UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Commission File Number: 000-25291

TUT SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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  ý  No  o

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

Yes  ý  No  o

As of April 30,July 26, 2004, 20,375,83820,431,650 shares of the Registrant’s common stock, par value $0.001 per share, were issued and outstanding.

TUT SYSTEMS, INC.

FORM 10-Q

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1.                                                                             CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)

NOTE 1—DESCRIPTION OF BUSINESS:

The Company designs, develops, and sells digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals over their networks. The Company also offers video processing systems that enable private enterprise and government entities to transport video signals over satellite, fiber, radio, or copper networks for surveillance, distance learning, and TV production applications. The Company also designs, develops and marketsoffers broadband transport and service management products that enable the provisioning of high speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

Historically, the Company derived most of its sales from its broadband transport and service management products. In November 2002, the Company acquired VideoTele.com, or VTC, from Tektronix, Inc. to extend its product offerings to include digital video processing systems. Video-based products now represent a majority of the Company’s sales.

The Company has incurred substantial losses and negative cash flows from operations since inception. For the threesix months ended March 31,June 30, 2004, the Company incurred a net loss of $4,450$8,084 and negative cash flows from operating activities of $1,504,$5,163, and has an accumulated deficit of $286,503$290,137 at March 31,June 30, 2004. Management believes that the cash and cash equivalents as of March 31,June 30, 2004 are sufficient to fund its operating activities and capital expenditure needs for the next twelve months.  However, in the event that general economic conditions worsen, the Company may require additional cash to fund its operations. The Company plans to seek additional equity funding to provide working capital, fund potential acquisitions and potentially redeem the VTC acquisition indebtedness.  The Company cannot assure that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material impact on the Company’s ability to achieve its intended business objectives.

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Basis of presentation

The accompanying condensed consolidated financial statements as of March 31, 2004 and December 31, 2003 and June 30, 2004 and for the three and six months ended March 31,June 30, 2003 and 2004 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of December 31, 2003 and March 31,June 30, 2004, its results of operations for the three and six months ended March 31,June 30, 2003 and 2004 and its cash flows for the threesix months ended March 31,June 30, 2003 and 2004. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K/A, filed with the Securities and Exchange Commission on April 7,June 11, 2004. The balance sheet as of December 31, 2003 was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. The results for the three and six months ended March 31,June 30, 2004 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2004.

Revenue recognition

The Company generates revenue primarily from the sale of hardware products, including third-party products, through professional services, and through the sale of its software products. The Company sells products through direct sales channels and through distributors. Generally, product revenue is

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generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.

Product revenues

Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.

Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. The Company sells these products through its own direct sales channels and also through distributors.

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The Company’s revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2, and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

In the case of software arrangements which require significant production, modification or customization of software, which encompasses all of the Company’s turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The Company recognizes revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCSpost contract support (“PCS”) element, for which the Company has established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value of the arrangement prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

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For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, the Company must also make a judgment regarding collectibility of the arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to the Company’s credit review policy. The Company sells to customers for which there is a history of successful collection and to new customers for which no similar history may exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are increased only after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon the Company’s credit review process, no credit is extended and revenue is recognized on a cash-collected basis.basis, after shipment has occurred or the revenue has been earned under the percentage-of-completion method.

The Company also maintains accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. The Company’s products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

License and Royalty Revenue

License and royalty revenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by the Company for products sold by its licensees. Currently, the majority of the Company’s license and royalty revenue is comprised of non-refundable license fees paid in advance. Such revenue is recognized ratably over the period during which post-contract customer support is expected to be provided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by the Company for products sold by its licensees.

Should changes in conditions cause usthe Company to determine that the criteria for revenue recognition are not met for certain

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future transactions, revenue recognition for any reporting period could be adversely affected.

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Inventories

Inventories are stated at the lower of cost or market. Cost is computed using standard cost which approximates actual cost on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than those estimated by the Company, additional inventory provisions may be required.

Allowance for doubtful accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make payments. These estimated allowances are periodically reviewed and take into account customers’ payment history and information regarding customers’ creditworthiness that is known to the Company. If the financial condition of any of its customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.

Accounting for long-lived assets

The Company periodically assesses the impairment of long-lived assets. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period and the Company’s market capitalization relative to net book value.

When management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment measured is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Company’s current business model.

During the threesix months ended March 31,June 30, 2004, the Company determined that certain of the technology acquired as part of the purchase of the Viagate Technologies, Inc. assets in September 2001 had become impaired.  As a result, the Company incurred a loss of $202 to write-off the technology.

Future events could cause the Company to conclude that impairment indicators exist. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

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Accounting for stock based compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25,” and complies with the disclosure provisions of Statement of Financial Accounting Standard No. 148 (“SFAS No. 148”), “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair market value of the Company’s stock and the exercise price. The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 148 and the Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.”

The Company amortizes stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and earnings per share is presented and has been determined as if the Company had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

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The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation:

The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the

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fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and net loss/earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

Recent accounting pronouncements

In January 2003, the Financial Accounting Standards Board, the (“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” which was subsequently revised in December 2003 with the issuance of FIN46-R. This interpretation requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Application of this Interpretation is required in financial statements for periods ending after March 15, 2004. The adoption of this Interpretation in the periodsix months ended March 31,June 30, 2004 did not have a material impact on the Company’s results of operations, financial position or cash flows.

Reclassifications

Certain reclassifications have been made to prior period balances in order to conform to the current period presentation.

NOTE 3—NET LOSS PER SHARE:

Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding. Options were not included in the computation of diluted net loss per share because the effect would be antidilutive.

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The calculation of net loss per share follows:

NOTE 4—COMPREHENSIVE LOSS:

Comprehensive loss includes net loss, unrealized gains and losses on investments, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders’ equity. The following table sets forth the calculation of comprehensive loss:

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NOTE 5—BALANCE SHEET COMPONENTS:

The Company recorded a provision for inventory within cost of goods sold totalling $974totaling $21 in the three months ended March 31,June 30, 2004, and $995 in the six months ended June 30, 2004, related to the costs of raw materials and finished goods in excess of what the Company reasonably expected to sell in the foreseeable future as of the firstsecond quarter of 2004.  The Company also reduced inventory costs to market value.

Intangible and other assets:

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During the threesix months ended March 31,June 30, 2004, the Company determined that certain of the technology acquired as part of the purchase of the Viagate Technologies, Inc. assets in September 2001 had become impaired.  As a result, the Company incurred a loss of $202 to write-off the technology.

The aggregate amortization expense for the three months ended March 31,June 30, 2003 and 2004 was $459 and $396, respectively.$376, respectively and $918 and $772 for the six months ended June 30, 2003 and 2004.

Minimum future amortization expense as of March 31,June 30, 2004 is as follows:

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NOTE 6—COMMITMENTS AND CONTINGENCIES:

Lease obligations

The Company leases equipment and office, assembly and warehouse space under non-cancelable operating leases that expire from 2004 through 2005.

Minimum future lease payments under operating leases as of March 31,June 30, 2004 are as follows:

Purchase commitments

The Company had non-cancelable commitments to purchase finished goods inventory totaling $1,009 and $364$447 in aggregate at December 31, 2003 and March 31,June 30, 2004, respectively.

Contingencies

Whalen v. Tut Systems, Inc. et al

On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., , Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the Securities Act. The complaint also names as defendants the underwriters for the Company’s initial public offering and secondary offering.  Similar suits were filed in the Southern District of New York challenging over 300 other initial public offerings and secondary offerings conducted in 1999 and 2000.  Therefore, for pretrial purposes, the Whalen action is being coordinated with the approximately 300 other suits before United States District Court Judge Shira Scheindlin of the Southern District of New York under the matter In Re Initial Public Offering Securities LitigationLitigation.  . The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’AuriaD ‘Auria and Matthew Taylor, were dismissed without prejudice by an October 9, 2002 Order of the Court, approving the parties’ October 1, 2002 Stipulation of Dismissal.  On February 19, 2003, the Court issued an Opinion and Order denying the Company’s motion to dismiss.

InA stipulation of settlement for the claims against the issuer-defendants, including the Company, was submitted to the Court on June and July 2003, nearly all of the issuers named as defendants14, 2004 in the In Re Initial Public Offering Securities Litigation (collectively, the “issuer-defendants”), including the Company, approved a tentative.  The settlement proposal that is reflected in a memorandum of understanding. The Company’s Board of Directors approved the memorandum of understanding in June 2003 on certain conditions, including the number of issuers participating in the settlement. The memorandum of understanding is not a legally

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binding agreement. Further, any final settlement agreement would be subject to a number of conditions, most of which would beare outside of the Company’s control, including approval by the Court.  The underwriter-defendantsunderwriters named as defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “underwriter-defendants”), including the underwriters named in the Whalen suit, are not parties to the memorandumstipulation of understanding.settlement.

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The memorandumstipulation of understandingsettlement provides that, in exchange for a release of claims against the settling issuer-defendants, the insurers of all of the settling issuer-defendants will provide a surety undertaking to guarantee plaintiffs a $1 billion recovery from the non-settling defendants, including the underwriter-defendants. The ultimate amount, if any, that may be paid on behalf of the Company will therefore depend on the final terms of the settlement, agreement, including the number of issuer-defendants that ultimately approveparticipate in the final settlement, agreement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants.

In the event that all or substantially all of the issuer-defendants approveparticipate in the final settlement, agreement, the amount that the Company wouldmay be required to paypaid to the plaintiffs on behalf of the Company could range from zero to approximately $3.5 million, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties.  If the plaintiffs recover at least $1 billion from the underwriter-defendants, no settlement payments would be made on behalf of the Company would have no liability for settlement payments under the proposed terms of the settlement.  If the plaintiffs recover less than $1 billion,  the Company believes that its insurance will likely cover some or all of its share of any payments towards satisfying plaintiffs’ $1 billion recovery deficit. Management estimates that its range of loss relative to this matter is zero to $3.5 million. Presently there is no more likely point estimate of loss within this range. As a consequence of the uncertainties described above regarding the amount the Company will ultimately be required to pay, if any, as of March 31,June 30, 2004, the Company has not accrued a liability for this matter.

In re Tut Systems, Inc. Securities Litigation, Civil Action No. C-01-2659-JCS (the “Securities Litigation Action”).

Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of investors who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Company’s business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints were consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs were appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, defendants answered the remaining allegations of the amended complaint. Defendants reached a settlement of the Securities Litigation Action in December 2003. Subject to preliminary and final approval by the Court, the Company’s insurance carriers agreed to pay $10 million, on behalf of the Company, to settle the suit. The settlement includes a release of all defendants. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carriers agreed to pay the entire $10 million settlement amount and, therefore, recovery from the insurance carriers was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The insurance carriers paid the settlement amount to plaintiffs’ escrow agent in January 2004. The Court preliminarily approved the settlement on February 24, 2004 and finally approved the settlement on May 14, 2004. The settlement amount will be paid out of escrow if andbecame final on June 15, 2004, the date when the Court finally approvesappeals period ended. Therefore, in the settlement. A hearing beforesecond quarter of 2004, the Court to consider final approval of$10 million was removed from the terms of

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insurance settlement is currently scheduled for May 14, 2004. Becausereceivable and the legal settlement is subject to Court approval, there is no guarantee the settlement will become final.liability.

Lefkowitz v. D’Auria, et al

On March 19, 2003, Chesky Lefkowitz, a stockholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment, and improper insider stock trading based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The Company and the individual defendants reached a settlement of the derivative action in December 2003. The settlement involves the Company’s adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $722,000 and an incentive award to the derivative plaintiff in the amount of $3,000. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carrier involved in this suit agreed to pay the entire $725,000 settlement amount and, therefore, recovery from the insurance carrier was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The settlement was approved by the Court on January 12, 2004, and, shortly thereafter, the insurance carrier paid the settlement amount to the derivative plaintiff’s counsel. Therefore, in the first quarter of 2004, the $725,000 was removed from the insurance settlement receivable and the legal settlement liability.  The settlement includes a release of the Company and the individual defendants.

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

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NOTE 7—SEGMENT INFORMATION:

The Company currently targets its sales and marketing efforts to both public and private service providers and users across two related markets. The Company currently operates in a single business segment as there is only one measurement of profitability for its operations. Revenues are attributed to the following countries based on the location of customers:

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Two customers, Atlantic Telephone Membership Corporation and Home Telephone CompanyNo individual customer accounted for 12%greater than 10% of the Company’s revenue for the three and six months ended June 30, 2003.  One customer, Enterasys Networks Ltd. accounted for 11%, respectively of the Company’s revenue for the three months ended March 31, 2003.  OneJune 30, 2004.  No individual customer Pioneer Long Distance Inc., accounted for greater than 10% of the Company’s revenue for the threesix months ended March 31,June 30, 2004.

Products

The Company designs, develops, and sells video processing systems and broadband transport and service management products. Video processing systems include both digital TV headend systems and video systems. The digital TV headend system enables telephony-based service providers to transport broadcast quality digital video signals across their networks and our digital video transmission systems optimize the delivery of video signals across enterprise, government and education networks. The broadband transport and service management products enable the transmission of broadband data over existing hotels and private campus networks.

Revenue relating to the broadband transport and service management products was $1,658$2,532 and $1,936$2,016 for the three months ended March 31,June 30, 2003 and 2004, respectively and $4,189 and $3,916 for the six months ended June 30, 2003 and 2004, respectively. Revenue related to video processing systems was $4,943$5,333 and $4,241$3,107 for the three months ended March 31,June 30, 2003 and 2004, respectively and $10,277 and $7,383 for the six months ended June 30, 2003 and 2004, respectively.

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

The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. When used herein, the words “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “seeks,” “should,” “will” or the negative of these terms or similar expressions are generally intended to identify forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The forward-looking statements contained in this quarterly report include statements about the following: (1)our belief that there is and will continue to be growing demand for video services in the future (2) our belief that video products will provide most of our growth opportunities for the foreseeable future, (2)(3) our belief that the number of telco video subscribers will grow significantly between 2004 and 2007 and that this market space will continue to become more competitive, (3)(4) our expectation that we will see growing demand for our products in the future, (5) our expectation that we will compete with larger public companies as we begin to target larger telco customers, (4)(6) our expectation that emerging advancements in video compression technology will allow more efficient transport of video streams, (7) our expectation that digital subscriber line or DSL technology will continue to dominate telco broadband networks for the foreseeable future, (5)(8) our belief that new controls and procedures have addressed the conditions identified by our auditors as material weaknesses, (6)  our expectation that sales related to VTC products will continue to increase in 2004 and sales relating to our broadband transport and service management products will also increase in 2004, but at a lower rate of increase, (7)(9) our expectation that capital expenditures for research and development will decrease in 2004, (8)(10) our expectation that our research and development expenses will increase throughout the remainder of 2004, (11) our expectation that capital expenditures in 2004 will be comparable to 2003 and that these capital expenditures will be funded from operations, (9)(12) our expectation that we will pay accrued interest on the note issued to Tektronix beginning January 31, 2006,(13) our belief that our cash and cash equivalents as of March 31,June 30, 2004 are sufficient to fund our operating activities and capital expenditure needs for the next twelve months, (10)(14) our expectation that working capital will begin to increase in future periods, (11) our expectation that the amount of cash used to fund our operations will decrease in 2004, (12)(15) our expectation that we will seek additional equity funding in the secondthird quarter of 2004, (13)(16) our expectation that future license and royalty revenue will consist primarily of royalties received by us for products sold by our licensees and that such license and royalty revenue will not constitute a substantial portion of our revenuedecrease in future periods, (14) our expectation that we will incur losses in the near future, (15) our expectation that some competitors will market some of their products for use in TV over DSL applications, (16)(17) our anticipation that our sales and operating margins will continue to fluctuate, (17)(18) our expectation that revenue for the second half of 2004 will exceed revenue for the first half of the year, (19) our anticipation that we will generally continue to invoice foreign sales in U.S. dollars, (18)(20) our intention to continue to evaluate new acquisition candidates, divesture and diversification strategies, and (19)(21) our expectation that customers outside of the United States will represent a significant and growing portion of our revenue.

The cautionary statements contained under the caption “Additional Risk Factors that Could Affect Our Operating Results and the Market Price of Our Stock” and other similar statements contained elsewhere in this report, identify important factors with respect to such forward-looking statements, including certain risks and uncertainties that could cause our actual results, performance or achievements expressed or implied by such forward-looking statements.

Although we believe that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. We disclaim any obligation or undertaking to disseminate any updates or revision to any forward-looking statement contained herein or reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

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Overview

Our Business

We design, develop, and sell digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals across their networks. We refer to these systems as digital TV headends or video content processing systems. We also offer digital video processing systems that enable private enterprise and government entities to transport video signals across satellite, fiber, radio, or copper facilities for surveillance, distance learning, and TV production applications.

We also offer broadband transport and service management products that enable the provisioning of high speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

Our History

Prior to November 2002, most of our sales were derived from our broadband transport and service management products. In 2000 and 2001, we acquired three companies (FreeGate Corporation, Xstreamis Limited and ActiveTelco, Inc.) and the assets from two other companies (OneWorld Systems, Inc. and ViaGate Technologies, Inc.) in order to expand our sales of broadband transport and service management products. However, the significant downturn in the world economy in general, and the telecommunications

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market in particular, beginning in late 2000 had a severe and sustained adverse effect on our business, financial condition and results of operations. Our sales of broadband transport and service management products decreased substantially beginning in 2001, which required us to take a number of restructuring efforts and incur significant impairment and other charges in order to realign our cost structure in light of the economic environment. For the period January 1, 2001 through December 31, 2002, we incurred an aggregate of $32.6 million in intangible asset impairment charges and $11.5 million in restructuring charges. In 2003, sales from our broadband transport and service management products stabilized, as we began to experience an improvement in sales of broadband transport and service management products to the hospitality industry.

With our November 2002 acquisition of Tektronix’s subsidiary VTC, we extended our product offerings to add video processing systems for digital TV headends and for the transmission of video signals over private and government networks. The acquisition of VTC resulted in significant changes in our business, including: (1) changes in our organizational structure and employee staffing; (2) relocation of our administrative offices, executive offices (as of January 2004) and a significant portion of our operations from Pleasanton, California to Lake Oswego, Oregon, the prior headquarters of VTC; (3) an expansion of our sales and marketing efforts to include VTC products; and (4) a reprioritization of our research and development efforts to focus on products that we acquired in our acquisition of VTC. With our acquisition of VTC, sales of video processing systems now represent a majority of our total revenues and will provide most of our growth opportunities for the foreseeable future.

We earn revenue primarily by selling video content processing systems both directly and through resellers to telecommunications service providers. We also earn revenue by selling video transmission systems to TV broadcasters, government agencies and educational institutions, and by selling broadband transport and service management products directly and through distributors to the hospitality industry and to owners of private multi-tenant campus facilities.

Prior to our acquisition of VTC, international sales represented 56.3% and 43.0% of our total sales in 2001 and 2002, respectively. Since our acquisition of VTC, international sales have represented a smaller percentage of our overall business relative to prior years, though international sales are still a material portion of our total sales. In 2003, international sales represented 18.4% of our total sales and for the three and six months ended March 31,June 30, 2004, international sales represented 11.2%26.7% and 19.0%, respectively, of our total sales.

Material Trends and Uncertainties

We pay close attention to and monitor various trends and uncertainties emerging in the markets we serve. There is a growing demand by independent operating telephone companies to offer video services to

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their customer base. According to a report released by InStat/MDR in April 2003, the number of telco video subscribers worldwide will increase from 572,000 at the end of 2003 to over 19.0 million by the end of 2007. While this growing market presents opportunities to serve a larger customer base, we are also seeing the emergence of intense competition as more companies compete to sell digital TV headend products. We expect this market space will continue to become more competitive in the future. As we begin to target larger telco customers, we expect to compete with larger public companies, including Harmonic, Motorola and Tandberg Television. Our immediate competitors in the digital TV headend markets are primarily small private companies that are focused on a more narrow product line than ours and thereby may be able to devote substantially more targeted resources to developing, marketing and selling new products than we are able to. In addition, these companies may become targets for acquisition by larger companies, in which case we would face competitors with substantially greater name recognition, and technical, financial and marketing resources than we have.

The emergence of new technologies to serve the digital TV headend market means that we must continue to invest in these new technologies to maintain our market position.  Digital subscriber line (“DSL”) technologies use sophisticated modulation schemes to pack data onto copper wires.  DSL technologies are sometimes referred to as “last mile” technologies because they are used only for connections from a telephone switching station to a home or office, not between switching stations.  The limitations on the amount of data that can be transmitted in a fixed amount of time (“bandwidth”) and distance limitations of the copper based last mile constrain both the number of video channels that may be delivered simultaneously over a DSL network and the number of customers that are reachable from a telco central office.  Emerging advancements in video compression technology will soon enable high quality video streams to be transported at lower data transfer rates or “bit rates” than currently deployed.  These emerging compression advancements also introduce the possibility of delivering high-definition television over bandwidth constrained asymmetric DSL, or ADSL, lines for the first time.  ADSL is a new technology that allows more data to be sent over existing copper telephone lines.  Additionally, there are DSL advancements emerging that expand the available bandwidth from the telco to the subscriber thereby supporting higher DSL bit rates over longer distances.  As our products continue to incorporate these new technological advancements we expect demand for our products will increase since they will enable more telcos to reach a higher percentage of their customers with a larger number of video channels.

While DSL technologies will continue to dominate telco broadband networks for the foreseeable future, telephone companies are beginning to construct fiber optic networks to their customers’ homes. Though fiber-to-the-home will eliminate bandwidth limitations on delivering higher speed data services and high-quality video offerings, telephone companies deploying fiber-to-the-home will require advanced video processing systems, such as our Astria Product line, to convert signals between multiple protocols used in their networks.

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The digital media industry continues to be intensely competitive.  We are continuing to focus on developing technologies and introducing new products and we expect that our research and development expenses will increase throughout the remainder of 2004. We continue to aggressively market our new and existing products and to expand our marketing efforts domestically and internationally.  Nevertheless, our operations have been subject, and will continue to be subject, to pressure from weakness in the overall technology sector as well as the digital media industry.  During the first quartertwo quarters of 2004 our sales cycle generally increased and customers delayed purchasing decisions.  The deferral of customer orders reduced our revenue in the first quartertwo quarters of 2004.2004 compared with prior periods and compared with what we had expected for those quarters.  We believe this lengthening of the decision making process is the result of an increasing variety of other products that interface with our systems. We have been operating at a loss since inception and, based on expected revenues, we anticipate that we will continue to operate at loss during the remainder of 2004.  As we announced on April 26,July 8, 2004, we expect revenues during the second quarterhalf of 2004 to increase by 5% and our gross margin to increase to approximately 40%.will exceed revenue for the first half of the year.  However, the deferral of customer orders we experienced during the first quarterhalf of 2004 may continue, which may result in reduced revenues in the future.

Internal Controls and Disclosure Controls and Procedures

Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31,June 30, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to ensure that our disclosure controls and procedures are designed to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisionsdiscussions regarding required disclosure. This evaluation also included consideration of our internal controls and procedures for the preparation of our financial statements. There are inherent limitations to the effectivenessAs of any system of disclosure controls and procedures, including the possibility of human error and the circumvention of the controls and procedures.  Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.  Notwithstanding these limitations, as of the end of the period covered by this report, based upon the evaluation,June 30, 2004, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controlscontrol and procedures are effective.

During the three months ended March 31,In January 2004 we implemented the following measures:

•                                          Perform quarterly physical inventory counts at all locations;

•                                          Established improved inventory systems and accounting controls, hired additional qualified personnel, improved intra-company communications, implemented appropriate organizational and line of reporting changes; and

•                                          Established improved procedures for the timely reconciliation and confirmation of accounts payable balances.

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We implemented these measures because in connection with the completion of PricewaterhouseCoopers LLP’sits audit of our financial statements for the year ended December 31, 2003, PricewaterhouseCoopers LLP, the Company’s independent registered public accounting firm, advised management and the audit committee of the Board of Directors that it had identified deficiencies in our internal controls and processes relating to inventory management and reporting that it consideredconsiders to be material weaknesses, as defined by Statement on Auditing Standards No. 60, “Communication of Internal Control Related Matters Noted in an Audit.” PricewaterhouseCoopers LLP identified the following twoThe material weaknesses in our internalthat PricewaterhouseCoopers identified related to inventory controls and processes:the accounts payable process for the Company’s Videotele.com business, which the Company acquired in November 2002. Specifically:

1.                                       Our internal controls wereare inadequate to properly record our inventory quantities in an accurate and timely manner; and

2.                                       Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.

Management believes its newWhile these material weaknesses had an immaterial effect on our reported results, they nevertheless constituted deficiencies in our disclosure controls. In light of these material weaknesses and the requirements enacted by the Sarbanes-Oxley Act of 2002 and the related rules and regulations adopted by the SEC, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2003, our disclosure controls and procedures needed improvement and were not effective. Despite those deficiencies in our disclosure controls, management believed that as of December 31, 2003, there were no material inaccuracies, or omissions of material facts necessary to make the statements not misleading in light of the circumstances under which they were made.

At the time of our acquisition of the Videotele.com business in November 2002, we had in place disclosure controls and procedures and processes for our existing business (i.e., our pre-November 2002 business) that our CEO and CFO at the time believed to be sufficient to record, process, summarize and report information required to be reported within the time periods specified by the SEC. Likewise, we had in place internal controls that our CEO and CFO believed at the time of the VTC acquisition to be sufficient to “provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with generally accepted accounting principles.”

Since December 31, 2002, we have addressedcontinued to review our disclosure controls and procedures and internal controls periodically in connection with our Form 10-Q filings. Throughout 2003, our CEO and CFO have continued to believe that our disclosure controls and procedures and internal controls have allowed us to provide all material and necessary disclosure in a timely manner, as required by the Exchange Act and the applicable rules thereunder.

In January 2004, during the audit of our financial statements for the fiscal year ended December 31, 2003, PricewaterhouseCoopers LLP discovered the material weaknesses noted above and brought these weaknesses to our attention. Based on discussions with PricewaterhouseCoopers LLP and the audit committee of our Board of Directors, we worked throughout our year-end 2003 accounting close and audit to identify the nature, scope and materiality of these weaknesses in our internal controls and their impact

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on our fiscal year 2003 financial statements and to determine the extent to which these internal control weaknesses might adversely affect our disclosure controls and procedures. Based on further detailed review of our internal controls as they relate to inventory and accounts payable during the fourth quarter of fiscal 2003, we determined that the accounts payable process had failed to record certain liabilities associated with VTC products that we purchased, principally from our contract manufacturer and certain other suppliers. We quantified this internal control weakness relating to accounts payable recordation by reconciling our records to that of our contract manufacturer and reviewing our liabilities with other vendors. We quantified the inventory process control weakness by taking complete physical inventories at each VTC inventory location and reconciling the results to our records. Upon completion of our analysis and testing, we identified an additional charge of approximately $34,000 to cost of goods sold related to the internal control weaknesses identified above. We recorded this charge prior to issuing our financial statements for the year ended December 31, 2003. In addition to our review of the financial statements for the fiscal year ended December 31, 2003, we re-confirmed that our accounts payable recordation and inventory controls were effective for the year ended December 31, 2002.

During our review of these internal controls weaknesses, we identified the cause of these internal control weaknesses to be the result of prior VTC accounting staff turnover that occurred during the first quarter of 2003. During this quarter, key accounting staff of VTC left the company without sufficient time to transition all of the internal controls and institutional knowledge to our remaining finance and accounting staff.

In addition to identifying the above two internal control weaknesses relating to inventory and the accounts payable process, we also tested our other internal controls to determine whether there were other such material weaknesses aside from the inventory and accounts payable weaknesses mentioned above that affected our financial statements for the fiscal year ended December 31, 2003. In particular, we tested our other internal controls by reviewing processes, analytical reviews and substantive testing that included other third-party confirmations and by reviewing activity subsequent to year-end 2003. Based on these tests, we did not identify any other material weaknesses in internal controls. Therefore, our CEO and CFO believed at the time of the original filing of the Form 10-K on February 2, 2004 that they had reasonable grounds to conclude that the weaknesses in internal controls related solely to those items mentioned above and resulted in an immaterial charge of approximately $34,000.

Based on their review of our internal controls as described above, our CEO and CFO also assessed our disclosure controls and procedures for the fiscal year ended December 31, 2003. Our CEO and CFO believed at the time of the original filing of the Form 10-K that they had reasonable grounds to conclude that, other than the inventory and accounts payable weaknesses that PricewaterhouseCoopers LLP had identified, there were no other material weaknesses in our disclosure controls and procedures and that the information required to be reported in the Form 10-K was recorded, processed, summarized and reported within the time periods specified by the applicable Exchange Act rules.

In order to ensure that we have eliminated the two weaknesses in our internal controls for purposes of future reporting, we have undertaken significant efforts to improve our processes and procedures as they relate to inventory reporting and accounts payable reconciliation. The audit committee is taking an active role in these efforts, including overseeing management’s implementation of corrective measures. With respect to inventory management, we have performed physical inventory counts at least at the end of each quarter in 2004. We have implemented improved inventory systems and accounting controls and have hired an additional full-time staff accountant to account for and control our inventory accounting, given our operations manager company-wide responsibility for inventory management, have reiterated to key operations and accounting personnel the importance of proper inventory management and control. We will be expanding our inventory receiving process to include remote locations, as appropriate and reconciling inventory to each customer order. Regarding accounts payable reconciliation, we have confirmed our key accounts payable balances with our vendors and reconciled the confirmations to our accounting records on a quarterly basis in 2004.

Management believes that the controls and procedures identified above have and will address the conditions identified by PricewaterhouseCoopers LLP as material weaknesses. These changes will become permanent elements of our internal controls. We are now confident that we have and are in the process of implementing the proper level of controls to correct the material weaknesses. We plan to continue to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.

Definitions for Discussion of Results of Operations

Our discussion of our results of operations focuses on the following items from our income statement: Total revenues consists of product sales, and license and royalty fees. Product revenue consists of sales of our video processing systems, which includes both digital TV headend and video transmission systems. Product revenue also consists of revenue from our broadband transport and service management products. License and royalty fees consist of non-refundable license fees and royalties received by us for products sold by our licensees. Since our acquisition of VTC, a large part of our quarterly revenue has been associated with the sale of digital TV headends. Furthermore, each individual headend sale has represented a significant portion of our revenue for each quarter. If we were to sell even one less system than our forecasted number of headend sales per quarter, our quarterly revenue would be materially impacted. As we have not entered into any new license or royalty agreements since 2000, we expect that our license and

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royalty revenue will decrease in the foreseeable future. Cost of goods sold, or COGS, consists of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance for products, and the cost of licensed technology included in our products. Raw materials, contract manufacturing and licensed technology are the principal elements of COGS and vary directly with product sales. Sales and marketing expense consists primarily of selling and marketing personnel costs, including sales commissions, travel, trade shows, promotions and outside services. Research and development expense consists primarily of personnel and facilities costs, contract consultants, outside testing services, and equipment and supplies associated with enhancing existing products and developing new products. General and administrative expense consists primarily of personnel costs for administrative officers and support personnel, professional services and insurance expenses. Amortization of intangible assets consists primarily of expenses associated with the amortization of technology and patents related to prior years’ acquisitions.

Results of Operations

The following table sets forth items from our statements of operations as a percentage of total revenues for the periods indicated:

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Three and Six Months Ended March 31,June 30, 2003 and 2004

Total Revenues.  Our total revenues decreased to $5.1 million and $11.3 million for the three and six months ended June 30, 2004, respectively, when compared with total revenues of $7.9 million and $14.5 million for the same periods in 2003. For the three months ended March 31,June 30, 2004, our total revenues decreasedproduct revenue from video processing systems declined by 6.4%41.5% to $6.2$3.1 million from $6.6$5.3 million for the three months ended March 31,June 30, 2003.  During this same period,For the six months ended June 30, 2004, our product revenue from video processing systems decreased by 3.8%$2.9 million, or 28.2%, to $6.2$7.4 million from $6.4$10.3 million for the three months ended March 31,same period in 2003.    This $0.2 million decreaseThe decreases in video processing systems product revenue waswere due primarily to the adverse effect of several digital TV headend sales not closing induring the quarterperiod as expected.  While we believe the market for digital TV headend sales continues to expand, we are seeing an increase in a variety of factors that isare causing many prospective customers to delay their purchase decision.decisions.  Sales of broadband transport and service management products increaseddecreased from $1.7$2.5 million in the firstsecond quarter of 2003 to $1.9$2.0 million in the firstsecond quarter of 2004 and decreased from $4.2 million for the six months ended June 30, 2003 to $3.9 million for the six months ended June 30, 2004.   Included in sales of broadband transport and service management products were sales to one customer, Enterasys Networks Ltd. which accounted for 11% of our total revenue for the three months ended June 30, 2004.  For the three months ended March 31,June 30, 2004, our license and royalty revenue decreased to $18 thousand$18,000 from $0.2 million for the three months ended March 31,June 30, 2003 and decreased to $35,000 for the six months ended June 30, 2004 from $0.4 million for the six months ended June 30, 2003.  We expect that our license and royalty revenue will continue to decrease in the foreseeable future.

Cost of Goods Sold.  For the three months ended March 31,June 30, 2004, our cost of goods sold increaseddecreased by $1.8$0.6 million to $5.1$3.4 million from $3.3$4.0 million for the three months ended March 31,June 30, 2003. The increasedecrease in cost of goods sold was due to a $1.0$0.9 million increasedecrease in our reserves for obsolete inventory and amaterial costs relating to lower of cost or market adjustment for certain inventory components,sales volume, partially offset by an increase in materiallabor costs of  $0.2 million direct labor and other direct expenses of $0.5 million related to completion of certain project installations, and other miscellaneous expensesan increase in overhead costs of $0.1 million.   Our gross profit decreasedCost of goods sold increased by $2.3$1.3 million to $1.0$8.6 million during the six months ended June 30,

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2004 from $7.3 million for the threesix months ended March 31, 2004 from $3.3 million for the three months ended March 31,June 30, 2003.  This decreaseincrease in gross profit is due tocosts of goods sold includes an increase of $1.0 million in inventory reserves recorded during the first quarter of 2004.  The remaining increase in costs of goods sold of $0.3 million includes an increase in labor costs of $0.3 million and a gross margin decreasean increase in overhead costs of $1.5$0.5 million, relating to our video content processing products.  The decrease in our gross margin was partially offset by an increasea decrease in material costs of $0.2 million attributable to our broadband transport and service management products.$0.5 million.

Sales and Marketing.  For the three and six months ended March 31,June 30, 2004 and 2003, our sales and marketing expenses remained consistent at $1.9 million.million and $3.8 million respectively.

Research and Development.  For the three months ended March 31,June 30, 2004, our research and development expense decreased by 12.7%17.3% to $1.8$1.9 million from $2.1$2.2 million for the three months ended March 31,June 30, 2003. The $0.3 million decrease in our research and development expense for the firstsecond quarter of 2004 when compared with the same period in 2003 was due to a decrease of $0.3 million in personnel related costs. We continued to reduce research and development expenses in the first quarter of 2004 to bring them into better alignment with our current revenues. We expect that our research and development expenses will increase throughout the remainder of 2004. Research and development expense decreased by $0.6 million to $3.7 million for the six months ended June 30, 2004 from $4.3 million for the six months ended June 30, 2003.  The $0.6 million decrease was due to a decrease of $0.6 million in personnel related costs.  Our capital expenditures for research and development were $0.1 million and $0.3 million$19,000 for the three months ended March 31,June 30, 2003 and 2004, respectively and $0.1 million and $0.3 million for the six months ended June 30, 2003 and 2004, respectively. We expect capital expenditures for research and development to decrease in 2004.

General and Administrative.  For the three months ended March 31,June 30, 2004 and 2003, our general and administrative expense remained consistent at $1.1 million.  For the six months ended June 30, 2004, general and administrative expense decreased by 7.1% to $1.1$2.2 million from $1.2$2.3 million for the threesix months ended March 31,June 30, 2003.  The $0.1 million decrease in our general and administrative expense for the first quarter of 2004 when compared with the same period in 2003 was due to decreases ofa $0.2 million decrease in personnel related costs fromand a workforce reduction in the third quarter of 2003 and $0.1$0.2 million decrease in insurance expenses, partiallycosts offset by ana $0.3 million increase of $0.2 million in professionaloutside services.

Impairment of Intangible Assets.  During the first quarter of 2004, we determined that certain of the technology acquired as part of the purchase of the ViaGate Technology assets had become impaired. As a result, we recorded an impairment charge of $0.2 million to write off the book value of the intangible assets associated with this technology. There was no such impairmentDuring the second quarter of 2003, we recognized a loss of $0.1 million for the three months ended March 31, 2003.impairment of certain technology acquired as part of the acquisition of the assets of ViaGate. 

Amortization of Intangible Assets.  Amortization of intangible assets is comprised of intangibles related to the acquisitions of Xstreamis Limited in 2000, and VTC in 2002. The remaining intangible assets subject to amortization from these acquisitions consist primarily of completed technology and patents. For

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the three months ended March 31,June 30, 2004, amortization of intangible assets decreased by 13.7%18.1% to $0.4 million from $0.5 million for the three months ended March 31,June 30, 2003.  The $0.1 decreaseAmortization of intangible assets decreased by $15.9% to $0.8 million for the first quarter ofsix months ended June 30, 2004 when compared withfrom $0.9 million for the same period in 2003 was due to a reduction in amortization expense, from an intangible asset reaching full amortization in the fourth quarter ofsix months ended June 30, 2003.

Interest and Other Income, Net.  Interest and other income, net consists primarily of interest income and expense and foreign currency exchange gains and losses. For the threesix months ended March 31,June 30, 2004, our interest and other income, decreased to a net expense of $0.1 million from a net interest and other income of $0.1 million for the threesix months ended March 31,June 30, 2003. The decrease in the first quarter ofsix months ended June 30, 2004 of $0.2 million compared with the first quarter ofsix months ended June 30, 2003 was primarily the result of lower interest rates on lower average cash balances and increased interest expense associated with the $3.2 million note issued in connection with our purchase of VTC in November 2002.

Liquidity and Capital Resources

Cash and cash equivalents totaled $12.3$8.8 million at March 31,June 30, 2004, compared with cash and cash equivalents of $14.4 million at December 31, 2003, reflecting a net reduction in cash and cash equivalents of $2.1$5.6 million.

Cash used in operating activities was $1.5$5.2 million for the threesix months ended March 31,June 30, 2004, compared with $4.4$9.4 million for the threesix months ended March 31,June 30, 2003. The reduced cash used in operating activities was primarily due to a decrease in accounts receivable due to lower revenue levels in the firstsecond quarter of 2004 and an increase in accounts payable and accrued liabilities due to an increase in end of quarter purchases offset by an increase in prepaid expenses.inventory purchases.  We recorded a provision for excess and obsolete inventory within cost of goods sold totaling $1.0 million in the first quarter of 2004, related to the costs of raw materials and finished goods in excess of what we reasonably expected to sell in the foreseeable future as of the first quarter ofsix months ended June 30, 2004. We also reduced inventory costs to market value.

Additions to property and equipment were $0.7$0.8 million in the first quarter ofsix months ended June 30, 2004, compared with $0.3$0.5 million in the first quarter ofsix months ended June 30, 2003, primarily reflecting an increased investment in research and development assets. In 2004total we expect capital expenditures for 2004 to be comparable to 2003. We expect these capital expenditures to be funded from operations.

Cash from financing activities were $0.3 million in the six months ended June 30, 2004, compared with $11,000 for the six months ended June 30, 2003 from increased exercises of stock options.

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The following table sets forth our contractual obligations as of March 31,June 30, 2004:

We do not have any off balance sheet arrangements.

As part of our acquisition of VTC from Tektronix in November 2002, we issued a note payable to Tektronix for $3.2 million, with repayment in sixty months, or by November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest is added to the principal balance of the note. Thereafter, we will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in full. Principal and accrued interest on the note payable is $3.6$3.7 million at March 31,June 30, 2004.  Accrued interest in the first quarter ofsix months ended June 30, 2004 was $0.1 million.

In connection with the settlementsettlements of certain legal matters in December 2003, we have recorded a liability and a receivable, each in the amount of $10.7 million, in our December 31, 2003 balance sheet. This amount will beThe settlements were formerly approved by the respective courts during the six months ended June 30, 2004. These amounts were paid by our insurance carriers and accordingly, such liability is not reflected induring the above table.six months ended June 30, 2004. The settlement amount will be reversed from our balance sheet during 2004, at such time as the settlements arewere formally approved by the respective courts.  One ofcourts during the settlements was formally approved by the courts in the first quarter ofsix months ended June 30, 2004 and therefore, we reversed $0.7removed the $10.7 million relatingliability and receivable related to that settlementthe settlements from the balance sheet.  Assheet as of March 31, 2004, we have a receivable and liability of $10.0, respectively, on our balance sheet.June 30, 2004.

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We have incurred substantial losses and negative cash flows from operations since inception. For the threesix months ended March 31,June 30, 2004, we incurred a net loss of $4.5$8.1 million, negative cash flows from operating activities of $1.5$5.2 million, and have an accumulated deficit of $286.5$290.1 million.

We believe that the cash and cash equivalents as of March 31,June 30, 2004 are sufficient to fund our operating activities and capital expenditure needs for the next twelve months. However, in the event that general economic conditions worsen, we may require additional cash to fund our operations. We plan to seek additional equity funding to provide working capital, fund potential acquisitions and potentially redeem the VTC acquisition indebtedness. We cannot assurebe assured that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material adverse effect on our ability to achieve our intended business objectives.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We have identified the policies below as critical to our business operations and the understanding of our results of operations.

Revenue recognition.  We generate revenue primarily from the sale of hardware products, including third-party products, through professional services, and through the sale of our software products. We sell products through direct sales channels and through distributors. Generally, product revenue is generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.

Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.

Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. We sell these products through our own direct sales channels and also through distributors.

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Our revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2 and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.           Those amendments deferred and then clarified, respectively, the

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specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

In the case of software arrangements that require significant production, modification or customization of software, which encompasses all of our turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We recognize revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element of the multi-element arrangement, for which we have established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance.  The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, we may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, we must also make a judgment regarding collectibility of the arrangement fee.  Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to our credit review policy.  We sell to customers for which there is a history of successful collection and to new customers for which such history may not exist.  New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position.  Such credit limits are only increased after a successful collection history with the customer has been established.  If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, no credit is extended and revenue is recognized on a cash-collected basis.basis after shipment has occurred or the revenue has been earned under the percentage-of-completion method.

We also maintain accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. Our products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

License and royalty revenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by us for products sold by our licensees. Currently, the majority of our license and royalty revenue is comprised of non-refundable license fees paid in advance. Such revenue is recognized ratably over the period during which post-contract customer support is expected to be provided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by us for products sold by our licensees. We expect that such license and royalty revenue will not constitute a substantial portion of our revenue in future periods.

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