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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the Quarterly period ended September 30, 2004

OR

For the transition period from              to             

000-32743

(Commission File Number)

ZHONE TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

(510) 777-7000

(Registrant’s telephone number, including area code)

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

As of October 31, 2004, there were 96,106,000 shares of the Registrant’s Common Stock issued and outstanding.

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Zhone Technologies, Inc.

FORM 10-Q

Quarterly Period Ended September 30, 2004

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(In thousands, except par value)

See accompanying notes to condensed consolidated financial statements.

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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Operations

(In thousands, except per share data)

All per share amounts have been retroactively adjusted to reflect the one-for-ten reverse split of common stock and the effect of the Tellium merger. (See Note 1(b)).

See accompanying notes to condensed consolidated financial statements.

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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Zhone Technologies, Inc. and its subsidiaries (collectively, “the Company”) designs, develops and markets telecommunications hardware and software products for network service providers. The Company has developed an integrated hardware and software architecture designed to simplify the way network service providers deliver communication services to their subscribers. The Company’s products enable service providers to use their existing networks to deliver voice, video, data, and entertainment services to their customers. The Company was incorporated under the laws of the state of Delaware in June 1999. The Company began operations in September 1999 and is headquartered in Oakland, California.

The condensed consolidated financial statements are unaudited and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2003.

In July 2002, in conjunction with the Company’s equity restructuring, the Company’s Board of Directors approved a reverse stock split of the Company’s common stock at a ratio of one-for-ten (the “Reverse Split”), causing each outstanding share of common stock to convert automatically into one-tenth of a share of common stock. In November 2003, the Company consummated its merger with Tellium, Inc. (“Tellium”). As a result of the merger with Tellium, stockholders of Zhone prior to the merger received 0.47 of a share of Tellium common stock for each outstanding share of Zhone common stock, following the conversion of all outstanding shares of Zhone preferred stock into Zhone common stock. Immediately following the closing of the merger, the combined company was renamed Zhone.

For accounting purposes, the merger with Tellium was treated as a reverse merger, in which Zhone was treated as the acquirer based on factors including the relative voting rights, board control, and senior management composition. The financial statements of the combined company after the merger reflect the financial results of Zhone on a historical basis after giving effect to the merger exchange ratio to historical share-related data. The results of operations for Tellium were included in Zhone’s results of operations from the effective date of the merger.

Stockholders’ equity has been restated to give retroactive recognition to the Reverse Split and the effect of the Tellium merger for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital. All references to preferred share, common share and per common share amounts for all periods presented have been retroactively restated to reflect the Reverse Split and the effect of the Tellium merger.

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

The Company recognizes revenue when the earnings process is complete. The Company recognizes product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. The Company’s arrangements generally do not have any significant post-delivery obligations. The Company offers products and services such as support, education and training, hardware upgrades and extended

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warranty coverage. For multiple element revenue arrangements, the Company establishes the fair value of these products and services based primarily on sales prices when the products and services are sold separately. When collectibility is not reasonably assured, revenue is recognized when cash is collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. The Company makes certain sales to product distributors. These customers are given certain privileges to return a portion of inventory. The Company recognizes revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors, unless there is sufficient customer specific sales and sales returns history to support revenue recognition upon shipment. Revenue from sales of software products is recognized provided that a purchase order has been received, the software has been shipped, collection of the resulting receivable is probable, and the amount of the related fees is fixed or determinable. To date, revenue from software transactions has not been significant. The Company accrues for warranty costs, sales returns, and other allowances at the time of shipment based on historical experience and expected future costs.

The Company has an allowance for sales returns for estimated future product returns related to current period product revenue. The Company bases its allowance on periodic assessment of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the reserve had been established, the Company’s revenue could be adversely affected.

The Company has an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments. The Company bases its allowance on periodic assessment of its customers’ liquidity and financial condition through analysis of information obtained from credit rating agencies, financial statement reviews, and historical collection trends. Additional allowances may be required if the liquidity or financial condition of its customers were to deteriorate.

Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) method. In assessing the net realizable value of inventories, the Company is required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its estimated net realizable value, its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or the Company experiences a higher incidence of inventory obsolescence due to rapidly changing technology and customer requirements, the Company may incur significant charges for excess inventory.

