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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2004

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

For the transition period from                      to                     

Commission File Number: 0-30757

Sunrise Telecom Incorporated

(Exact name of Registrant as specified in its charter)

302 Enzo Drive, San Jose, California 95138

(Address of principal executive offices, including zip code)

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

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

None

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

Common Stock, par value $0.001 per share

(Title of class)

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

    Yes x    No ¨

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

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

    Yes ¨    No x

As of June 30, 2004, the aggregate market value of the Common Stock of the Registrant held by non-affiliates was $51,590,048 based upon the last sale price for that date reported for such sale on the NASDAQ National Market.

As of March 1, 2005, there were 50,768,501 shares of the Registrant’s Common Stock outstanding, par value $0.001.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the 2005 Annual Meeting of Stockholders are incorporated by reference in Part III.

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SUNRISE TELECOM INCORPORATED

Index to Annual Report on Form 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

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Forward-Looking Statements

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

PART I.

ITEM 1.    BUSINESS

OVERVIEW

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

In October 1991, we were incorporated in California as Sunrise Telecom, Inc. In July 2000, we reincorporated in Delaware and changed our name to Sunrise Telecom Incorporated. “Sunrise Telecom,” “SunSet,”, “SunLite”, “STT”, “Sunset MTT”, “Oculist”, “NetTracker”, “Ghepardo”, “Lantrend”, and “CaLan” are trademarks of Sunrise Telecom Incorporated. This Report on Form 10-K also includes references to registered service marks and trademarks of other entities.

INDUSTRY BACKGROUND

High-Speed Data Access

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

One primary investment area is the redesign of the access network to support broadband access to end users. This portion of the network between the customer’s premise and the service provider’s central office is also known as the “last-mile.” The last mile typically consists of copper wires that operate at substantially lower transmission speeds than those offered in the long-haul segment of a network or by some available broadband alternatives. These copper wires

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were originally intended to carry only analog circuit-switched, low-speed voice signals and, as a result, have become a bottleneck that limits high-speed data transmission. Several access technologies are being deployed to support higher-speed Internet access in the networks, including digital subscriber lines, digital cable broadband, fiber optics, and broadband wireless. In addition, the signaling portion of the network is essential to the integration of new broadband services into the existing telecommunications network. We summarize some of these technologies below.

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

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

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

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

The Need for Service Verification Equipment

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

Field Verification Equipment.    Field verification equipment is used by service providers to probe the actual wires, cables, or airwaves to verify that a service works. In the case of a service malfunction, a field technician can use the equipment to locate the exact fault so that repairs can be made. Research and development labs, manufacturing

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departments, and central office technicians also use field verification equipment in their day-to-day operations. Of the three types of service verification equipment, field verification equipment delivers the most detailed service information. Service providers have found field verification to be an effective method to ensure that the lines operate properly.

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

Alarm and Surveillance Equipment.    Alarm and surveillance equipment constantly monitors the telephone network, searching for facility or service degradations, including outages. When a problem is noticed, a report may be sent immediately to an automated trouble diagnostic system or to a human operator who interprets the message and decides what further action is required. Corrective action typically involves field verification or remote test equipment to identify and correct specific problems. This equipment may also collect data on network operation and forward the information to a system for developing statistics on network quality or other attributes of interest.

Because the competition is intense for subscribers for high-speed bandwidth access, the quality and reliability of network service has become critical to service providers. These service providers can ill afford the loss of customers, loss of revenue, and negative publicity resulting from poor service. Field technicians who use service verification equipment allow service providers to verify and repair service problems effectively and, thus, increase the quality and reliability of the network.

THE SUNRISE SOLUTION

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

Because of the design and functionality of our products, we provide the following benefits to our customers:

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PRODUCTS

Our major products in each product category are as follows:

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

CUSTOMERS

Our customers include telecommunications service providers, cable network operators, network infrastructure suppliers and installers, technicians, and engineers in North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region. We generally sell through distributors internationally and sell direct in the United States. Our international sales offices may also sell directly. The following is a selected list of some of our largest customers in 2004:

As of December 31, 2004, we had sold versions of our products to over 2,000 customers in over 60 countries. No individual end customer or distributor accounted for 10% or more of our net sales in 2004, SBC Communications Inc. accounted for 13% of our net sales in 2003, and no individual end customer or distributor accounted for 10% or more of our net sales in 2002. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Customer Concentration.”

SALES, MARKETING AND CUSTOMER SERVICE

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

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

Outside the United States, we sell our products through a mix of our own sales offices and independent distributors, which are directed by our country managers and our regional directors of marketing and sales. In general, we sell our products to the distributor at a discount from the end user price, and the distributor or sales office then resells the products to the end user. International sales, including North American sales to Canada, were $30.2 million (49%) of total sales in 2004, $21.3 million (39%) of total net sales in 2003, and $16.1 million (30%) in 2002. We expect that international sales will continue to account for a significant portion of our net sales in future periods. In

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addition to our network of international distributors, we have sales offices based in Anjou, Canada; Beijing, Xi’an, Guangzhou, Shenzhen and Hong Kong, China; Tokyo, Japan; Seoul, Korea; Modena, Italy; Paris, France; Mexico City, Mexico; and Stuttgart, Germany. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Risks of International Operations.”

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

We generally do not sell our products with rights of return. On the few occasions when we have agreed to provide customers with rights of return, we have deferred recognition of sales revenue until the rights of return have lapsed. We generally do not provide extended payment terms to our customers. Our normal terms are typically 30 days for North America and up to 60 days in other markets.

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

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

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SEASONALITY

Our sales have traditionally been seasonal in nature and tied to the buying patterns of our customers. The largest volume of quarterly sales has typically been during the last calendar quarter of the year. In 2004, sales during the fourth quarter rose to $20.1 million, or 33% of annual sales. Our 2003 and 2002 fourth quarter sales were $20.4 million (37% of annual sales) and $16.5 million (30% of annual sales) respectively. Prior to 2000, the largest volume of quarterly sales had usually been during the last calendar quarter of the year, however, in 2001 and 2000, there was a change in this fourth quarter seasonality as our customers had fewer remaining unused budget dollars available for use. Our 2005 fiscal year visibility is limited, and we expect that our quarterly operating results may fluctuate significantly and will be difficult to predict due to the lengthy and unpredictable buying patterns of our customers, the degree to which our customers allocate and spend their yearly budgets, and the timing of our customers’ budget processes. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Quarterly Fluctuations.”

BACKLOG

Our backlog of customer orders at December 31, 2004 was approximately $5.3 million compared to approximately $6.4 million at December 31, 2003. The timing of customer orders in 2003 was impacted by the introduction of new products. The resulting increase in year-end orders at December 31, 2003, and subsequent delivery in 2004, is the primary cause of the backlog decline for 2004 from 2003. Variations in the size and delivery schedules of purchase orders that we receive, as well as changes in customers’ delivery requirements may result in substantial fluctuations in the amount of backlog orders for our products from quarter to quarter.

RESEARCH AND DEVELOPMENT

We have assembled a team of highly skilled engineering professionals who are experienced at designing telecommunications service verification test equipment. Our engineering personnel have expertise in a number of fields, including interfacing test equipment with digital loop carriers, voice and data switching technology, local loop equipment, and operations support systems. We spent approximately $16.2 million on research and development in 2004, $16.1 million in 2003, and $16.7 million in 2002. Research and development represents our largest direct employment expense. At December 31, 2004, we had a total of 132 employees engaged in research and development in San Jose, California; Norcross, Georgia; Anjou, Canada; Modena, Italy; Taipei, Taiwan; Beijing, China; and Geneva, Switzerland.

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

REGULATIONS AND INDUSTRY STANDARDS

Our products are designed to comply with a significant number of industry standards and regulations, some of which are evolving as new technologies are deployed. In the United States, our products must comply with various

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regulations defined by the Federal Communications Commission and Underwriters Laboratories as well as industry standards established by Telcordia Technologies, Inc., formerly Bellcore, the American National Standards Institute, the Internet Engineering Task Force (IETF), and various industry interest groups. Internationally, our products must comply with standards established by the European Committee for Electrotechnical Standardization, the European Committee for Standardization, the European Telecommunications Standards Institute, telecommunications authorities in various countries, and with recommendations of the International Telecommunications Union. The failure of our products to comply, or delays in compliance, with the various existing and evolving standards could negatively impact our ability to sell our products.

MANUFACTURING AND SOURCES OF SUPPLY

Our production process consists of planning, procurement, fabrication, rework, system assembly, system final test, software option customization, and shipping. We purchase substantially all parts, including resistors, integrated circuit boards, LCDs, and printed circuit boards, from distributors and manufacturers worldwide. We package these parts into kits and either send them to local contract manufacturers to assemble into printed circuit boards or we assemble them ourselves at our Taipei, Taiwan facility. We perform substantially all remaining manufacturing operations. We maintain sourcing and manufacturing operations in San Jose, California; Anjou, Canada; Taipei, Taiwan; and Modena, Italy, with the Taipei facility being our largest manufacturing center. Our San Jose, Taipei, and Modena, Italy operations are ISO 9001 certified.

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

A total of $24.8 million of our net property and equipment is located in the United States and $2.4 million is located in other countries. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Risks of International Operations.”

COMPETITION

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

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

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

INTELLECTUAL PROPERTY AND PROPRIETARY TECHNOLOGY

Our intellectual property, including our proprietary technology, processes and know-how, trade secrets, patents, trademarks, and copyrights, is important to our business and to our continued success. We have nine issued U.S. patents relating to communications testers that expire between 2015 and 2023, and we have filed several applications for additional patents with the U.S. Patent and Trademark Office and with foreign patent offices. Our research and development and manufacturing process typically involves the use and development of a variety of forms of intellectual property and proprietary technology, although no one particular form of this intellectual property and proprietary technology is material to our business. In addition, we incorporate software, some of which we may license from third party sources. These licenses generally renew automatically on an annual basis. We believe that alternative technologies for this licensed software are available both domestically and internationally.

We protect our proprietary technology by the following means:

EMPLOYEES

At December 31, 2004, we had a total of 480 full-time employees, consisting of 196 in the United States, 135 in Taiwan, 30 in Italy, 71 in Canada, 6 in Korea, 5 in Switzerland, 29 in China, 4 in Japan, and 4 in Germany. We also had 18 temporary employees at December 31, 2004. Of the total full-time employees, 132 were engaged in research and development, 120 were engaged in sales, marketing and customer support, 177 were engaged in operations, and 51 were engaged in administration and finance. None of our employees is subject to a collective bargaining agreement. The employees of our Pro.Tel subsidiary are protected by certain provisions of Italian law. We believe that our relations with our employees are good. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors Affecting Future Operating Results—Dependence on Key Employees.”

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EXECUTIVE OFFICERS

The following table sets forth certain information regarding our executive officers as of March 30, 2005:

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

Paul A. Marshall co-founded Sunrise in October 1991 and has served as Chief Operating Officer since December 1999, as Vice President of Marketing since March 1992, and as a director since October 1991. Mr. Marshall also served as Chief Financial Officer of Sunrise from March 1992 until December 1999 and Acting Chief Financial Officer from October 2002 until February 2005. From 1980 to 1992, Mr. Marshall held various positions with the Wiltron division of Anritsu Corporation, most recently as Marketing Staff Engineer. Mr. Marshall holds an M.B.A. from the Harvard Business School and a B.S. in Mechanical Engineering from the University of California at Davis.

Richard D. Kent joined Sunrise as Chief financial Officer in February 2005. Mr. Kent was Vice-President of Finance from February 2003 to January 2005 at Natural Selection Foods, LLC, a producer of organic fruits and vegetables. Prior to his employment with Natural Selection Foods, he was Managing Director from June 2002 to February 2003 at RAMP Partners, an accounting and financial management firm. Mr. Kent served as Chief Financial Officer, Chief Operating Officer and Corporate Secretary from January 1997 to January 2002 at Cidco Incorporated, a publicly-traded producer of telecommunications products and personal Internet communications products and services. Mr. Kent is a member of the American Institute of Certified Public Accountants.

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

Kirk O. Williams joined Sunrise in December 2002 and served as General Counsel and Secretary from January 2003 to December 2004. Mr. Williams was appointed Vice President, General Counsel and Secretary in December 2004. Mr. Williams is the Company’s chief legal, compliance, and ethics officer and is responsible for the Company’s corporate governance initiatives and the protection of the Company’s legal interests and operations worldwide. Prior to joining the Company, Mr. Williams served in positions of increasing responsibility at Exodus Communications, Inc. including most recently as Vice President, Legal and Corporate Affairs, Assistant General Counsel. Prior to joining Exodus, Mr. Williams practiced corporate and securities law with the law firm Gray Cary Ware & Freidenrich LLP in Palo Alto, California. Mr. Williams holds a J.D. from New York University School of Law and a dual B.A. in Economics and Political Science from Stanford University.

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AVAILABLE INFORMATION

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

ITEM 2.    PROPERTIES

Our owned headquarters and manufacturing and research and development facility, which we built during 2001 on property that we acquired that year, occupies 91,700 square feet in San Jose, California. As of December 31, 2004, we also leased 10,000 square feet of office and manufacturing space in Montreal, Canada; 16,500 square feet of office and manufacturing space in Norcross, Georgia; 10,000 square feet of office and manufacturing space in Modena, Italy; 26,290 square feet of office space in Taipei, Taiwan; 6,742 square feet of office space in Santa Rosa, California; and 2,000 square feet of office space in Geneva, Switzerland. We lease sales offices in Beijing, Xi’an, Guangzhou, Shenzhen and Hong Kong, China; Seoul, Korea; Tokyo, Japan; and Stuttgart, Germany.

ITEM 3.    LEGAL PROCEEDINGS

On March 31, 2004, Acterna, LLC (“Acterna”) filed a lawsuit against us and Consultronics, Ltd. and Consultronics, Inc. (the latter two, collectively, “Consultronics”) in the United States District Court for the District of Maryland. Acterna alleged that our SunSet xDSL and SunSet MTT products infringe its United States Patent Nos. 6,064,721 (the “721 patent”), 6,385,300 (the “‘300 patent”), and 6,590,963 (the “963 patent”) and that our STT product infringes its United States Patent No. 5,511,108 (the “108 patent”). Acterna also alleged that the Consultronics CoLT 450 product infringes its ‘721 patent. Acterna seeks injunctive relief, unspecified damages, and attorneys’ fees and costs. In October 2004, we learned that Acterna and Consultronics had reached a settlement with respect to Acterna’s claim against Consultronics and that the matter with respect to Consultronics had been dismissed with prejudice.

On April 23, 2004, we filed a lawsuit against Acterna in the United States District Court for the Northern District of California. The lawsuit alleged that Acterna’s ANT-5 SDH Access Tester and ANT-20 Advanced Network Tester infringe our United States Patent No. 5,619,489 (the “489 patent”). We are seeking injunctive relief, unspecified damages, and attorneys’ fees and costs.

On September 7, 2004, Acterna filed an answer in the United States District Court for the Northern District of California, seeking declaratory judgment that its ANT-5 SDH Access Tester and ANT-20 Advanced Network Tester do not infringe the ‘489 patent, that the ‘489 patent is invalid, and that the ‘489 patent is unenforceable. At the same time, Acterna also filed a counterclaim against us, alleging that certain products, namely the CM 1000, CM 500, CM 250, N1776A, AT 2000 and AT 2500, all of which are manufactured and sold by our subsidiaries, infringe its United States Patent No. 5,751,766 (the “766 patent”). Acterna seeks injunctive relief, unspecified damages and attorneys fees and costs.

We believe that the lawsuits against us are without merit, and we intend to defend ourselves vigorously against the allegations that Acterna is making against us. Specifically, we are defending ourselves against Acterna’s allegations by seeking declaratory judgment that our products do not infringe any of the ‘721 patent, the ‘300 patent, the ‘963 patent, the ‘108 patent, or the ‘766 patent; that the ‘721 patent, the ‘300 patent, the ‘963 patent, the ‘108 patent, and the ‘766 patent are invalid; and that the ‘721 patent, the ‘300 patent, the ‘963 patent, the ‘108 patent, and the ‘766 patent are unenforceable. In addition, we are seeking declaratory judgment that our products do not infringe a sixth, recently issued Acterna patent, United States Patent No. 6,738,454 (the “454 patent”). The ‘454 patent is a continuation patent issued May 18, 2005 related to the ‘721 patent, the ‘300 patent, and the ‘963 patent. We are also seeking declaratory judgment that the ‘454 patent is invalid and unenforceable.

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On January 5, 2005, Acterna asserted in the Maryland case that our products also infringe its ‘454 patent.

We are presently unable to estimate the likely costs of the litigation and/or any settlement of these legal proceedings with Acterna.

From time to time, we may be involved in litigation or other legal proceedings, including those noted above, relating to claims arising out of our day-to-day operations or otherwise. Litigation is inherently uncertain, and the Company could experience unfavorable rulings. Should we experience an unfavorable ruling, there exists the possibility of a material adverse impact on its financial condition, results of operations, or cash flows or on our business for the period in which the ruling occurs and/or future periods.

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

During the quarter ended December 31, 2004, there were no matters submitted to a vote of the security holders.

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Part II.

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

INFORMATION ABOUT OUR COMMON STOCK

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

As of December 31, 2004, we had approximately 76 stockholders of record of our common stock. We estimate that as of March 5, 2005, there were approximately 2,200 beneficial owners of our common stock.

In February 2005, our board of directors declared a cash dividend for 2005 in the aggregate amount of approximately $2.5 million. We paid this dividend in March 2005. In February 2004 we declared and paid a cash dividend of approximately $2.5 million. In July 2003, we declared and paid a cash dividend in the aggregate amount of approximately $2.0 million. We did not declare or pay any cash dividend on our common stock in 2002 or 2001. Our board of directors will determine the amount of future dividends based on our future financial condition and results of operations.

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ITEM 6.    SELECTED FINANCIAL DATA

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

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

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

OVERVIEW

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

Companies in the telecommunications industry throughout the world have been experiencing decreased profitability resulting from many factors. The most significant of these factors are overbuilding of certain portions of the telecommunications infrastructure during the late 1990s and increased overlap between the previously separate businesses of wireless, local telephone services, and cable TV service, which has lead to increased competition. In addition, there has been substantial consolidation within the telecommunications industry during this time, particularly in the North American markets, which has led to delay and reduction of orders for test equipment. We have been affected by this downturn and consolidation, and after nine consecutive years of profitability, we were unprofitable during each of the years ended December 31, 2002, 2003 and 2004. We are encouraged to have earned a small profit before tax in 2004 after substantially weaker performance in 2002 and 2003. We compete in the challenging telecommunications equipment market by pursuing a strategy of offering products that address the needs of diverse telecommunications and cable service providers and by investing heavily in research and development to create high-quality products that address evolving telecommunications technologies in innovative ways. We also continuously work to minimize operating costs while executing this strategy.

We assess the overall performance of our business primarily through the use of financial metrics. Management considers several factors to be particularly important when assessing past business success and projecting future performance. The first such factor is the maintenance of high levels of working capital and low levels of debt. See “Liquidity and Capital Resources.”

This first factor is enabled by the second factor: The generation of cash flows from our operating activities. Ultimately, the ability to consistently generate substantial positive cash flows is the primary indicator of our business’s success and is an imperative for our business’s survival. See “Liquidity and Capital Resources.”

The third factor is profitability. In general, profitability indicates our success in generating present and future cash flows from our operating activities. The key components of our profitability are net sales, cost of sales, and operating expenses. See the discussion directly below and “Comparison of Years Ended December 31, 2004 and 2003” and “Comparison of the Years Ended December 31, 2003 and 2002.”

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Sources of Net Sales

We generate our cash flows primarily from selling telecommunications and broadband cable network testing equipment, and our future cash flows are largely dependent on our continuing ability to sell our products and collect cash for the sales from our customers. Our sales largely depend upon our ability to provide products that test most types of telecommunications network technologies, including those related to twisted-pair copper, cable broadband, and fiber optics networks. We are also developing products to test wireless networks. Within these technologies, we provide products that test the entire length of the network, from the point of installation in a building or residence through system back-offices and trunk lines, including the signaling processes that set up and tear down phone calls and transmit packets. We consider investment in research and development and selling and marketing activities to be critical to our ability to generate strong sales volume in the future. To that end, we continually offer new products to meet our customer’s needs, including most notably in 2003 modules for our hand-held SunSet MTT product line, which tests a variety of types of network, and for our SunSet STT, which is primarily a fiber optics testing product, and the realWORX cable broadband testing product

We sell our products predominantly to large telecommunications service providers. These types of customers generally commit significant resources to the evaluation of our and our competitors’ products and require each vendor to expend substantial time, effort, and money educating them about the value of the proposed solutions. Delays associated with potential customers’ internal approval and contracting procedures, procurement practices, and testing and acceptance processes are common and may cause potential sales to be delayed or foregone. As a result of these and related factors, the sales cycle of new products for large customers typically ranges from six to twenty-four months. Substantially all of our sales are made on the basis of purchase orders rather than long-term agreements or requirements contracts. As a result, we commit resources to the development and production of products without having received advance or long-term purchase commitments from customers. We anticipate that our operating results for any given period will continue to be dependent to a significant extent on purchase orders, which can be delayed or cancelled by our customers.

Historically, a significant portion of our net sales have come from a small number of relatively large orders from a limited number of customers. One customer, SBC Communications Inc., comprised $7.2 million, or 13%, of our sales in 2003. No customers comprised more than 10% of our sales in 2004 and 2002. Overall, we anticipate that our operating results for a given period will be dependent on a small number of customers.

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

We have a small amount of sales denominated in Euros and the Canadian dollar and have, in prior years, used derivative financial instruments to hedge our foreign exchange risks. As of December 31, 2004, we had no derivative financial instruments. To date, foreign exchange exposure from sales has not been material to our operations. We have also been exposed to fluctuations in non-U.S. currency exchange rates related to our manufacturing activities in Taiwan. In the future, we expect that a growing portion of international sales may be denominated in currencies other than U.S. dollars, thereby exposing us to gains and losses on non-U.S. currency transactions. See “Risk Factors Affecting Future Operating Results—Risks of International Operations.”

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Cost of Sales

Our cost of sales consist primarily of the following:

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

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

Operating Costs

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

We allocate the total cost of overhead and facilities to each of the functional areas that use overhead and facilities based upon the square footage of facilities used or the headcount in each of these areas. These allocated charges include facility rent, utilities, communications charges, and depreciation expenses for our building, equipment, and office furniture.

In 2004 and 2003, we recorded amortization of the deferred stock-based compensation expense of $0.3 and $1.8 million related to the grant of pre-IPO options to purchase our common stock at exercise prices subsequently deemed to be below fair market value. Total compensation expense related to these options, which were granted in 1999 and the first quarter of 2000, is amortized on a straight-line basis, over the respective four-year vesting periods of the options, to the departments of the employees who received these below-market option grants. The 1999 options were

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fully amortized by the end of 2003. During 2004 and 2003, we allocated amortization of the deferred stock-based compensation expense of $0.0 and $0.3 million to cost of sales, $0.1 and $0.6 million to research and development expense, $0.1 million and $0.5 million, respectively, to selling and marketing expense, and $0.1 million and $0.4 million, respectively, to general and administrative expense. At December 31, 2004, the deferred stock-based compensation expense related to the grant of pre-IPO options was fully amortized.

Also, during 2004, 2003, and 2002, we charged $2.7, $3.3 and $3.3 million to general and administrative expense for amortization of intangible assets obtained through various business acquisitions.

Acquisitions and Consolidation of Wireless Operations

On February 28, 2002, we acquired the CaLan Cable TV test business from Agilent Technologies for $7.2 million in cash and acquisition costs. We recorded acquired identifiable intangible assets of $3.5 million, to be amortized on a straight-line basis over their original estimated useful lives of two-and-a-half to five years, and goodwill of $2.6 million, which we review for impairment on an annual basis as required by SFAS No. 142.

On June 19, 2002, we acquired the ADSL Tester business from Integrated Telecom Express, Inc. (“ITeX”) for $100,000 in cash. We recorded goodwill of $68,000, which we review for impairment on an annual basis as required by SFAS No. 142.

On September 4, 2002, we acquired Luciol Instruments SA (“Luciol”), a Swiss corporation specializing in fiber optic measurement and instrumentation, for $1.2 million in cash and acquisition costs. We recorded acquired intangible assets of $0.1 million, to be amortized on a straight-line basis over their original estimated useful lives of five years, and goodwill of $1.3 million, which we will review for impairment on an annual basis as required by SFAS No. 142. Concurrent with this acquisition, and as amended in February 2004, we entered into a non-compete agreement with certain former owners of Luciol that will result in payments to the former owners totaling approximately $116,000 over four years, provided that they perform as agreed to under the agreements. We are amortizing the corresponding non-compete assets on a straight-line basis over their four-year estimated useful lives. We also entered into employment agreements with these same former owners that will result in bonus payments to the former owners totaling approximately $349,000 over four years, in addition to their regular salaries and subject to certain conditions, primarily related to their continued employment by Sunrise, which is being expensed over four years.

On February 28, 2003, we acquired substantially all of the assets of GIE GmbH (“GIE”), a German corporation located in Mannheim and specializing in wireless and RF measurement instrumentation, for $554,000 in cash and acquisition costs. We recorded acquired intangible assets of $89,000, of which $37,000 was assigned to in-process research and development assets that were written off at the date of the acquisition. The remaining $52,000 of acquired intangible assets is developed technology, which we wrote off during 2003. We did not record any goodwill on this acquisition. Concurrent with this acquisition, we entered into a non-compete agreement with certain former owners of GIE obligating us to make payments to the former owners totaling approximately $100,000 over four years, provided that they perform as agreed to under the agreements. We also entered into employment agreements with these same former owners obligating the Company to make bonus payments to the former owners totaling approximately $200,000 over four years, in addition to their regular salaries and subject to certain conditions, primarily related to their continued employment by us. As of March 2004, the three former owners of GIE were no longer employed by the Company. In December 2004, we entered into a settlement agreement with the former owners of GIE, agreeing to pay a total of $40,000 to settle any and all differences between the parties.

During the three month period ended September 30, 2003, we initiated a plan to move our wireless product research and development operations to our existing facility in Santa Rosa, California. Subsequently, we shut down the Santa Rosa facility and moved the engineers to our San Jose location where we continue our wireless research. We

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expect that this consolidation will allow us to make the best use of our engineering talent and to closely control our wireless operations. We have not identified additional material future costs to be incurred as a result of closing the Santa Rosa facility.

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

RESULTS OF OPERATIONS

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

COMPARISON OF YEARS ENDED DECEMBER 31, 2004 AND 2003

Net Sales.    Net sales increased 12%, to $61.7 million in 2004 from $54.9 million in 2003. During 2004, sales of our wireline access products increased by $2.5 million or 10%, sales of our fiber optics products increased by $0.3 million or 2%, sales of our broadband products increased by $1.3 million, or 9%, and sales of our signaling products increased by $2.9 million or 107% over sales in the prior year. These sales increases were generally due to increased demand for our products resulting from our continuing penetration of diverse geographic markets with product lines that we continue to enhance in terms of breadth, functionality, and performance.

During 2004, sales decreased $1.8 million or 5% in North America, increased $5.5 million or 70% in Europe/Africa/Middle East, and increased $3.0 million or 29% in Asia/Pacific compared to 2003. Sales were substantially unchanged in Latin America. The decrease in North American sales is primarily the result of decreased sales of cable broadband products. Our growth in Asia reflects the results of our ongoing development of distribution channels in these regions, and our growth in Europe continues to rebound from a particularly weak 2002. International sales, including North American sales in Canada, increased to $30.2 million, or 49% of net sales, in 2004, from $21.3 million, or 39% of net sales, in 2003.

Cost of Sales.    Cost of sales decreased 5%, to $18.4 million in 2004 from $19.3 million in 2003. Cost of sales represented 30% and 35% of net sales in 2004 and 2003, respectively. This decrease in cost of sales was primarily the

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result of the lower cost of labor due to the transition of production activity to our Taiwan facility, a reduction in the overall cost of materials due to the sale of materials with an original cost of $0.6 million that had previously been fully reserved, and the impact of product mix. Although cost of sales has declined as a percentage of sales in 2004 and 2003, this percentage is susceptible to change from variations in our product mix, changes in the proportion of our sales going to international customers, and pricing pressures.

Research and Development.    Research and development expenses remained substantially the same at $16.2 million in 2004 compared to $16.1 million in 2003. Research and development expenses represented 26% of net sales in 2004 and 29% of net sales in 2003. Research and development expenses tend to fluctuate from period to period, depending on requirements at the various stages of our product development cycles. Through our research and development activities, we are attempting to balance two conflicting strategic priorities. The first is to tightly control costs in response to sales volume that has significantly decreased from the levels of 2000 and 2001. The second is to continue to develop products that address customer needs in a rapidly changing and very competitive market so that we can increase share in new markets and grow the company’s sales. In any given time period, research and development expenses may increase in absolute dollars and/or as a percentage of sales as we continue to invest in product development and expand our product lines. The company has recently opened a Chinese research facility, which will lower the average cost per man-hour of engineering during the next year.

Selling and Marketing.    Selling and marketing expenses increased 4%, to $17.6 million in 2004 from $17.0 million in 2003. Selling and marketing expenses represented 29% of net sales in 2004 and 31% of net sales in 2003. During 2003 and 2004, we reached a level of selling and marketing effort that allowed us to actively promote our products to potential customers, but that simultaneously recognized the cost constraints that we face during a period of economic difficulty in the telecommunications industry. However, in the future, selling and marketing expense may increase in absolute dollars and/or as a percentage of sales as we continue to develop our selling and marketing capabilities. In particular, the consolidation of the North American sales channel and the establishment of sales offices in France and Mexico will increase sales expenses in the near term but are planned to result in increased sales, which will generate overall operating profit improvement if and when the increase occurs. In addition, the commission expenses included in selling and marketing can fluctuate both with changes in sales volume and with changes in the channels through which the sales flow. We use different distribution methods to supply our products to different geographical regions and different customers, and the commission rates we incur can vary among these channels.

General and Administrative.    General and administrative expenses increased 1%, to $9.9 million in 2004 from $9.8 million in 2003. General and administrative expenses represented 16% of net sales in 2004 and 18% of net sales in 2003. We try to carefully control our general and administrative expenses. However, general and administrative expenses may increase in absolute dollars and/or percentage of sales if we experience growth in our business or higher litigation costs, expand our infrastructure, pursue additional acquisitions, or experience increased costs related to our collection of receivables. These costs could also rise if regulatory and/or public company compliance costs increase, including costs related to complying with the Sarbanes-Oxley Act of 2002 and its associated regulations, particularly Section 404 dealing with internal controls, or if unforeseen matters arise.

Other Income, Net.    Other income, net primarily represents interest earned on cash and investment balances and gains and/or losses on assets, liabilities, and transactions denominated in foreign currencies. Other income, net remained unchanged at $0.9 million in 2004 and 2003.

Income Tax Expense (Benefit).    Income tax expense (benefit) consists of federal, state, and foreign income taxes. During the three months ended March 31, 2004, we reevaluated our need for a valuation allowance in light of forecast industry conditions. As a result of this assessment, the consideration of cumulative losses in prior periods, uncertain industry conditions and the inability to predict future earnings we recorded a valuation allowance against our deferred tax assets in most jurisdictions aggregating $7.4 million.

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COMPARISON OF YEARS ENDED DECEMBER 31, 2003 AND 2002

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

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

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

Research and Development.    Research and development expenses decreased 4%, to $16.1 million in 2003 from $16.7 million in 2002. This decrease is primarily due to reduced parts and prototype and design service costs. Research and development expenses represented 29% of net sales in 2003 and 31% of net sales in 2002. Research and development expenses tend to fluctuate from period to period, depending on requirements at the various stages of our product development cycles.

Selling and Marketing.    Selling and marketing expenses increased 1%, to $17.0 million in 2003 from $16.8 million in 2002. Selling and marketing expenses represented 31% of net sales in 2003 and 2002. During 2002 and 2003, we reached a level of selling and marketing effort that allowed us to actively promote our products to potential customers, but that simultaneously recognized the cost constraints that we face during a period of economic difficulty in the telecommunications industry.

General and Administrative.    General and administrative expenses decreased 14%, to $9.8 million in 2003 from $11.4 million in 2002. The main reason for this decrease was a reduction in bad debt expenses related to uncollectible accounts receivable. Since 2001, we have experienced a trend of decreasing uncollectible accounts receivable. We believe that the reason for this trend is that many of our customers with questionable financial resources have gone out of business or have reduced the scope of their operations as a result of the telecommunications downturn and that those customers that continue to buy from us are those with the most financial resources to pay for their purchases. General and administrative expenses represented 18% of net sales in 2003 and 21% of net sales in 2002.

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

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

LIQUIDITY AND CAPITAL RESOURCES

Cash Requirements and Capital Resources

As of December 31, 2004 and 2003, we had working capital of $50.6 million and $54.7 million, respectively, and cash, cash equivalents and short-term investments of $33.9 million and $39.9 million, respectively. As explained in the notes to our December 31, 2004 consolidated financial statements, our $1.4 million investment in marketable securities at December 31, 2004 consisted entirely of equity securities of Top Union Electronics Corp., a Taiwan R.O.C. company. During the quarter ended June 30, 2003, these securities became listed on the GreTai Securities Market, Taiwan’s over-the-counter exchange. We do not consider this to be a liquid investment, and accordingly classify it as a non-current asset.

During 2004 we used $1.5 million of cash in operating activities as accounts receivable and inventories increased in response to increasing sales. We generated positive cash flows from our operating activities from 1992 through 2003. We believe that current cash balances and future cash flows from operations will be sufficient to meet our anticipated cash needs for our operations, complete needed business projects, achieve our plans and objectives, meet financial commitments, meet working capital requirements, make capital expenditures, and fund other activities well beyond the next 12 months. However, a large acquisition of complementary businesses, products, or technologies, or material joint ventures could require us to obtain additional equity or debt financing. We cannot assure you that such additional financing would be available on acceptable terms, if at all. However, no such activities are anticipated at this time and our present levels of debt and other future commitments are small compared to our present cash balances, so we presently anticipate that our most significant cash requirements during at least the next 12 months will be for our normal research and development, selling and marketing, and production activities.

Sources and Uses of Cash

In general, we have financed our operations and capital expenditures primarily using cash flows generated by our operating activities. We foresee relying on cash flows from our operating activities and existing cash resources to fund our business activities during at least the next 12 months, and we do not expect to rely on any significant financing activities during that time.

Cash used in operating activities was $1.5 million in 2004. Cash provided by operating activities was $5.8 million in 2003 and $0.7 million in 2002. Operating cash flows decreased during 2004 compared to 2003 primarily due to a significant increase in inventory levels and in accounts receivable. These items were partially offset by the increase in sales volumes and improved overall gross margins on sales. Operating cash flow increased during 2003 compared to 2002 primarily due to a significantly lower net loss once non-cash items are excluded, a lower employment retention bonus payment to the former vice president and general manager of our cable broadband operation, and the collection during 2003 of income taxes receivable. These items were partially offset by a reduction in deferred revenue. In general, our ability to continue to generate positive cash flows from operations will depend on our ability to generate and collect the cash from future sales, while maintaining a cost structure lower than those sales amounts. Therefore, sales volume is by far the most significant uncertainty in our ability to generate cash flow from operations.

Cash used in investing activities was $2.5 million in 2004 and $9.6 million in 2002. Cash provided by investing activities was $6.1 million in 2003. The $8.5 million increase in net cash used in investing activities during 2004 compared to 2003 is primarily due to an increase in capital expenditures and a decrease in proceeds received from the

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sale of short-term investments. The $15.7 million decrease in net cash used in investing activities during 2003 from 2002 is primarily due to a decrease in business acquisition related expenditures and due to a non-recurring event, a loan made to our Chief Executive Officer made in 2002 and repaid in 2003 and changes in our investment portfolio. As of December 31, 2004, we had no plans for large capital expenditures outside the usual course of those needed for our ongoing production, research and development, and selling and marketing activities.

Cash used in financing activities was $1.9 million in 2004, $1.7 million in 2003 and $3.7 million in 2002. The increase in cash used in financing activities during 2004 from 2003 is primarily due to an increase in restricted cash and an increase in dividends paid our stockholders. These increases were partially offset by an increase in notes payable, a reduction in payments on notes payable, and an increase in proceeds from common stock issued under our Employee Stock Purchase Plan. The decrease in cash used in financing activities during 2003 from 2002 is primarily due to the completion of a stock repurchase program during 2002. This decrease was partially offset by a $2.0 million dividend paid to our stockholders during 2003, while no dividend was paid during 2002.

Our outstanding debt at December 31, 2004 consisted primarily of a $1.0 million loan from the Italian government for research and development that is payable over a period of eight years through semi-annual payments ending in 2011 and three notes payable related to acquisitions totaling $0.1 million that are being paid in quarterly installments ending in 2006. We have not used off-balance sheet financing arrangements, issued or purchased derivative instruments linked to our stock, or used our stock as a form of liquidity. We do not believe that there are any known or reasonably likely changes in credit ratings or ratings outlook or an inability to achieve such changes which would have any significant impact on our operations. We are not subject to any debt covenants that we believe might have a material impact on our business.

Debt Instruments, Guarantees, and Related Covenants

We have low levels of debt, and our operating, financing, and investing activities are not subject to any significant constraints related to outstanding debt, guarantees, or other contingent obligations. We are not, and during at least the next 12 months are not reasonably likely to be, in breach of material covenants. We are not subject to any significant debt covenants that may limit our ability to borrow additional funds or issue equity securities.

