UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31,June 30, 2006

Commission File Number: 000-25291

TUT SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (971)217-0400

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act:

Large accelerated filer  ¨                    Accelerated filer  ¨                    Non-accelerated filer  x

Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):     Yes  ¨    No  x

As of May 5,August 17, 2006, 33,680,99033,782,193 shares of the Registrant’s common stock, par value $0.001 per share, were issued and outstanding.

TUT SYSTEMS, INC.

FORM 10-Q

INDEX

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

(unaudited)

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

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.

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.

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. Additionally, the Company designs, develops and markets private broadband network 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.

In November 2002, the Company acquired VideoTele.com, referred to in this report as VTC, from Tektronix, Inc. to extend its product offerings to include digital video processing systems. On June 1, 2005, the Company acquired Copper Mountain Networks, Inc., referred to in this report as Copper Mountain, for its additional product and engineering resources to further address the Company’s expanding video market opportunities. The Company does not expect significant future revenue from the sale of Copper Mountain’s historical product line. 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, 2006, the Companycompany incurred a net loss of $3,136$7,779 and negative cash flows from operating activities of $3,184,$6,846, and has an accumulated deficit of $316,294$320,937 at March 31,June 30, 2006. Management believes that its cash and cash equivalents and availability under the credit facility as of March 31, 2006 are sufficientThe Company will require additional capital to fund its operating activities andoperations as it believes that it does not have sufficient capital expenditure needsas of June 30, 3006 to fund its operations for at least the next twelve months. However,There can be no assurance that capital will be available on acceptable terms, if at all. Management’s plans with regard to those matters include seeking additional financing arrangements in the event that the Company does not meet its revenue and earnings expectations, the Company may requireform of either equity or additional cash to fund operations.debt obligations. Failure to generate positive cash flow in the future wouldsufficient revenues, raise additional capital or reduce certain discretionary spending could have a materialan adverse effectimpact on the Company’s ability to achieve its intendedlong-term business objectives.

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Basis of presentation

The accompanying condensed consolidated financial statements as of December 31, 2005 and March 31,June 30, 2006 and for the three and six months ended March 31,June 30, 2005 and 2006 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements, except for the adoption of Statement of Financial Accounting Standard No. 123R, “Share-Based Payment (Revised 2004)” (SFAS No. 123R) on January 1, 2006, as described in Note 10 - 11—Stock Based Compensation. In the opinion of management, the unaudited interim condensed consolidated financial statements reflect,reflect all adjustments, which include only normal recurring adjustments, necessary to state fairly the Company’s financial position as of December 31, 2005 and March 31,June 30, 2006, its results of operations for the three and six months ended March 31,June 30, 2005 and 2006 and its cash flows for the threesix months ended March 31,June 30, 2005 and 2006. 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, filed with the Securities and Exchange Commission on February 23, 2006. The balance sheet as of December 31, 2005 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, 2006 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2006.

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, revenue is generated from the sale of video processing systems and components and the sale of private broadband network products.

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

Revenue is also generated from the sale of video processing component products, the sale of private broadband network products, and the sale of certain legacy products acquired with the Copper Mountain merger. The Company sells these products through its own direct sales channels and also through distributors.

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 post contract support (or 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. In connection with certain contracts, the Company may perform the work prior to when the revenue is billable pursuant to the contract. The termination clauses in most of the Company’s contracts provide for the payment for the fair value of products delivered and services performed in the event of an early termination. In connection with certain of the Company’s contracts, it has recorded unbilled receivables consisting of costs and estimated profit in excess of billings as of the balance sheet date. Many of the contracts which give rise to unbilled receivables at a given balance sheet date are subject to billings in the subsequent accounting period. Management reviews unbilled receivables and related contract provisions to ensure it is justified in recognizing revenue prior to billing the customer and that we have objective evidence which allows it to recognize such revenue. 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, direct sale of broadband transport products and service management products and the sales of legacy products acquired with the Copper Mountain merger, 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.

Management must make significant judgments and estimates 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 with whom the Company has 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, revenue is recognized on a cash-collected basis.

The Company also maintains accruals and allowances for 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.

Should changes in conditions cause us to determine that the criteria for revenue recognition are not met for certain future transactions, revenue recognition for any reporting period could be adversely affected.

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.