The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, Internet service providers, wireless carriers, and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts. For the three and nine months ended September 30, 2004, sales to one customer represented 19% and 15% of net revenue, respectively. For the three months ended September 30, 2003, sales to two customers represented 16% and 14% of net revenue, respectively. For the nine months ended September 30, 2003, sales to two customers represented 18% and 12% of net revenue, respectively. As of September 30, 2004, the Company had accounts receivable balances from two customers individually representing 21% and 19% of accounts receivable, respectively. As of December 31, 2003, the Company had accounts receivable balances from two customers individually representing 31% and 11% of accounts receivable, respectively.

The Company has elected to account for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”) and related interpretations. Under this method, compensation expense is recorded on the date of grant only if the current fair value exceeds the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123, as amended.

In March 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft on the Proposed SFAS, “Share-Based Payment - an amendment of FASB Statements No. 123 and 95”. The proposed statement addresses the accounting for share-based payment transactions. The proposed standard would eliminate the ability to account for share-based compensation transactions using APB No. 25, and generally would require that such transactions be accounted for using a fair-value-based method. If the final standard is approved as currently drafted in the exposure draft, it may have a material impact on the amount of earnings we report for interim periods beginning after June 15, 2005. We are currently determining the impact that the proposed statement will have on our results of operations and financial position.

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For the nine month periods ended September 30, 2004 and 2003, the fair value of the Company’s stock-based awards to employees was estimated using the following weighted average assumptions: expected option life 4.0 years; dividend yield of 0%; risk-free interest rate of 3.2% and 4.5%, respectively; and volatility of 89% and 80%, respectively.

The following table illustrates the effect on net loss and net loss per share if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share data):

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Sorrento

In July 2004, the Company completed the acquisition of Sorrento Networks Corporation (“Sorrento”) in exchange for total consideration of $97.8 million, consisting of common stock valued at $57.7 million, options and warrants to purchase common stock valued at $12.3 million, assumed liabilities of $26.8 million, and acquisition costs of $1.0 million. The Company acquired Sorrento to obtain its line of Optical Transport products and enhance its competitive position with cable operators. One of the Company’s directors is a partner of a venture capital firm which is a major stockholder of Zhone, and which also held warrants to purchase Sorrento common stock that were assumed by Zhone.

The purchase consideration was allocated to the fair values of the assets acquired as follows: net tangible assets - $23.3 million, amortizable intangible assets - $14.8 million, purchased in-process research and development - $2.4 million, goodwill - $57.1 million and deferred compensation - $0.2 million. The amount allocated to purchased in-process research and development was charged to expense during the third quarter of 2004, because technological feasibility had not been established and no future alternative uses for the technology existed. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology. Of the amount allocated to amortizable intangible assets, $9.2 million was allocated to core technology, which is being amortized over an estimated useful life of 5 years. The remaining $5.6 million was allocated to customer relationships, which is being amortized over an estimated useful life of 4 years.

Assumed liabilities related to the Sorrento acquisition totaled $26.8 million, the most significant component of which was long-term debt and debentures totaling $15.8 million. The assumed liabilities also included employee severance and exit costs totaling $2.2 million, which were recorded based on Emerging Issues Task Force (“EITF”) 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”. A rollforward of the EITF 95-3 related activity was comprised as follows (in thousands):

The remaining costs accrued under EITF 95-3 are expected to be paid by the first quarter of 2005.

This preliminary purchase price allocation is subject to revision as more detailed analysis is completed and additional information as to the fair value of Sorrento assets and liabilities becomes available in the fourth quarter of 2004.

The following table reflects the unaudited pro forma combined results of operations of the Company on the basis that the acquisition of Sorrento had taken place at the beginning of each period presented (in thousands, except per share data).

In conjunction with the acquisition of Sorrento, the Company has classified certain acquired facilities held for sale in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long Lived Assets”. The Company intends to sell these facilities within the next year in an effort to consolidate operations. As of September 30, 2004, the Company has entered into an agreement to sell certain of these facilities subject to final negotiations. The recorded fair value of all acquired assets held for sale as of September 30, 2004 was $6.9 million. Accordingly, the mortgage obligation associated with these assets has been classified as current.

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Gluon

In February 2004, the Company acquired the assets of Gluon Networks, Inc. (“Gluon”) in exchange for total consideration of $6.49 million, consisting of common stock valued at $5.74 million, $0.65 million of cash and $0.1 million of acquisition related costs. One of the Company’s directors is a partner of a venture capital firm which is a major stockholder of Zhone, and which was also a major stockholder of Gluon. The transaction was accounted for as an asset acquisition rather than a business combination, since only assets were acquired, which consisted primarily of Gluon’s intellectual property. Gluon was a development stage company that had developed a product for customer trials but had not generated any revenue to date. The Company agreed to acquire Gluon’s intellectual property and hired approximately ten of the former Gluon employees. The Company intends to incorporate elements of the Gluon technology into its future product offerings but does not anticipate generating material revenue from such products until the second half of 2005.

The purchase price for the Gluon transaction was allocated to purchased in-process research and development - $6.19 million, and acquired workforce - $0.3 million. The amount allocated to purchased in-process research and development was charged to expense during the first quarter of 2004, because technological feasibility had not been established and no future alternative uses for the technology existed. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology. Because the transaction did not constitute a business combination, no goodwill was recorded and a portion of the purchase price was allocated to the acquired workforce, which was being amortized over a two year period. An impairment charge of $0.2 million was subsequently recorded in the second quarter of 2004 relating to the Gluon acquired workforce, because the majority of the former Gluon employees were no longer employed by the Company.

Tellium

In November 2003, the Company completed the acquisition of Tellium in exchange for total consideration of approximately $173.3 million, consisting of common stock valued at $119.4 million, options and warrants to purchase common stock valued at $7.9 million, assumed liabilities of $42.8 million, and acquisition costs of $3.2 million. The transaction was treated as a reverse merger for accounting purposes, in which the Company was treated as the acquirer based on factors including the relative voting rights, board control, and senior management composition. The purchase price was allocated to the fair values of the assets acquired as follows: net tangible assets - $144.4 million, goodwill - $25.7 million and deferred compensation - $3.1 million. During the quarter ended September 30, 2004, the Company recorded an adjustment to increase the recorded goodwill by $0.4 million, relating to additional severance incurred as a result of the resolution of a contingent liability. A rollforward of the severance and exit costs recorded under EITF 95-3 was comprised as follows (in thousands):

The remaining costs accrued under EITF 95-3 are expected to be paid by the first quarter of 2005.

As of January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill no longer be amortized, but should be tested for impairment at least annually. The Company completed its transitional and first annual goodwill impairment test as of January 2002 and November 2002, respectively. As the Company has determined that it operates in a single segment with one operating unit, the fair value of its reporting unit was performed at the Company level using a combination of the income, or discounted cash flows, approach and the market approach, which utilizes comparable companies’ data. As of November 2003, the Company performed the annual goodwill impairment test using the market approach, reflecting the fact that the Company’s stock was publicly traded following the consummation of the Tellium merger. At September 30, 2004 and December 31, 2003, the Company had goodwill with a carrying value of $157.8 million and $100.3 million, respectively. No goodwill impairment charges have been recorded since the initial adoption of SFAS No. 142.

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In accordance with SFAS No. 144, the Company reviews long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.

The Company estimates the fair value of its long-lived assets based on a combination of the market, income and replacement cost approaches. In the application of the impairment testing, the Company is required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed variables could differ from these estimates.

Details of the Company’s acquisition-related intangible assets are as follows:

Amortization expense of acquisition-related intangible assets was $2.9 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively, and $7.1 million and $5.9 million for the nine months ended September 30, 2004 and 2003, respectively. In addition, during the nine months ended September 30, 2004, the Company recorded an impairment charge of $0.2 million relating to the Gluon acquired workforce.

Projected future amortization expense for the fiscal years ending December 31 is as follows: 2004 (remainder of year) - $2.9 million, 2005 - $7.6 million, 2006 - $3.5 million, 2007 - $3.3 million, 2008 - $2.5 million and 2009 - $0.9 million.

The changes in the carrying amount of goodwill are as follows (in thousands):

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Inventories as of September 30, 2004 and December 31, 2003 are as follows (in thousands):

During the three and nine months ended September 30, 2003, the Company had Series AA and Series B redeemable convertible preferred stock outstanding, and was recording accretion relating to this preferred stock as described below. There were no shares of preferred stock outstanding during the three and nine months ended September 30, 2004. All outstanding shares of preferred stock were converted to common stock prior to the consummation of the Tellium merger in November 2003.

Prior to April 17, 2003, the Company’s Series AA and Series B redeemable convertible preferred stock contained a redemption feature, such that holders of the redeemable convertible preferred stock could require the Company to redeem the preferred stock at, or any time after, November 1, 2004, 2005, and 2006, in three annual installments, that number of shares of redeemable convertible preferred stock equal to not less than 33.3%, 66.7%, and 100%, respectively. On April 17, 2003, the terms of the redeemable convertible preferred stock were changed to eliminate the redemption feature. Upon the elimination of the redemption feature, the convertible preferred stock was reclassified to stockholders’ equity.

Prior to April 17, 2003, the Company was accreting the redeemable convertible preferred stock to its stated redemption price. The Company accreted, by charging paid in capital, $12.7 million on all outstanding Series AA and Series B redeemable convertible preferred stock through April 17, 2003, which was reflected as an increase in the carrying value of the preferred stock. Upon the elimination of the redemption feature for the Series AA and Series B preferred shares, the Company stopped recording accretion on the convertible preferred stock. The accretion of the redemption value of the redeemable convertible preferred stock for the three and nine months ended September 30, 2003 was zero and $12.7 million, respectively.

The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share data):

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The following table sets forth potentially dilutive securities that have been excluded from the diluted net loss per share calculation because their effect would be antidilutive for the periods indicated (in thousands, except exercise price data):

The components of comprehensive loss, net of tax, for the three and nine months ended September 30, 2004 and 2003 were as follows (in thousands):

Line of Credit and Long-Term Debt

The Company has a $25.0 million line of credit agreement, under which $14.5 million was outstanding at September 30, 2004, and an additional $8.4 million was committed as security for obligations under the Company’s secured real estate loan facility and other letters of credit. Borrowings under the line of credit agreement bear interest at the financial institution’s prime rate or LIBOR plus 2.9%, at the Company’s election. The interest rate was 4.8% at September 30, 2004. As part of the agreement, the Company must also comply with certain financial covenants which have been waived by the financial institution for the period ended September 30, 2004.

At September 30, 2004, the Company had $32.3 million of debt outstanding under a secured real estate loan facility which matures in April 2006. The interest rate on this debt was 8.0% at September 30, 2004.

The Company also assumed debt and convertible debentures relating to the acquisition of Sorrento totaling $15.8 million. The interest rate of these obligations approximates 7.5%. The outstanding principal amount of the convertible debentures was $11.7 million as of September 30, 2004 and matures in August 2007. The debentures are callable by the Company at any time, and can be converted into common stock at the option of the holder at a conversion price of $6.02 per share. Other debt represents the mortgage obligation on assets held for sale which has been classified as current.

As of September 30, 2004 the annual contractual commitments on the $48.1 million debt is as follows: $4.3 million for the remainder of 2004, $1.0 million in 2005, $31.1 million in 2006, and $11.7 million in 2007.

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Leases

The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options.

Future minimum lease payments under all non-cancelable operating leases with terms in excess of one year are as follows (in thousands):

The amount shown above for 2004 includes projected payments and obligations for leases that the Company is no longer utilizing, most of which relate to excess facilities obtained through acquisitions. At September 30, 2004, $2.6 million was accrued relating to excess facilities.

Warranties & Other Commitments

The Company accrues for warranty costs based on historical trends for the expected material and labor costs to provide warranty services. Warranty periods are generally one year from the date of shipment.

The following table reconciles changes in the Company’s accrued warranties and related costs for the nine months ended September 30, 2004 and 2003 (in thousands):

The Company depends on sole source and limited source suppliers for several key components and on contract manufacturers to manufacture certain product lines. If the Company was unable to obtain these components on a timely basis, or if its contract manufacturers were unable to meet the Company’s delivery requirements, the Company’s operating results could be materially adversely affected.

The Company has agreements with various contract manufacturers which include inventory repurchase commitments on excess material based on the Company’s sales forecasts. The Company has recorded a liability of $4.8 million and $4.6 million related to these arrangements as of September 30, 2004 and December 31, 2003, respectively.

In connection with the acquisition of Sorrento, the Company has recorded assumed liabilities for possible contingencies related to the resolution of a pension plan. In 2000, Sorrento sold one of its subsidiaries to Entrada Networks, Inc. In connection with this transaction, Entrada assumed all responsibilities for a defined benefit plan. Although Entrada is the sponsor of the benefit plan, it disclaims responsibility for the minimum funding contributions to the benefit plan and insists that the Company is responsible for any liability related thereto. The Company has reserved an estimated amount which the Company feels is sufficient to cover potential claims regarding the resolution of the benefit plan.

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Letters of Credit

The Company has issued letters of credit to ensure its performance or payment to third parties in accordance with specified terms and conditions, which amounted to $0.3 million and $0.6 million as of September 30, 2004 and December 31, 2003, respectively. The Company has recorded restricted cash equal to the amount outstanding under these letters of credit.

Legal Proceedings

The Company is involved in various litigation matters relating to the operations of Tellium prior to the merger as described below.

On various dates between approximately December 10, 2002 and February 27, 2003, numerous class-action securities complaints were filed against Tellium in the United States District Court, District of New Jersey. These complaints allege, among other things, that Tellium and its then-current directors and executive officers and its underwriter violated the Securities Act of 1933 by making false and misleading statements preceding its initial public offering and in its registration statement prospectus relating to the securities offered in the initial public offering. The complaints further allege that these parties violated the Securities Exchange Act of 1934 by acting recklessly or intentionally in making the alleged misstatements. The actions seek damages in an unspecified amount, including compensatory damages, costs, and expenses incurred in connection with the actions and equitable relief as may be permitted by law or equity. On May 19, 2003, a consolidated amended complaint representing all of the actions was filed. On August 4, 2003, Tellium and its underwriters filed motions to dismiss the complaint. On April 1, 2004, the Court issued its decision granting Tellium’s and the underwriters’ motions to dismiss, while allowing plaintiffs an opportunity to seek leave to file a further amended complaint. On May 14, 2004, the plaintiffs filed a second consolidated and amended class action complaint. On June 25, 2004, the Company, as Tellium’s successor-in-interest, moved to have the second consolidated and amended class action complaint dismissed with prejudice. The motion to dismiss has been fully briefed, and the parties are awaiting the Court’s decision on the motion. It remains too early in the legal process to determine what impact, if any, these suits will have upon the Company’s business, financial condition, or results of operations. The Company intends to continue vigorously defending against the claims made in these actions.

On January 8, 2003 and January 27, 2003, two shareholder derivative complaints were filed on behalf of Tellium in the Superior Court of New Jersey. These complaints were made by plaintiffs who purport to be Tellium shareholders on behalf of Tellium, alleging, among other things, that Tellium directors breached their fiduciary duties to the company by engaging in stock transactions with individuals associated with Qwest Communications International Inc., and in making materially misleading statements regarding Tellium’s relationship with Qwest. The actions seek damages in an unspecified amount, including imposition of a constructive trust in favor of Tellium for the amount of profits allegedly received through stock sales, disgorgement of proceeds in connection with the stock option exercises, damages allegedly sustained by Tellium in connection with alleged breaches of fiduciary duties, costs, and expenses incurred in connection with the actions. These cases have been stayed by the court pending the resolution of motions to dismiss in the above-referenced federal court securities actions. It is too early in the legal process to determine what impact, if any, these suits will have upon the Company’s business, financial condition, or results of operations. The Company intends to vigorously defend the claims made in these actions, which have been consolidated.

The Denver, Colorado regional office of the SEC is conducting two investigations titled In the Matter of Qwest Communications International Inc. and In the Matter of Issuers Related to Qwest. The first of these investigations does not involve any allegation of wrongful conduct on the part of Tellium. In connection with the second investigation, the SEC is examining various transactions and business relationships involving Qwest and eleven companies having a vendor relationship with Qwest, including Tellium. This investigation, insofar as it relates to Tellium, appears to focus generally on whether Tellium’s transactions and relationships with Qwest were appropriately disclosed in Tellium’s public filings and other public statements. In addition, the United States Attorney in Denver is conducting an investigation involving Qwest, including Qwest’s relationships with certain of its vendors, including Tellium. In connection with that investigation, the U.S. Attorney has sought documents and information from Tellium and has sought interviews and/or grand jury testimony from persons associated or formerly associated with Tellium, including certain of its officers. The U.S. Attorney has indicated that, while aspects of its investigation are in an early stage, neither Tellium nor any of the Company’s current or former officers or employees is a target of the investigation. The Company is cooperating fully with these investigations. The Company is not able, at this time, to say when the SEC or U.S. Attorney investigations will be completed and resolved, or what the ultimate outcome with respect to the Company will be. These investigations could result in substantial costs and a diversion of management’s attention and may have a material and adverse effect on the Company’s business, financial condition, and results of operations.

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The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s results of operations or financial position.

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Zhone designs, develops and markets telecommunications hardware and software products for network service providers. The Company derives substantially all of its revenues from the sales of the Zhone product family. The Company’s chief operating decision maker is the Company’s chief executive officer, or CEO. The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. The Company has determined that it has operated within one discrete reportable business segment since inception. The Company is required to disclose certain information about geographic concentrations and revenue by product family.