CRITICAL ACCOUNTING POLICIES

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

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

Allowance for Doubtful Accounts Receivable

We determine our allowance for doubtful accounts receivable by making our best estimate considering our historical accounts receivable collection experience and the information that we have about the current status of our

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

Valuation of Excess and Obsolete Inventory

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

Valuation of Goodwill and Other Intangible Assets

We evaluate the valuation of goodwill in the manner prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. As required by SFAS No. 142, we test goodwill for impairment annually, during our fourth fiscal quarter. We would also test goodwill for impairment if certain events or changes in circumstances stipulated by SFAS No. 142 were to occur. SFAS No. 142 prescribes a two-phase process for the impairment testing of goodwill. The first screens for impairment by comparing the fair value of our reporting unit, which we consider to be the market capitalization of our entire telecommunications testing equipment business, to its carrying value. If the carrying value were to exceed the fair value, the second phase of the process would occur. In the second phase, we would recognize an impairment for the excess of the carrying value, if any, of our goodwill over its implied fair value. The implied fair value of our goodwill is the excess of our reporting unit’s total fair value over the combined net fair values of its individual assets and liabilities. Based on the annual test for impairment performed during our fourth fiscal quarter, goodwill was determined not to be impaired, and no subsequent indicators of impairment have been noted.

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

Product Warranties

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

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the future costs of meeting these obligations differ from our historical experience, additional reserves for warranty obligations may be required. We charge provisions for future warranty costs to cost of sales in our statement of operations.

Deferred Income Tax Assets and Liabilities

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

During 2004, the Company recorded a valuation allowance against all of the Company’s net deferred tax assets in most jurisdictions in the amount of $7,429,000. The Company evaluated all significant available positive and negative evidence, including the existence of cumulative net losses in recent periods, benefits that could be realized from available tax strategies, and forecasts of future taxable income, in determining the need for a valuation allowance on its deferred tax assets. Notwithstanding the Company’s reporting of a pre-tax profit of $550,000 for 2004, however, the cumulative net losses in recent periods, represented sufficient negative evidence that was difficult for positive evidence to overcome under the evaluation guidance of SFAS No. 109. Accordingly, a valuation allowance was recorded. The Company intends to maintain this valuation allowance until sufficient positive evidence, such as the resumption of a consistent earnings pattern, exists to support its reversal in accordance with SFAS No. 109. The expense for recording the valuation allowance is a non-cash item, and the recording of this expense does not imply that the Company owes additional income taxes.

On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Jobs Act”). Among other provisions, the Jobs Act contains a deduction for income from qualified domestic production activities, phased in from 2005 through 2010, and a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad. We are not intending to repatriate foreign earnings under the Jobs Act and we have not yet determined the impact of the deduction for domestic productions activities that will first be effective for our 2005 fiscal year. At this time, it is not anticipated that the deduction will have a material impact on our reported income or tax rate.

Revenue Recognition

We recognize revenue from a customer order when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the price is fixed or determinable; and collectibility is reasonably assured. For product sales, we consider delivery to have occurred when title and risk of loss have been transferred to the customer, which is usually when the product has been received by a common carrier. For services, we consider delivery to have occurred once the service has been provided. We use objective evidence of fair value to allocate revenue to

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elements in multiple element arrangements and recognize revenue when the criteria for revenue recognition have been met for each element. In the absence of objective evidence of fair value of a delivered element, we allocate revenue to the fair value of the undelivered elements and the residual revenue to the delivered elements. The price charged when an element is sold separately generally determines fair value.

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

Emerging Issues Task Force (“EITF”) Issue 00-21, “Revenue Arrangements with Multiple Deliverables” addresses the accounting, by a vendor, for contractual arrangements in which multiple revenue-generating activities will be performed by the vendor. It is effective prospectively for all arrangements entered into in fiscal periods beginning after June 15, 2003.

EITF Issue 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. Our multiple deliverables arrangements are those arrangements with customers in which our products are sold together as a “package.” Because these off-the-shelf products are delivered at the same time and the four revenue recognition criteria are met at that time, the adoption of EITF 00-21 had no impact on our financial position and results of operations.

Stock-based compensation.

In December 2002, the FASB issued SFAS No. 148-Accounting for Stock-Based Compensation-Transition and Disclosure (“FAS 148”). This statement amends SFAS No. 123-Accounting for Stock-Based Compensation, providing alternative methods of voluntarily transitioning to the fair market value based method of accounting for stock based employee compensation. FAS 148 also requires disclosure of the method used to account for stock-based employee compensation and the effect of the method in both the annual and interim financial statements. The Company elected to continue to account for stock-based compensation plans using the intrinsic value-based method of accounting prescribed by APB No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and related interpretations. Under the provisions of APB No. 25, compensation expense is measured at the grant date for the difference between the fair value of the stock and the exercise price. In December 2004, the Financial Accounting Standards Board (“FASB”) issued the revised Statement of Financial Accounting Standards (“FAS”) No. 123, “Share-Based Payment” (“FAS 123R”), which addresses the accounting for share-based payment transactions in which the Company obtains employee services in exchange for (a) equity instruments of the Company or (b) liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. This statement eliminates the ability to account for employee share-based payment transactions using APB No. 25 and requires instead that such transactions be accounted for using the grant-date fair value based method. This statement will be effective as of the end of the first interim or annual reporting period that begins after June 15, 2005, the quarter ending September 30, 2005 for the Company.

OFF-BALANCE SHEET ARRANGEMENTS

As of December 31, 2004, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our current or future financial condition, revenues or expenses, results of operations, liquidity, or capital resources.

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CONTRACTUAL OBLIGATIONS

The following table summarizes, as of December 31, 2004, the timing of future cash payments due under certain contractual obligations (in thousands):

RISK FACTORS AFFECTING FUTURE OPERATING RESULTS

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

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

The factors listed above may affect our business and stock price in several ways. Given our high fixed costs from overhead, research and development, and advertising and marketing, and other activities necessary to run our business, if our net sales are below our expectations in any quarter, we may not be able to adjust spending accordingly. Our stock price may decline and may be volatile, particularly if public market analysts and investors perceive the factors listed above may contribute to unfavorable changes in operating results. Furthermore, the above factors, taken together may make it more difficult for us to issue additional equity in the future or raise debt financing to fund future acquisitions and accelerate growth.

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

The current economic downturn has resulted in reduced purchasing and capital spending in the telecommunications and cable broadband industries, which have been in a downward cycle characterized by diminished product demand, excess manufacturing capacity, and the increasing erosion of average selling prices. The downturn has adversely affected the businesses and cash flows of many of our customers and has even caused some

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of them to file for bankruptcy. We are uncertain how long the current downturn will last. Continuation of the downturn or any further decline in our customers’ markets or in general economic conditions would likely result in a further reduction in demand for our products and services and also would further limit our customers’ ability to pay for the products that they buy from us. All of these circumstances could harm our consolidated financial position, results of operations, cash flows, and stock price and could hinder our ability to reach our goals of restoring long-term profitability and growth.

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

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

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

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

Sales of our DSL and other wireline access products represented approximately 43% of our net sales during 2004 and 44% during 2003. Currently, our DSL products are primarily used by a limited number of incumbent local exchange carriers, including the regional Bell operating companies, and competitive local exchange carriers who offer DSL services. These parties, and other Internet service providers and users, are continuously evaluating alternative high-speed data access technologies, including cable modems, fiber optics, wireless technology, and satellite technologies, and may at any time adopt these competing technologies. These competing technologies may ultimately prove to be superior to DSL services and reduce or eliminate the demand for our DSL products.

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

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

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

After the passage of the Telecommunications Act of 1996, the telecommunications industry experienced rapid growth. The growth led to great innovations in technology, intense competition, short product life cycles, and, to some

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

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

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

Cable Broadband Industry Health—Many of the major companies in the cable broadband industry have debt and profitability problems, and face increasing competition from direct broadcast satellite and telecom service providers, which may negatively impact our cable equipment sales.

The cable broadband industry has taken on significant debt as companies aggressively consolidated and built up impressive new digital networks to allow them to provide better picture quality, internet access, and voice telephony Profits, however, have declined during the past few years within the industry. As a result, cable companies may reduce their capital expenditures and/or hiring, both of which could adversely impact our cable business more than we currently anticipate.

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

Our customer base is concentrated, and a relatively small number of companies have accounted for a large percentage of our net sales. Net sales from our top five customers represented approximately 26% of total net sales in 2004 and 36% in 2003. In general, our customers are not subject to long-term supply contracts with us and are not obligated to purchase a specific amount of products from us or to provide us with binding forecasts of purchases for any period.

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

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

Our balance sheet at December 31, 2004 includes an amount designated as “goodwill” that represents approximately 12% of total assets and 13% of total stockholders’ equity. Goodwill arises when an acquirer pays more for

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

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

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

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

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

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

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

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

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

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

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

We experienced rapid growth in revenues and in our business during 1999 and 2000 followed by significant slowdowns in 2001 and 2002 that have placed, and may continue to place, a significant strain on our management and operations. Our revenues increased to $113.5 million in 2000 from $61.5 million in 1999, fell to $79.1 million in 2001 and then to $54.3 million in 2002. Revenues increased slightly to $54.9 million in 2003 and grew to $61.7 million in 2004. As a result of our historical growth and potential future growth or slowdowns, we face several risks, including the following:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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difficulties of our suppliers, shortages, and discontinuations resulting from component obsolescence or other shortages or allocations by suppliers. Our reliance on these third parties involves a number of risks, including the following:

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

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

Sales to customers located outside of the United States represented 49% of our net sales in 2004, 39% in 2003, and 30% in 2002, and we expect international revenues to continue to account for a significant percentage of net sales for the foreseeable future. In addition, an important part of our strategy calls for further expansion into international markets. As a result, we will face various risks relating to our international operations, including the following:

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

In addition, the Asia/Pacific and Latin America regions, both high-growth emerging markets for communications equipment, have experienced instability in many of their economies and significant devaluations in local currencies.

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24% of our sales in 2004, 22% of our sales in 2003, and 17% of our sales in 2002 were from customers located in these regions. These instabilities may continue or worsen, which could have a materially adverse effect on our results of operations. If international revenues are not adequate to offset the additional expense of expanding international operations, our future growth and profitability could suffer.

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

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

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

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

As of December 31, 2004, Paul Ker-Chin Chang, Paul A. Marshall, and Robert C. Pfeiffer beneficially owned approximately 25%, 23%, and 12%, respectively, of our outstanding shares of common stock. Consequently, these three individuals, control approximately 60% of our outstanding shares of common stock and to the extent they act together would be able to control the election of our directors and the approval of significant corporate transactions that must be submitted to a vote of stockholders. In addition, Mr. Chang, Mr. Marshall, and Mr. Pfeiffer constitute three of the six members of the board of directors and have significant influence in directing the actions taken by the board. The interests of these persons may conflict with the interests of other stockholders, and the actions they take or approve may be contrary to those desired by other stockholders. This concentration of ownership and control of the management and affairs of our company may also have the effect of delaying or preventing a change in control of our company that other stockholders may consider desirable.

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

Our products are complex and may contain undetected defects or errors when first introduced or as enhancements are released. These errors may occur despite our testing and may not be discovered until after a product has been shipped and used by our customers. Many of the products that we ship contain imperfections that we consider to be insignificant at the time of shipment. We may misjudge the seriousness of a product imperfection and allow it to be shipped to our customers. These risks are compounded by the fact that we offer many products with multiple hardware and software modifications, which makes it more difficult to ensure high standards of quality control in our

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manufacturing process. The existence of these errors or defects could result in costly repairs and/or returns of products under warranty and, more generally, in delayed market acceptance of the product or damage to our reputation and business.

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

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

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

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

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

In the future, we may receive notices from holders of patents that raise issues as to possible infringement by our products. As the number of telecommunications test, measurement, and network management products increases and the functionality of these products further overlap, we believe that we may become subject to allegations of infringement given the nature of the telecommunications industry and the high incidence of these kinds of claims. Questions of infringement and the validity of patents in the field of telecommunications technologies involve highly technical and subjective analyses. These kinds of proceedings are time consuming and expensive to defend or resolve, result in a substantial diversion of management resources, cause product shipment delays, and could force us to enter into royalty or license agreements rather than dispute the merits of the proceedings initiated against us.

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

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

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

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We sell our products in North America, Asia, Latin America, Africa, the Middle East, and Europe and maintain operations in several different countries. Changes in currency exchange rates affect the valuation in our financial statements of the assets and liabilities of these operations. We also have a small amount of sales denominated in Euros and the Canadian dollar, which are also affected by changes in currency exchange rates. To hedge these risks, we have, at certain times, used derivative financial instruments. As of December 31, 2004, we had no derivative financial instruments or other foreign exchange risk hedging devices. With or without hedges, our financial results could be affected by changes in foreign currency exchange rates, although foreign exchange risks have not been material to our financial position or results of operations to date.

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

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

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Sunrise Telecom Incorporated:

We have audited the accompanying consolidated balance sheets of Sunrise Telecom Incorporated and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sunrise Telecom Incorporated and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S generally accepted accounting principles.

Mountain View, California

February 8, 2005

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SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

Consolidated Balance Sheets

(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

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SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

Consolidated Statements of Operations

(in thousands, except per share data)