UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

COMMISSION FILE NUMBER: 000-24647

 

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)

 

 

 

 

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

 

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

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

 

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

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

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 December 31, 2006.

 

 

INDEX

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

 

Restatement

 

As described in our Annual Report on Form 10-K for the year ended December 31, 2005, we restated our condensed consolidated financial statements for the first two quarters of the year ended December 31, 2005. This Quarterly Report on Form 10-Q includes restated quarterly information for the quarter ended March 31, 2005.

 

For further discussion of the effects of the restatement see Note 2 to Condensed Consolidated Financial Statements and Item 4 — Controls and Procedures.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except for share data)

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

TERAYON COMMUNICATION SYSTEMS, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

TERAYON COMMUNICATION SYSTEMS, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

 

Description of Business

 

Terayon Communication Systems, Inc. (Company) was incorporated under the laws of the State of California on January 20, 1993. In June 1998, the Company reincorporated in the State of Delaware.

 

The Company develops, markets and sells digital video equipment to network operators and content aggregators who offer video services.

 

In 2004, the Company refocused to make digital video solutions (DVS) the core of its business. As part of this strategic refocus, the Company elected to continue selling its home access solutions (HAS) products, including cable modems, embedded multimedia terminal adapters (eMTA) and home networking devices, but ceased future investment in its cable modem termination systems (CMTS) product line. In January 2006, the Company announced that it was discontinuing its HAS product line.

 

 

On December 29, 2006, the Company filed its Annual Report on Form 10-K for the year ended December 31, 2005 (2005 Form 10-K), and restated its consolidated financial statements for the first and second quarters of 2005 and prior periods.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

EFFECTS OF THE RESTATEMENT

 

The following table presents the effects of the restatement adjustments by financial statement line item for the condensed consolidated balance sheet as of March 31, 2005 (in thousands) (unaudited):

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Explanation of Current Quarterly Adjustments:

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table presents the effects of the restatement adjustments by financial statement line item for the condensed consolidated statement of operations for the three months ended March 31, 2005 (in thousands, except per share data) (unaudited):

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table presents the errors identified in the restatement of the consolidated financial statements for the year ended December 31, 2005 which specifically relate to the first quarter of 2005 (in thousands) (unaudited):

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Explanation of Current Quarterly Adjustments:

 

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Basis of Presentation

 

The accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) for interim financial information and in accordance with the instructions to Quarterly Reports on Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the condensed consolidated financial statements at March 31, 2006 and for the three months ended March 31, 2006 and 2005 have been included.

 

Results for the three months ended March 31, 2006 are not necessarily indicative of results for the entire fiscal year or future periods. These financial statements should be read in conjunction with the consolidated financial statements and the accompanying notes included in the Company’s 2005 Form 10-K, as filed with the United States Securities and Exchange Commission (Commission). The accompanying condensed consolidated balance sheet at December 31, 2005 is derived from audited consolidated financial statements at that date.

 

Basis of Consolidation

 

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

 

Use of Estimates

 

The preparation of the condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Estimates are based on historical experience, input from sources outside of the Company, and other relevant facts and circumstances. Actual results could differ from those estimates. Areas that are particularly significant include the valuation of its accounts receivable and inventory, warranty obligations, accrued vendor cancellation charges, the assessment of recoverability and the measurement of impairment of fixed assets, and the recognition of restructuring liabilities.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist of cash equivalents, accounts receivable, inventory, accounts payable and other accrued liabilities. The Company does not have any derivative financial instruments. The Company believes the reported carrying amounts of its financial instruments approximate fair value due to their short-term maturities.

 

Revenue Recognition

 

In accordance with Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition” (SAB 101), as amended by SAB 104, for all products and services, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services were rendered, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is not recognized until all acceptance criteria have been met. Contracts and customer purchase orders are used to determine the existence of an arrangement. Delivery occurs when product is delivered to a common carrier. Certain products are delivered on a free-on-board (FOB) destination basis and the Company does not recognize revenue associated with these transactions until the delivery has occurred to the customers’ premises. The Company assesses whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

price is subject to adjustment. The Company assesses collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

 

In establishing its revenue recognition policies for its products, the Company assesses software development efforts, marketing and the nature of post contract support (PCS). