, and Redback Networks, among others. If we are unable to compete effectively in the market for DSL and BRAS equipment, our revenue levels and future results from operations could be materially adversely affected. Many of our current and potential competitors have significantly greater selling and marketing, technical, manufacturing, financial, and other resources, including better access to the capital markets, larger cash reserves, higher market capitalizations, and vendor-sponsored lease financing programs. Moreover, our competitors may foresee the course of market developments more accurately than we do and could in the future develop new technologies that compete with our products or render our products obsolete. Although we believe we may have certain technological and other advantages over our competitors, realizing and maintaining such advantages will require a continued level of investment in research and development, marketing and customer service and support. Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and greater financial resources, including other large telecommunications equipment manufacturers, may enter those markets, thereby further intensifying competition. We may not have sufficient resources to continue to make the investments or achieve the technological advances necessary to compete successfully with existing competitors or new competitors.

Future Consolidation in the Telecommunications Equipment Industry May Increase Competition That Could Harm Our Business

The markets in which we compete are characterized by increasing consolidation both within the data communications sector and by companies combining or acquiring data communications assets and assets for delivering voice-related services. We cannot predict with certainty how industry consolidation will affect our competitors. We may not be able to compete successfully in an increasingly consolidated industry. Increased competition and consolidation in our industry could require that we reduce the prices of our products and result in our loss of market share, which would materially adversely affect our business, financial condition and results of operations. Because we may be dependent on certain strategic relationships with third parties in our industry, any additional consolidation involving these parties could reduce the demand for our products and otherwise harm our business prospects.

28

Table of Contents

We May Experience Difficulties in the Introduction of New Products That Could Cause Us to Incur Significant Unexpected Expenses or Delay the Launch of New Products

We intend to continue to invest in product and technology development. The development of new or enhanced products, including but not limited to the VantEdge line of products and new or enhanced DSL concentrator products, is a complex and uncertain process requiring the accurate anticipation of technological and market trends. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent our development, introduction or marketing of new products and enhancements. The introduction of new or enhanced products also requires that we manage the transition from older products in order to minimize disruption in customer ordering patterns and ensure that adequate supplies of new products can be delivered to meet anticipated customer demand. In the future, we expect to develop certain new products, which may include new BRAS products and associated line cards, new broadband services concentrators and line cards for different variants of access technology including, but not limited to, DSL, T1/E1, and various optical access technologies. We may not successfully develop, introduce or manage the transition of these new products. Furthermore, products such as those we currently offer may contain undetected or unresolved errors when they are first introduced or as new versions are released. Despite testing, errors may be found in new products or upgrades after commencement of commercial shipments. These errors could result in:

Any of these could materially adversely affect our business, financial condition and results of operations.

We are Dependent on Widespread Market Acceptance of Our Products

Widespread market acceptance of our products is critical to our future success. Factors that may affect the market acceptance of our products include market acceptance of BRAS products in general and our BRAS products in particular, market acceptance of DSL technology, the performance, price and total cost of ownership of our products, the availability and price of competing products and technologies and the success and development of our distribution partnerships and field sales channels. Many of these factors are beyond our control. The introduction of new and enhanced products may cause certain customers to defer or return orders for existing products. Although we maintain reserves against such returns, such reserves may not be adequate. We cannot be certain that we will not experience delays in product development in the future. Failure of our existing or future products to maintain and achieve meaningful levels of market acceptance would materially adversely affect our business, financial condition and results of operations.

Because Substantially All of Our Revenue is Derived From Sales of a Small Number of Products, Our Future Operating Results Will Be Dependent on Sales of These Products

We currently derive substantially all of our revenue from sales of a small number of products and we expect that this concentration will continue in the foreseeable future. The market may not continue to accept or order our current products, and we may not be successful in marketing any new or enhanced products, including, but not limited to, our VantEdge products. Any reduction in the demand for our current products or our failure to successfully develop or market and introduce new or enhanced products could materially adversely affect our operating results and cause the price of our common stock to decline. We have already experienced these effects as a result of the financial troubles facing many of our CLEC customers, including the filing of a petition for Chapter 11 protection by our two historically largest customers, Northpoint Communications, Inc. and Rhythms Netconnections, Inc. and several other CLEC customers. Factors that could, in the future, affect sales of our current or new or enhanced products include:

29

Table of Contents

Our Limited Ability to Protect Our Intellectual Property May Adversely Affect Our Ability to Compete

Our success and ability to compete are dependent in part upon our proprietary technology. Any infringement of our proprietary rights could result in significant litigation costs, and any failure to adequately protect our proprietary rights could result in our competitors offering similar products, potentially resulting in loss of a competitive advantage and decreased revenues. We rely on a combination of copyright, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our proprietary rights. Despite our efforts to protect our proprietary rights, existing copyright, trademark and trade secret laws afford only limited protection. In addition, the laws of certain foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, we may not be able to protect our proprietary rights against unauthorized third-party copying or use. Furthermore, policing the unauthorized use of our products is difficult. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our future operating results.

Claims Against Us Alleging Our Infringement of a Third Party’s Intellectual Property Could Result in Significant Expense to Us and Result in Our Loss of Significant Rights

The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert patent, copyright, trademark and other intellectual property rights to technologies that are important to our business. Any claims asserting that our products infringe or may infringe proprietary rights of third parties, if determined adversely to us, could have a material adverse effect on our business, financial condition or results of operations. In addition, in our agreements, we agree to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. As the number of entrants in our market increases and the functionality of our products is enhanced and overlaps with the products of other companies, we may become subject to claims of infringement or misappropriation of the intellectual property rights of others. Any claims, with or without merit, could be time-consuming, result in costly litigation, divert the efforts of our technical and management personnel, cause product shipment delays or require us to enter into royalty or licensing agreements, any of which could have a material adverse effect upon our operating results. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all. Legal action claiming patent infringement may be commenced against us. We cannot assure you that we would prevail in such litigation given the complex technical issues and inherent uncertainties in patent litigation. In the event a claim against us was successful and we could not obtain a license to the relevant technology on acceptable terms or license a substitute technology or redesign our products to avoid infringement, our business, financial condition and results of operations would be materially adversely affected.

If We Lose Key Personnel We May Not Be Able to Successfully Operate Our Business

Our success depends to a significant degree upon the continued contributions of the principal members of our sales, marketing, engineering and management personnel, many of whom perform important

30

Table of Contents

management functions and would be difficult to replace. Specifically, we believe that our future success is highly dependent on our engineering personnel and our senior management. The loss of the services of any key personnel, particularly senior management and engineers, could materially adversely affect our business, financial condition and results of operations.

If We Are Unable to Retain and Hire Additional Qualified Personnel As Necessary, We May Not Be Able to Successfully Achieve Our Objectives

We may not be able to attract and retain the necessary personnel to accomplish our business objectives and we may experience constraints that will adversely affect our ability to satisfy customer demand in a timely fashion or to support our customers and operations, including, but not limited to, constraints which could prevent us from offering cash- and stock-based compensation sufficient to attract and retain key personnel. We have at times experienced, and continue to experience, difficulty in recruiting qualified personnel. Recruiting qualified personnel is an intensely competitive and time-consuming process.

In addition, companies in the telecommunications industry whose employees accept positions with competitors frequently claim that such competitors have engaged in unfair hiring practices. We may receive notice of such claims as we seek to hire qualified personnel and such notices may result in material litigation. We could incur substantial costs in defending ourselves against any such litigation, regardless of the merits or outcome of such litigation.

Our Dependence on Sole and Single Source Suppliers Exposes Us to Supply Interruption

Although we generally use standard parts and components for our products, certain key components are purchased from sole or single source vendors for which alternative sources are not currently available or practical. The inability to obtain sufficient quantities of these components may in the future result in delays or reductions in product shipments, which could materially adversely affect our business, financial condition and results of operations. We have evaluated alternative source vendors in the past for these key components and will continue to do so as appropriate, but any alternative vendors may not meet our quality standards for component vendors. In the event of a reduction or interruption of supply of any such components, as much as nine months could be required before we would begin receiving adequate supplies from alternative suppliers, if any. It is possible that a source may not be available for us or be in a position to satisfy our production requirements at acceptable prices and on a timely basis, if at all. Alternatively, as a result of the long lead times associated with ordering certain materials or components, we may not be able to accurately forecast our need for materials and components and this could result in excess inventory and related write-offs, which could have a material adverse effect on our business.

In addition, the manufacture of certain of these single or sole source components is extremely complex, and our reliance on the suppliers of these components exposes us to potential production difficulties and quality variations, which could negatively impact cost and timely delivery of our products. Any significant interruption in the supply, or degradation in the quality, of any component could have a material adverse effect on our business, financial condition and results of operations.

Our Dependence on Independent Manufacturers Could Result in Product Delivery Delays

We currently use a small number of independent manufacturers to provide certain printed circuit boards, chassis and subassemblies and, in certain cases, to complete final assembly and testing of our products. Our reliance on independent manufacturers involves a number of risks, including the absence of adequate capacity, the unavailability of or interruptions in access to certain process technologies and reduced control over delivery schedules, manufacturing yields and costs. If our current manufacturers are unable or unwilling to continue manufacturing our components in required volumes, it is possible that a source may not be available to us when needed or be in a position to satisfy our production requirements at acceptable prices and on a timely basis, if at all. Any significant interruption in supply would result in the allocation of products to customers in volumes, which do not meet some or all of the customers’ requirements, which in turn could have a material adverse effect on our business, financial condition and results of operations.

31

Table of Contents

Intense Demand for Parts and Components May Create Allocations or Shortages Which May Expose Us to Supply Interruption

From time to time, the demand for parts and components, including semiconductors, programmable devices and printed circuit boards, can be intense. During these periods manufacturers and suppliers who provide such components to us experience supply shortages which may in turn affect their ability to meet our production demands. Moreover, the terms and conditions for purchase of such parts and components, including order cancellation rights, may vary widely, may be onerous and may result in adverse purchase commitments and excess inventory. To date, we have not experienced any shortages of components or parts, which have impacted our ability to meet the shipment requirements of our customers. However, in the event that we receive allocations of components from our suppliers or experience outright interruption in the supply of components we could experience an inability to ship or deliver our products to our customers in a timely fashion. Any significant allocation of or interruption in the supply of any component could have a material adverse effect on our business, financial condition and results of operations.

The Number of Prospective Large Carrier Customers For Our VantEdge Product May Vary Substantially Over Time

On an ongoing basis, large carrier customers such as ILECs, IXCs, PTTs and large IOCs evaluate numerous communications products in a wide range of categories based on many factors, including but not limited to cost, budget availability, customer requirements, emerging technologies, competitive pressures, and the relative merits of various products in any given category. These carriers dedicate their resources to such evaluations, and in some cases potential purchases, based on strategic priorities which may fluctuate over time, and vendors’ competition for these evaluation resources is fierce. Prospective large carrier customers may not communicate to us their shifting priorities relative to BRAS products. Therefore, over time, the number of prospective large carrier customers evaluating BRAS products, if any, may vary widely and we may not be aware immediately, if at all, of any given vendor’s reduced interest in evaluating and purchasing BRAS products in general or our VantEdge product in particular.

Our Customers May Demand Preferential Terms, or They May Delay, or Cease Evaluation of Our Products, Any of Which Would Adversely Affect Our Results of Operations

In certain cases, our current and prospective customers are able to exert a high degree of influence over us. These customers may have sufficient bargaining power to demand low prices and other terms and conditions that may materially adversely affect our business, financial condition and results of operations. In addition, prior to selling our products to such customers, we must typically undergo lengthy product approval processes; these processes are subject to unpredictable delays and may be cancelled by the prospective customers at any time with little or no advance notice to us. Historically this product approval process has taken as long as one year; in the future we expect this process to take two years or longer, especially for ILECs, IXCs and PTTs. Accordingly, we believe we will be required to submit successive versions of our products as well as new products to our current and prospective customers for approval. The length of the approval process can vary and is affected by a number of factors, including customer priorities, customer budgets, customers’ evaluation of competing products and regulatory issues affecting telecommunication service providers. Delays in the product approval process or failure to gain any such approval could materially adversely affect our business, financial condition and results of operations. While we have been successful in the past in obtaining product approvals from our customers, future approvals, if any, and the ensuing sales of such products, if any, likely will be much more difficult to attain than in the past, likely will take far longer to attain than in the past, and such approval and sales may not occur at all. Delays can also be caused by late deliveries by other vendors, changes in implementation priorities and slower than anticipated growth in demand for the services that our products support. A delay in, or cancellation of, the sale of our products could adversely affect our results from operations or cause them to significantly vary from quarter to quarter.

32

Table of Contents

Changes to Regulations Affecting the Telecommunications Industry Could Reduce Demand for Our Products or Adversely Affect Our Results of Operations

Any changes to legal requirements relating to the telecommunications industry, including the adoption of new regulations by federal or state regulatory authorities under current laws or any legal challenges to existing laws or regulations relating to the telecommunications industry, could have a material adverse effect upon the market for our products. Our current and prospective customers’ demand for our products may decline significantly due to changes in federal or state regulations governing such customers’ operations. Moreover, our distributors or telecommunications service provider customers may require, or we may otherwise deem it necessary or advisable, that we modify our products to address actual or anticipated changes in the regulatory environment. Our inability to modify our products or address any regulatory changes could have a material adverse effect on our business, financial condition or results of operations.

Our Failure to Comply with Regulations and Evolving Industry Standards Could Delay or Prevent Our Introduction of New Products

The market for our products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. In order to meet the requirements of our customers, our products may be required to comply with various industry standards and regulations including those promulgated by the Federal Communications Commission, or FCC, and standards established by various organizations, including, but not limited to, Underwriters Laboratories and Bell Communications Research. Failure of our products to comply, or delays in compliance, with the various existing and evolving industry regulations and standards could delay or prevent the introduction of our products or adversely impact product sales. Moreover, enactment by federal, state or foreign governments of new laws or regulations, changes in the interpretation of existing laws or regulations or a reversal of the trend toward deregulation in the telecommunications industry could have a material adverse effect on our customers, and thereby materially adversely affect our business, financial condition and results of operations.

If Our Products Contain Defects, We May Be Subject to Significant Liability Claims from Our Customers, Distribution Partners and the End-Users of Our Products and Incur Significant Unexpected Expenses and Lost Sales

Our products have in the past contained, and may in the future contain, undetected or unresolved errors when first introduced or as new versions are released. Despite extensive testing, errors, defects or failures may be found in our current or future products or enhancements after commencement of commercial shipments. If this happens, we may experience delay in or loss of market acceptance and sales, product returns, diversion of development resources, injury to our reputation or increased service and warranty costs, any of which could have a material adverse effect on our business, financial condition and results of operations. Moreover, because our products are designed to provide critical communications services, we may receive significant liability claims. We attempt to include in our agreements with customers and distribution partners provisions intended to limit our exposure to liability claims. Our customers and distribution partners may not be willing to agree to such provisions, and in any event such provisions may not be effective in any or all cases or under any or all scenarios, and they may not preclude all potential claims resulting from a defect in one of our products or from a defect related to the installation or operation of one of our products. Although we maintain product liability insurance covering certain damages arising from implementation and use of our products, our insurance may not cover any claims sought against us. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. As a result, any such claims, whether or not successful could seriously damage our reputation and our business.

We May Engage in Future Acquisitions That Dilute the Percentage Ownership of Our Stockholders, Cause Us to Incur Debt and Assume Contingent Liabilities

As part of our business strategy, we expect to review acquisition prospects that would complement our current product offerings, augment our market coverage or enhance our technical capabilities, or that may otherwise offer growth opportunities. We may acquire businesses, products or technologies in the future. In the event of such future acquisitions, we could:

33

Table of Contents

Such actions by us could materially adversely affect our liquidity and capital resources, our results of operations and/or the price of our common stock. Acquisitions also entail numerous risks, including:

We may not be able to successfully integrate any businesses, products, technologies or personnel that we have acquired or might acquire in the future, and our failure to do so could have a material adverse effect on our business, financial condition and results of operations.

We May Expand or Reduce Our Operations in International Markets. Our Failure to Effectively Manage Our International Operations Could Harm Our Business.

Entering new international markets may require significant management attention and expenditures and could adversely affect our operating margins and earnings. To date, we have not been able to successfully penetrate these markets. To the extent that we are unable to do so, our growth in international markets would be limited, and our business could be harmed.

We expect that our international business operations will be subject to a number of material risks, including, but not limited to:

34

Table of Contents

Our Stock Price Has Been and May Continue to be Extremely Volatile

The trading price of our common stock has been and is likely to continue to be extremely volatile. Our stock price could be subject to wide fluctuations in response to a variety of factors, including the following:

In addition, the stock market in general, and the Nasdaq National Market and technology companies in particular, have experienced extreme price and volume fluctuations and the trading prices of many technology companies’ stocks, including ours, have been and may continue to be highly volatile. These broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class-action litigation has often been instituted against such companies. We have become the target of such litigation, and several class action lawsuits have been filed against us and certain of our officers alleging violation of federal securities laws related to declines in our stock price. Such litigation could result in substantial costs and a diversion of management’s attention and resources, which could materially adversely affect our business, financial condition and results of operations.

Substantial Future Issuances of Our Common or Preferred Stock in Private Placements or in the Public Market Could Cause Our Common Stock Price to Fall

Issuance of debt that is convertible into our common or preferred stock, or sales of a large number of shares of our common or preferred stock in private placements or in the public market or the perception that such transactions could occur could cause the market price of our common stock to drop. Such transactions could be accompanied by the issuance of warrants for the purchase of preferred or common stock, and such

35

Table of Contents

transactions could include other terms and conditions, which would cause the price of our common stock to fall. As of September 30, 2004, we had approximately 8.0 million shares of common stock outstanding. We have filed seven registration statements on Form S-8 with the Securities and Exchange Commission covering approximately 3.1 million shares of common stock reserved for issuance under our 1996 Equity Incentive Plan, 1999 Non-Employee Directors’ Stock Option Plan, 1999 Employee Stock Purchase Plan, the OnPREM 1998 Stock Option Plan, the 2000 Nonstatutory Stock Option Plan and for options issued outside such plans. As of September 30, 2004, approximately 0.7 million shares are currently subject to exercisable options and 0.9 million shares of restricted stock are outstanding and begin to vest in 2005. In connection with our private placement completed in May 2004, the Company issued 0.3 million common stock warrants at an exercise price of $10 per share. As of September 30, 2004 all of these warrants were outstanding. Issuance of debt convertible into a large number of shares or sales of a large number of shares could adversely affect the market price for our common stock.

Certain Provisions in Our Corporate Charter and Bylaws May Discourage Take-Over Attempts and Thus Depress the Market Price of Our Stock

Provisions in our certificate of incorporation, as amended and restated, may have the effect of delaying or preventing a change of control or changes in our management. These provisions include:

Each of these provisions could discourage potential take-over attempts and could adversely affect the market price of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to changes in interest rates primarily from our debt arrangements and our investments in certain marketable securities. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve, which represents the Company’s expectation for a reasonably possible near-term change in such rates, would not materially affect the fair value of its interest sensitive financial instruments at September 30, 2004.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures. Our management, including our Chief Executive Officer and Chief Financial Officer, has conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in ensuring that all material information required to be filed in this quarterly report has been made known to them in a timely fashion.

Changes in internal controls. There has been no change in our internal control over financial reporting during the fiscal quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

36

Table of Contents

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Reference is made to the descriptions of legal proceedings contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

IPO Litigation. In December 2001, the Company and certain of its officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation, Case No. 01-CV-10943. In the amended complaint, the plaintiffs allege that the Company, certain of its officers and directors and the underwriters of its initial public offering (“IPO”) violated Section 11 of the Securities Act of 1933 based on allegations that the Company’s IPO registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The amended complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted deceit on investors. The plaintiffs seek unspecified monetary damages and other relief. Similar complaints, collectively referred to here as the “IPO Lawsuits,” were filed in the same court against hundreds of other public companies (“Issuers”) who conducted IPOs between 1998 and 2000.

On August 8, 2001, the IPO Lawsuits were consolidated for pretrial purposes before United States Judge Shira Scheindlin of the Southern District of New York. On July 15, 2002, the Company joined in a global motion to dismiss the IPO Cases filed by all of the Issuers (among others). On October 9, 2002, the Court entered an order dismissing the Company’s named officers and directors from the IPO Lawsuits without prejudice, pursuant to an agreement tolling the statute of limitations with respect to these officers and directors until September 30, 2003. On February 19, 2003, the Court issued a decision denying the motion to dismiss the Section 11 claims against the Company and almost all of the Issuers, and denying the motion to dismiss the Section 10(b) claims against the Company and many of the other issuers.

In June 2003, Issuers reached a tentative settlement agreement with the plantiffs that would, among other things, result in the dismissal with prejudice of all claims against the Issuers and their officers and directors in the IPO Lawsuits. In addition, the tentative settlement guarantees that, in the event that the Plaintiffs recover less than $1 billion in settlement or judgment against the Underwriter defendants in the IPO Lawsuits, the Plaintiffs will be entitled to recover the difference between the actual recovery and $1 billion from the insurers for the Issuers. In September 2003, in connection with the tentative settlement, those officers and directors who had entered tolling agreements (described above) agreed to extend those agreements so that they would not expire prior to any settlement being finalized. In June 2004, the Company executed a final settlement agreement with the plaintiffs. The settlement is still subject to a number of conditions, including action by the Court certifying a class action for settlement purposes and formally approving the settlement. The Underwriter defendants have opposed both the certification of a settlement class action and judicial approval of the settlement.

Aaron v. Gilbert, et. al. On November 22, 2002, a derivative complaint alleging securities fraud against certain current and former Copper Mountain officers and directors, titled Aaron v. Gilbert, et. al., No. 812877, was filed in Santa Clara Superior Court based upon various alleged statements and omissions to the public and to the securities markets. On January 31, 2003, the plaintiffs stipulated to consolidate the case with another derivative complaint pending in Santa Clara Superior Court, Czajowski v. Gilbert et. al, No. 797885. On June 28, 2004 and July 2, 2004, the Santa Clara Superior Court granted plaintiff’s voluntary dismissal of these two derivative actions.

Glassman v. Gilbert, et. al. On November 15, 2000, a derivative complaint alleging securities fraud against certain current and former Copper Mountain officers and directors, titled Glassman v. Gilbert et. al, Civil Action No. 18491-NC, was filed in the Delaware Chancery Court based upon various alleged statements and omissions to the public and to the securities markets. On August 26, 2004, plaintiff voluntarily dismissed that action.

37

Table of Contents

The Company is party to other legal proceedings and claims in the ordinary course of business. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. Consequently, management is unable to ascertain the ultimate aggregate amount of monetary liability, amounts which may be covered by insurance, or the financial impact with respect to these matters as of September 30, 2004. However, management believes that the final resolution of these matters, individually and in the aggregate, will not have a material adverse impact upon the Company’s financial position, results of operations or cash flows.

Item 6. Exhibits