Short-term investments

The Company’s short-term investments are stated at fair value, and are principally comprised of corporate debt securities. The Company classifies its investments as available for sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and states its investmentscarries them at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss). The specific identification method is used to determine the cost of securities disposed of, with realized gains and losses reflected in interest and other income (expense), net. A liquid market exists for these short-term investments.

Unbilled Receivables

Unbilled receivables (costs and estimated profit in excess of billings) may be recorded in connection with certain turnkey solution contracts. Unbilled receivables are not billable at the balance sheet date but are recoverable over the remaining life of the contract through billings made in accordance with contractual agreements. Management reviews unbilled receivables and related contract provisions to ensure the Company is justified in recognizing revenue prior to billing the customer and that there is objective evidence which allows the Company to recognize such revenue.

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. The Company assesses individual accounts receivable over a specific aging and amount. If the financial condition of any of the Company’s customers were to deteriorate, resulting in their inability to make payments, the Company would need to record an additional allowance.

Property and equipment

Property and equipment are stated at cost less accumulated depreciation. The Company provides for depreciation by charges to expense which are sufficient to write off the cost of the assets over their estimated useful lives on the straight-line basis. Leasehold improvements are amortized over the lesser of the lease term or the estimated useful life of the improvement. Useful lives by principal classifications are as follows:

When assets are sold or otherwise disposed of, the cost and accumulated depreciation are removed from the asset and accumulated depreciation accounts, respectively. Upon the disposition of property and equipment, the accumulated depreciation is deducted from the original cost and any gain or loss on that sale or disposal is credited or charged to income.

Maintenance, repairs, and minor renewals are charged to expense as incurred. Expenditures which substantially increase an asset’s useful life are capitalized.

Intangible assets

Intangible assets are stated at cost less accumulated amortization. Intangible assets consist of completed technology and patents, customer lists, maintenance contract renewals and trademarks. These intangible assets are amortized on a straight line basis over the estimated periods of benefit, which are as follows:

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 2005, the Company determined that certain long-lived assets and certain intangible long-lived assets were impaired and recorded losses accordingly under SFAS No. 144. No such impairment was recorded in the threesix months ended March 31,June 30, 2006. Future events could cause the Company to conclude that impairment indicators once again exist. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

Goodwill

Goodwill represents the excess of the purchase price of an acquired business over the fair value of the identifiable assets acquired and liabilities assumed. Management tests for impairment of goodwill on an annual basis and at any other time if events occur or circumstances change that would indicate that it is more likely than not that the fair value of the reporting unit has been reduced below its carrying amount.

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.

The impairment test for goodwill is a two-step process. Step one consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to the reporting unit. Measurement of the fair value of a reporting unit is based on one or more fair value measures including present value techniques of estimated future cash flows and estimated amounts at which the unit as a whole could be bought or sold in a current transaction between willing parties. If the carrying amount of the reporting unit exceeds the fair value, step two requires the fair value of the reporting unit to be allocated to the underlying assets and liabilities of that reporting unit, resulting in an implied fair value of goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss equal to the excess is recorded in net earningsincome (loss).

Accounting for stock based compensation

Effective January 1, 2006, the Company adopted SFAS No. 123R on a modified prospective basis. As a result, the Company has included stock-based compensation costs in its results of operations for the three and six months ended March 31,June 30, 2006, as more fully described in Note 10.11.

Reclassifications

Certain reclassifications have been made to prior year balances in order to conform to the current year presentation. Amortization of intangible assets relating to completed technology and patents have been reclassified from operating expenses to cost of goods sold. This reclassification did not affect cash flows, financial position or net loss.

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.

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 components of comprehensive loss:

NOTE 5—CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:

At December 31, 2005 and March 31,June 30, 2006, cash, cash equivalents and short term investments are summarized as follows:

The following is a summary of available-for-sale securities:

NOTE 6—ACQUISITIONS:

On June 1, 2005, the Company acquired 100% of the outstanding common stock of Copper Mountain for approximately $11,729. The purchase price consisted of 2,467 shares of the Company’s common stock valued in aggregate at $9,787, warrants to purchase the Company’s common stock valued at $58, acquisition related expenses consisting of legal, insurance and other professional fees of $1,503 and employee severance costs of $351. The value of the Company’s common stock was determined based on the average market price over the two day period before and after the acquisition was announced on February 11, 2005. The results of operations of Copper Mountain have been included in the consolidated statement of operations from June 1, 2005. The Company

acquired Copper Mountain for its additional product and engineering resources, which are being refocused to address the Company’s

expanding video market opportunities. The Company believes that the acquisition of Copper Mountain is accelerating the Company’s plans to address the growing number of opportunities in the market for video processing systems. During the three and six months ended March 31,June 30, 2006, the Company recognized revenue of $48$133 and $181, respectively, from the sale of legacy Copper Mountain’s products. The Company will honor Copper Mountain’s existing customer support agreements but does not expect significant future revenue from the sale of Copper Mountain’s historical product lines.

The Company determined the fair value of the acquired intangibles using established valuation techniques. The purchase price of $11,729 exceeded the fair value of the net assets acquired of $10,057, thereby resulting in goodwill of $1,672. The allocation of the purchase price was as follows:

Completed technology and patents are being amortized over a weighted average life of five years. Amortization of $341 and $682, respectively, has been included in cost of goods sold for the three and six months ended March 31,June 30, 2006. The goodwill of $1,672 will not be deductible for tax purposes.

The following unaudited pro forma consolidated information gives effect to the acquisition of Copper Mountain as if it had occurred on January 1, 2005 by consolidating the results of operations of Copper Mountain with the results of operations of the Company for the three and six months ended March 31,June 30, 2005.

		Three Months Ended June 30,				Six Months Ended June 30,
		2005				2005
Revenue		$	9,822			$	17,192
Net loss		$	(7,667	)		$	(16,160	)
Basic and diluted net loss per share		$	(0.29	)		$	(0.63	)

NOTE 7—BALANCE SHEET COMPONENTS:

Intangibles and other assets:

		As of December 31, 2005
		Gross Carrying Amount			Accumulated Amortization				Net Intangibles
Amortized intangible assets:
Completed technology and patents		$	13,681		$	(7,769	)		$	5,912
Customer list			86			(39	)			47
Maintenance contract renewals			50			(32	)			18
Trademarks			315			(142	)			173
		$	14,132		$	(7,982	)			6,150
Other non-current assets										155
									$	6,305
		As of June 30, 2006
		Gross Carrying Amount			Accumulated Amortization				Net Intangibles
Amortized intangible assets:
Completed technology and patents		$	13,681		$	(8,583	)		$	5,098
Customer list			86			(45	)			41
Maintenance contract renewals			50			(37	)			13
Trademarks			315			(165	)			150
		$	14,132		$	(8,830	)			5,302
Other non-current assets										173
									$	5,475

The aggregate amortization expense for the three months ended March 31,June 30, 2005 and 2006 was $376,$400, and $423 respectively.$424 respectively and $775 and $847 for the six months ended June 30, 2005 and 2006.

Minimum future amortization expense for subsequent years is as follows:

NOTE 8—INDEBTEDNESS

Line of Credit

On September 23, 2004, the Company entered into a revolving asset based credit facility (“credit facility”), with Silicon Valley Bank (“the Bank”) which was amended on December 29, 2005.2005 and modified in June 2006. This facility expires on September 23, 2007. Borrowings under the credit facility are formula based and limited to the lesser of $10.0 million or an amount based on a percentage of eligible accounts receivable and eligible inventories. The interest rate on outstanding borrowings is equal to the bank’s prime rate, 7.75%8.25% as of March 31,June 30, 2006, plus 0.5%1.75%. The rate may increase by 1.0% if the Company does not meet certain financial covenants. All of the Company’s assets are pledged as collateral and the credit facility contains various covenants. The Company was in compliance with these financial covenants as of March 31,June 30, 2006. Based on the maximum percentages of eligible accounts receivable and eligible inventory levels, the Company had borrowed the maximum amount of available borrowings under this facility were $9,746 as of March 31,June 30, 2006. In addition, this credit facility allows for long-term borrowings of up to $1.2 million for the purchase of fixed assets. The Company had outstanding borrowings under this facility of $8,149$7,711 against the revolving credit facility at March 31,June 30, 2006.

Note Payable

As part of the Company’s acquisition of VTC from Tektronix, Inc. in November 2002, the Company issued a note payable to Tektronix, Inc. for $3,232, with repayment in sixty months, or November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest was added to the principal balance of the note. Thereafter, the Company 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. As of March 31,June 30, 2006, this note payable balance, including accrued interest, was $4,203.$4,221. The Company paid $65 of interest in the three and six months ended June 30, 2006.

NOTE 9—RESTRUCTURING COSTS

In April 2006, the Company announced a restructuring program that included a workforce reduction and closing of the UK office. As a result of this restructuring program, the Company recorded restructuring costs of $359 consisting of severance payments and office closure costs. As of June 30, 2006, there were $12 of costs remaining to be paid in the third quarter of 2006.

NOTE 10—COMMITMENTS AND CONTINGENCIES:

Lease obligations

The Company leases office, manufacturing and warehouse space under noncancelable operating leases that expire in 2007 and 2010. In January 2006, the Company entered into a lease agreement for a facility in San Diego, California that expires in February, 2010. The Company also leases certain office equipment under capitalized lease obligations that expire in 2008.

Minimum future lease payments under operating and capital leases at March 31,June 30, 2006 are as follows:

		Operating Leases			Capital Leases
2006		$	593		$	30
2007			1,076			59
2008			330			44
2009			404			—
2010			61			—
		$	2,464			133
Less amount representing interest						(10	)
						123
Less current portion						(56	)
					$	67

Rent expense for the three months ended March 31,June 30, 2005 and 2006 was $317$364 and $370 respectively.$311 respectively and $681 for both the six months ended June 30, 2005 and 2006. At March 31,June 30, 2006, the cost of the leased capital assets were $168 with accumulated amortization of $28$42 resulting in a net book value of leased capital assets of $140.$126.

Purchase commitments

The Company had noncancelable commitments to purchase finished goods inventory totaling $450 and $586$1,155 in aggregate at December 31, 2005 and March 31,June 30, 2006, respectively. These purchase commitments represent outstanding purchase orders submitted to the Company’s third party manufacturers for goods to be produced and delivered to the Company in 2006.

Contingencies

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 Litigation. The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’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.

In June 2004, a stipulation of settlement for the claims against the issuer-defendants, including the Company, was submitted to the Court in the In Re Initial Public Offering Securities Litigation. On August 31, 2005, the Court granted preliminary approval of the settlement. The settlement is subject to a number of conditions, most of which are outside of the Company’s control, including final approval by the Court. The underwriters 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 stipulation of settlement.

The stipulation of settlement 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, including the number of issuer-defendants that ultimately participate in the final settlement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants.

In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation

Copper Mountain, which the Company acquired on June 1, 2005, was in December 2001, along with certain of its officers and directors, named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation, Case No. 01-CV-10943 alleging violations of securities law under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Exchange Act. As a result of the acquisition, the Company has inherited the responsibility and obligations of Copper Mountain to defend the claims in that case and the Company is exposed to any liability that may come out of the claims. The Copper Mountain action described in this paragraph like the Whalen action described above has been coordinated for pretrial purposes under

the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Copper Mountain action were also dismissed without prejudice pursuant to the 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 granting in part and denying in part Copper Mountain’s motion to dismiss. Thereafter, Copper Mountain entered into the same stipulation of settlement as the Company did in the Whalen action described above. TheCopper Mountain stipulation of settlement is subject to the same terms, conditions and contingencies as the stipulation of settlement the Company entered into with respect to the Whalen action described above.

In the event that all or substantially all of the issuer-defendants participate in the final settlement, the amount that may be paid to the plaintiffs on behalf of the Company could range from zero to approximately $7.0 million which consists of the approximately $3.5 million from theCopper Mountain action described above and approximately $3.5 million from theWhalen action described above, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties and the amount of insurance available under the Company’s applicable insurance policies. If the plaintiffs recover at least $1 billion from the underwriter-defendants, no settlement payments would be made on behalf of the Company 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 its entire share of any payments towards satisfying its share of plaintiffs’ $1 billion recovery amount. Management estimates that its range of loss relative to this matter is zero to $7.0 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, 2006, the Company has not accrued a liability for this matter.

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.

NOTE 10—11—STOCK-BASED COMPENSATION

Stock option plans

In November 1993, the Company adopted the 1992 Stock Plan (the “1992 Plan”), under which the Company may grant both incentive stock options and nonstatutory stock options to employees, consultants and directors. Options issued under the 1992 Plan can have an exercise price of no less than 85% of the fair market value, as defined under the 1992 Plan, of the stock at the date of grant. The 1992 Plan, including amendments, allows for the issuance of a maximum of 178 shares of the Company’s common stock. This number of shares of common stock has been reserved for issuance under the 1992 Plan. The Company is no longer granting stock options from the 1992 Plan. As stock options are terminated or cancelled from the 1992 Plan, the stock options are being retired and are no longer available for future grant.

The Company’s 1998 Stock Plan (the “1998 Plan”) was adopted by the Board of Directors in July 1998 and was approved by the stockholders in September 1998 and has rights and privileges similar to the 1992 Plan. The 1998 Plan allows for the issuance of a maximum of 1,000 shares of the Company’s common stock with annual increases starting in 2000, subject to certain limitations. In January 2000, the 1998 Plan was amended to increase the maximum number of shares that may be issued to 1,358. In January 2001, January 2002, September 2004, January 2005, August 2005 and January 2006, the 1998 Plan was amended to increase the maximum number of shares that may be issued by 375 to 1,733. In January 2002, the 1998 Plan was amended to increase the maximum number of shares by 375 to 2,108. In January 2005, the 1998 Plan was amended to increase the maximum number of shares by 375 to 2,483. In August 2005, the 1998 Plan was amended to increase the maximum number of shares by 500 to 2,983. In January 2006, the 1998 Plan was amended to increase the maximum number of shares by 375 to 3,358.4,108.

The Company’s 1999 Nonstatutory Stock Option Plan (the “1999 Plan”) was adopted by the Board of Directors in December 1999. The 1999 Plan allows for the issuance of a maximum of 1,000 shares of the Company’s common stock. Additions to the Plan may be approved by the Board of Directors. The 1999 Plan has rights and privileges similar to the 1998 Plan. In April 2000, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 1,425. In October 2000, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 1,825. In October 2002, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 2,625. In August 2005, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 3,125.

Generally, stock options are granted with vesting periods of four years and have an expiration date of ten years from the date of grant. However, in the event of a change in control, as defined in our Change in Control plans adopted June 2000, employees who are terminated as a direct result of the change in control will be entitled to certain separation benefits including acceleration of unvested options ranging from six months to full vesting and severance pay ranging from one to eighteen months. Benefits may be limited in certain circumstances due to certain tax code provisions.

Stock Option Activity

The following is a summary of options activities:

At March 31,June 30, 2006 options to purchase 4,5484,993 shares of common stock were unexercised. The weighted average exercise price of these options was $5.00$4.73 per share and the aggregate intrinsic value was $3,469.$1,604. The weighted-average remaining term was 6.957.09 years.

At March 31,June 30, 2006 vested options to purchase 4,2894,151 shares of common stock were unexercised. The weighted average exercise price of these options was $5.14$5.12 per share and the aggregate intrinsic value was $3,371.$1,587. The weighted-average remaining contractual term was 6.836.58 years.

Total unrecognized compensation cost as of March 31,June 30, 2006 was $461.$1,524. The weighted-average remaining contractual termrecognition period was 1.181.65 years.

The weighted average exercise price of options granted during the three and six months ended March 31,June 30, 2006 was $3.04$2.80 and $2.81 per share. The total cash received from employees as a result of employee stock option exercises during the three and six

months ended March 31,June 30, 2006 was approximately $248.$68 and $319. The intrinsic value of these options for the three and six months ended June 30, 2006, was $277.$68 and $345, respectively. In connection with these exercises, there was no tax benefit realized by the Company due to the Company’s current loss position. The Company issues new shares of common stock upon exercise of stock options.

The following table summarizes information about stock options outstanding at March 31,June 30, 2006:

SFAS No.123R

Effective January 1, 2006, the Company adopted SFAS No. 123R on a modified prospective basis. Under the modified prospective application, prior periods are not revised for comparative purposes. The valuation provisions of SFAS No. 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date will be recognized over the remaining service period using the compensation cost previously calculated for pro forma disclosure purposes under FASB Statement No. 123.

Periods prior to adoption of SFAS No. 123R

Prior to the adoption of SFAS No. 123R, the Company accounted for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” Financial Accounting Standards 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 SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” The Company generally did not recognize stock-based compensation expense in its statement of operations for periods prior to the adoption of SFAS No. 123R as most options granted had an exercise price equal

to the market value of the underlying common stock on the date of grant. The Company amortized 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 net loss 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.

The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123R123 to options granted under the Company’s stock-based compensation plans prior to the adoption. For the purposes of this pro forma disclosure, the value of options was estimated using a Black-Scholes valuation model and amortized on a straight-line basis over the vesting periods of the awards. Disclosures for the threesix months ended March 31,June 30, 2006 are not presented because stock-based payments were accounted for under SFAS No. 123R’s fair value method during this period.

Adoption of SFAS No. 123R

Under SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the awards and is recognized as expense over the employee’s requisite service period. The Company has no awards with market or performance conditions.

As required by SFAS No. 123R, management has made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

On December 29, 2005, the Board of Directors approved full acceleration of unvested stock options with an exercise price of $3.02 or greater, previously granted under the Company’s 1998 Stock Option Plan and 1999 Non-statutory Stock Option Plan held by Company officers and employees. Options to purchase approximately 876,550 shares of the Company’s common stock, including approximately 126,390 shares held by the Company’s named executive officers, were subject to acceleration effective as of December 29, 2005. The closing market price per share of the Company’s common stock on December 29, 2005 was $3.10 and the exercise price of the approximately 876,550 in unvested options on that date ranged from $3.02 to $6.16, with a weighted exercise price of $3.95. As a result, stock based compensation expense in periods subsequent to the acceleration will be significantly reduced.

During the three and six months ended March 31,June 30, 2006, the Company granted approximately 41,500679 and 735 options, respectively, with an estimated total grant-date fair value of $91.$1,373 and $1,464. During the three and six months ended March 31,June 30, 2006, the Company recorded stock-based compensation related to stock options of $101$278 and $378, respectively, for the options that vested during the three and six months ended March 31,June 30, 2006. There was no income benefit realized because of the Company’s loss position.

As a result of adopting SFAS No. 123R on January 1, 2006, our net loss for the three-monththree-and six month ended March 31,June 30, 2006, is $101$236 and $337, respectively, higher than had we continued to account for stock-based employee compensation under APB No. 25. The adoption of SFAS No. 123R did not have a material impact on basic and diluted net loss per share for the three months ended March 31,June 30, 2006. The adoption of SFAS No. 123R had no impact on cash flows from operationsoperating or financing.financing activities.

Valuation Assumptions

In connection with the adoption of SFAS No. 123R, the Company estimated the fair value of stock options using a Black-Scholes valuation model. The following table outlines the weighted average assumptions for both the stock options granted and the purchase rights issued:

		Stock Option Plans Three Months Ended June 30,						Employee Stock Purchase Plan Three Months Ended June 30,
		2005			2006			2005			2006
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		3.7	%		4.9	%		3.7	%		5.0	%
Expected volatility		87.0	%		79.0	%		87.0	%		39.0	%
Expected life (in years)		4.0			6.25			0.5			0.5

Expected Term: The expected term was calculated in accordance with the simplified method stated in Staff Accounting Bulletin (SAB) 107. The expected term represents the period that the Company’s stock-based awards are expected to be outstanding.

Expected Volatility: The volatility factor was based on the Company’s historical stock prices for the four years from 2002 to 2005.

Expected Dividend: The Company has not paid any dividends and does not anticipate paying any dividends. Accordingly, an expected dividend yield of 0% was used.

Risk-Free Interest Rate: The Company bases the risk-free interest rate used in the Black Scholes valuation method on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of the Company’s stock-based awards do not correspond with the terms for which interest rates are quoted, the Company performed a straight-line interpolation to determine the rate from the available maturities.

Estimated Pre-vesting Forfeitures: When estimating forfeitures, the Company considers historical voluntary and involuntary terminations prior to vesting.

Restricted Stock

In connection with restricted shares granted upon the acquisition of Copper Mountain, the Company recorded deferred stock compensation which was calculated as the fair market value of the Company’s common shares on the dates the awards were granted. This stock compensation was being amortized on a straight-line basis over the vesting periods of the underlying stock rewards. Through March 31,June 30, 2006, the Company had amortized approximately $71$76 of such compensation expense, with $7$4 and $11 being recorded in the three and six months ended March 31,June 30, 2006. These restricted shares are expected to fully amortize over the next sixthree months.

In May and June 2006, the Company issued restricted shares to the directors of the Company. The stock compensation is being amortized on a straight-line basis over the vesting periods of the underlying stock rewards. Through June 30, 2006, the Company had amortized approximately $9 of such expense, recorded in the three months ended June 30, 2006. These restricted shares are expected to fully amortize over the next three years.

A summary of the status of the Company’s unvested restricted shares as of March 31,June 30, 2006 and changes during the threesix months ended March 31,June 30, 2006 is presented below:

NOTE 11—12—SEGMENT INFORMATION:

Revenue

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. Revenue relating to the private broadband network products was $1,142$1,260 and $999$1,151 for the three months ended March 31,June 30, 2005 and 2006, respectively. Revenue relating to the private broadband network products was $2,402 and $2,150 for the six months ended June 30, 2005 and 2006, respectively. Revenue related to video processing systems was $5,911$6,902 and $10,475$6,811 for the three months ended March 31,June 30, 2005 and 2006, respectively. Revenue related to video processing systems was $12,813 and $17,286 for the six months ended June 30, 2005 and 2006, respectively. Revenue related to legacy product sales from the Copper Mountain merger was $48$1,512 and $133 for the three months ended March 31, 2006.June 30, 2005 and 2006, respectively. Revenue related to legacy product sales from the Copper Mountain merger was $1,512 and $181 for the six months ended June 30, 2005 and 2006, respectively. Revenues are attributed to the following countries based on the location of customers:

Two customers, FTC ManagementOne customer, Iowa Network Services, Inc. and Major League Baseball Advanced Media accounted for 23%13% and 11%10%, respectively of the Company’s revenue for the three and six months ended March 31, 2005. Huawei Technologies Company Ltd. and Hutchinson Telephone Company eachJune 30, 2006. One customer, FTC Management, Inc. accounted for 11%15.1% of the Company’s revenue for the six months ended June 30, 2005. No individual customer accounted for greater than 10% of the Company’s revenue for the three months ended March 31, 2006.June 30, 2005.

Products

The Company designs, develops, and sells video processing systems and private broadband network 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 private broadband network products enable the transmission of broadband data over existing hotels and private campus networks.

NOTE 12—SUBSEQUENT EVENT:

In April 2006, the Company announced a restructuring program that included a workforce reduction The workforce reduction represents approximately 8% of the Company’s employees. As a result of the restructuring the Company recorded a restructuring charge of $240 in April 2006 which primarily comprised of severance and benefit costs.

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 the number of IPTV subscribers will grow significantly by the end of 2009 and that this market space will continue to become more competitive, (2) our expectation that we will compete with larger public companies as we begin to target larger telco customers, (3) our expectation that digital subscriber line or DSL technology will continue to dominate telco broadband networks for the foreseeable future, (4) our expectation that demand for our products will increase, (5) our expectation that our sales and marketing expenses will increase in 2006, (6) our expectation that sales of private broadband network products will increase for the remainder of 2006 (7) our expectation that capital expenditures for research and development will be comparable with 2005 expenditures, (8) our expectation that capital expenditures in 2006 will be comparable with 2005 expenditures and that these capital expenditures will be funded from cash, cash equivalents and availability under the credit facility, (9) our belief that our cash and cash equivalents and availability under the credit facilitywe do not have sufficient capital as of March 31,June 30, 2006 are sufficient to fund our operating activities and capital expenditure needsoperations for the next twelve months, (10) our expectation that we will incur losses in the near future, (11) our expectation that some competitors will market some of their products for use in TV over DSL applications, (12) our anticipation that our sales and operating margins will continue to fluctuate, (13) our anticipation that we will generally continue to invoice foreign sales in U.S. dollars, (14) our intention to continue to evaluate new acquisition candidates, divesture and diversification strategies, and (15) our expectation that customers outside of the United States will represent a significant and growing portion of our revenue, (16) our expectation that research and development expenditures will be less than expenditures incurred in 2005.

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.

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 private broadband network 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

In November 2002, we acquired VideoTele.com, referred to in this report as VTC, from Tektronix, Inc. to extend our product offerings to include digital video processing systems. On June 1, 2005, we acquired Copper Mountain Networks, Inc., referred to in this report as Copper Mountain, for its technology and engineering resources which we have refocused to further address our expanding video market opportunities for delivering advanced video services over coax and fiber networks.

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 and governments, and by selling private broadband network products directly and through distributors to the hospitality industry and to owners of private multi-tenant campus facilities.

For the three months ended March 31,June 30, 2005 and 2006, international sales represented 18.0%15.6%, and 19.2%10.4% of our total sales, respectively. For the six months ended June 30, 2005 and 2006, international sales represented 16.6% and 15.5% of our total sales, respectively.

Material Trends and Uncertainties

We pay close attention to and monitor various trends and uncertainties about our business. There is a growing demand by independent operating telephone companies to offer video services to their customer base. According to a recent release from Infonetics Research in November 2005, the number of IPTV subscribers worldwide is expected to grow to over 53.7 million by the end of 2009. While this growing market presents opportunities to serve a larger customer base, we are also encountering increasing 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. Our immediate competitors in the digital TV headend markets have been primarily small private companies that were focused on a narrower product line than ours and thereby may have been able to devote substantially more targeted resources to developing, marketing and selling new products than we are able to. Certain of these companies have become targets for acquisition by larger companies, in which case we may face competitors with substantially greater name recognition, and technical, financial and marketing resources than we have. This increased competitive pressure may adversely affect the amount and timing of our revenue in future periods, thereby making it more difficult for us to accurately forecast our future revenue, and may also adversely affect our product margins.

The emergence of new technologies to serve the digital TV headend market means that we must continue to invest in these technologies to remain competitive. Digital subscriber line, or DSL, technologies use sophisticated signal blending techniques to transmit data through copper wires. The limitations on the amount of data that can be transmitted in a fixed amount of time (such limitations are referred to as bandwidth) and the distance data may be transmitted using copper wire constrain both the number of video channels that may be delivered simultaneously and the number of customers that are reachable from a telco central office over a DSL network. Advancements in video compression technology are now enabling high quality video streams to be transported at lower data transfer rates than has been previously available. These compression advancements also allow for the delivery of high-definition television over bandwidth constrained asymmetric DSL, or ADSL, lines for the first time. ADSL is a technology that allows more data to be transmitted over existing copper telephone lines compared with standard DSL. Additionally, DSL advancements are emerging that expand the available bandwidth from the telco to the subscriber thereby supporting higher DSL data transfer rates over longer distances. As our products continue to incorporate new technological advancements, we expect the demand for our products will increase because our products will enable more telcos to reach more of their customers with a greater number of video channels and features over their DSL networks. However, because of the increasing competition in the markets in which we compete, regardless of our revenue and product margins in future periods, we will continue to devote significant resources to research and development in future periods in order to enable us to offer our customers competitive products that incorporate these emerging technologies. We expect our research and development expenses in 2006 to be less than research and development expenditures we incurred in 2005, since we recently completed a major product development cycle and restructuring.

As we continue to capitalize on the growing number of telcos deploying video services in the United States and abroad, we will continue to aggressively market our new and existing products and expand our marketing and sales efforts domestically and internationally. Nevertheless, our sales activities have been and will continue to be subject to competitive market pressure. We believe that in certain competitive markets, our prospective customer purchase decisions continue to be impacted by lengthening of the purchase decision because of several factors that are affecting the overall digital TV headend market. Such factors include, but are not limited to, the delays in the introduction of advanced compression technology set top boxes, the transition to more efficient data transmission technologies and the emergence of video signal encryption requirements. Nevertheless, given the opportunities offered by the growing number of our target customers deploying or enhancing video services and despite the length of the sales cycle, we expect our sales and marketing expenses to increase in 2006 compared to our spending in 2005.

Definitions for Discussion of Results of Operations

Our discussion of our results of operations focuses on the following items from our income statement: Revenue consists of sales of our video processing systems, which includes both digital TV headend and video transmission systems. Revenue also includes sales of our private broadband network products. Since our acquisition of VTC, a large part of our revenue has been associated with the sale of digital TV headends. Furthermore, each individual headend sale has represented a significant portion of our revenue. If we were to sell even one less system than our forecasted number of headend sales, our revenue would be materially impacted. 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: