UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

 

 

 

COMMISSION FILE NUMBER: 0000-24647

 

 

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

2450 WALSH AVENUE

SANTA CLARA, CALIFORNIA 95051

(408) 235-5500

(Address, Including Zip Code, and Telephone Number,
Including Area Code, of the Registrant’s Principal Executive Offices)

 

 

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

COMMON STOCK, par value $0.001 per share

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 requirement for the past 90 days.  Yes o     No þ

 

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

 

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. (Check one).

Large Accelerated Filer o     Accelerated Filer þ     Non-Accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).  Yes o     No þ

 

The aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant was approximately $186,172,000 on June 30, 2006. For purposes of this calculation only, the registrant has excluded stock beneficially owned by directors and officers and owners of more than ten percent of its common stock. By doing so, the registrant does not admit that such persons are affiliates within the meaning of Rule 405 under the Securities Act of 1933 or for any other purpose.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: Common Stock, $0.001 par value, 77,637,177 shares outstanding as of November 30, 2006.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None

 

 

INDEX

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

 

The Company’s Annual Report on Form 10-K (Form 10-K) for the year ended December 31, 2005, includes restated and audited consolidated financial statements for the years ended December 31, 2004 and 2003, restated financial statements for the year ended December 31, 2002, and adjusted financial statements for the year ended December 31, 2001. This Form 10-K also includes information for the quarterly periods ended September 30, 2005 and December 31, 2005 and the restated quarterly information for the first two quarters of 2005 and for the four quarters of 2004. This information is disclosed in Note 3, “Restatement of Consolidated Financial Statements,” and Note 18, “2005 Unaudited Condensed Consolidated Quarterly Information,” to Consolidated Financial Statements.

Background of the Restatement

 

On November 7, 2005, the Company announced that it initiated a review of its revenue recognition policies after determining that certain revenues recognized in the second half of the year ended December 31, 2004 from a customer may have been recorded in incorrect periods. The review included the Company’s revenue recognition policies and practices for current and past periods and its internal control over financial reporting. Additionally, the Audit Committee of the Board of Directors (Audit Committee) conducted an independent inquiry into the circumstances related to the accounting treatment of certain of the transactions at issue and retained independent legal counsel to assist with the inquiry.

 

On March 1, 2006, the Company announced that the Audit Committee had completed its independent inquiry and that the Company would restate its consolidated financial statements for the year ended December 31, 2004 and for the four quarters of 2004 and the first two quarters of 2005. The principal findings of the Audit Committee review were: there was no intent by Company personnel to recognize revenue in contravention of what Company personnel understood to be the applicable rules at the time; that Company personnel did not consider or sufficiently focus on relevant accounting rules; and there was no intent by Company personnel to mislead the Company’s auditors or engage in other wrongful conduct. Additionally, the Audit Committee and management reviewed the Company’s revenue recognition practices and policies as they related to the delivery of certain products and services (including the development and customization of software) to Thomson Broadcast (Thomson) under a series of contractual arrangements (Thomson Contract). The Company had recognized revenue under this series of contractual arrangements under two separate revenue arrangements in accordance with Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition” (SAB 101), as amended by SAB No. 104 (SAB 104). However, based on the guidance under American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2), SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1), SAB 104 and Financial Accounting Standards Board (FASB), Emerging Issues Task Force (EITF) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (EITF 00-21), management determined that this series of contractual arrangements should have been treated as a single contract, and therefore a single revenue arrangement for accounting purposes. Factors that contributed to the determination of a single revenue arrangement included the documentation of the series of contractual arrangements under a single memorandum of understanding (MOU) and the ongoing nature of discussions between parties to define product specifications and deliverables that extended beyond the initial agreed upon contracted deliverables. Additionally, the Company determined it could not reasonably estimate progress towards completion of the project, and therefore, in accordance with SOP 81-1, used the completed contract method. As a result, revenue previously recognized in the third and fourth quarters of 2004 and in the first two quarters of 2005 under this series of contractual arrangements was deferred and ultimately recognized as revenue in the quarter ended December 31, 2005 upon completion of the Thomson Contract and final acceptance received from Thomson for all deliverables under the Thomson Contract. Direct contract expenses, primarily research and development, associated with the completion of the project previously recognized in each quarter of 2004 and in the first two quarters of 2005 were also deferred and ultimately recognized in the quarter ended December 31, 2005 in accordance with the completed contract methodology under SOP 81-1.

 

On March 1, 2006, the Company announced a further review of the Company’s revenue recognition policies relating to the recognition of products and related software sold in conjunction with post-contract support (PCS) under SOP 97-2, SAB 104, EITF 00-21 and FASB Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts.” As a result, management determined that the Company did not account properly for the sale of digital video products under SOP 97-2 and did not establish vendor specific objective evidence (VSOE) of fair value for its PCS revenue element related to these sales. Accordingly, revenue for digital video products sold in conjunction with PCS and previously recognized as separate elements in each quarter of 2003 and 2004, and also in the first and second quarters of 2005, was deferred and recognized ratably over the contract service period.

 

On November 8, 2006, the Company announced that the Audit Committee, upon the recommendation of management, had concluded that the Company’s consolidated financial statements for the years ended December 31, 2003, 2002 and 2000 and for the quarters of 2003, 2002 and 2000 should no longer be relied upon. The restatement of financial statements for 2003 would correct errors primarily relating to revenue

recognition, cost of goods sold and estimates of reserves. The restatement of financial statements for 2000 and 2002 would correct errors primarily relating to the need to separately value and account for embedded derivatives associated with the Company’s 5% convertible subordinated notes issued in July 2000, and other estimates. While no determination was made that the financial statements for 2001 could not be relied upon, adjustments would be made to 2001 that would be reflected in the financial statements to be included in its periodic reports to be filed with the Securities and Exchange Commission (Commission) and reported as “adjusted.”

 

The Company’s previous auditors resigned effective as of September 21, 2005 and on that date, the Audit Committee engaged Stonefield Josephson, Inc. (Stonefield) as the Company’s new independent registered public accounting firm. On May 26, 2006, the Company announced that it had engaged Stonefield, its current independent auditor, to also re-audit the Company’s consolidated financial statements for the year ended December 31, 2004 and, if necessary, to re-audit the Company’s consolidated financial statements for the year ended December 31, 2003. On November 8, 2006, the Company announced that it had engaged Stonefield to re-audit the Company’s consolidated financial statements for the year ended December 31, 2003.

 

In June 2006, the Company, through outside counsel, retained FTI Consulting, Inc. to provide an independent accounting perspective in connection with the accounting issues under review.

 

In connection with the Company’s accounting review of the Thomson Contract, the Commission initiated a formal investigation. This matter was previously the subject of an informal Commission inquiry. The Company has been cooperating fully with the Commission and will continue to do so in order to bring the investigation to a conclusion as promptly as possible.

 

Restatement of Historical Financial Statements

 

The following is a description of the significant adjustments to previously reported financial statements resulting from the restatement process and additional matters addressed in the course of the restatement. While this description does not purport to explain each correcting entry, the Company believes that it fairly describes the significant factors underlying the adjustments and the overall impact of the restatement in all material respects.

 

Revenue Recognition.  The Company did not properly account for revenue as described below. As part of the restatement process, the Company applied the appropriate revenue recognition methods to each element of all multiple-element contracts, corrected other errors related to revenue recognition and corrected errors to other accounts, including cost of goods sold and deferred revenue resulting in adjustments to these accounts in each period covered by the restatement.

 

Video Product and Post Contract Support.  The Company did not properly recognize revenue in accordance with generally accepted accounting principles (GAAP), specifically SOP 97-2 for its digital video products. The Company previously recognized revenue for its digital video products in accordance with SAB 101, as amended by SAB 104 based upon meeting the revenue recognition criteria in SAB 104. In order for the Company to recognize revenue from individual elements within a multiple element arrangement under SOP 97-2, the Company must establish vendor specific objective evidence (VSOE) of fair value for each element. The Company determined that it did not establish VSOE of fair value for the undelivered element of PCS on the digital video products. Therefore, as part of the restatement process the Company corrected this error and recognized revenue of the hardware element sold in conjunction with the undelivered PCS element ratably over the period of the customer support contract. The cost of goods sold for the sale for the hardware element and the PCS element was also recognized ratably over the period of the customer support contract. Accordingly, revenue and cost of goods sold previously recognized based on meeting the revenue recognition criteria in SAB 104 for the individual elements for digital video products sold in conjunction with PCS in each quarter of 2003, 2004 and 2005 were deferred and recognized ratably over the contract service period.

 

Thomson Contract.  The Company recognized revenue as it related to the delivery of certain products and services (including the development and customization of software) to Thomson under a series of contractual arrangements in accordance with SAB 101, as amended by SAB 104. However, based on SOP 97-2 and SOP 81-1, this series of contractual arrangements under a single memorandum of understanding (MOU) should have been treated as a single contract, and therefore as a single revenue arrangement for accounting

purposes. Factors that contributed to the determination of a single revenue arrangement included the documentation of the series of contractual arrangements under a single MOU and the ongoing nature of discussions between parties to define product specifications and deliverables that extended beyond the initial agreed upon contracted deliverables. In accordance with SOP 81-1, the Company determined it could not reasonably estimate progress towards completion of the project and therefore used the completed contract methodology. As a result, $7.8 million of revenue previously recognized in the third and fourth quarters of 2004 and $0.3 million of revenue previously recognized in the first two quarters of 2005 were deferred and ultimately recognized as revenue in the quarter ended December 31, 2005 upon completion of the Thomson Contract and final acceptance received from Thomson for all deliverables under the Thomson Contract. Additionally, $1.2 million of cost of goods sold previously recognized in 2004 and $1.8 million related to direct development costs previously recognized from the fourth quarter of 2003 through the second quarter of 2005 were also deferred and ultimately recognized in the quarter ended December 31, 2005.

 

Inventory Consignment.  During the quarter ended December 31, 2003, the Company entered into an agreement to consign specific spare parts inventory to a certain customer for the customer’s demonstration and evaluation purposes. The consignment period was to terminate during the quarter ended March 31, 2004, at which time the customer would either purchase or return the spare parts inventory to the Company. During the quarter ended March 31, 2004, the Company notified the customer that the consignment period terminated and in accordance with the agreement, the customer should either return or purchase the spare parts inventory. The Company did not receive a reply and subsequently invoiced the customer $0.9 million for the spare parts inventory in the quarter ended March 31, 2004. During the quarter ended June 30, 2004, the customer agreed to purchase a portion of the spare parts inventory and returned the remaining spare parts inventory to the Company. Accordingly, for the quarter ended June 30, 2004, the Company issued the customer a credit memo for $0.9 million, which was the amount of the sale that was invoiced in the quarter ended March 31, 2004 and was the entire amount originally consigned to the customer. During the course of the restatement, it was determined that at March 31, 2004, accounts receivable was overstated by $0.9 million, inventory was understated by $0.5 million and both deferred revenue and deferred cost of goods sold were overstated by $0.9 million and $0.5 million, respectively. As a result, the consolidated balance sheets for the quarters ending March 31, 2004 and June 30, 2004 were appropriately revised to correct these errors.

 

Other Revenue Adjustments.  The Company also made other adjustments in 2003, 2004 and 2005 to correct the recognition of revenue for transactions where the Company did not properly apply SAB 101, as amended by SAB 104. The Company made other immaterial adjustments for certain transactions related to revenue. See Note 3, “Restatement of Consolidated Financial Statements,” to Consolidated Financial Statements.

 

Allowance for Doubtful Accounts.  During the restatement process, the Company reassessed its accounting regarding the allowance for doubtful accounts based on its visibility of its collections and write-offs of the allowance for doubtful accounts. Prior to 2004, the Company’s policy was to estimate the allowance for doubtful accounts and the corresponding bad debt expense based on a fixed percentage of revenue during a specific period. Beginning in 2004, the Company adopted a specific reserve methodology for estimating the allowance for doubtful accounts and corresponding bad debt expense. During the restatement, the Company adjusted the allowance for doubtful accounts and bad debt with a reduction of $5.2 million, an increase of $1.9 million and an increase of $0.6 million for the years ended December 31, 2000, 2001 and 2002, respectively, to reflect the specific reserve methodology and to correct errors resulting from the Company’s former policy. The Company made adjustments to the allowance for doubtful accounts of $0.1 million, $0.6 million, and $0.3 million for the years ended December 31, 2003 and 2004 and for the first two quarters of 2005, respectively.

 

In addition, during the restatement, the Company made other adjustments to the allowance for doubtful accounts to offset the accounts receivable and related reserve related to customers who were granted extended payment terms, experiencing financial difficulties or where collectibility was not reasonably assured. Accordingly, the Company classifies these customers as those with “extended payment terms” or with “collectibility issues.” For these customers, the Company historically deferred all revenue and recognized the revenue when the fee was fixed or determinable or collectibility reasonably assured or cash was received, assuming all other criteria for revenue recognition were met. The Company adjusted the allowance for doubtful accounts, eliminating the receivable and

related reserve, for these customers by an increase of $5.7 million, a decrease of $4.4 million and by an immaterial amount for the years ended December 31, 2003 and 2004 and for the first two quarters of 2005, respectively.

 

In summary, the above restatements gave rise to an adjustment to the allowance for doubtful accounts of an increase of $5.8 million, a decrease of $3.8 million and an increase of $0.3 million for the years ended December 31, 2003 and 2004 and for the first two quarters of 2005, respectively. The allowance for doubtful accounts related to international customers was reduced by $0.5 million based on the activity for the year ended December 31, 2004.

 

Deferred Revenues and Deferred Cost of Goods Sold.  As part of the restatement process, the Company determined that it did not properly account for deferred revenue as it related to specific transactions to certain customers where the transaction did not satisfy revenue recognition criteria of SAB 104 related to customers with acceptance terms, transactions with free-on-board (FOB) destination shipping terms, customers where the arrangement fee was not fixed or determinable or customers where collectibility was not reasonably assured. While revenue was generally not recognized for these customers, the Company improperly recognized a deferred revenue liability and a deferred cost of goods sold asset, thereby overstating assets and liabilities, and during the restatement determined that deferred revenues and deferred cost of goods sold should not be recognized for these transactions. As a result, the Company adjusted deferred revenues by $1.6 million, $1.0 million and $0.9 million for the years ended 2003 and 2004 and the first two quarters of 2005, respectively, and adjusted deferred cost of goods sold by $0.9 million, $0.3 million and $0.6 million for the years ended 2003 and 2004 and the first two quarters of 2005, respectively.

 

Use of Estimates.  The Company did not correctly estimate, monitor and adjust balances related to certain accruals and provisions as set forth below.

 

Access Network Electronics.  In July 2003, the Company sold certain assets related to its Miniplex products to Verilink Corporation (Verilink). The assets were originally acquired through the Company’s acquisition of Access Network Electronics (ANE) in April 2000. As part of the agreement with Verilink, Verilink agreed to assume all warranty obligations related to ANE products sold by the Company prior to, on, or after July 2003. The Company agreed to reimburse Verilink for up to $2.4 million of warranty obligations for ANE products sold by the Company prior to July 2003 related to certain power supply failures of the product and other general warranty repairs (Warranty Obligation). The $2.4 million Warranty Obligation negotiated with Verilink included up to $1.0 million for each of two specific customers issues and a general warranty obligation of $0.4 million that expired in the quarter ended March 31, 2005. During the sale process, the Company disclosed to Verilink that it had received an official specific customer complaint related to the sale of the Miniplex product from one of the two customers. In accordance with SFAS No. 5, “Accounting for Contingencies,” the Company established a reserve as a result of this complaint. Under the agreement with Verilink, the Company was able to quantify its exposure at $1.0 million based upon the terms of the Warranty Obligation. No other obligations were accrued by the Company related to the Miniplex products because the Company had not received formal notice of any complaints from other customers. Formerly, the Company amortized the $1.0 million warranty accrual starting in the quarter ended March 31, 2004 through the expiration of the Warranty Obligation in the quarter ended March 31, 2005. However, during the course of the restatement, the Company determined that the warranty obligation accrual should not have been reduced unless there were actual expenses incurred in connection with the obligation or upon the expiration of the Warranty Obligation in the quarter ended March 31, 2005. Since the Company did not incur any expenses in connection with this obligation and did not establish a basis for this reduction, during the restatement, the Company corrected the reduction of this accrual by $0.2 million in each of the four quarters of 2004 and deferred the reduction of the warranty accrual until the warranty period expired in the quarter ended March 31, 2005. Accordingly, the $1.0 million reduction of the warranty obligation in the quarter ended March 31, 2005, reduced cost of goods sold by $0.8 million for that period and increased cost of goods sold by $0.2 million in each quarter of 2004.

 

Israel Restructuring Reserve.  During 2001, the Board of Directors approved a restructuring plan and the Company incurred restructuring charges in the amount of $12.7 million for excess leased facilities of which $7.4 million related to Israel and $1.7 million remained accrued at December 31, 2004. In 2002, the Company did not include in its assessment the ability to generate and collect sublease income in its Israel facility. As a

result, the Company increased its reserve by $1.2 million due to lowered sublease assumptions. In the quarter ended December 31, 2004, the Company analyzed the reserve and reduced the reserve by $1.5 million to $1.7 million, reducing operating expenses. During the restatement process, the Company determined that $1.2 million of the $1.5 million reserve reduction recognized in the quarter ended December 31, 2004 properly related to the year ended December 31, 2002. As a result, the Company reversed the previously recorded $1.2 million increase in restructuring reserve expense in 2002, thereby decreasing the net loss for the quarter ended December 31, 2002. The Company also corrected the entry that reduced the restructuring reserve in 2004 by reversing the $1.2 million decrease in the reserve that occurred in 2004.

 

License Fee.  In 1999, the Company entered into an intellectual property (IP) license agreement (License Agreement) with a third party. Pursuant to the License Agreement, the Company recorded a prepaid asset of $2.0 million related to its licensing of the IP. The License Agreement allowed the Company to incorporate the IP into “manufactured products” for the cost of the license fee which was $2.0 million. Additionally, the Agreement also incorporated a clause for the Company to pay a royalty fee of $1 per unit of “component products” sold to third parties by the Company. During 1999, the Company began designing semiconductor chips using this IP and paying the license fee for the IP. In June 2000, the Company made its final payment on the $2.0 million license, and the Company had a $2.0 million prepaid asset. The Company amortized the prepaid asset based on applying the royalty rate of $1 per unit established in the License Agreement. However, the Company incorrectly applied the $1 per unit rate to units produced rather than units sold. As part of correcting this error, the Company adjusted the amortization rate of the prepaid asset to reflect actual units sold resulting in a reduction in the per unit amortization rate. Adjustments to cost of goods sold were a decrease of $0.8 million in 2003, an increase of $0.5 million in 2004 and an increase of $0.2 million during the first two quarters of 2005.

