UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.DC 20549

FORM 10-Q

(Mark One)

For the Quarterly period ended March 31, 2004

OR

x    QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period fromto

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003.000-32743

(Commission File Number)

OR

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

FOR THE TRANSITION PERIOD FROMTO.

Commission File Number: 000-32743

TELLIUM,ZHONE TECHNOLOGIES, INC.

(Exact name of Registrantregistrant as specified in its charter)

2 Crescent Place

Oceanport, New Jersey 07757-0901

(Address of Principal Executive Offices) (Zip Code)

(732) 923-4100(510) 777-7000

(Registrant’s Telephone Number, Including Area Code)telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d)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.

Yesx    No¨

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

Yes¨    Nox                        No  ¨

As of SeptemberApril 30, 2003,2004, there were 116,901,95478,127,000 shares outstanding of the registrant’s common stock, par value $0.001 per share.Registrant’s Common Stock issued and outstanding.

TELLIUM, INC.Zhone Technologies, Inc.

FORM 10-Q

Quarterly Period Ended March 31, 2004

INDEXTable of Contents

PART I. FINANCIAL INFORMATION

Item 1.  ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Condensed Consolidated Financial Statements (Unaudited).Balance Sheets

(In thousands, except par value)

TELLIUM,ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETSUnaudited Condensed Consolidated Statements of Operations

(Unaudited)

(In thousands, except per share data)

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

See Notesaccompanying notes to Condensed Consolidated Financial Statements.condensed consolidated financial statements.

TELLIUM,ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See Notes toUnaudited Condensed Consolidated Financial Statements.

TELLIUM, INC.Statements of Cash Flows

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)(In thousands)

See Notesaccompanying notes to Condensed Consolidated Financial Statements.condensed consolidated financial statements.

TELLIUM,ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

TELLIUM, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

We design, develop,Zhone Technologies, Inc. and market high-speed, high-capacity, intelligent optical switching solutions that enablesubsidiaries (“the Company”) designs, develops and markets telecommunications hardware and software products for network service providers. The Company has developed an integrated hardware and software architecture designed to simplify the way network service providers deliver communication services to quicklytheir subscribers. The Company’s products enable service providers to use their existing networks to deliver voice, video, data, and cost-effectively deliver new high-speed services. Our product line consistsentertainment services to their customers. The Company was incorporated under the laws of several hardware productsthe state of Delaware in June 1999. The Company began operations in September 1999 and related software tools.is headquartered in Oakland, California.

The continued deteriorating conditions in the telecommunications industry has hindered our ability to secure additional customers and has caused current customers’ purchases to decline. As a result, on January 9, 2003, we announced a business restructuring plan designed to decrease our operating expenses. During the first quarter of 2003, we recorded a restructuring charge of approximately $6.7 million associated with a workforce reduction of approximately 130 employees. These charges included approximately $3.2 million for severance and extended benefits and $3.5 million for the consolidation of excess facilities, resulting in non-cancelable lease costs.

We also completed an assessment of the current carrying value of fixed assets on our balance sheet during the first quarter of 2003. Our analysis resulted in a write off of approximately $0.7 million related to these assets, which were idled as a result of our restructuring and for which management has a committed plan of disposal.

On July 28, 2003, Tellium and Zhone Technologies, Inc. (“Zhone”) announced that they had entered into a definitive merger agreement.

Under the terms of the agreement, the security holders of Zhone would receive 60% of the combined company’s outstanding fully-converted shares at closing and the security holders of Tellium would continue to hold the remaining 40% of the combined company’s outstanding fully-converted shares as of closing. The exact number of shares Tellium will issue will depend on Tellium’s fully-converted shares outstanding immediately prior to closing. The proposed stock-for-stock transaction is intended to qualify as tax-free to the stockholders of Tellium and Zhone.

The transaction is subject to the approval of each company’s security holders, regulatory review, as well as other customary closing conditions. The transaction is expected to close on or about November 13, 2003 or as soon thereafter as is practicable.

The accompanying unaudited condensed consolidated financial statements included herein for Tellium have been prepared by us pursuant to the rulesare unaudited and regulations of the Securities and Exchange Commission. In our opinion, the condensed consolidated financial statements included in this report reflect all adjustments (consisting only of normal recurring adjustments which we consideradjustments) that, in the opinion of management, are necessary for thea fair presentation of the results for the interim periods presented. The results of operations for the current interim periods covered and of our financial position at the date of the interim balance sheet. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, we believe that the disclosures are adequate to understand the information presented. The operating results for interim periodsperiod are not necessarily indicative of the operating results to be expected for the entire year.current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related footnotesnotes thereto included in the Company’s Form 10-K for the year ended December 31, 2003.

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

For accounting purposes, the merger with Tellium was treated as a reverse merger, in which Zhone was treated as the acquirer based on factors including the relative voting rights, board control, and senior management composition. The financial statements of the combined company after the merger reflect the financial results of Zhone on a historical basis after giving effect to the merger exchange ratio to historical share-related data. The results of operations for Tellium were included in our Annual Report on Form 10-K filed withZhone’s results of operations from the Securitieseffective date of the merger.

Stockholders’ equity has been restated to give retroactive recognition to the Reverse Split and Exchange Commission on March 31, 2003.

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

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

The Company recognizes revenue when the earnings process is complete. The Company recognizes product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such

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

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

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

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

The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, Internet service providers, wireless carriers, and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts. For the three months ended March 31, 2004, sales to two customers represented 11% and 10% of net revenue, respectively. For the three months ended March 31, 2003, sales to one customer represented 18% of net revenue. As of March 31, 2004, the Company had accounts receivable balances from three customers individually representing 24%, 16% and 10% of accounts receivable, respectively. As of December 31, 2003, the Company had accounts receivable balances from two customers individually representing 31% and 11% of accounts receivable, respectively.

The Company has elected to account for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”) and related interpretations. Under this method, compensation expense is recorded on the date of grant only if the current fair value exceeds the exercise price. SFAS No. 123,Equity-BasedAccounting for Stock-Based Compensation—Prior to 2003, we accounted, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation arrangements underplans. As allowed by SFAS No. 123, the recognitionCompany has elected to continue to apply the intrinsic-value-based method of accounting described above, and measurement provisionshas adopted the disclosure requirements of APB OpinionSFAS No. 25, “Accounting for Stock Issued to Employees” (APB No. 25)123, as amended.

For the three months ended March 31, 2004 and related interpretations. Effective January 1, 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation.” We selected the prospective method of adoption described in SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” This method applies fair value accounting to all new grants and modification or settlement of old grants after the beginning of the yearCompany’s stock-based awards to employees was estimated using the following weighted average assumptions: expected option life of adoption. All other old grants will continue4.0 years; dividend yield of 0%; risk-free interest rate of 3.0% and 4.5%, respectively; and volatility of 95% and 0%, respectively. Prior to be accountedentering into its merger agreement with Tellium, Inc. in July 2003, the Company used the minimum value option pricing model for underprivately-held companies, which does not consider the intrinsic value provisionimpact of APB No. 25. We recorded approximately $26.2 million of stock-based compensation for new grants accounted for under SFAS No. 123. The remaining $4.6 million of stock-based compensation recorded in the nine months ended September 30, 2003 related to options granted prior to January 1, 2003.stock price volatility.

Had we elected to recognize compensation expense for stock options according to SFAS No. 123 since our inception, basedThe following table illustrates the effect on the fair value at the grant dates of the awards, net loss and net loss per share wouldif the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share data):

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”),“Consolidation of Variable Interest Entities.” In December 2003, the FASB issued a revision to FIN 46 (“FIN 46R”). FIN 46R requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN 46R are effective immediately for all new arrangements entered into after December 31, 2003. The Company does not have any financial interests in variable interest entities created prior to December 31, 2003, for which the provisions of FIN 46R became effective on January 1, 2004. The adoption of FIN 46R did not have a material impact on the Company’s consolidated financial statements.

(2)	Acquisitions

Gluon

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

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

Tellium

In November 2003, the Company completed the acquisition of Tellium in exchange for total consideration of approximately $173.3 million, consisting of common stock valued at $119.4 million, options and warrants to purchase common stock valued at $7.9 million, assumed liabilities of $42.8 million, and acquisition costs of $3.2 million. The transaction was treated as a reverse merger for accounting purposes, in which the Company was treated as the acquirer based on factors including the relative voting rights, board control, and senior management composition. The purchase price was allocated to the fair values of the assets acquired as follows: net tangible assets - $144.4 million, goodwill - $25.7 million and deferred compensation - $3.1 million. The Company recorded severance and facility exit costs for the Tellium acquisition in accordance with EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”. A rollforward of the EITF 95-3 reserve activity was comprised as follows (in thousands):

The remaining costs accrued under EITF 95-3 are expected to be paid within the next nine months.

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

In accordance with SFAS No. 144, the Company reviews long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable

based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.

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

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

Amortization expense of acquisition-related intangible assets was $2.1 million and $1.8 million for the three months ended March 31, 2004 and 2003, respectively.

Estimated amortization expense for the future periods ending December 31 is as follows: 2004 (remainder of year) - $6.3 million, 2005 - $4.6 million, and 2006 - $0.3 million.

The weighted average fair valuechanges in the carrying amount of ourgoodwill are as follows (in thousands):

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

(5)	Redeemable Convertible Preferred Stock

During the three months ended March 31, 2003, the Company had Series AA and Series B redeemable convertible preferred stock optionsoutstanding, and was calculated using the Black-Scholes Model with the following weighted average assumptions used for grants:recording accretion relating to this preferred stock as described below. There were no dividend yield; risk free interest rates between 1.19% andshares of 6.25%; expected volatility of 0% (80% for grants issued during and after September 2000); and expected lives of one to four years. The weighted average fair value of options grantedpreferred stock outstanding during the three months ended September 30, 2002March 31, 2004. All outstanding shares of preferred stock were converted to common stock prior to the consummation of the Tellium merger in November 2003.

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

Prior to April 17, 2003, the Company was accreting the redeemable convertible preferred stock to its stated redemption price. The Company accreted, by charging paid in capital, $12.7 million on all outstanding Series AA and Series B redeemable convertible preferred stock through April 17, 2003, which was reflected as an increase in the nine months ended September 30, 2002 and 2003 was $0.50, $0.52, $1.42 and $0.20 per share, respectively.

Net Loss Per Share—Basic net loss per share is computed by dividingcarrying value of the net losspreferred stock. Upon the elimination of the redemption feature for the period bySeries AA and Series B preferred shares, the weighted average numberCompany stopped recording accretion on the convertible preferred stock. The accretion of common shares outstanding during the period. Weighted average common shares outstandingredemption value of the redeemable convertible preferred stock for purposes of computing basic net loss per share excludes the unvested portion of restricted stock. For the three months and nine months ended September 30,March 31, 2003 9,908,495 vested shareswas $10.6 million.

The following table sets forth the computation of restricted stock were treated as treasury stock for the calculation of weighted average common shares outstanding as a result of the accounting for the Management Incentive Compensation Program. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potentially dilutive common shares outstanding during the period, if dilutive. Potentially dilutive common shares are composed of the incremental common shares issuable upon the conversion of preferred stock and the exercise of stock options and warrants, using the treasury stock method. Due to our net loss, the effect of potentially dilutive common shares is anti-dilutive; therefore, basic and diluted net loss per share are(in thousands, except per share data):

The components of comprehensive loss, net of tax, for the three months ended September 30, 2002March 31, 2004 and 2003 and the nine months ended September 30, 2002 and 2003, potentially dilutive shares of 107,533, 3,450,402, 2,736,484 and 2,318,448, respectively, were excluded from the diluted weighted average shares outstanding calculation.as follows (in thousands):

Recent Financial Accounting Pronouncements—In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. The statement requires that contracts with comparable characteristics be accounted for similarly and clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, except in certain circumstances, and for hedging relationships designated after June 30, 2003. Management does not expect that the adoption of this standard will have a material effect on Tellium’s financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. Management does not expect that the adoption of this standard will have a material effect on Tellium’s financial position or results of operations.

On June 24, 2002, in response to deteriorating conditions in the telecommunications industry, we announced a business restructuring plan designed to decrease our operating expenses. We recorded a restructuring charge of approximately $12.8 million associated with a workforce reduction and the consolidation of excess facilities, resulting in non-cancelable lease costs and write down of certain leasehold improvements.

Continued deteriorating conditions in the telecommunications industry have contributed to our inability to secure additional customers and caused purchases by current customers to decline. On January 9, 2003, in response to these conditions, we announced a business restructuring plan designed to decrease our operating expenses. We recorded a restructuring charge of approximately $6.7 million associated with a workforce reduction and the consolidation of excess facilities, resulting in non-cancelable lease costs.

During the nine months ended September 30, 2003, we terminated approximately 130 employees. During the first quarter of 2003, we recorded charges for the workforce reduction of approximately $3.2 million primarily related to severance and extended benefits. The remaining balance related to the workforce reduction of approximately $0.1 million will be paid during 2003.

During the first quarter, we recorded a charge of approximately $3.5 million related to the consolidation of facilities. We ceased use of our West Long Branch, NJ facility during the quarter ended March 31, 2003. The remaining facilities balance of approximately $6.0 million as of September 30, 2003 is related to the net lease expense of non-cancelable leases, which will be paid over the respective lease terms through the year 2007.

The following displays the activity and balances of the restructuring reserve account for the nine months ended September 30, 2003:

In addition, during the first quarter of 2003, we wrote down net property, plant, and equipment by approximately $0.7 million. This charge covers assets idled by restructuring for which we have a committed disposal plan.

Inventories consist of the following:

5.	PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

Changes to Management Incentive Compensation ProgramLeases

On various dates between AprilThe Company has entered into operating leases for certain office space and June 2000, we loaned fundsequipment, some of which contain renewal options. The Company has options to memberspurchase the leased assets at the end of our management teamthe lease terms.

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

Warranty Costs

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

The following table summarizes the activity related to the product warranty liability for the three months ended March 31, 2004 and 2003 (in thousands):

The Company depends on sole source and limited source suppliers for several key components and contract manufacturing. If the Company was unable to obtain these components on a full-recoursetimely basis, the Company would be unable to enable them to exercise previously granted stock options with average exercise prices of $2.14 per share. Individuals receiving loans included executive officers, vice presidents, and other employees. Upon exercise of the stock options, each of these individuals received restricted stock that vested over four years, and pledged the restricted shares to secure payment of their loans to us,meet its customers’ product delivery requirements which generally become due in full in April through June 2005. Our stock price has fallen substantially below $2.14 per share, causing these loans to be under-collateralized while the individuals remain personally liable for payment on the loans when they come due.could adversely impact operating results.

         This circumstance posed personal financial problems for the individuals involvedThe Company has agreements with various contract manufacturers which include inventory repurchase commitments on excess material. The Company has recorded a liability of $4.6 million related to these arrangements as of March 31, 2004 and undercut the intended incentivizing effect of the restricted stock program. In an effort to restructure our management incentive arrangements, in July 2002, our board of directors authorized changes to this restricted stock and management loan program for the 12 participating individuals (then consisting of three executive officers—Messrs. Carr, Bala, and Losch, five vice presidents, three other employees, and one former vice president). These changes included our repurchase of the shares of restricted stock and related reduction of the loans, modifications of the terms of the remaining loans and establishment of new incentive compensation arrangements which would include a bonus program applicable in the event of a change of control and providing for bonuses in an amount sufficient to repay, on an after-tax basis, the then remaining balance of the loans.December 31, 2003.

        We attemptedLetters of Credit

The Company has issued letters of credit to implement these board-approved changes,ensure its performance or payment to third parties in accordance with specified terms and in late July 2002 repurchase agreements and other implementing documents were signed. However, certain problems arose in the implementationconditions, which amounted to $0.6 million as of the changes and the board subsequently determined that the documented changes did not reflect its intentions and the scope of what it had authorized and that we should not go forward with changes in theMarch 31, 2004. The Company has recorded restricted stock and loan program at that time. Accordingly, the board determined that it should not ratify and approve the implementing documents that had been executed and that the documents and the transactions provided for by them were void and unenforceable against us. The board also determined to continue to consider changes to our management incentive compensation arrangements, including the management loan arrangements. As previously disclosed, Tellium was not aware of what position the executives who signed implementing agreements in July 2002 would take with respectcash equal to the board’s action to void those agreements and was, therefore, unable to assess at that time whether those developments would have a material adverse effect on us.amount outstanding under these letters of credit.

During January 2003, our board of directors approved a set of changes to our management compensation arrangements, including changes in the restricted stock and loan program for the individualsLegal Proceedings

The Company is involved in that program, other than with respect to our executive officers. The board concluded that the existing arrangements, which were based largely on the restricted stock and related loans, were not providing proper incentives to our management. The changes approved by the board affected 15 continuing and former non-executive senior managers, 12 of whom owed us approximately $13.6 million, including interest, secured by approximately 5.8 million shares of restricted stock. Based on the actions described above, despite the fact that the loans remained legally outstanding, accounting standards required that these notes, originally recourse notes, be treated as non-recourse in our financial statements.

As of May 13, 2003, all of the continuing and former non-executive senior managers participating in the program had executed agreements incorporating the

board-approved changes to the program, including a general release and waiver of all claims against us relating to his or her employment, including without limitation, any claimsvarious litigation matters relating to the agreements signed by these individuals in July 2002. In addition, we have taken the following actions in accordance with the termsoperations of these agreements:

In connection with the approval of these changes to the outstanding loans, the board also approved the cancellation of stock options to purchase approximately 2.7 million shares of our common stock held by 11 non-executive senior managers, including three non-executive senior managers who did not have loans, and re-issuance of new stock options to purchase approximately 5.3 million shares of our common stock. The exercise price of the stock options cancelled was substantially above the current market price of our common stock. In May 2003, we cancelled the stock options to purchase approximately 2.9 million shares of our common stock and issued new options with an exercise price of $0.63 per share (the average of the daily closing prices of our common stock during the month prior to the approval of the changes by the board, December 2002). The offer to cancel and reissue these stock options was made during the quarter ended March 31, 2003. We accounted for this offer in accordance with the provisions of SFAS No. 123, and charges related to this offer are included in the approximately $25.9 million of stock-based compensation recorded for new grants for the nine months ended September 30, 2003.

The board’s primary basis for approving these changes to the program was to stabilize and retain a core group of our managers in the wake of the major reductions in force that we have implemented and to restore incentives for their future performance. The board determined among other things that elimination of the loans would help address morale and productivity issues affecting the continuing non-executive senior managers and that the re-pricing of the stock options held by our non-executive senior managers would realign their equity incentives with future shareholder value.