 

Goods Received Not Invoiced.  The Company maintains an account to accrue for obligations arising from instances in which the Company has received goods but has not yet received an invoice for the goods (RNI). During 2002 the Company established the reserve after management determined that the process being used to track RNI obligations was not properly stating the liability. During the quarter ended March 31, 2004, the Company analyzed the RNI account and determined that it was carrying an excess reserve of $0.8 million and began amortizing the $0.8 million excess reserve at the rate of $0.2 million per quarter thereby decreasing operating expenses by that amount in each quarter of 2004. During the restatement, the Company determined that the excess reserve should have been reduced to zero as of December 31, 2002 and adjusted the financial statements accordingly. The impact of this change is to decrease operating expenses by $0.8 million in 2002 and increase operating expenses by $0.8 million during 2004.

 

Other.  In conjunction with the restatement, the Company also made other adjustments and reclassifications to its accounting for various other errors for the periods presented, including: (1) correction of estimates of legal expenses, property tax and excess and obsolete inventory accruals; (2) reclassification to the proper accounting period of: bonus accruals to employees, federal income taxes payable, and operating expenses related to an operating lease; (3) correction of accounting for impaired and disposed assets; and (4) expenses related to an extended warranty provided to a customer. See Note 3, “Restatement of Consolidated Financial Statements,” to Consolidated Financial Statements.

 

Convertible Subordinated Notes.  In July 2000, the Company issued $500 million of 5% convertible subordinated notes (Notes) due in August 2007 resulting in net proceeds to the Company of approximately $484 million. The Notes were convertible into shares of the Company’s common stock at a conversion price of $84.01 per share at any time on or after October 24, 2000 through maturity, unless previously redeemed or repurchased. Under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), the Notes are considered a hybrid instrument since, and as described below, they contained multiple embedded derivatives.

 

The Notes contained several embedded derivatives. First, the Notes contain a contingent put (Contingent Put) where in the event of any default by the Company, the Trustee or holders of at least 25% of the principal amount of the Notes outstanding may declare all unpaid principal and accrued interest to be due and payable immediately. Second, the Notes contain an investor conversion option (Investor Conversion Option) where the holder of the Notes

may convert the debt security into Company common stock at any time after 90 days from original issuance and prior to August 1, 2007. The number of shares of common stock that is issued upon conversion is determined by dividing the principal amount of the security by the specified conversion price in effect on the conversion date. The initial conversion price was $84.01 which was subject to adjustment under certain circumstances described in the Indenture. Third, the Notes contain a liquidated damages provision (Liquidated Damages Provision) that obligated the Company to pay liquidated damages to investors of 50 basis points on the amount of outstanding securities for the first 90 days and 100 basis points thereafter, in the event that the Company did not file an initial shelf registration for the underlying securities within 90 days of the closing date. In the event that the Company filed its initial shelf registration within 90 days but failed to keep it effective for a two year period from the closing date, the Company would pay 50 basis points on the amount of outstanding securities for the first 90 days and 100 basis points thereafter. Fourth, the Notes contain an issuer’s call option (Issuer Call Option) that allowed the Company to redeem some or all of the Notes at any time on or after October 24, 2000 and before August 7, 2003 at a redemption price of $1,000 per $1,000 principal amount of the Notes, plus accrued and unpaid interest, if the closing price of the Company’s stock exceeded 150% of the conversion price, or $126.01, for at least 20 trading days within a period of 30 consecutive trading days ending on the trading day prior to the date of the mailing of the redemption notice. In addition, if the Company redeemed the Notes, it was also required to make a cash payment of $193.55 per $1,000 principal amount of the Notes less the amount of any interest actually paid on the Notes prior to redemption. The Company had the option to redeem the Notes at any time on or after August 7, 2003 at specified prices plus accrued and unpaid interest.

 

Under SFAS 133, an embedded derivative must be separated from its host contract (i.e., the Notes) and accounted for as a stand-alone derivative if the economic characteristics and risks of the embedded derivative are not considered “clearly and closely related” to those of the host. An embedded derivative would not be considered clearly and closely related to the host if there was a possible future interest rate scenario (even though it may be remote) in which the embedded derivative would at least double the initial rate of return on the host contract and the effective rate would be twice the current market rate as a contract that had similar terms as the host and was issued by a debtor with similar credit quality. Furthermore, per SFAS 133, the embedded derivative would not be considered clearly and closely related to the host contract if the hybrid instrument could be settled in such a way the investor would not recover substantially all of its initial investment.

 

During the restatement process, the Company determined under SFAS 133 that both the Issuer Call Option and the Liquidated Damages Provision represented an embedded derivative that was not clearly and closely related to the host contract, and therefore needed to be bifurcated from the Notes and valued separately. As it related to the Liquidated Damages Provision and based on a separate valuation that included Black-Scholes valuation methodologies, the Company assessed a valuation of $0.4 million. Based on the need to amortize the $0.4 million over the 7-year life of the Notes, the impact to the Company’s financial results related to the Liquidated Damages Provision was not material.

 

As it related to the Issuer Call Option and based on a separate valuation that included Black-Scholes valuation methodologies, the Company assessed a valuation of $11.9 million. As a result, at the time the Notes were issued in July 2000, the Company should have created an asset to record the value of the Issuer Call Option for $11.9 million and created a bond premium to the Notes for $11.9 million. In accordance with SFAS 133, the asset value would then be marked to market at the end of each accounting period and the bond premium would be amortized against interest expense at the end of each accounting period. Due to the decrease in the price of the Company’s common stock, the value of the Issuer Call Option became effectively zero and the Company should have written off the asset related to the Issuer Call Option in 2000. Additionally, as part of the bond repurchase activity where the Company repurchased $325.9 million and $109.1 million of face value of the Notes (for a total of $435.0 million) that occurred in 2001 and 2002, the Company should have recognized an additional gain from the retirement of the bond premium associated with the Issuer Call Option of $7.0 million in 2001 and $1.9 million in 2002. The Company determined that the $7.0 million non-cash gain on the early retirement of the premium to be immaterial to 2001 financial results.

 

In the quarter ended March 31, 2006, the Company paid off the entire principal amount of the outstanding Notes, including all accrued and unpaid interest and related fees, for a total of $65.6 million. In addition, the

Company recognized $0.3 million into other income, net representing the remaining unamortized bond premium associated with the Issuer Call Option.

 

For further discussion of the restatement adjustments and the net effects of all of the restatement adjustments on the Company’s balance sheet and statements of operations, please refer to Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 3 to the Consolidated Financial Statements.

 

Reliance on Prior Consolidated Financial Statements.  The Company has not amended its previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by the restatement. The information that has been previously filed or otherwise reported for these periods is superseded by the information in this Form 10-K. As such, other than the Company’s Form 10-K for the year ended December 31, 2005, the Company does not anticipate amending its previously filed Annual Reports on Form 10-K or its Quarterly Reports on Form 10-Q for any prior periods.

 

Overview

 

We currently develop, market and sell digital video equipment to networks operators and content aggregators who offer video services. Our primary products include the Network CherryPicker^® line of digital video processing systems and the CP 7600 line of digital-to-analog decoders. Our products are used for multiple digital video applications, including the rate shaping of video content to maximize the bandwidth for standard definition (SD) and high definition (HD) programming, grooming customized channel line-ups, carrying local ads for local and national advertisers and branding by inserting corporate logos into programming. Our products are sold primarily to cable operators, television broadcasters, telecom carriers and satellite providers in the United States, Europe and Asia.

 

This Report on Form 10-K includes trademarks and registered trademarks of Terayon Communication Systems, Inc. and its consolidated subsidiaries. As used in this report, the terms “Terayon,” the “Company,” “we,” “us” or “our” refer to Terayon Communication Systems, Inc. and its consolidated subsidiaries. Products or service names of other companies mentioned in this Report on Form 10-K may be trademarks or registered trademarks of their respective owners.

 

We were incorporated in California and reincorporated in Delaware in 1998. Our principal executive headquarters are located at 2450 Walsh Avenue, Santa Clara, California 95051. Our telephone number is (408) 235-5500.

 

History of the Company

 

We were founded in 1993 to provide cable operators with a cable data system enabling them to offer high-speed, broadband Internet access to their subscribers. By 1999, we were primarily selling this cable data system — composed of cable modems and cable modem termination systems (CMTS) — which utilized our proprietary Synchronous Code Division Multiple Access (S-CDMA) technology. Also in 1999, we initiated an acquisition strategy that ultimately included the acquisition of ten companies to expand our product offerings within the cable industry and outside of the cable industry to the telecom and satellite industries. With the market downturn in 2000, we refocused our business to target the cable industry and began selling data and voice products based on industry standard specifications, particularly the Data Over Cable System Interface Specification (DOCSIS), thereby beginning our transition from proprietary-based products to standards-based products. Also at this time, we focused our business on providing digital video products to cable operators and satellite providers. Since 2000, we have terminated our data-over-satellite business and all of our acquired telecom-focused businesses and incurred restructuring charges in connection with these actions.

 

In 2004, we refocused the Company to make digital video solutions (DVS) the core of our business. In particular, we began expanding our focus beyond cable operators to more aggressively pursue opportunities for our digital video products with television broadcasters, telecom carriers and satellite television providers. As part of this strategic refocus, we elected to continue selling our home access solutions (HAS) product, including cable modems, embedded multimedia terminal adapters (eMTA) and home networking devices, but ceased future investment in our CMTS product line. This decision was based on weak sales of the CMTS products and the anticipated extensive research and development investment required to support the product line in the future. As part of our decision to cease investment in the CMTS product line, we incurred severance, restructuring and asset impairment charges and were subject to litigation from Adelphia, one of the principal purchasers of our CMTS product. In March 2005, we sold certain cable modem semiconductor assets to ATI Technologies, Inc. and terminated our internal semiconductor division.

 

In January 2006, we announced that the Company would focus solely on digital video product lines, and as a result, we discontinued our HAS product line. We determined that there were no short or long-term synergies between our HAS product line and digital video product lines which made the HAS products increasingly irrelevant given our core business of digital video. Though we continued to sell our remaining inventory of HAS products and

CMTS products in 2006, the profit margins for our cable modems and eMTAs have continued to decrease due to competitive pricing pressures and the ongoing commoditization of the products.

 

Industry Dynamics

 

We participate in the worldwide market for equipment sold primarily to network operators, including cable operators, television broadcasters, telecom carriers and satellite providers. Our business is influenced by the following significant trends in our industry:

 

Migration of cable operators to all-digital networks

 

During the next several years, we believe that most North American and many foreign cable operators will continue to migrate their networks to all-digital operations in order to deliver new services and substantially improve network efficiency. Current efforts in this migration include digital simulcasting, which is a transition step to an all-digital network infrastructure. Digital simulcasting is being adopted by all major U.S. cable operators, and we further expect it to be adopted by second and third-tier cable operators in the U.S. and by major operators worldwide.

 

Ability to leverage network infrastructures to offer multiple products and services

 

Within the last few years, several cable operators and telecom carriers have begun offering a “triple play” bundle of services that includes video, voice and high-speed data over a single network. Their key objectives are to capture higher average revenues per subscriber, secure market share and reduce the “churn” of subscribers. The delivery of “triple play” services has led to increased competition between the cable operators and telecom carriers. This competition has led network operators to upgrade their infrastructure by purchasing equipment that allows them to provide the “triple play” of services.

 

Delivering digital video services is a key area of growing competition between cable operators and telecom carriers. Verizon and AT&T, the two largest telecom carriers in the U.S., are currently rolling out digital video services in select cities nationwide. We believe that as telecom carriers expand their digital video service rollouts, they will increasingly require products that have technology like our Network CherryPicker^® products to generate advertising revenues. Additionally, we are currently working with Alcatel, Motorola, Inc. (Motorola), and other leading telecom equipment vendors which have been selected by several large telecom carriers to serve as systems integrators responsible for the carriers’ deployment of digital video services.

 

Network operators and content aggregators must combat ad skipping technologies

 

Consumers’ increasing use of digital video recorders (DVRs) capable of skipping over commercial advertisements is a growing threat to network operators and content aggregators, which face the possibility of lower advertising revenues from advertisers who pay in large part based on the number of viewers watching a program. To overcome the reduction of advertising viewers because of ad skipping DVRs, network operators and content aggregators are increasingly seeking solutions based on digital overlay techniques to directly insert ads into the program being aired. These “overlaid ads” typically appear in a lower corner of the television picture and cannot be skipped by DVRs since they appear within the TV program itself. This approach has already been proven by programmers such as SpikeTV and MTV, and we believe that network operators and content aggregators will increasingly rely on overlay techniques to maintain or even increase their advertising revenues.

 

Continued network investment to support new product requirements in competitive and emerging markets

 

The cable, digital broadcast satellite and telecom companies will continue their investments in equipment to provide advanced services in a cost-effective manner to increase average revenues per unit from their subscribers. According to Kagan Research, LLC, in 2005 U.S. cable operators spent $10.6 billion on infrastructure, compared to $10.1 billion in 2004, an increase of 5%. In addition, we believe that telecom carriers (in particular Verizon and AT&T) will become an increasing source of competition to traditional video service providers as they continue to upgrade their networks to offer video services, including high definition digital television (HDTV) services. While

in the early stages, the development of a mobile video network is underway, and we expect that digital program insertion video application capabilities will play an important part in the growth of this emerging market.

 

Consolidation of the cable industry

 

In the late 1990s, U.S. cable operators began an unprecedented wave of consolidation, with several of the larger operators initiating aggressive growth strategies primarily through the acquisition of small, medium and large cable operators. Comcast Corporation (Comcast) — the largest U.S. operator today with more than 21 million subscribers — took the top spot in 2002 when it acquired AT&T Broadband, which had become the nation’s largest operator after acquiring TCI and MediaOne in 1999. In August 2006, Adelphia Communications Corporation (Adelphia), formerly the fifth largest operator with approximately 4.8 million subscribers, was purchased by Comcast and Time Warner Cable (TWC). Currently, 58.2 million of the estimated 65.6 million cable subscribers in the U.S. are served by the top ten U.S. cable operators, representing more than 89 percent of the market. With fewer — but much larger — cable operators to sell to, cable equipment vendors must continue adding new products and services to win business.

 

This has led to a consolidation of cable equipment vendors seeking to expand their product lines and to strengthen relationships with key operators. For example, General Instrument Corporation and Scientific-Atlanta, Inc. (Scientific-Atlanta) were acquired by Motorola, Inc. and Cisco Systems, Inc. (Cisco), respectively. Consolidation amongst smaller vendors has also taken place, including the acquisition of BroadBus by Motorola; Arroyo Video Solutions by Cisco; Entone by Harmonic, Inc. (Harmonic); nCUBE by C-COR, and BigBand Network’s purchase of ADC Telecommunications’ CMTS business.

 

Business

 

We currently develop, market and sell digital video equipment, including our Network CherryPicker^® digital video processing systems and our CP 7600 line of digital-to-analog decoders. Our products are sold to and used by cable, telecom, broadcast and satellite operators for multiple digital video applications, including the rate shaping of video content to maximize the bandwidth for SD and HD programming, grooming customized channel line-ups, carrying local ads for local and national advertisers, and branding themselves by inserting their corporate logos into their programming. We also continue to sell our remaining inventory of CMTS and HAS products, including cable modems and eMTAs, that we discontinued in January 2006.

 

The design of digital video processing equipment requires expertise in Motion Picture Experts Group (MPEG) digital video formats and Internet Protocol (IP). Our expertise in MPEG and IP, coupled with our experience in designing, developing and manufacturing complex equipment, has helped us secure a leadership position in statistical remultiplexing (rate shaping) which provides the cable and satellite operators with bandwidth management capabilities for their SD and HD digital video services. We believe we are well positioned to capitalize on the growing demand for network operators to provide advanced bandwidth intensive video services such as adding additional HDTV channels.

 

Our DVS products are designed to enable “localization on-demand,” or the delivery of on-demand, real-time video constructed to meet the advertising needs of local and regional markets. Further, we believe our digital video products enable network operators and content aggregators to more cost-effectively overlay advertisements directly into their programming. This approach is more efficient compared to the traditional approach which requires the advertisements and the program to first be converted from digital to analog video, the insertion of the overlaid advertisements, and the subsequent re-encoding of the program and the advertisements back to digital. Since our method works entirely in the digital domain, there is no need for decoders to convert the digital video to analog or for separate re-encoders to then convert the analog video back to digital. To complement our cable and satellite product offerings, we developed new software for the DM 6400 model of our Network CherryPicker^® line to support the new MPEG-4/AVC digital video format that most telecom carriers have chosen for their video services.

Business Strategy

 

Our goal is to be the leading provider of digital video products that enable network operators and content aggregators to more efficiently deliver digital video services to meet the needs of local and regional markets, thereby reducing costs and generating new revenues. To achieve this goal, we are pursuing the following strategies:

 

 

The ongoing migration of network operators to all-digital IP-based networks represents a significant opportunity for companies like us with products and technologies that enable these operators to maximize their bandwidth and to manipulate their digital video content completely within the digital domain, which maximizes flexibility and reduces costs. We believe we are well positioned to capitalize on this expanding market in large part because of the success that our digital video products have had with the major U.S. cable operators and satellite providers.

 

Products

 

Historically, we had multiple product lines that we sold to cable operators, satellite providers and telecom carriers. Our cable data product line consisted initially of a proprietary system composed of a CMTS and cable modems. We later expanded our cable data product line with standards-based offerings, including CMTS, cable modems and eMTA products meeting the DOCSIS and EuroDOCSIS specifications. We discontinued sales of our CMTS products in 2004 and our modems and eMTAs in 2006. Our cable data products were complemented by our Multigate voice-over-cable solution, which we inherited through our acquisition of Telegate Ltd. We discontinued the Multigate product line in 2004. Our telecom product line consisted of our IPTL digital subscriber line access multiplexer, MainSail multi-service access platform and MiniPlex digitally added main line products, all of which we acquired through our acquisitions of Radwiz, MainSail Systems and the Access Network Electronics division of Tyco International. We discontinued these telecom products in 2003. Our Internet-over-satellite product line consisted of the SatStream system we inherited via our acquisition of ComBox. We discontinued our satellite product in 2002.

 

We continue to sell our digital video product lines, which currently consist of the Network CherryPicker^® products and our CP 7600 digital-to-analog decoder. Our Network CherryPicker^® line of digital video processing systems give cable, telecom and satellite operators flexibility in managing their digital video content, including the rate shaping of video content to maximize the bandwidth for SD and HD programming, grooming customized channel line-ups, carrying ads for local advertisers and branding themselves by inserting their corporate logos into their programming. To date, cable, satellite and telecommunications providers have deployed more than 7,500 of our digital video systems.

 

Our CherryPicker^® DM line is currently composed of two models, the DM 6400 and the DM 3200. Our DM 6400 helps cable operators seamlessly insert commercials for local advertisers into their digital programming without the need for a cumbersome and inefficient digital-to-analog-back-to-digital process that requires additional equipment. The newest version of software for our DM 6400 is designed for telecom carriers and specifically supports the new MPEG-4/AVC digital video format that most telecom carriers have chosen for their video services. According to Kagan Research, LLC, in 2005, U.S. cable operators earned more than $4.6 billion running local ads, a 12% increase over the $4.1 billion billed in 2004. We believe this market will continue to grow and that we are well

positioned in this space based on our current success in digital ad insertion and the relationships we have with the major advertising server companies, particularly SeaChange and C-Cor. Our DM 3200 provides statistical remultiplexing functionality, ad insertion and advance stream processing for smaller capacity architectures.

 

Our CherryPicker^® BP 5100 broadcast platform system has been developed specifically for television broadcasters utilizing the same proven statistical remultiplexing technology and components from the DM line. The BP 5100 provides broadcasters with exceptional flexibility in managing their digital video content, including rate shaping their video content to maximize the bandwidth for SD and HD programming, switching seamlessly between local and national video feeds and branding themselves by overlaying their corporate logos onto their programming.

 

Our CP 7600 digital-to-analog video decoder is used by cable operators to implement a “digital simulcast” architecture to improve the bandwidth efficiency of their networks. All major U.S. cable operators have adopted digital simulcasting and both second and third-tier operators are in the process of deploying the architecture. Prior to digital simulcasting, operators had to send all of their programming in both digital and analog formats to support both groups of subscribers. This traditional approach consumes enormous amounts of bandwidth within their networks. With simulcasting, operators now deliver just one set of programming digitally and use the CP 7600 at the ‘edge’ of their networks (just before reaching subscribers’ homes) to decode the programming to analog for their analog subscribers, and to pass the digital programming on to their digital subscribers untouched. This more bandwidth-efficient approach is an evolutionary step towards an architecture that is completely digital and IP-based and that will support the delivery of a new generation of services.

 

Our CP 7585 off-air demodulator allows cable and satellite operators to convert SD or HD programming transmitted over-the-air by television broadcasters in the 8VSB format to the ASI format used by cable and satellite operators. This allows cable and satellite providers to retransmit broadcasters’ programming over their own networks. We discontinued the CP 7585 in April 2006 after selling off our inventory and determining the cost of developing and building new models was not warranted.

 

We continue to develop video applications to enable advanced capabilities for digital video programming, more localized advertising and other digital video services. Upcoming digital video products include a suite of overlay applications that enable static and motion graphics to be superimposed on digital video programs and advertising, and applications for statistical re-multiplexing for MPEG-4 high definition sources.

 

Product research and development

 

We maintain ongoing research and development activities for our digital video product line. Our research and development efforts are focused on developing new software applications and improved hardware platforms designed to address customer requirements across multiple industries and to obtain a competitive technological leadership of our products. Another key goal is to improve the gross margins of our existing products by reducing their component and manufacturing costs.

 

Our research and development expense was $17.7 million for the year ended December 31, 2005 compared with $33.2 million and $42.6 million for the years ended December 31, 2004 and 2003, respectively. We currently anticipate that overall research and development spending in 2006 will decline compared to 2005, and will focus almost entirely on developing new hardware platforms and software applications for digital video solutions.

 

Developing new and innovative solutions is important for us to remain competitive with larger companies that devote considerably more resources to product development.

 

Customers

 

We market and sell our digital video products to multiple vertical target markets consisting of the largest cable, satellite and telecom operators in North America.

 

Some of our principal customers include the following:

 

 

 

We believe that a substantial majority of our revenues will continue to be derived from sales to a relatively small number of customers located in the United States for the foreseeable future. For example, Harmonic, Thomson Broadcast and Comcast accounted for approximately 12%, 11% and 10%, respectively, of our total revenue for the year ended December 31, 2005. For the year ended December 31, 2004, two customers, Adelphia and Comcast accounted for approximately 20% and 13%, respectively, of our total revenue. Three customers, Adelphia, Cross Beam Networks and Comcast, accounted for approximately 21%, 16% and 13%, respectively, of our total revenues for the year ended December 31, 2003. With the discontinuation of our data products, our sales have become increasingly concentrated in the United States and our presence outside the United States has decreased. A small percentage of our total digital video revenue has historically been derived from customers located outside the United States. We expect that trend will continue. The loss of any of our significant customers generally could have a material adverse effect on our business and results of operations.

 

Market Competition

 

The market for broadband equipment vendors is extremely competitive and is characterized by rapid technological change and, more recently, market consolidation. With our digital video products, we believe that we are currently the market leader in ad insertion, grooming and remultiplexing with our Network CherryPicker^® line of digital video processing systems. However, several companies have entered this market, including Cisco through its acquisition of Scientific-Atlanta, Scopus Video Networks Ltd., BigBand Networks and RGB Networks, Inc. (RGB). We believe that this increase in competition may lead to additional pricing pressures and declining gross margins.

 

The principal competitive factors in our market include the following:

 

 

Many of our competitors and potential competitors are substantially larger and have significant advantages over us, including, without limitation:

 

 

Some of the above competitive factors are outside of our control. Conditions in the market could change rapidly and significantly as a result of technological advancements. Additionally, there may be pressure to develop new or alternative industry standards and specifications for video products and applications. The broader adoption

of any such standards and specifications would necessitate greater spending on developing new products. The development and market acceptance of new or alternative technologies could decrease the demand for our products or render them obsolete, and could impact the pricing and gross margin of our digital video products. Our competitors, many of which have greater resources than we do, may introduce products that are less costly, provide superior performance or achieve greater market acceptance than our products. These competitive pressures have impacted and are likely to continue to adversely impact our business.

 

Given these competitive and other market factors, we continually look for opportunities to compete effectively and create value for our stockholders. We may, at any time and from time to time, be in the process of identifying or evaluating product development initiatives, partnerships, strategic alliances or transactions and other alternatives in order to maintain market position and maximize shareholder value. Market and other competitive factors may cause us to change our strategic direction, and we may not realize the benefits of any such initiatives, partnerships, alliances or transactions. We cannot assure you that any such initiatives, partnerships, alliances or transactions that we identify and pursue would actually result in our competing effectively, maintaining market position or increasing stockholder value. Our failure to realize any expected benefits from such initiatives, partnerships, alliances or transactions could negatively impact our financial position, results of operations, cash flows and stock price.

 

Sales and Marketing

 

We market and sell our products directly to network operators and content aggregators through our direct sales forces in North America and our limited sales forces in EMEA and Asia. We also market and sell our products through distributors, system integrators and resellers throughout the world and rely on this network to sell the majority of our products sold outside the United States.

 

We support our sales activities through marketing communication vehicles, such as industry press, trade shows, advertising and the Internet. Through our marketing efforts, we strive to educate network operators and content aggregators on the technological and business benefits of our products, as well as our ability to provide quality support and service. We participate in the major trade shows and industry events in the United States and limited events outside the United States. Industry referrals and reference accounts are significant marketing tools we develop and utilize.

 

We also make our products available for customers to test, which is very often a prerequisite for making a sale of our more complex products. These tests can be comprehensive and lengthy, and can dramatically increase the sales cycle for these products. Participating in these tests often requires us to devote considerable time and resources from our engineering and customer support organizations.

 

International Sales

 

We have international sales offices in Brussels, Belgium; Hong Kong; Seoul, South Korea; and Tel Aviv, Israel. In the years ended December 31, 2005, 2004 and 2003, approximately 42%, 47% and 45%, respectively, of our net revenues were derived from customers outside of the United States. Japan and Israel were the only international countries into which we made sales in excess of 10% of net revenues in 2003. Sales to Japan were 2%, 7% and 16%, of net revenues while sales to Israel were 8%, 12% and 12% of net revenues in the years ended December 31, 2005, 2004 and 2003, respectively. During 2005, we focused our business on the sale of our digital video products, which have historically had much higher sales in the United States, and placed our sales emphasis on the U.S. market. However, we focused sales of our data products, which have historically had much higher sales outside the United States, on those markets outside the United States, including Israel and Europe. In 2005, we placed a lower emphasis on customers in certain locations outside the United States, such as Asia Pacific, Canada and South America. Additionally, we expect the portion of our overall revenue generated from outside the United States to continue to decrease in 2006 with the discontinuance of our HAS products and our data business.

 

The majority of our international sales are currently invoiced in U.S. dollars. However, we do enter into certain transactions in Euros and other currencies. Invoicing in other currencies subjects us to risks associated with foreign exchange rate fluctuations. Although we do not currently have any foreign currency hedging arrangements in place, we will consider the need for hedging or other strategies to minimize these risks if the amount of invoicing in non-dollar denominated transactions materially increases.

Our international operations are subject to certain risks common to foreign operations in general, such as governmental regulations and import restrictions. In addition, there are social, political, labor and economic conditions in specific countries or regions, difficulties in staffing and managing foreign operations and potential adverse foreign tax consequences, among other factors, that could also have an adverse impact on our business and results of operations outside of the United States.

 

Customer Service and Technical Support

 

We believe that our ability to provide consistently high quality service and support will continue to be a key factor in attracting and retaining customers. Our technical services and support organization, with personnel in North America, Europe, Israel and Asia, offers support 24 hours a day, seven days per week. Prior to the deployment of our products, each customer’s needs are assessed and proactive solutions are implemented, including various levels of training, periodic management and coordination meetings and problem escalation procedures.

 

Backlog

 

We typically ship product and invoice customers shortly upon receipt of a purchase order as our customers typically request the immediate delivery of product. Assuming product availability, our practice is to ship our products promptly upon the receipt of purchase orders from our customers. We only have backlog if the product is not available to ship to the customer. Therefore, we have limited backlog and believe that backlog information is not material to an understanding of our business.

 

Manufacturing

 

Our finished goods are produced by subcontract manufacturers. Our digital video products are single sourced from a manufacturer in San Jose, California. Our HAS products, which were discontinued in January 2006, were single sourced from a manufacturer in China.

 

Our manufacturing operations employ semiconductors, electromechanical components and assemblies as well as raw materials such as plastic resins and sheet metal. Although we believe the materials and supplies necessary for our manufacturing operations are currently available in the quantities we require, we sometimes experience a shortage in the supply of certain component parts as a result of strong demand in the industry for those parts.

 

Our subcontractors purchase materials, supplies and product subassemblies from a substantial number of vendors. For many of our products, there are existing alternate sources of supply. However, we sole source certain components contained in our products, such as the semiconductors used in our products. While this has not resulted in material disruptions in the past, should any change in these relationships or disruptions to our vendors’ operations occur, our business and results of operations could be adversely affected.

 

In an effort to prevent shortages of supplies used in the manufacturing process by some of our subcontractors, we source and inventory various raw products and components as part of our supply chain program. In doing so we may put ourselves at risk of carrying inventory that may become excessive based on our future sales failing to meet current sales forecasts or become obsolete before utilization by those manufacturers. We have recorded costs as a result of vendor cancellation charges.

 

Intellectual Property

 

We rely on a combination of patent, trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in our products. Even though we seek to establish and protect proprietary rights in our products, there are associated risks. Our pending patent applications may not be granted. Even if they are granted, the claims covered by the patent may be reduced from those included in our applications. Any patent might be subject to challenge in court and, whether or not challenged, might not be broad enough to prevent third parties from developing equivalent technologies or products without a license from us.

 

We have entered into confidentiality and invention assignment agreements with our employees and consultants, and we enter into non-disclosure agreements with many of our suppliers, distributors and appropriate customers so as to limit access to and disclosure of our proprietary information. These contractual arrangements, as

well as statutory protections, may not prove to be sufficient to prevent misappropriation of our technology or deter independent third-party development of similar technologies. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States. Litigation may be necessary to enforce our intellectual property rights.

 

The development of standards or specifications is common in our industry, as is the contribution of intellectual property to associated intellectual property pools. These standards and specifications allow for the development and availability of intellectual property pools, such as the MPEG pool, the standardization of delivery and techniques and the interoperability of products. CableLabs, the research and development consortium representing the cable operators, developed the DOCSIS standard to allow for the interoperability of products used by the cable operators. In connection with the development of the DOCSIS 2.0 specification by CableLabs, we entered into an agreement with CableLabs whereby we licensed to CableLabs on a royalty-free basis all of our intellectual property rights to the extent that such rights may be asserted against a party desiring to design, manufacture or sell DOCSIS based products, including DOCSIS 2.0 based products. This license agreement grants to CableLabs the right to sublicense our intellectual property, including our intellectual property rights in our S-CDMA patents, to others, including manufacturers that compete with us in the marketplace for DOCSIS based products. There may be pressure to develop new industry standards and specifications for video products and applications. Vendors like us may have to build products that meet these standards in order to sell to network operators.

 

The contractual arrangements, as well as statutory protections, we employ may not prove to be sufficient to prevent misappropriation of our technology or deter independent third-party development of similar technologies. We have in the past received letters claiming that our technology infringes the intellectual property rights of others. We have consulted with our patent counsel and have or are in the process of reviewing the allegations made by such third parties. If these allegations were submitted to a court, the court could find that our products infringe third party intellectual property rights. If we are found to have infringed third party rights, we could be subject to substantial damages and/or an injunction preventing us from conducting our business. In addition, other third parties may assert infringement claims against us in the future. A claim of infringement, whether meritorious or not, could be time-consuming, result in costly litigation, divert our management’s resources, cause product shipment delays or require us to enter into royalty or licensing arrangements. These royalty or licensing arrangements may not be available on terms acceptable to us, if at all.

 

We pursue the registration of our trademarks in the United States and have applications pending to register several of our trademarks throughout the world. However, the laws of certain foreign countries might not protect our products or intellectual property rights to the same extent as the laws of the United States. Effective trademark, copyright, trade secret and patent protection may not be available in every country in which our products may be manufactured, marketed or sold.

 

Employees

 

As of December 31, 2005, we had 156 employees, of which 128 were located in the United States, and 28 were located outside the United States in Israel, Canada, Europe and Asia. We had 46 employees in research and development, 63 in marketing, sales and customer support, 19 in operations and 28 in general and administrative functions.

 

As of December 19, 2006, we had 114 employees, of which 99 were located in the United States, and 15 were located outside the United States in Israel, Canada, Europe and Asia. We had 49 employees in research and development, 33 in marketing, sales and customer support, 16 in operations and 16 in general and administrative functions. In connection with our most recent decision in January 2006 to discontinue HAS products, we implemented a headcount reduction that resulted in a charge of $0.6 million through December 31, 2006. None of our employees are represented by collective bargaining agreements. We believe that our relations with our employees are good.

 

Access to Our Reports

 

Our Internet Web site address is www.terayon.com. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to

Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act) are available free of charge through our Web site as soon as reasonably practicable after they are electronically filed with, or furnished to, the Commission. We will also provide those reports in electronic or paper form free of charge upon a request made to Mark A. Richman, Chief Financial Officer, c/o Terayon Communication Systems, Inc., 2450 Walsh Avenue, Santa Clara, CA 95051. Furthermore, all reports we file with the Commission are available free of charge via EDGAR through the Commission’s Web site at www.sec.gov. In addition, the public may read and copy materials filed by us at the Commission’s public reference room located at 100 F. Street, N.E., Washington, D.C., 20549 or by calling 1-800-SEC-0330.

 

The following is a summary description of some of the many risks we face in our business. You should carefully review the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business could be harmed. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment. You should also consider the other information described in this report.

 

Risks Related to the Restatement

 

The restatement of our consolidated financial statements has had a material adverse impact on us, including increased costs, the delisting of our common stock from The NASDAQ Stock Market, the increased possibility of legal or administrative proceedings, and a default under our subordinated note agreement.

 

As a result of the restatement process, we have become subject to a number of additional risks and uncertainties, including the following:

 

 

 

Material weaknesses or deficiencies in our internal control over financial reporting could harm stockholder and business confidence in our financial reporting, our ability to obtain financing and other aspects of our business.

 

Maintaining an effective system of internal control over financial reporting is necessary for us to provide reliable financial reports. We have restated our consolidated financial statements for the years ended December 31, 2000, 2002, 2003 and 2004 and for the four quarters in 2004 and the first two quarters of 2005. As described in Item 9A — Controls and Procedures of this Form 10-K, management, under the supervision of the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), conducted an evaluation of disclosure controls and procedures. Based on that evaluation, the CEO and CFO concluded that our disclosure controls and procedures were not effective at a reasonable assurance level as of December 31, 2005 and as of the filing date of this Form 10-K due to the material weaknesses discussed below. Because the material weaknesses described below have not been remediated as of the filing date of this Form 10-K, the CEO and CFO continue to conclude that our disclosure controls and procedures are not effective as of the filing date of this Form 10-K. A material weakness in internal control over financial reporting is defined by the Public Company Accounting Oversight Board’s Audit Standard No. 2 as being a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements would not be prevented or detected. A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects our ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles (GAAP) such that there is more than a remote likelihood that a misstatement of the annual or interim financial statements that is more than inconsequential will not be prevented or detected.

 

We were not able to fully execute the remediation plans that were established to address material weaknesses previously identified in 2004. As a result, these material weaknesses were not fully remediated and remain ongoing as of December 31, 2005 and as of the date of this filing.

 

We have identified the following material weaknesses as of December 31, 2005:

 

 

For further information about these material weaknesses, please see Item 9A — Controls and Procedures — Management’s Report on Internal Control over Financial Reporting included in this Form 10-K. Because of these material weaknesses, management concluded that, as of December 31, 2005, our internal control over financial reporting was not effective.

 

Because we have concluded that our internal control over financial reporting is not effective and our independent registered public accountants issued an adverse opinion on the effectiveness of our internal controls, and to the extent we identify future weaknesses or deficiencies, there could be material misstatements in our consolidated financial statements and we could fail to meet our financial reporting obligations.

 

While we are in the process of implementing the remediation efforts described in Item 9A — Controls and Procedures — Remediation Steps to Address Material Weaknesses, we may continue to experience difficulties or delays in implementing measures to remediate the material weaknesses. Additionally, if the remedial measures are insufficient to address the identified material weaknesses or if additional material weaknesses or significant deficiencies in our internal controls are discovered in the future, we may fail to meet our future reporting obligations on a timely basis, our financial statements may contain material misstatements, our operating results may be harmed, and we may be subject to litigation.

 

Any failure to address the identified material weaknesses or any additional material weaknesses or significant deficiencies in our internal controls could also adversely affect the results of future management evaluations and auditor attestation reports regarding the effectiveness of our internal control over financial reporting that are required under Section 404 of the Sarbanes-Oxley Act of 2002.

 

Any material weakness or unsuccessful remediation could affect investor confidence in the accuracy and completeness of our financial statements. As a result, our ability to obtain any additional financing, or additional financing on favorable terms, could be materially and adversely affected, which, in turn, could materially and adversely affect our business, our strategic alternatives, our financial condition and the market value of our securities. In addition, perceptions of us among customers, lenders, investors, securities analysts and others could also be adversely affected. Current material weaknesses or any weaknesses or deficiencies identified in the future could also hurt confidence in our business and the accuracy and completeness of our financial statements, and adversely affect our ability to do business with these groups.

 

We can give no assurances that the measures we have taken to date, or any future measures we may take, will remediate the material weaknesses identified or that any additional material weaknesses will not arise in the future due to our failure to implement and maintain adequate internal controls over financial reporting. In addition, even if we are successful in strengthening our controls and procedures, those controls and procedures may not be adequate to prevent or identify irregularities or ensure the fair presentation of our financial statements included in our periodic reports filed with the Commission.

 

Our revenue recognition policy on digital video products has been corrected.

 

We now recognize revenue from our digital video products under SOP 97-2, SAB 104 and EITF 00-21. Our new revenue recognition policy under these accounting standards is complex. We rely upon key accounting personnel and consultants to maintain and implement the controls surrounding such policy. If the policy is not applied on a consistent basis or if we lose any of our key accounting personnel or consultants the accuracy of our consolidated financial statements could be materially affected. This could cause future delays in our earnings announcements, regulatory filings with the Commission and potential delays in listing with a securities exchange.

 

Our common stock has been de-listed from The NASDAQ Stock Market and trades on the Pink Sheets.

 

Effective April 4, 2006, our common stock was delisted from The NASDAQ Stock Market and was subsequently quoted by the National Quotation Service Bureau (Pink Sheets). The trading of our common stock on the Pink Sheets may reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the trading of our common stock on the Pink Sheets may materially and adversely affect our access to the capital markets, and the limited liquidity and reduced price of our common stock could materially and adversely affect our ability to raise capital through alternative financing sources on terms acceptable to us or at

all. Stocks that trade on the Pink Sheets are no longer eligible for margin loans, and a company trading on the Pink Sheets cannot avail itself of federal preemption of state securities or “blue sky” laws, which adds substantial compliance costs to securities issuances, including pursuant to employee option plans, stock purchase plans and private or public offerings of securities. Our delisting from The NASDAQ Stock Market and quotation on the Pink Sheets may also result in other negative ramifications, including the potential loss of confidence by suppliers, customers, employees, investors, and security analysts, the loss of institutional investor interest and fewer business development opportunities.

 

If we are not able to become or remain current in our filings with the Commission, we will face several adverse consequences.

 

If we are unable to become and remain current in our financial filings, we will face several restrictions. We will not be able to have a registration statement under the Securities Act of 1933, covering a public offering of securities, declared effective by the Commission, or make offerings pursuant to existing registration statements; we will not be able to make an offering to any purchasers not qualifying as “accredited investors” under certain “private placement” rules of the Commission under Regulation D; we will not be eligible to use a “short form” registration statement on Form S-3 for a period of at least 12 months after the time we become current in our periodic and current reports under the Securities Exchange Act of 1934, as amended (Exchange Act); we will not be able to deliver the requisite annual report and proxy statement to our stockholders to hold our annual stockholders meeting; our employees cannot be granted stock options, nor will they be able to exercise stock options registered on Form S-8, as Form S-8 is currently not available to us; and our common stock may not be eligible for re-listing on The NASDAQ Stock Market or alternative exchanges. These restrictions may impair our ability to raise funds in the public markets, should we desire to do so, and to attract and retain employees.

 

Risks Related to Our Business

 

We have a history of losses and may continue to incur losses in the future.

 

It is difficult to predict our future operating results. We began shipping products commercially in June 1997, and we have been shipping products in volume since the quarter ended March 31, 1998. As of December 31, 2005, we had an accumulated deficit of approximately $1.1 billion. We believe that we will continue to experience challenges in selling our products at a profit and may continue to operate with net losses for the foreseeable future.

 

As a result of our losses, we have had to use available cash and cash equivalents to supplement the operation of our business. Additionally, we generally have been unable to significantly reduce our short-term expenses in order to compensate for unexpected decreases in anticipated revenues or delays in generating anticipated revenues. For example, we have fixed commitments with some of our suppliers that require us to purchase minimum quantities of their products at a specified price irrespective of whether we can subsequently use such quantities in our products. In addition, we have significant operating lease commitments for facilities and equipment that generally cannot be cancelled in the short-term without substantial penalties, if at all.

 

We depend on capital spending from the cable, satellite and telecommunications industries for our revenues, and any decrease or delay in capital spending in these industries would negatively impact our revenues, financial condition and cash flows.

 

Historically, a significant portion of our revenues have been derived from sales to cable television operators. Future demand for our products will depend on the magnitude and timing of capital spending by cable television operators, satellite operators, telephone companies and broadcasters for constructing and upgrading their systems. Customers view the purchase of our products as a significant and strategic decision. Digital video, movie and broadcast products are relatively complex and their purchase generally involves a significant commitment of capital. Our customers’ capital spending patterns are dependent on a variety of factors, including:

 

 

 

Financial and budgetary pressures on our existing and potential customers in the cable, satellite and telecom industries will adversely impact purchasing decisions and may cause delays in the purchase of our products. Any one of the above factors could impact spending by cable operators on digital video equipment and thus could impact our business and result in excess inventory, decreased sales and revenue or other adverse effects.

 

Due to the lengthy sale cycle involved in the sale of our products, our financial results may vary and should not be relied on as an indication of future performance.

 

Our products have a lengthy and unpredictable sales cycle that contributes to the uncertainty of our operating results. Our customers’ decision to purchase our products is often accompanied by delays frequently associated with large capital expenditures and implementation procedures within an organization. Our customers generally conduct significant technical evaluations, including customer trials, of our products as well as competing products prior to making a purchasing decision. Moreover, the purchase of these products typically requires coordination and agreement among a potential customer’s corporate headquarters and regional and local operations. Even if corporate headquarters agrees to purchase our products, local operations may retain a significant amount of autonomy and may not elect to purchase our products. Additionally, a portion of our expenses related to anticipated orders is fixed and is difficult to reduce or change, which may further impact our revenues and operating results for a particular period.

 

We expect that there will be fluctuations in the number and value of orders received. Because of the lengthy sales cycle and the size of customer orders, if orders forecasted for a specific customer for a particular period do not occur in that period, our revenues and operating results for that particular period could suffer. As a result, period-to-period comparisons of our results of operations are not necessarily meaningful, and these comparisons should not be relied upon as indications of future performance.

 

Additionally, because of the lengthy sales cycle combined with a lengthy product development cycle, our customers may elect not to purchase our products or new features or functionality because they have elected to select alternate technologies or vendors. We may be unable to forecast the new products, features or functionality desired by our customers. We may spend considerable research and development dollars without having our products, features or functionality be accepted in the market. Because we are now focused solely on the development of digital video products, our inability to develop products, features and functionality that our customers might purchase would have a significant impact on us, and would adversely affect sales, revenue, margins and the cash available for future development efforts.

 

We may continue to experience fluctuations in our operating results and face unpredictability in our future revenues.

 

Our revenues have fluctuated and are likely to continue to fluctuate significantly in the future due to a number of factors, many of which we cannot control. Period-to-period comparisons of our operating results are not necessarily meaningful, and these comparisons should not be relied upon as indications of the future. Because these factors are difficult for us to forecast, our business, financial condition and results of operations from one period or a series of periods may be adversely affected and may be below the expectations of analysts and investors, resulting in

a decrease in the market price of our common stock. Our business and product mix has also changed in the past several years based on our business restructuring, making historical comparisons more unreliable as indicators of future performance.

 

Factors that affect our revenues include, among others, the following:

 

 

Our financial results are affected by the gross margin we achieve for the year relative to our gross revenues. A variety of factors influence our gross margin for a particular period, including, among others, the following:

 

 

Our expenses for any given quarter are based on expected sales and if sales are below expectations, our operating results may be adversely impacted by our inability to adjust spending to compensate for the shortfall in revenue.

 

We often recognize a substantial portion of our revenues in the last month of the quarter. We establish our expenditure levels for product development and other operating expenses based on projected sales levels, and expenses are relatively fixed, particularly in the short term. For example, a significant percentage of these operating expenses are fixed due to operating leases for our facilities and equipment. Also, we have fixed commitments with

some of our suppliers that require us to purchase minimum quantities of their products at a specified price. Because we have in the past been unable to use all of the products that we purchased from our suppliers, we have taken vendor cancellation charges as a result of these fixed commitments, and we may have to take additional charges in the future if we are unable to use all of the products that we purchase from our suppliers. As of December 31, 2005, $12.1 million of purchase obligations were outstanding. The obligations are generally expected to become payable at various times throughout 2006. Our expenses for any given quarter are typically based on expected sales and if sales are below expectations, our operating results may be adversely impacted by our inability to adjust spending to compensate for the shortfall. Moreover, our research and development expenses fluctuate in response to new product development, changing industry requirements and customer demands.

 

Because our customer base is highly concentrated among a limited number of large customers, the loss of or reduced demand from these customers could have a material adverse effect on our business, financial condition and results of operations.

 

Our customers in the cable industry have undergone and continue to undergo significant consolidation in both North America and internationally, as a limited number of cable operators control an increasing number of systems. We expect this consolidation to continue in the foreseeable future. As of June 2006, the top ten US Multiple System Operators (MSOs) (based on total subscribers) collectively served 58.2 million cable subscribers, which is approximately 89% of the total 65.6 million cable subscribers in the US, according to Kagan Research, LLC. The top 10 MSOs are Comcast Corporation; Time Warner Cable; Cox Communications, Inc.; Charter Communications, Inc.; Adelphia Communications Corporation; Cablevision System Corporation; Brighthouse Networks; Mediacom LLC; Insight Communications Company, Inc.; and CableOne. As a result of the consolidation among cable operators, our revenues from digital video products has been and will continue to be highly concentrated among a limited number of large customers.

 

Typically, our sales are made on a purchase order or system contract basis, and none of our customers has entered into a long-term agreement requiring it to purchase our products. Moreover, we do not typically require our customers to purchase a minimum quantity of our products, and our customers can generally cancel or significantly reduce their orders on short notice without significant penalties. Our sales to these customers tend to vary significantly from year to year depending on the customer’s budget for capital expenditures and our new product introductions and improvements. A significant amount of our revenues will continue to be derived from a limited number of large customers. The loss of or reduced demand for products from any of our major customers could have a material adverse effect on our business, financial condition and results of operations. Also, we may not succeed in attracting new customers as many of our potential customers have pre-existing relationships with our current or potential competitors and the continued consolidation of the cable industry may also reduce the number of potential customers. To attract new customers and retain existing customers, we may be faced with price competition, which may adversely affect our gross margins and revenues.

 

A portion of our sales are made to a small number of resellers, who often incorporate our products and applications in systems that are sold to an end-user customer, which is typically a cable operator, satellite provider or broadcast operator. If one or more of these resellers develop their own products or elect to purchase similar products from another vendor, our ability to generate revenue and our results of operations may suffer.

 

We are attempting to diversify our customer base beyond cable and satellite customers, principally into the telecom market, as well as the broadcast market. Major telecom operators have begun to implement plans to rebuild or upgrade their networks to offer bundled video, voice and data services. In order to be successful in this market, we may need to build alliances with integrators that sell telecom equipment to the telecom operators, adapt our products for telecom applications, adopt pricing specific to the telecom industry and the integrators that sell to the telecom operators, and build internal expertise to handle particular contractual and technical demands of the telecom industry. As a result of these and other factors, we cannot give any assurances that we will be able to increase our revenues from the telecom market, or that we can do so profitably, and any failure to generate revenues and profits from telecom customers could adversely affect our business, financial condition and results of operations.

The reductions in workforce associated with our restructuring efforts could disrupt the operation of our business, distract our management from focusing on revenue-generating efforts, result in the erosion of employee morale, and impair our ability to respond rapidly to growth opportunities in the future.

 

We have implemented a number of restructuring plans since 2001. The employee reductions and changes in connection with our restructuring activities, as well as any future changes in senior management and key personnel, could result in an erosion of morale, and affect the focus and productivity of our remaining employees, including those directly responsible for revenue generation and the management and administration of our accounting and finance department, which in turn may adversely affect our future revenues or cause other administrative deficiencies. Additionally, employees directly affected by the reductions may seek future employment with our business partners, customers or competitors. Although all employees are required to sign a proprietary information agreement with us at the time of hire, there can be no assurances that the confidential nature of our proprietary information will be maintained in the course of such future employment. Additionally, we may face wrongful termination, discrimination, or other claims from employees affected by the reductions related to their employment and termination. We could incur substantial costs in defending ourselves or our employees against such claims, regardless of the merits of such actions. Furthermore, such matters could divert the attention of our employees, including management, away from our operations, harm productivity, harm our reputation and increase our expenses. We cannot assure you that our restructuring efforts will be successful, and we may need to take additional restructuring efforts, including additional personnel reductions, in the future.

 

We are dependent on key personnel.

 

Due to the specialized nature of our business, we are highly dependent on the continued service of and on our ability to attract and retain qualified senior management, accounting and finance, engineering, sales and marketing personnel and employees with significant experience and expertise in video, data networking and radio frequency design. The competition for some of these personnel is intense, particularly for engineers with Motion Picture Experts Group (MPEG), Internet Protocol (IP) and real time processing experience. We may incur additional expenses to attract and retain key personnel. We have also recently experienced turnover in our accounting and finance organization and have augmented internal resources to address staffing deficiencies primarily through the engagement of external contractors. Additionally, we have retained FTI Consulting, Inc. to provide accounting services, which has increased operating expenses, and we may be unable to prepare our financial statements without their assistance. There can be no assurances that the additional expenses we may incur, or our efforts to recruit such individuals, will be successful. Additionally, we do not have key person insurance coverage for the loss of any of our employees. Any officer or employee can terminate his or her relationship with us at any time. Our employees generally are not bound by non-competition agreements. The loss of the services of any key personnel, or our inability to attract or retain qualified personnel could have a material adverse effect on our business, financial condition and results of operations.

 

Our future growth depends on developments in the digital video industry, on the adoption of new technologies and on several other industry trends.

 

Future demand for our products will depend significantly on the growing market acceptance of several emerging services, including digital video, high definition television (HDTV), IP-based TV, ad insertion, and logo overlays. The effective delivery of these services will depend, in part, on a variety of new network architectures and standards, such as: FTTP and DSL networks designed to facilitate the delivery of video services by telecom operators; new video compression standards such as MPEG-4/H.264; the greater use of protocols such as IP; and the introduction of new consumer devices, such as advanced set-top boxes and DVRs. If adoption of these emerging services and/or technologies is not as widespread or as rapid as we expect, or if we are unable to develop new products based on these technologies on a timely basis, our net sales growth will be materially and adversely affected.

 

Furthermore, other technological, industry and regulatory trends will affect the growth of our business. These trends include the following:

 

 

 

If, for instance, operators do not pursue the “triple play” or new video products and technology aggressively or in the timeline we expect, our ability to sell our digital video products and grow our revenues will be materially and adversely affected.

 

The markets in which we operate are characterized by rapidly changing technology, and we need to develop and introduce new and enhanced products in a timely manner to remain competitive.

 

The markets in which we operate are characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and relatively short product life. To compete successfully in the markets in which we operate, we must design, develop, manufacture and sell new or enhanced products that provide increasingly higher levels of performance and reliability. Digital video markets are relatively immature, making it difficult to accurately predict the markets’ future growth rates, sizes or technological directions. In view of the evolving nature of these markets, network operators and content aggregators may decide to adopt alternative architectures, industry standards or technologies that are incompatible with our current or future video products and applications. The development and greater market acceptance of new architectures, industry standards or technologies could decrease the demand for our products or render them obsolete, and could negatively impact the pricing and gross margin of our digital video products. Our competitors, many of which have greater resources than we do, may introduce products that are less costly, provide superior performance or achieve greater market acceptance than our products. If we are unable to design, develop, manufacture and sell products that incorporate or are compatible with these new architectures, industry standards or technologies, our business and financial results will be materially and adversely impacted. Our ability to realize revenue growth depends on our ability to:

 

 

The pursuit of necessary technological advances and the development of new products require substantial time and expense. We may not be able to successfully develop or introduce new or enhanced products if they are not cost effective, are not brought to the market in a timely manner, are not in accordance with evolving industry standards and architecture, fail to achieve market acceptance, or are ahead of the market. If the technologies we are currently developing or intend to develop do not achieve feasibility or widespread market acceptance, our business will be materially and adversely impacted. In addition, in order to successfully develop and market certain of our current or future digital video products, we may be required to enter into technology development or licensing agreements with third parties. Failure to enter into development or licensing agreements, when necessary, could limit our ability to develop and market new products and could cause our operating results to suffer. The entry into such development or licensing agreements may not be on terms favorable to us and could negatively impact our gross margins.

Average selling prices of our digital video products may decline, which would materially and adversely affect our financial performance.

 

The ASPs for our digital video products may decline due to the introduction of new products, the adoption of new industry standards, the entry into licensing agreements, an increase in the number of competitors, competitive pricing pressures, promotional programs and customers possessing strong negotiating positions which require price reductions as a condition of purchase. The adoption of industry standards and specifications may erode ASPs on our digital video products if the adoption of such standards lead to the commoditization of products similar to ours. The entry into technology development or licensing agreements, as necessitated by industry developments and business needs, could also reduce our ASPs. Decreasing ASPs may also require us to sell our products at much lower gross margins than in the past, and could result in decreased revenues even if the number of units that we sell increases. We may experience substantial period-to-period fluctuations in future revenue, gross margin and operating results due to ASP erosion in our digital video products. Therefore, we must continue to develop and introduce on a timely basis and a cost-effective manner new products or next-generation products with enhanced functionalities that can be sold at higher gross margins. If we fail to do so, our revenues and gross margins may decline further.

 

We must achieve cost reductions or increase revenues to attain profitability.

 

In order to achieve profitability, we must significantly increase our revenues, continue to reduce the cost of our products, and maintain or reduce our operating expenses. In prior years, we experienced revenue declines which were, in large part, due to declining product ASPs resulting from our transition from a proprietary platform to the Data Over Cable System Interface Specification (DOCSIS) standards platform. Although we have implemented expense reduction and restructuring plans in the past that have focused on cost reductions and operating efficiencies, we continue to operate at a loss. A large portion of our expenses, including rent and operating lease expenditures, is fixed and difficult to reduce or change. Accordingly, if our revenue does not meet our expectations, we may not be able to adjust our expenses quickly enough to compensate for the shortfall in revenue which, in turn, could materially and adversely impact our business, financial condition and results of operations.

 

While we continue to work to reduce the cost of our products through design and engineering changes, we may not be successful in redesigning our products, and, even if we are successful, our efforts may be delayed or our redesigned products may contain significant errors and product defects. In addition, any redesign may not result in sufficient cost reductions to allow us to reduce significantly the prices of our products or improve our gross margins. Reduction in our product costs may require us to use lower-priced components that are highly integrated in future products and may require us to enter into high volume or long-term purchase or manufacturing agreements. Volume purchase or manufacturing agreements may not be available on acceptable terms, if at all, and we could incur significant expenses without related revenues if we cannot use the products or services offered by such agreements. We have incurred significant vendor cancellation charges related to volume purchases and manufacturing agreements in the past and may incur such charges in the future.

 

Our repayment of our Notes could adversely affect our financial condition, and we may not be able to raise additional funds to continue operating our business.

 

Our main source of liquidity continues to be our unrestricted cash and cash equivalents on hand. As a result of our history of operating losses, we expect to continue to use our unrestricted cash to fund operating losses in the future. Our unrestricted cash, cash equivalents and short-term investments totaled $101.3 million and $97.7 million as of December 31, 2005 and 2004, respectively. On March 21, 2006, we paid off the entire principal amount of the outstanding Notes due August 2007, including all accrued and unpaid interest thereon and related fees, for an aggregate amount of $65.6 million. Our repayment in full of the Notes reduced our unrestricted cash, decreased our liquidity and could materially impair our ability to operate our business, especially if we are unable to generate positive cash flow from operations.

 

If our operating losses are more severe than expected or continue longer than expected, we may find it necessary to seek other sources of financing to support our operations and to provide available funds for working capital. We may need to raise additional funds in order to support more rapid expansion, develop new or enhanced services, respond to competitive pressures, acquire complementary businesses or technologies or respond to

unanticipated requirements. We may seek to raise additional funds through private or public sales of securities, strategic relationships, bank debt, and financing under leasing arrangements or otherwise. If additional funds are raised through the issuance of equity securities, the percentage ownership of our current stockholders will be reduced, stockholders may experience additional dilution or such equity securities may have rights, preferences or privileges senior to those of the holders of our common stock. No assurances can be given that additional financing will be available on acceptable terms, if at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to continue operations, develop our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, which could have a material adverse effect on our business, financial condition, operating results and liquidity.

 

Substantially all of our future revenue will be derived from the sale of our digital video products, and our operating results, financial conditions and cash flows will depend upon our ability to generate sufficient revenue from the sale of our digital video products.

 

In January 2006 we announced that we will focus solely on our digital video products and applications. Accordingly, we are susceptible to adverse trends affecting this market segment, including technological obsolescence and the entry of new competition. We expect that this market may continue to account for substantially all of our revenue in the near future. As a result, our future success depends on our ability to continue to sell our digital video products and applications, the gross margin of such sales, our ability to maintain and increase our market share by providing other value-added services to the market, and our ability to successfully adapt our technology and services to other related markets. Markets for our existing services and products may not continue to expand and we may not be successful in our efforts to penetrate new markets.

 

We may be unable to provide adequate customer support.

 

Our ability to achieve our planned sales growth and retain current and future customers will depend in part upon the quality of our customer support operations. Our customers generally require significant support and training with respect to our products, particularly in the initial deployment and implementation stages. Spikes in demand of our support services may cause us to be unable to serve our customers adequately. We may not have sufficient personnel to provide the levels of support that our customers may require during initial product deployment or on an ongoing basis especially during peak periods. Our inability to provide sufficient support to our customers could delay or prevent the successful deployment of our products. In addition, our failure to provide adequate support could harm our reputation and relationships with our customers and could prevent us from selling products to existing customers or gaining new customers.

 

Furthermore, we may experience transitional issues relating to customer support in connection with our decision to dispose of or discontinue various investments and product lines. We may incur liability associated with customers’ dissatisfaction with the level of customer support maintained for discontinued product lines.

 

The deployment process for our equipment may be lengthy and may delay the receipt of new orders and cause fluctuations in our revenues.

 

The timing of deployment of our equipment can be subject to a number of other risks, including the availability of skilled engineering and technical personnel, the availability of other equipment such as fiber optic cable, and the need for local zoning and licensing approvals. We believe that changes in our customers’ deployment plans have delayed, and may in the future delay, the receipt of new orders. Since the majority of our sales have been to relatively few customers, a delay in equipment deployment with any one customer could have a material adverse effect on our sales for a particular period.

 

We may have financial exposure to litigation.

 

We and/or our directors and officers are defendants in a number of lawsuits, including securities litigation lawsuits and patent litigation. See Item 3 — Legal Proceedings for more information regarding our litigation. As a result, we may have financial exposure to litigation as a defendant and because we are obligated to indemnify our officers and members of our Board of Directors for certain actions taken by our officers and directors on our behalf.

In order to limit financial exposure arising from litigation and/or our obligation to indemnify our officers and directors, we have historically purchased directors’ and officers’ insurance (D&O Insurance). There can be no assurance that D&O Insurance will be available to us in the future or, if D&O Insurance is available, that it will not be prohibitively expensive.

 

If there is no insurance coverage for the litigation or, even if there is insurance coverage, if a carrier is subsequently liquidated or placed into liquidation, we will be responsible for the attorney fees and costs resulting from the litigation. The incurrence of significant fees and expenses in connection with the litigation could have a material adverse effect on our results of operations.

 

The loss of existing reseller and system integrator relationships or the failure to establish new relationships or strategic partnerships could have a material adverse effect on our business, financial conditions and results of operations.

 

Our products have been traditionally sold to large cable operators and satellite operators with recent, limited sales to television broadcasters. A portion of our sales are made to a small number of resellers and system integrators, who often incorporate our products and applications in systems that are sold to an end-user customer, which is typically a cable operator, satellite provider or broadcast operator. The resale relationships provide an opportunity to sell our products to our resellers’ customer bases. We rely upon these resellers for recommendations of our products during the evaluation stage of the purchasing process, as well as for implementation and customer support services. A number of our competitors also have strong relationships with the resellers. Although we intend to establish new strategic relationships with leading resellers worldwide to gain access to new customers, including telecom providers, we may not succeed in establishing these relationships. Even if we do establish and maintain these relationships, our resellers or strategic partners may not succeed in marketing our products to their customers. Some of our competitors have established long-standing relationships with cable, satellite and telecom operators that may limit our and our resellers’ ability to sell our products to those customers. Even if we were to sell our products to those customers, it would likely not be based on long-term commitments, and those customers would be able to terminate their relationships with us at any time without significant penalties. Our resellers or strategic partners may also terminate their relationship with us upon short notice without significant penalties.

 

Based on our sole focus on our digital video products, the reduction of our sales force, and our increasing focus on the telecom market, we are increasingly reliant on resellers and system integrators. In order to successfully market to telecom companies, we believe we will need to build alliances with system integrators that sell telecom equipment to the telecom operators. We may be unsuccessful in maintaining our current reseller and system integrator relationships as well as attracting system integrators that sell to telecom companies.

 

Some of our resellers and system integrators have sold in the past, and may sell in the future, products that compete with our products. The loss of existing reseller and system integrator relationships or the failure to establish new relationships or strategic partnerships could have a material adverse effect on our business, financial condition and results of operations.

 

We may fail to accurately forecast customer demand for our products, which could have a negative impact on our customer relationships and our revenues.

 

The nature of the broadband industry makes it difficult for us to accurately forecast demand for our products. Our inability to forecast accurately the actual demand for our products may result in too much or too little supply of products or an over/under capacity of manufacturing or testing resources at any given point in time. The existence of any one or more of these situations could have a negative impact on our business, operating results or financial condition. We have incurred significant vendor cancellation charges related to volume purchase and manufacturing agreements in the past and may incur such charges in the future. We had purchase obligations of approximately $12.1 million as of December 31, 2005, primarily to purchase minimum quantities of materials and components used to manufacture our products. We may be obligated to fulfill these purchase obligations even if demand for our products is lower than we anticipate.

 

Forecasting to meet our customers’ demand is particularly difficult for our products. Our ability to meet customer demand will depend significantly on the availability of our single contract manufacturer. In recent years,

in response to lower sales and falling ASPs, we significantly reduced our headcount and other expenses. As a result, we may be unable to respond to customer demand that increases more quickly than we expect. If we fail to meet customers’ supply expectations, our sales would be adversely affected and we may lose key customer relationships.

 

We may not be able to manage expenses and inventory risks associated with meeting the demand of our customers.

 

From time to time, we receive indications from our customers as to their future plans and requirements to ensure that we will be prepared to meet their demand for our products. If actual orders differ materially from these indications, our ability to manage inventory and expenses may be affected. If we enter into purchase commitments to acquire materials, or expend resources to manufacture products and such products are not purchased by our customers, our business and operating results could suffer.

 

Although we generally do not have long term supply agreements with our customers and have limited backlog of orders for our products, we must maintain or have available sufficient inventory levels to satisfy anticipated demand on a timely basis. Maintaining sufficient inventory levels to ensure prompt delivery of our products increases the risk of inventory obsolescence and associated write-offs, which could harm our business, financial conditions and results of operations.

 

We are dependent on a key third-party manufacturer and any failure of our manufacturer could materially adversely affect our financial condition and operating results.

 

Our products are single sourced from a manufacturer in San Jose, California. Any interruption in the operations of our manufacturer could adversely affect our ability to meet our scheduled product deliveries to customers. If we experience delays or quality control problems or any failure from our current manufacturer, we may be unable to supply products in a timely manner to our customers. While we believe that there are alternative manufacturers available, we believe that the procurement from alternative suppliers could take several months. In addition, these alternative suppliers may not be able to supply us products that are functionally equivalent, or make our products available to us on a timely basis or on similar terms. Resulting delays, quality control problems or reductions in product shipments could materially and adversely affect on our financial performance, damage customer relationships, and expose us to potential damages that may arise from our inability to supply our customers with products. Further, a significant increase in the price of underlying components, such as our semiconductor components, could harm our gross margins or operating results. There may not be manufacturers that are able to meet our future volume or quality requirements at a price that is favorable to us. Any financial, operational, production or quality assurance difficulties experienced by our single manufacturer could harm our business and financial results.

 

Additionally, we attempt to limit this risk by maintaining safety stocks of these components, subassemblies and modules. As a result of this investment in inventories, we have in the past been and in the future may be subject to risk of excess and obsolete inventories, which could harm our business. In this regard, our gross margins and operating results could be adversely affected by excess and obsolete inventory.

 

Our products are assembled and tested by our single manufacturer using testing equipment that we provide. As a result of our dependence on the contract manufacturer for the assembly and testing of our products, we do not directly control product delivery schedules or product quality. Any product shortages or quality assurance problems could increase the costs of manufacturing, assembling or testing our products. In addition, as manufacturing volume increases, we will need to procure and assemble additional testing equipment and provide it to our contract manufacturer. The production and assembly of testing equipment typically require significant lead times. We could experience significant delays in the shipment of our products if we are unable to provide this testing equipment to our contract manufacturers in a timely manner.

 

We are dependent upon international sales and there are many risks associated with international operations, any of which could harm our financial condition and results of operations.

 

We are dependent upon international sales, even though we expect sales to customers outside of the United States to represent a significantly smaller percentage of our revenues for the foreseeable future compared to our historical

revenues. For the years ended December 31, 2005, 2004 and 2003, approximately 42%, 47% and 45%, respectively, of our net revenues were from customers outside of the United States. We may be unable to maintain or increase international sales of our products. International sales are subject to a number of risks, including the following:

 

 

One or more of these factors may have a material adverse effect on our future operations and consequently, on our business, financial conditions and operating results.

 

While we generally invoice our foreign sales in U.S. dollars, we invoice some of our sales in Europe in Euros and local currency in other countries. Since we have also elected to take payment from our customers in local currencies and may elect to take payment in other foreign currencies in the future, we are exposed to losses as the result of foreign currency fluctuations. We currently do not engage in foreign currency hedging transactions. We may in the future choose to limit our exposure by the purchase of forward foreign exchange contracts or through similar hedging strategies. No currency hedging strategy can fully protect against exchange-related losses. In addition, if the relative value of the U.S. dollar in comparison to the currency of our foreign customers should increase, the resulting effective price increase of our products to our foreign customers could result in decreased sales. If our customers are affected by currency devaluations or general economic downturns, their ability to purchase our products could be reduced significantly.

 

We are subject to regulation by U.S. and foreign governments and qualification requirements by non-governmental agencies. If we are unable to obtain and maintain regulatory qualifications for our existing and future products, our financial results may be adversely affected.

 

The cable, satellite and telecom industries are subject to extensive regulation in the United States and in foreign countries, which may affect the sale of our products and the growth of our business domestically and internationally. The growth of our business and our financial performance depend in part on regulations in these industries. Our products are also subject to qualification, clearance, and approval in certain countries, and we cannot make any assurances that we will be able to maintain these qualifications, clearances or approvals in all the countries in which we operate. If we do not comply with the applicable regulatory requirements in each of the jurisdictions where our products are sold, we may be subject to regulatory enforcement actions which could require us to, among other things, cease selling our products.

 

We are subject to the Foreign Corrupt Practices Act (FCPA) and other laws which prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. and other business entities for the purpose of obtaining or retaining business. We make sales in countries known to experience corruption. Our sales activities in such countries create the risk of unauthorized payments or offers of payments by one of our employees, consultants, sales agents or distributors which could be in violation of various laws including the FCPA, even though such parties are not always subject to our control. We have attempted to implement

safeguards to prevent losses from such practices and to discourage such practices by our employees, consultants, sales agents and distributors. However, our safeguards may prove to be less than effective and our employees, consultants, sales agents or distributors may engage in conduct for which we might be held responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could adversely affect our business, financial condition and results of operations.

 

Furthermore, foreign countries may decide to prohibit, terminate or delay the construction of new infrastructure or the adoption of new technology for a variety of reasons. These reasons include environmental issues, economic downturns, availability of favorable pricing for other communications services and the availability and cost of related equipment. Regulations dealing with access by competitors to the networks of incumbent operators could slow or stop additional construction or expansion of these operators. Increased regulation of our customers’ pricing or service offerings could limit their investments and consequently the sale of our products. Changes in regulations could have an adverse impact on our business and financial results.

 

The markets in which we operate are intensely competitive and many of our competitors are larger and more established.

 

The markets for digital video products and applications are extremely competitive and have been characterized by rapid technological changes. Competitors vary in size and in the scope and breadth of the products and services they offer. Our current competitors include Scopus Video Networks Ltd.; RGB Networks, Inc.; BigBand Networks; and Cisco Systems, Inc. through its acquisition of Scientific-Atlanta, Inc. Competitors who could enter into the digital video applications and products market include larger and more established players such as Motorola, Inc. Companies that have historically not had a large presence in digital video applications and products market have recently begun to expand their market share through mergers and acquisitions. Further, our competitors may bundle their products or incorporate functionality into existing products in a manner that discourages users from purchasing our products or which may require us to lower our selling prices resulting in lower gross margins. Consolidation in the industry also may result in larger competitors that may have significant combined resources with which to compete against us. We also face competition from early stage companies with access to significant financial backing that seek to improve existing technologies or develop new technologies. Increased competition could result in reductions in price and revenues, lower profit margins, loss of customers and loss of market share. Any one of these factors could materially and adversely affect our business, financial condition and operating results.

 

The principal competitive factors in our market include the following:

 

 

Many of our competitors and potential competitors are substantially larger and have significant advantages over us, including, without limitation:

 

 

Our competitors and potential competitors may be in a better position to withstand any significant reduction in capital spending by customers in these markets or to reduce selling prices for competitive reasons. They often have broader product lines and market focus and may not be as susceptible to downturns in a particular market. In addition, many of our competitors and potential competitors have been in operation longer than we have and therefore have more long-standing and established relationships with domestic and foreign customers.

 

If any of our competitors’ products or technologies were to become the industry standard, our business could be seriously harmed. If our competitors are successful in bringing these products to market earlier, or if these products are more technologically capable than ours, then our sales could be materially and adversely affected. Our competitors may be in a stronger position to respond quickly to new or emerging technologies and changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of their products and services than we can. Accordingly, we may not be able to maintain or expand our revenues if competition increases and we are unable to respond effectively.

 

Given these competitive and other market factors, we continually look for opportunities to compete effectively and create value for our stockholders. We may, at any time and from time to time, be in the process of identifying or evaluating product development initiatives, partnerships, strategic alliances or transactions and other alternatives in order to maintain market position and maximize shareholder value. Market and other competitive factors may cause us to change our strategic direction, and we may not realize the benefits of any such initiatives, partnerships, alliances or transactions. We cannot assure you that any such initiatives, partnerships, alliances or transactions that we identify and pursue would actually result in our competing effectively, maintaining market position or increasing stockholder value. Our failure to realize any expected benefits from such initiatives, partnerships, alliances or transactions could negatively impact our financial position, results of operations, cash flows and stock price.

 

Our business is subject to the risks of warranty returns, product liability and product defects.

 

Products like ours are very complex and can frequently contain undetected errors or failures, especially when first introduced or when new versions are released. Despite testing, errors may occur. Product errors could affect the performance or interoperability of our products, delay the development or release of new products or new versions or upgrades of products, and adversely affect our reputation, our customers’ willingness to buy products from us, and market acceptance and perception of our products. Any such errors or delays in releasing new products or new versions or upgrades of products or allegations of unsatisfactory performance could cause us to lose revenue or market share, increase our service costs, cause us to incur substantial costs in redesigning the products, subject us to liability for damages and divert our resources from other tasks, any one of which could materially and adversely affect our business, results of operations and financial condition. Although we have limitation of liability provisions in our standard terms and conditions of sale, they may not be effective as a result of federal, state or local laws or ordinances or unfavorable judicial decisions in the United States or other countries. The sale and support of our products also entails the risk of product liability claims. We maintain insurance to protect against certain claims associated with the use of our products, but our insurance coverage may not adequately cover any claim asserted against us. In addition, even claims that ultimately are unsuccessful could result in our expenditure of funds in litigation and divert management’s time and other resources.

 

We may be unable to adequately protect or enforce our intellectual property rights.

 

We rely on a combination of patent, trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in our products. Even though we seek to establish and protect proprietary rights in our products, there are risks. There are no assurances that any patent, trademark, copyright or other intellectual property rights owned by us will not be invalidated, circumvented or challenged, that such intellectual property rights will provide competitive advantages to us or that any of our pending or future patent applications will be issued with the scope of the claims sought by us, if at all. There are no assurances that others will not develop technologies that are similar or superior to our technology, duplicate our technology, or design around the patents that we own. In addition, effective patent, copyright and trade secret protection may be unavailable or limited in certain foreign countries in which we do business or may do business in the future.

Our pending patent applications may not be granted. Even if they are granted, the claims covered by any patent may be reduced from those included in our applications. Any patent might be subject to challenge in court and, whether or not challenged, might not be broad enough to prevent third parties from developing equivalent technologies or products without a license from us.

 

We believe that the future success of our business will depend on our ability to translate the technological expertise and innovation of our employees into new and enhanced products. We have entered into confidentiality and invention assignment agreements with our employees, and we enter into non-disclosure agreements with many of our suppliers, distributors and appropriate customers so as to limit access to and disclosure of our proprietary information. These contractual arrangements, as well as statutory protections, may not prove sufficient or effective to prevent misappropriation of our technology, trade secrets or other proprietary information or deter independent third-party development of similar technologies. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States. We may, in the future, take legal action to enforce our patents and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could negatively affect our business, operating results, financial position and liquidity.

 

We pursue the registration of our trademarks in the United States and have applications pending to register several of our trademarks throughout the world. However, the laws of certain foreign countries might not protect our products or intellectual property rights to the same extent as the laws of the United States. Effective trademark, copyright, trade secret and patent protection may not be available in every country in which our products may be manufactured, marketed or sold.

 

Third party claims of infringement or other claims against us could adversely affect our ability to market our products, require us to redesign our products or seek licenses from third parties, and seriously harm our operating results and disrupt our business.

 

The industry in which we operate is characterized by vigorous protection of intellectual property rights, which on occasion have resulted in significant and often protracted litigation. As is typical in our industry, we have been and may from time to time be notified of claims asserting that we are infringing intellectual property rights owned by third parties. We also have in the past agreed to, and may from time to time in the future agree to, indemnify customers of our technology or products for claims against such customers by a third party based on claims that our technology or products infringe patents of that third party. Currently, in the cable industry, there is industry-wide patent litigation involving the DOCSIS standard and certain video technologies. Our customers have been sued for using certain DOCSIS complaint products and video products, including our products. Our customers have requested indemnity pursuant to the terms and conditions of our sales to them, and we are contributing to the legal fees and costs of these litigations. Additionally, we may have further liability under indemnity obligations if there is a settlement or judgment. Please see Item 3 — Legal Proceedings for additional information.

 

We further believe that companies may be increasingly subject to infringement claims as distressed companies and individuals attempt to generate cash by enforcing their patent portfolio against a wide range of products. These types of claims, meritorious or not, may result in costly and time-consuming litigation; divert management’s attention and other resources; require us to enter into royalty arrangements; subject us to significant damages or injunctions restricting the sale of our products; require us to indemnify our customers for the use of the allegedly infringing products; require us to refund payment of allegedly infringing products to our customers or to forgo future payments; require us to redesign certain of our products; invalidate our proprietary rights; or damage our reputation. Although we carry general liability insurance, our insurance may not cover potential claims of this type and may not be adequate to indemnify us for all liability that may be imposed. Our failure to obtain a license for key intellectual property rights from a third party for technology used by us could cause us to incur substantial liabilities and prevent us from manufacturing and selling products utilizing the technology. Alternatively, we could be required to expend significant resources to develop non-infringing technology with no assurances that we would be successful in such endeavors. The occurrence of any of the above events could materially and adversely affect our business, results of operations and financial condition.

We are exposed to the credit risk of our customers and to credit exposures in weakened markets, which could result in material losses.

 

Most of our sales are on an open credit basis. Payment terms in the United States are typically 30 to 60 days, and because of local customs or conditions, longer in some markets outside the United States. Beyond our open credit arrangements, we have also experienced a request for customer financing and facilitation of leasing arrangements, which we have not provided to date and do not expect to provide in the future. We expect demand for enhanced open credit terms, for example, longer payment terms, customer financing and leasing arrangements, to continue and believe that such arrangements are a competitive factor in obtaining business. Our decision not to provide these types of financing arrangements may adversely affect our ability to sell products, and therefore, our revenue, operations and business.

 

Because of current conditions in the global economy, our exposure to credit risks relating to sales on an open credit basis has increased. Although we monitor and attempt to mitigate the associated risk, there can be no assurance that our efforts will be effective in reducing credit risk. Additionally, there have been significant insolvencies and bankruptcies among our customers, which have caused and may continue to cause us to incur economic and financial losses. There can be no assurance that additional losses would not be incurred and that such losses would not be material. Although these losses have generally not been material to date, future losses, if incurred, could harm our business and have a material adverse effect on our operating results and financial condition.

 

We have and we may seek to expand our business through acquisitions which could disrupt our business operations and harm our operating results.

 

In order to expand our business, we may make strategic acquisitions of other companies or certain assets. We plan to continue to evaluate opportunities for strategic acquisitions from time to time, and may make an acquisition at some future point. However, the current volatility in the stock market and the current price of our common stock may adversely affect our ability to make such acquisitions. Any acquisition that we make involves substantial risks, including the following:

 

 

Acquisitions may also cause us to:

 

 

For example, we made ten acquisitions during the period between 1999 and 2000. Due to various economic conditions, none of the products from our acquired businesses, other than the digital video products, have achieved the level of market acceptance that was forecasted at the time of their acquisitions. Additionally, certain product

groups have not achieved the level of technological development needed to be marketable or to expand the market. Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that our future acquisitions will be successful and will not materially adversely affect our business, operating results or financial condition. Failure to manage and successfully integrate acquisitions we make could materially harm our business and operating results. Even when an acquired company has already developed and marketed products, there can be no assurance that product enhancements will be made in a timely fashion or that all pre-acquisition due diligence will have identified all possible issues that might arise with respect to such products.

 

Our products are subject to safety approvals and certifications.

 

In the United States, our products are required to meet certain safety requirements. For example, we are required to have our video products certified by Underwriters Laboratory in order to meet federal requirements. Outside the United States, our products are subject to the regulatory requirements of each country in which the products are manufactured or sold. These requirements are likely to vary widely. We may be unable to obtain on a timely basis, or at all, the regulatory approvals that may be required for the manufacture, marketing and sale of our products.

 

Compliance with current and future environmental regulations may be costly which could impact our future earnings.

 

We may be subject to environmental and other regulations due to our production and marketing of products in certain states and countries. In addition, we could face significant costs and liabilities in connection with product take-back legislation, which enables customers to return a product at the end of its useful life and charges us with financial and other responsibility for environmentally safe collection, recycling, treatment and disposal. We also face increasing complexity in our product design and procurement operations as we adjust to new and upcoming requirements relating to the materials composition of our products, including the restrictions on lead and certain other substances in electronics that will apply to specified electronics products put on the market in the European Union as of July 1, 2006 (Restriction of Hazardous Substances in Electrical and Electronic Equipment Directive (EU RoHS)). The European Union has also finalized the Waste Electrical and Electronic Equipment Directive (WEEE), which makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for enacting and implementing this directive by individual European Union governments was August 13, 2004 (WEEE Legislation), although extensions were granted in some countries. Producers became financially responsible under the WEEE Legislation beginning in August 2005. Other countries, such as the United States, China and Japan, have enacted or may enact laws or regulations similar to the EU RoHS or WEEE Legislation. Other environmental regulations may require us to reengineer our products to utilize components which are more environmentally compatible. Such reengineering and component substitution may result in additional costs to us. Although we currently do not anticipate any material adverse effects based on the nature of our operations and the effect of such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on us.

 

Various export licensing requirements could materially and adversely affect our business or require us to significantly modify our current business practices.

 

Various government export regulations may apply to the encryption or other features of our products. We may have to make certain filings with the government in order to obtain permission to export certain of our products. In the past, we may have inadvertently failed to file certain export applications and notices, and we may have to make certain filings and request permission to continue exportation of any affected products without interruption while these applications are pending. If we do have to make such filings, there are no assurances that we will obtain permission to continue exporting the affected products or that we will obtain any required export approvals now or in the future. If we do not receive the required export approvals, we may be unable to ship those products to certain customers located outside of the United States. In addition, we may be subject to fines or other penalties due to the failure to file certain export applications and notices.

Compliance with changing laws and regulations relating to corporate governance and public disclosure has resulted, and will continue to result, in the incurrence of additional expenses.

 

New and changing laws and regulations, including the Sarbanes-Oxley Act of 2002, new Commission regulations and NASDAQ Stock Market Rules, impose stricter corporate governance requirements, greater disclosure obligations, and greater focus on disclosure and internal controls. These new laws and regulations have had the effect of increasing the complexity and cost of our Company’s corporate governance compliance, diverting the time and attention of our management from revenue-generating activities to compliance activities, and increasing the risk of personal liability for our board members and executive officers involved in our Company’s corporate governance process. Our efforts to comply with evolving laws and regulations have resulted, and will continue to result, in increased general and administrative expenses, and increased professional and independent auditor fees. In addition, it has become more difficult and expensive for us to obtain director and officer liability insurance.

 

In order to meet the new corporate governance and financial disclosure obligations, we have been taking, and will continue to take, steps to improve our controls and procedures, including disclosure and internal controls, and related corporate governance policies and procedures to address compliance issues and correct any deficiencies that we may discover. Our efforts to correct the deficiencies in our disclosure and internal controls have required, and will continue to require, the commitment of significant financial and managerial resources. In addition, we anticipate the costs associated with the continued testing and remediation of our internal controls will be significant and material in the year ended December 31, 2006 and may continue to be material in future years as these controls are maintained and continually evaluated and tested.

 

Furthermore, changes in our operations and the growth of our business may require us to modify and expand our disclosure controls and procedures, internal controls and related corporate governance policies. In addition, the new and changed laws and regulations are subject to varying interpretations in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. If our efforts to comply with new or changed laws and regulations differ from the conduct intended by regulatory or governing bodies due to ambiguities or varying interpretations of the law, we could be subject to regulatory sanctions, our reputation may be harmed and our stock price may be adversely affected.

 

Recent and proposed regulations related to equity compensation could adversely affect earnings, our ability to raise capital and affect our ability to attract and retain key personnel.

 

Since our inception, we have used stock options as a fundamental component of our employee compensation packages. We believe that our stock option plans are an essential tool to link the long-term interests of stockholders and employees, especially executive management, and serve to motivate management to make decisions that will, in the long run, give the best returns to stockholders. The Financial Accounting Standards Board has announced changes to GAAP that requires us to record a charge to earnings for employee stock option grants and employee stock purchase plan rights for all future periods beginning on January 1, 2006. In the event that the assumptions used to compute the fair value of our stock-based awards are later determined to be inaccurate or if we change our assumptions significantly in future periods, our stock-based compensation expense and results of operations could be materially affected which could impede any capital raising efforts. Additionally, to the extent that new accounting standards make it more difficult or expensive to grant options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business.

 

Our stock price has been and is likely to continue to be highly volatile.

 

The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future. Investors may be unable to resell our common stock at or above their purchase price. In the past, companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation.

Our stock price could be subject to extreme fluctuations in response to a variety of factors, including the following:

 

 

In addition, the stock markets in general, including the Pink Sheets and The NASDAQ Stock Market, and the stock price of broadband services and technology companies in particular, have experienced extreme price and volume volatility. This volatility and decline have affected many companies irrespective of or disproportionately to the operating performance of these companies. Additionally, industry factors may materially adversely affect the market price of our common stock.

 

We have adopted a stockholder rights plan, which, together with provisions in our charter documents and Delaware law, may delay or prevent an acquisition of us, which could decrease the value of our stock.

 

We adopted a stockholder rights plan pursuant to which we distributed one right for each outstanding share of common stock held by our stockholders of record as of February 20, 2001. If our Board of Directors believes that a particular acquisition is undesirable, the rights may substantially dilute the stock ownership of a person or group attempting a take-over of us, even if such a change in control is beneficial to our stockholders. As a result, the plan could make it more difficult for a third party to acquire us, or a significant percentage of our outstanding capital stock, without first negotiating with our Board of Directors.

 

Provisions of our Certificate of Incorporation and our Bylaws could make it more difficult for a third party to acquire control of us in a transaction not approved by our Board of Directors. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Any provision of our Certificate of Incorporation, Bylaws, stockholder rights plan or Delaware law that has the effect of delaying or preventing a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock.

 

We rely on complex information technology systems and networks to operate our business. Any significant system or network disruption could have a material adverse impact on our operations, sales and financial performance.

 

We rely on the efficient and uninterrupted operation of complex information technology systems and networks. All information technology systems are potentially vulnerable to damage or interruption from a variety of sources, including but not limited to computer viruses, security breach, energy blackouts, natural disasters, terrorism, war and telecommunication failures. There also may be system or network disruptions if new or upgraded business management systems are defective or are not installed properly. We have implemented various measures to

manage our risks related to system and network disruptions, but a system failure or security breach could negatively impact our operations and financial results. In addition, we may incur additional costs to remedy the damages caused by these disruptions or security breaches.

 

We, our sole manufacturer and our customers are vulnerable to earthquakes, disruptions to power supply, labor issues and other unexpected events.

 

Our corporate headquarters, the majority of our research and development activities and our sole source manufacturer are located in California, an area known for seismic activity. An earthquake, or other significant natural disaster, could result in an interruption in our business or the operations of our manufacturer. Some of the other locations in which we and our customers conduct business are prone to natural disasters. If there is a natural disaster in any of the locations where our customers are located, we face the risk that our customers may incur losses or substantial business interruptions which may impair their ability to continue to purchase their products from us.

 

Our California operations may also be subject to disruptions in power supply, such as those that occurred in 2001. In addition, the cost of electricity and natural gas has risen significantly. Power outages could disrupt our business operations and those of our suppliers, and could cause us to fail to meet the commitments to our customers. Our business may also be impacted by labor issues related to our operations and/or those of our manufacturer, network operators and content aggregators, or customers. Such an interruption could harm our current and prospective business relationships and adversely impact our operating results. We may not carry sufficient business interruption insurance to compensate for any losses that we may sustain as a result of any natural disasters or other unexpected events. Disruptions in power supply, labor issues and other unexpected events impacting our customers may affect their purchasing decisions and thus adversely impact our financial performance.

 

SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which are subject to the safe harbor created by those sections. All statements included or incorporated by reference in this report, other than statements that are purely historical in nature, are forward-looking statements. Forward-looking statements are generally written in the future tense and/or are preceded by words such as may, will, should, expect, plan, anticipate, believe, estimate, predict, future, intend, or certain or the negative of these terms or similar expressions to identify forward-looking statements. Forward-looking statements include, among other things, statements regarding:

 

 

 

 

 

Forward-looking statements are not guarantees of future performance and involve risks and uncertainties, including those discussed in Item 1A of this Report. The forward-looking statements contained in this report are based on information that is currently available to us and expectations and assumptions that we deemed reasonable at the time the statements were made. We do not undertake any obligation to update any forward-looking statements in this report or in any of our other communications, except as required by law. All such forward-looking statements should be read as of the time the statements were made and with the recognition that these forward-looking statements may not be complete or accurate at a later date. The business risks discussed in Item 1A of this Report on Form 10-K, among other things, should be considered in evaluating our prospects and future financial performance.

 

Not applicable.

 

Our principal executive offices are located in Santa Clara, California, where we lease approximately 63,069 square feet under a lease that expires in September 2009. We sub-sublease approximately 141,000 square feet of space in Santa Clara, California under a sublease that expires in October 2009 with the sub-sublease expiring on the same date as the sublease. In the United States, we also leased an additional facility in Costa Mesa, California that was subleased; the lease expired in March 2006 and the sublease expired in September 2005.

 

In addition, we lease properties worldwide. We had a facility in Tel Aviv, Israel consisting of approximately 136,000 square feet under a lease that expired in October 2005. We subleased approximately 107,000 square feet of the Israel property, and those subleases expired in October 2005. We have offices in Brussels, Belgium; Hong Kong; Shanghai, China; Tel Aviv, Israel; and Seoul, Korea. We had a facility in Ottawa, Ontario, Canada that we subleased and the lease and sublease expired in June 2006. We believe that our existing facilities are adequate to meet our needs for the foreseeable future. For additional information regarding obligations under leases, see Note 5, “Commitments,” to Consolidated Financial Statements.

 

Beginning in April 2000, several plaintiffs filed class action lawsuits in federal court against us and certain of our officers and directors. Later that year, the cases were consolidated in the United States District Court for the Northern District of California (Court) as In re Terayon Communication Systems, Inc. Securities Litigation. The Court then appointed lead plaintiffs who filed an amended complaint. In 2001, the Court granted in part and denied in part defendants’ motion to dismiss, and plaintiffs filed a new complaint. In 2002, the Court denied defendants’ motion to dismiss that complaint, which, like the earlier complaints, alleged that the defendants violated the federal securities laws by issuing materially false and misleading statements and failing to disclose material information regarding our technology. On February 24, 2003, the Court certified a plaintiff class consisting of those who purchased or otherwise acquired our securities between November 15, 1999 and April 11, 2000. On September 8, 2003, the Court heard defendants’ motion to disqualify two of the lead plaintiffs and to modify the definition of the plaintiff class. On September 10, 2003, the Court issued an order vacating the hearing date for the parties’ summary judgment motions, and, on September 22, 2003, the Court issued another order staying all discovery until further notice and vacating the trial date, which had been scheduled for November 4, 2003. On February 23, 2004, the Court issued an order disqualifying two of the lead plaintiffs and ordered discovery, which was conducted. In February 2006, we mediated the case with plaintiffs’ counsel. As part of the mediation, we reached a settlement of $15.0 million. After this mediation, our insurance carriers agreed to tender their remaining limits of coverage, and we contributed approximately $2.2 million to the settlement. On March 17, 2006, we, along with plaintiffs’ counsel,

submitted the settlement to the Court and the shareholder class for approval. The Court held a hearing to review the settlement of the shareholder litigation on September 25, 2006. To date, the Court has not approved the settlement.

 

On October 16, 2000, a lawsuit was filed against us and the individual defendants (Zaki Rakib, Selim Rakib and Raymond Fritz) in the Superior Court of California, San Luis Obispo County. This lawsuit was titled Bertram v. Terayon Communication Systems, Inc. The factual allegations in the Bertram complaint were similar to those in the federal class action, but the Bertram complaint sought remedies under state law. Defendants removed the Bertram case to the United States District Court, Central District of California, which dismissed the complaint. Plaintiffs appealed this order, and their appeal was heard on April 16, 2004. On June 9, 2004, the United States Court of Appeals for the Ninth Circuit affirmed the order dismissing the Bertram case.

 

In 2002, two shareholders filed derivative cases purportedly on behalf of us against certain of its current and former directors, officers and investors. (The defendants differed somewhat in the two cases.) Since the cases were filed, the investor defendants have been dismissed without prejudice, and the lawsuits have been consolidated as Campbell v. Rakib in the Superior Court of California, County of Santa Clara. We are a nominal defendant in these lawsuits, which allege claims relating to essentially the same purportedly misleading statements that are at issue in the securities class action filed in April 2000. In that securities class action, we disputed making any misleading statements. The derivative complaints also allege claims relating to stock sales by certain of the director and officer defendants. On September 15, 2006, we entered into a Stipulation of Settlement of Derivative Claims. On September 18, 2006, the Superior Court of California, County of Santa Clara approved the final settlement of the derivative litigation entitled In re Terayon Communication Systems, Inc. Derivative Litigation (Case No. CV 807650). In connection with the settlement, we paid $1.0 million in attorney’s fees and expenses to the derivative plaintiffs’ counsel and agreed to adopt certain corporate governance practices.

 

On June 23, 2006, a putative class action lawsuit was filed against us in the United States District Court for the Northern District of California by I.B.L. Investments Ltd. purportedly on behalf of all persons who purchased our common stock between October 28, 2004 and March 1, 2006. Zaki Rakib, Jerry D. Chase, Mark Richman and Edward Lopez are named as individual defendants. The lawsuit focuses on the our March 1, 2006 announcement of the restatement of our financial statements for the year ended December 31, 2004, and for the four quarters of 2004 and the first two quarters of 2005. The plaintiffs are seeking damages, interest, costs and any other relief deemed proper by the court. An unfavorable ruling in this legal matter could materially and adversely impact our results of operations.

 

In January 2005, Adelphia Communications Corporation (Adelphia) sued us in the District Court of the City and County of Denver, Colorado. Adelphia’s complaint alleged, among other things, breach of contract and misrepresentation in connection with our sale of cable modem termination systems (CMTS) products to Adelphia and our announcement to cease future investment in the CMTS market. Adelphia sought damages in excess of $25.0 million and declaratory relief. We moved to dismiss the complaint seeking an order blocking the case from going forward at a preliminary stage. The court denied our motion to dismiss the complaint, thereby permitting the case and discovery to go forward. We filed a response to Adelphia’s complaint and discovery began. On October 21, 2005, the parties settled the litigation in exchange for (i) full mutual releases of the other party for claims related to the CMTS and customer premise equipment products and (ii) a payment to Adelphia consisting of $3.0 million in cash, $0.8 million of DM 6400 products at list price and $0.8 million of modems at a price of $33.50 each. On December 1, 2005, the United States Bankruptcy Court of the Southern District of New York approved the settlement. On December 15, 2005, the court dismissed the case with prejudice.

 

On April 22, 2005, we filed a lawsuit in the Superior Court of California, County of Santa Clara against Adam S. Tom (Tom) and Edward A. Krause (Krause) and a company founded by Tom and Krause, RGB Networks, Inc. (RGB). We sued Tom and Krause for breach of contract and RGB for intentional interference with contractual relations based on breaches of the Noncompetition Agreements entered into between us and Tom and Krause, respectively. On May 24, 2006, RGB, Tom and Krause filed a Notice of Motion and Motion For Leave To File a Cross-Complaint, in which the defendants stated that they intended to file counter-claims against us for misappropriation of trade secrets, unfair competition, tortious interference with contractual relations and tortious interference with prospective economic advantage. On July 6, 2006, the court granted the defendants’ motion, and on July 20, defendants filed a cross-complaint for misappropriation of trade secrets, unfair competition, tortious

interference with contractual relations and tortious interference with prospective economic advantage. On August 21, 2006, we filed a demurrer to certain of those claims. The court granted our demurrer as to RGB’s request for declaratory judgment. On November 9, 2006, we filed our answer to RGB’s complaint. Damages in this matter are not capable of determination at this time and the case may be lengthy and expensive to litigate.

 

On September 13, 2005, a case was filed by Hybrid Patents, Inc. (Hybrid) against Charter Communications, Inc. (Charter) in the United States District Court for the Eastern District of Texas for patent infringement related to Charter’s use of equipment (cable modems, CMTS and embedded multimedia terminal adapters (eMTAs)) meeting the Data Over Cable System Interface Specification (DOCSIS) standard and certain video equipment. Hybrid has alleged that the use of such products violates its patent rights. Charter has requested that we and others supplying it with equipment indemnify Charter for these claims. We and others have agreed to contribute to the payment of the legal costs and expenses related to this case. On May 4, 2006, Charter filed a cross-complaint asserting its indemnity rights against us and a number of companies that supplied Charter with cable modems, and to date, this cross-complaint has not been dismissed. Trial is scheduled on Hybrid’s claims for July 2, 2007. At this point, the outcome is uncertain and we can not assess damages. However, the case may be expensive to defend and there may be substantial monetary exposure if Hybrid is successful in its claim against Charter and then elects to pursue other cable operators that use the allegedly infringing products.

 

On July 14, 2006, a case was filed by Hybrid against Time Warner Cable (TWC), Cox Communications Inc. (Cox), Comcast Corporation (Comcast), and Comcast of Dallas, LP (together, the MSOs) in the United States District Court for the Eastern District of Texas for patent infringement related to the MSOs’ use of data transmission systems and certain video equipment. Hybrid has alleged that the use of such products violate its patent rights. No trial date is known yet. To date, we have not been named as a party to the action. The MSOs have requested that we and others supplying them with cable modems and equipment indemnify the MSOs for these claims. We and others have agreed to contribute to the payment of legal costs and expenses related to this case. At this point, the outcome is uncertain and we cannot assess damages. However, the case may be expensive to defend and there may be substantial monetary exposure if Hybrid is successful in its claim against the MSOs and then elects to pursue other cable operators that use the allegedly infringing products.

 

On September 16, 2005, a case was filed by Rembrandt Technologies, LP (Rembrandt) against Comcast in the United States District Court for the Eastern District of Texas alleging patent infringement. In this matter, Rembrandt alleged that products and services sold by Comcast infringe certain patents related to cable modem, voice-over internet, and video technology and applications. To date, we have not been named as a party in the action, but we have received a subpoena for documents and a deposition related to the products we sold to Comcast. We continue to comply with this subpoena. Comcast requested that we and others supplying them with products for indemnity related to the products that we sold to them. We and others have agreed to contribute to the payment of legal costs and expenses related to this case. Trial is scheduled on Rembrandt’s claims for August 6, 2007. At this point, the outcome is uncertain and we cannot assess damages. However, the case may be expensive to defend and there may be substantial monetary exposure if Rembrandt is successful in its claim against Comcast and then elects to pursue other cable operators that use the allegedly infringing products.

 

On June 1, 2006, a case was filed by Rembrandt against Charter, Cox, CSC Holdings, Inc. (CSC) and Cablevisions Systems Corp. (Cablevision) in the United States District Court for the Eastern District of Texas alleging patent infringement. In this matter, Rembrandt alleged that products and services sold by Charter infringe certain patents related to cable modem, voice-over internet, and video technology and applications. To date, we have not been named as a party in the action, but Charter has made a request for indemnity related to the products that we and others have sold to them. We have not received an indemnity request from Cox, CSC and Cablevision but we expect that such request will be forthcoming shortly. To date, we and others have not agreed to contribute to the payment of legal costs and expenses related to this case. Trial date of this matter is not known at this time. At this point, the outcome is uncertain and we cannot assess damages. However, the case may be expensive to defend and there may be substantial monetary exposure if Rembrandt is successful in its claim against Charter and then elects to pursue other cable operators that use the allegedly infringing products.

 

On June 1, 2006, a case was filed by Rembrandt against TWC in the United States District Court for the Eastern District of Texas alleging patent infringement. In this matter, Rembrandt alleged that products and services sold by

TWC infringe certain patents related to cable modem, voice-over internet, and video technology and applications. To date, we have not been named as a party in the action, but TWC has made a request for indemnity related to the products that we and others have sold to them. We and others have agreed to contribute to the payment of legal costs and expenses related to this case. Trial date of this matter is not known at this time. At this point, the outcome is uncertain and we cannot assess damages. However, the case may be expensive to defend and there may be substantial monetary exposure if Rembrandt is successful in its claim against TWC and then elects to pursue other cable operators that use the allegedly infringing products.

 

On September 13, 2006, a second case was filed by Rembrandt against TWC in the United States District Court for the Eastern District of Texas alleging patent infringement. In this matter, Rembrandt alleged that products and services sold by TWC infringe certain patents related to the DOCSIS standard. To date, we have not been named as a party in the action, but TWC has made a request for indemnity related to the products that we and others have sold to them. We and others have agreed to contribute to the payment of legal costs and expenses related to this case. Trial date of this matter is not known at this time. At this point, the outcome is uncertain and we cannot assess damages. However, the case may be expensive to defend and there may be substantial monetary exposure if Rembrandt is successful in its claim against TWC and then elects to pursue other cable operators that use the allegedly infringing products.

 

We have received letters claiming that our technology infringes the intellectual property rights of others. We have consulted with our patent counsel and reviewed the allegations made by such third parties. If these allegations were submitted to a court, the court could find that our products infringe third party intellectual property rights. If we are found to have infringed third party rights, we could be subject to substantial damages and/or an injunction preventing us from conducting our business. In addition, other third parties may assert infringement claims against us in the future. A claim of infringement, whether meritorious or not, could be time-consuming, result in costly litigation, divert our management’s resources, cause product shipment delays or require us to enter into royalty or licensing arrangements. These royalty or licensing arrangements may not be available on terms acceptable to us, if at all.

 

Furthermore, we have in the past agreed to, and may from time to time in the future agree to, indemnify a customer of our technology or products for claims against the customer by a third party based on claims that its technology or products infringe intellectual property rights of that third party. These types of claims, meritorious or not, can result in costly and time-consuming litigation, divert management’s attention and other resources, require us to enter into royalty arrangements, subject us to damages or injunctions restricting the sale of our products, require us to indemnify our customers for the use of the allegedly infringing products, require us to refund payment of allegedly infringing products to our customers or to forgo future payments, require us to redesign certain of our products, or damage our reputation, any one of which could materially and adversely affect our business, results of operations and financial condition.

 

We may, in the future, take legal action to enforce our patents and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could negatively affect our business, results of operations and financial condition.

 

In December 2005, the Commission issued a formal order of investigation in connection with our accounting review of the Thomson Contract. These matters were previously the subject of an informal Commission inquiry. We have been cooperating fully with the Commission and will continue to do so in order to bring the investigation to a conclusion as promptly as possible.

 

We are currently a party to various other legal proceedings, in addition to those noted above, and may become involved from time to time in other legal proceedings in the future. While we currently believe that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse effect on our financial position or overall results of operations, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur in any of our legal proceedings, there exists the possibility of a material adverse impact on our financial condition and results of operations for the period in which the ruling occurs. The estimate of the potential impact on our financial position and overall results of operations for any of the above legal proceedings could change in the future.

 

There were no matters submitted to a vote of security holders during the year ended December 31, 2005.

 

(a) Prior to April 4, 2006, our common stock was traded on The NASDAQ Stock Market under the symbols “TERN” and “TERNE.” Our common stock was delisted from The NASDAQ Stock Market on April 4, 2006 and currently is quoted on the Pink Sheets under the symbol “TERN.PK.” The following table sets forth, for the periods indicated, the high and low per share sale prices of our common stock as reported on The NASDAQ Stock Market, for the respective periods.

 

 

As of December 19, 2006, the closing price of our common stock on the Pink Sheets was $1.87.

 

(b) As of November 30, 2006, there were approximately 522 holders of record of our common stock, as shown on the records of our transfer agent. The number of record holders does not include shares held in “street name” through brokers.

 

(c) We have not declared or paid any cash dividends on our common stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

(d) The following table provides certain information about our common stock that may be issued under our equity compensation plans as of December 31, 2005. Information is included for both equity compensation plans approved by our stockholders and equity compensation plans not approved by our stockholders.

 

 

 

 

The following selected consolidated financial data has been restated or adjusted, as applicable, and is derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements and notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial data included elsewhere in this report. Our historical results of operations are not necessarily indicative of results of operations to be expected for any future period. We have not amended our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by the restatement. The information that has been previously filed or otherwise reported for these periods is superseded by the information in this Form 10-K.

 

See Note 3, “Restatement of Consolidated Financial Statements,” to Consolidated Financial Statements for more detailed information regarding the restatement of our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and our selected consolidated financial data as of and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001.

 

 

 

 

The discussion and analysis set forth below reflects the restatement as described below and in Note 3, “Restatement of Consolidated Financial Statements,” to Consolidated Financial Statements. For this reason, the data set forth in this section may not be comparable to discussions and data in our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q.

 

Restatement of Consolidated Financial Statements and Related Proceedings

 

On November 7, 2005, the Company announced that it initiated a review of its revenue recognition policies after determining that certain revenues recognized in the second half of the year ended December 31, 2004 from a customer may have been recorded in incorrect periods. The review included the Company’s revenue recognition policies and practices for current and past periods and its internal control over financial reporting. Additionally, the Audit Committee of the Board of Directors (Audit Committee) conducted an independent inquiry into the circumstances related to the accounting treatment of certain of the transactions at issue and retained independent legal counsel to assist with the inquiry.

 

On March 1, 2006, the Company announced that the Audit Committee had completed its independent inquiry and that the Company would restate its consolidated financial statements for the year ended December 31, 2004 and for the four quarters of 2004 and the first two quarters of 2005. The principal findings of the Audit Committee review were: there was no intent by Company personnel to recognize revenue in contravention of what Company personnel understood to be the applicable rules at the time; that Company personnel did not consider or sufficiently focus on relevant accounting rules; and there was no intent by Company personnel to mislead the Company’s auditors or engage in other wrongful conduct. Additionally, the Audit Committee and management reviewed the Company’s revenue recognition practices and policies as they related to the delivery of certain products and services (including the development and customization of software) to Thomson Broadcast (Thomson) under a series of contractual arrangements (Thomson Contract). The Company had recognized revenue under this series of contractual arrangements under two separate revenue arrangements in accordance with Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition” (SAB 101), as amended by SAB No. 104 (SAB 104). However, based on the guidance under American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2), SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1), SAB 104 and Financial Accounting Standards Board (FASB), Emerging Issues Task Force (EITF) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (EITF 00-21), management determined that this series of contractual arrangements should have been treated as a single contract, and therefore a single revenue arrangement for accounting purposes. Factors that contributed to the determination of a single revenue arrangement included the documentation of the series of contractual arrangements under a single memorandum of understanding (MOU) and the ongoing nature of discussions between parties to define product specifications and deliverables that extended beyond the initial agreed upon contracted deliverables. Additionally, the Company determined it could not reasonably estimate progress towards completion of the project, and therefore, in accordance with SOP 81-1, used the completed contract method. As a result, revenue previously recognized in the third and fourth quarters of 2004 and in the first two quarters of 2005 under this series of contractual arrangements was deferred and ultimately recognized as revenue in the quarter ended December 31, 2005 upon completion of the Thomson Contract and final acceptance received from Thomson for all deliverables under the Thomson Contract. Direct contract expenses, primarily research and development, associated with the completion of the project previously recognized in each quarter of 2004 and in the first two quarters of 2005 were also deferred and ultimately recognized in the quarter ended December 31, 2005 in accordance with the completed contract methodology under SOP 81-1.

 

On March 1, 2006, the Company announced a further review of the Company’s revenue recognition policies relating to the recognition of products and related software sold in conjunction with post-contract support (PCS) under SOP 97-2, SAB 104, EITF 00-21 and FASB Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts.” As a result, management determined that the Company did not account properly for the sale of digital video products under SOP 97-2 and did not establish vendor specific objective evidence (VSOE) of fair value for its PCS revenue element related to these sales. Accordingly, revenue for digital video products sold in conjunction with PCS and previously recognized as separate elements in each quarter

of 2003 and 2004, and also in the first and second quarters of 2005 was deferred and recognized over the contract service period.

 

On November 8, 2006, the Company announced that the Audit Committee, upon the recommendation of management, had concluded that the Company’s consolidated financial statements for the years ended December 31, 2003, 2002 and 2000 and for the quarters of 2003, 2002 and 2000 should no longer be relied upon. The restatement of financial statements for 2003 would correct errors primarily relating to revenue recognition, cost of goods sold and estimates of reserves. The restatement of financial statements for 2000 and 2002 would correct errors primarily relating to the need to separately value and account for embedded derivatives associated with the Company’s 5% convertible subordinated notes issued in July 2000, and other estimates. While no determination was made that the financial statements for 2001 could not be relied upon, adjustments would be made to 2001 that would be reflected in the financial statements to be included in its periodic reports to be filed with the Securities and Exchange Commission (Commission) and reported as “adjusted.”

 

The Company’s previous auditors resigned effective as of September 21, 2005 and on that date, the Audit Committee engaged Stonefield Josephson, Inc. (Stonefield) as the Company’s new independent registered public accounting firm. On May 26, 2006, the Company announced that it had engaged Stonefield, its current independent auditor, to re-audit the Company’s consolidated financial statements for the year ended December 31, 2004 and, if necessary, to audit the Company’s consolidated financial statements for the year ended December 31, 2003. On November 8, 2006, the Company announced that it had engaged Stonefield to re-audit the Company’s consolidated financial statements for the year ended December 31, 2003.

 

In June 2006, the Company, through outside counsel, retained FTI Consulting, Inc. to provide an independent accounting perspective in connection with the accounting issues under review.

 

In connection with the Company’s accounting review of the Thomson Contract referred to above, the Commission initiated a formal investigation. This matter was previously the subject of an informal Commission inquiry. The Company has been cooperating fully with the Commission and will continue to do so in order to bring the investigation to a conclusion as promptly as possible.

 

The Restatement and Other Related Matters

 

The following is a description of the significant adjustments to previously reported financial statements resulting from the restatement process and additional matters addressed in the course of the restatement. While this description does not purport to explain each correcting entry, the Company believes that it fairly describes the significant factors underlying the adjustments and the overall impact of the restatement in all material respects.

 

Revenue Recognition.  The Company did not properly account for revenue as described below. As part of the restatement process, the Company applied the appropriate revenue recognition methods to each element of all multiple-element contracts, corrected other errors related to revenue recognition and corrected errors to other accounts, including cost of goods sold and deferred revenue resulting in adjustments to these accounts in each period covered by the restatement.

 

Video Product and Post Contract Support.  The Company did not properly recognize revenue in accordance with generally accepted accounting principles (GAAP), specifically SOP 97-2 for its digital video products. The Company previously recognized revenue for its digital video products in accordance with SAB 101, as amended by SAB 104 based upon meeting the revenue recognition criteria in SAB 104. In order for the Company to recognize revenue from individual elements within a multiple element arrangement under SOP 97-2, the Company must establish vendor specific objective evidence (VSOE) of fair value for each element. The Company determined that it did not establish VSOE of fair value for the undelivered element of PCS on the digital video products. Therefore, as part of the restatement process the Company corrected this error and recognized revenue of the hardware element sold in conjunction with the undelivered PCS element ratably over the period of the customer support contract. The cost of goods sold for the sale for the hardware element and the PCS element was also recognized ratably over the period of the customer support contract. Accordingly, revenue and cost of goods sold previously recognized based on meeting the revenue recognition

criteria in SAB 104 for the individual elements for digital video products sold in conjunction with PCS in each quarter of 2003, 2004 and 2005 were deferred and recognized ratably over the contract service period.

 

Thomson Contract.  The Company recognized revenue as it related to the delivery of certain products and services (including the development and customization of software) to Thomson under a series of contractual arrangements under a single memorandum of understanding (MOU) in accordance with SAB 101, as amended by SAB 104. However, based on SOP 97-2 and SOP 81-1, this series of contractual arrangements should have been treated as a single contract, and therefore as a single revenue arrangement for accounting purposes. Factors that contributed to the determination of a single revenue arrangement included the documentation of the series of contractual arrangements under a single MOU and the ongoing nature of discussions between parties to define product specifications and deliverables that extended beyond the initial agreed upon contracted deliverables. In accordance with SOP 81-1, the Company determined it would not reasonably estimate progress towards completion of the project and therefore used the completed contract methodology. As a result, $7.8 million of revenue previously recognized in the third and fourth quarters of 2004 and $0.3 million of revenue previously recognized in the first two quarters of 2005 were deferred and ultimately recognized as revenue in the quarter ended December 31, 2005 upon completion of the Thomson Contract and final acceptance received from Thomson for all deliverables under the Thomson Contract. Additionally, $1.2 million of cost of goods sold previously recognized in 2004 and $1.8 million related to direct development costs previously recognized from the fourth quarter of 2003 through the second quarter of 2005 were also deferred and ultimately recognized in the quarter ended December 31, 2005.

 

Inventory Consignment.  During the quarter ended December 31, 2003, the Company entered into an agreement to consign specific spare parts inventory to a certain customer for the customer’s demonstration and evaluation purposes. The consignment period was to terminate during the quarter ended March 31, 2004, at which time the customer would either purchase or return the spare parts inventory to the Company. During the quarter ended March 31, 2004, the Company notified the customer that the consignment period terminated and in accordance with the agreement, the customer should either return or purchase the spare parts inventory. The Company did not receive a reply and subsequently invoiced the customer $0.9 million for the spare parts inventory in the quarter ended March 31, 2004. During the quarter ended June 30, 2004, the customer agreed to purchase a portion of the spare parts inventory and returned the remaining spare parts inventory to the Company. Accordingly, for the quarter ended June 30, 2004, the Company issued the customer a credit memo for $0.9 million, which was the amount of the sale that was invoiced in the quarter ended March 31, 2004 and was the entire amount originally consigned to the customer. During the course of the restatement, it was determined that at March 31, 2004, accounts receivable was overstated by $0.9 million, inventory was understated by $0.5 million and both deferred revenue and deferred cost of goods sold were overstated by $0.9 million and $0.5 million, respectively. As a result, the consolidated balance sheets for the quarters ended March 31, 2004 and June 30, 2004 were appropriately revised to correct these errors.

 

Other Revenue Adjustments.  The Company also made other adjustments in 2003, 2004 and 2005 to correct the recognition of revenue for transactions where the Company did not properly apply SAB 101, as amended by SAB 104. The Company made other immaterial adjustments for certain transactions related to revenue. See Note 3, “Restatement of Consolidated Financial Statements,” to Consolidated Financial Statements.

 

Allowance for Doubtful Accounts.  During the restatement process, the Company reassessed its accounting regarding the allowance for doubtful accounts based on its visibility of its collections and write-offs of the allowance for doubtful accounts. Prior to 2004, the Company’s policy was to estimate the allowance for doubtful accounts and the corresponding bad debt expense based on a fixed percentage of revenue during a specific period. Beginning in 2004, the Company adopted a specific reserve methodology for estimating the allowance for doubtful accounts and corresponding bad debt expense. During the restatement, the Company adjusted the allowance for doubtful accounts and bad debt with a reduction of $5.2 million, an increase of $1.9 million and an increase of $0.6 million for the years ended December 31, 2000, 2001 and 2002, respectively, to reflect the specific reserve methodology and to correct errors resulting from the Company’s former policy. The Company made adjustments to the allowance for doubtful accounts of $0.1 million, $0.6 million, and $0.3 million for the years ended December 31, 2003 and 2004 and for the first two quarters of 2005, respectively.

In addition, during the restatement, the Company made other adjustments to the allowance for doubtful accounts to offset the accounts receivable and related reserve related to customers who were granted extended payment terms, experiencing financial difficulties or where collectibility was not reasonably assured. Accordingly, the Company classifies these customers as those with “extended payment terms” or with “collectibility issues.” For these customers, the Company historically deferred all revenue and recognized the revenue when the fee was fixed or determinable or collectibility reasonably assured or cash was received, assuming all other criteria for revenue recognition were met. The Company adjusted the allowance for doubtful accounts, eliminating the receivable and related reserve, for these customers by an increase of $5.7 million, a decrease of $4.4 million and by an immaterial amount for the years ended December 31, 2003 and 2004 and for the first two quarters of 2005, respectively.

 

In summary, the above restatements gave rise to an adjustment to the allowance for doubtful accounts of an increase of $5.8 million, a decrease of $3.8 million and an increase of $0.3 million for the years ended December 31, 2003 and 2004 and for the first two quarters of 2005, respectively. The allowance for doubtful accounts related to international customers was reduced by $0.5 million based on the activity for the year ended December 31, 2004.

 

Deferred Revenues and Deferred Cost of Goods Sold.  As part of the restatement process, the Company determined that it did not properly account for deferred revenue as it related to specific transactions to certain customers where the transaction did not satisfy revenue recognition criteria of SAB 104 related to customers with acceptance terms, transactions with free-on-board (FOB) destination shipping terms, customers where the arrangement fee was not fixed or determinable or customers where collectibility was not reasonably assured. While revenue was generally not recognized for these customers, the Company improperly recognized a deferred revenue liability and a deferred cost of goods sold asset, thereby overstating assets and liabilities, and during the restatement determined that deferred revenues and deferred cost of goods sold should not be recognized for these transactions. As a result, the Company adjusted deferred revenues by $1.6 million, $1.0 million and $0.9 million for the years ended 2003 and 2004 and the first two quarters of 2005, respectively, and adjusted deferred cost of goods sold by $0.9 million, $0.3 million and $0.6 million for the years ended 2003 and 2004 and the first two quarters of 2005, respectively.

 

Use of Estimates.  The Company did not correctly estimate, monitor and adjust balances related to certain accruals and provisions as set forth below.

 

Access Network Electronics.  In July 2003, the Company sold certain assets related to its Miniplex products to Verilink Corporation (Verilink). The assets were originally acquired through the Company’s acquisition of Access Network Electronics (ANE) in April 2000. As part of the agreement with Verilink, Verilink agreed to assume all warranty obligations related to ANE products sold by the Company prior to, on, or after July 2003. The Company agreed to reimburse Verilink for up to $2.4 million of warranty obligations for ANE products sold by the Company prior to July 2003 related to certain power supply failures of the product and other general warranty repairs (Warranty Obligation). The $2.4 million Warranty Obligation negotiated with Verilink included up to $1.0 million for each of two specific customer issues and a general warranty obligation of $0.4 million that expired in the quarter ended March 31, 2005. During the sale process, the Company disclosed to Verilink that it had received an official specific customer complaint related to the sale of the Miniplex product to one of the two customers. In accordance with SFAS No. 5, “Accounting for Contingencies,” the Company established a reserve as a result of this complaint. Under the agreement with Verilink, the Company was able to quantify its exposure at $1.0 million based upon the terms of the Warranty Obligation. No other obligations were accrued by the Company related to the Miniplex products because the Company had not received formal notice of any complaints from other customers. The Company amortized the $1.0 million warranty accrual starting in the quarter ended March 31, 2004 through the expiration of the Warranty Obligation in the quarter ended March 31, 2005. However, during the course of the restatement, the Company determined that the warranty obligation accrual should not have been reduced unless there were actual expenses incurred in connection with either the obligation or upon the expiration of the Warranty Obligation in the quarter ended March 31, 2005. Since the Company did not incur any expenses in connection with this obligation and did not establish a basis for this reduction, during the restatement, the Company corrected the reduction of this accrual by $0.2 million in each of the four quarters of 2004 and deferred the reduction of the warranty accrual until the warranty period expired in the quarter ended March 31, 2005. Accordingly, the $1.0 million reduction of the warranty obligation in the quarter ended March 31, 2005,

reduced cost of goods sold by $0.8 million for that period and increased cost of goods sold by $0.2 million in each quarter of 2004.

 

Israel Restructuring Reserve.  During 2001, the Board of Directors approved a restructuring plan and the Company incurred restructuring charges in the amount of $12.7 million for excess leased facilities of which $7.4 million related to Israel and $1.7 million remained accrued at December 31, 2004. In 2002, the Company did not include in its assessment the ability to generate and collect sublease income in its Israel facility. As a result, the Company increased its reserve by $1.2 million due to lowered sublease assumptions. In the quarter ended December 31, 2004, the Company analyzed the reserve and reduced the reserve by $1.5 million to $1.7 million reducing operating expenses. During the restatement process, the Company determined that $1.2 million of the $1.5 million reserve reduction recognized in the quarter ended December 31, 2004 properly related to the year ended December 31, 2002. As a result, the Company reversed the previously recorded $1.2 million increase in restructuring reserve expense in 2002, thereby decreasing the net loss for the quarter ended December 31, 2002. The Company also corrected the entry that reduced the restructuring reserve in 2004 by reversing the $1.2 million decrease in the reserve that occurred in 2004.

 

License Fee.  In 1999, the Company entered into an intellectual property (IP) license agreement (License Agreement) with a third party. Pursuant to the License Agreement, the Company recorded a prepaid asset of $2.0 million related to its licensing of the IP. The License Agreement allowed the Company to incorporate the IP into “manufactured products” for the cost of the license fee which was $2.0 million. Additionally, the Agreement also incorporated a clause for the Company to pay a royalty fee of $1 per unit of “component products” sold to third parties by the Company. During 1999, the Company began designing semiconductor chips using this IP and paying the license fee for the IP. In June 2000, the Company made its final payment on the $2.0 million license, and the Company had a $2.0 million prepaid asset. The Company amortized the prepaid asset based on applying the royalty rate of $1 per unit established in the License Agreement. However, the Company incorrectly applied the $1 per unit rate to units produced rather than units sold. As part of correcting this error, the Company adjusted the amortization rate of the prepaid asset to reflect actual units sold resulting in a reduction in the per unit amortization rate. Adjustments to cost of goods sold were a decrease of $0.8 million in 2003, an increase of $0.5 million in 2004 and an increase of $0.2 million during the first two quarters of 2005.

 

Goods Received Not Invoiced.  The Company maintains an account to accrue for obligations arising from instances in which the Company has received goods but has not yet received an invoice for the goods (RNI). During 2002 the Company established the reserve after management determined that the process being used to track RNI obligations was not properly stating the liability. During the quarter ended March 31, 2004, the Company analyzed the RNI account, determined that it was carrying an excess reserve of $0.8 million and began amortizing the $0.8 million excess reserve at the rate of $0.2 million per quarter thereby decreasing operating expenses by that amount in each quarter of 2004. During the restatement, the Company determined that the excess reserve should have been reduced to zero as of December 31, 2002 and adjusted the financial statements accordingly. The impact of this change is to decrease operating expenses by $0.8 million in 2002 and increase operating expenses by $0.8 million during 2004.

 

Other.  In conjunction with the restatement, the Company also made other adjustments and reclassifications to its accounting for various other errors for the periods presented, including: (1) correction of estimates of legal expenses, property tax and excess and obsolete inventory accruals; (2) reclassification to the proper accounting period of: bonus accruals to employees; federal income taxes payable; and operating expenses related to an operating lease; (3) correction of accounting for impaired and disposed assets; and (4) expenses related to an extended warranty provided to a customer. See Note 3, “Restatement of Consolidated Financial Statements,” to Consolidated Financial Statements.

 

Convertible Subordinated Notes.  In July 2000, the Company issued $500.0 million of 5% convertible subordinated notes (Notes) due in August 2007 resulting in net proceeds to the Company of approximately $484.0 million. The Notes were convertible into shares of the Company’s common stock at a conversion price of $84.01 per share at any time on or after October 24, 2000 through maturity, unless previously redeemed or repurchased. Under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133),

the Notes are considered a hybrid instrument since, and as described below, they contained multiple embedded derivatives.

 

The Notes contained several embedded derivatives. First, the Notes contain a contingent put (Contingent Put) where in the event of any default by the Company, the Trustee or holders of at least 25% of the principal amount of the Notes outstanding may declare all unpaid principal and accrued interest to be due and payable immediately. Second, the Notes contain an investor conversion option (Investor Conversion Option) where the holder of the Notes may convert the debt security into Company common stock at any time after 90 days from original issuance and prior to August 1, 2007. The number of shares of common stock that is issued upon conversion is determined by dividing the principal amount of the security by the specified conversion price in effect on the conversion date. The initial conversion price was $84.01 which was subject to adjustment under certain circumstances described in the Indenture. Third, the Notes contain a liquidated damages provision (Liquidated Damages Provision) that obligated the Company to pay liquidated damages to investors of 50 basis points on the amount of outstanding securities for the first 90 days and 100 basis points thereafter, in the event that the Company did not file an initial shelf registration for the securities within 90 days of the closing date. In the event that the Company filed its initial shelf registration within 90 days but failed to keep it effective for a two year period from the closing date, the Company would pay 50 basis points on the amount of outstanding securities for the first 90 days and 100 basis points thereafter. Fourth, the Notes contain an issuer’s call option (Issuer Call Option) that allowed the Company to redeem some or all of the Notes at any time on or after October 24, 2000 and before August 7, 2003 at a redemption price of $1,000 per $1,000 principal amount of the Notes, plus accrued and unpaid interest, if the closing price of the Company’s stock exceeded 150% of the conversion price, or $126.01, for at least 20 trading days within a period of 30 consecutive trading days ending on the trading day prior to the date of the mailing of the redemption notice. In addition, if the Company redeemed the Notes, it was also required to make a cash payment of $193.55 per $1,000 principal amount of the Notes less the amount of any interest actually paid on the Notes prior to redemption. The Company had the option to redeem the Notes at any time on or after August 7, 2003 at specified prices plus accrued and unpaid interest.

 

Under SFAS 133, an embedded derivative must be separated from its host contract (i.e., the Notes) and accounted for as a stand-alone derivative if the economic characteristics and risks of the embedded derivative are not considered “clearly and closely related” to those of the host. An embedded derivative would not be considered clearly and closely related to the host if there was a possible future interest rate scenario (even though it may be remote) in which the embedded derivative would at least double the initial rate of return on the host contract and the effective rate would be twice the current market rate as a contract that had similar terms as the host and was issued by a debtor with similar credit quality. Furthermore, per SFAS 133, the embedded derivative would not be considered clearly and closely related to the host contract if the hybrid instrument could be settled in such a way the investor would not recover substantially all of its initial investment.

 

During the restatement process, the Company determined under SFAS 133 that both the Issuer Call Option and the Liquidated Damages Provision represented an embedded derivative that was not clearly and closely related to the host contract, and therefore needed to be bifurcated from the Notes and valued separately. As it related to the Liquidated Damages Provision and based on a separate valuation that included Black-Scholes valuation methodologies, the Company assessed a valuation of $0.4 million. Based on the need to amortize the $0.4 million over the 7-year life of the Notes, the impact to the Company’s financial results related to the Liquidated Damages Provision was not material.

 

As it related to the Issuer Call Option and based on a separate valuation that included Black-Scholes valuation methodologies, the Company assessed a valuation of $11.9 million. As a result, at the time the Notes were issued in July 2000, the Company should have created an asset to record the value of the Issuer Call Option for $11.9 million and created a bond premium to the Notes for $11.9 million. In accordance with SFAS 133, the asset value would then be marked to market at the end of each accounting period and the bond premium would be amortized against interest expense at the end of each accounting period. Due to the decrease in the price of the Company’s common stock, the value of the Issuer Call Option became effectively zero and the Company should have written off the asset related to the Issuer Call Option in 2000. Additionally, as part of the bond repurchase activity where the Company repurchased $325.9 million and $109.1 million of face value of the Notes (for a total of $435.0 million) that occurred in 2001 and 2002, the Company should have recognized an additional gain from the retirement of the bond premium associated

with the Issuer Call Option of $7.0 million in 2001 and $1.9 million in 2002. The Company determined that the $7.0 million non-cash gain on the early retirement of the premium to be immaterial to 2001 financial results.

 

In the quarter ended March 31, 2006, the Company paid off the entire principal amount of the outstanding Notes, including all accrued and unpaid interest and related fees, for a total of $65.6 million. In addition, the Company recognized $0.3 million into other income, net representing the remaining unamortized bond premium associated with the Issuer Call Option.

The following tables present the effect of the restatement adjustments by financial statement line item for the consolidated statements of income, balance sheets and statements of cash flows:

 

CONSOLIDATED BALANCE SHEET
EFFECTS OF THE RESTATEMENT
(in thousands)

 

 

 

Explanation of Current Adjustments:

 

CONSOLIDATED BALANCE SHEET
EFFECTS OF THE RESTATEMENT
(in thousands)
(unaudited)

 

 

 

Explanation of Current Quarterly Adjustments:

 

CONSOLIDATED BALANCE SHEET

EFFECTS OF THE RESTATEMENT

(in thousands)

(unaudited)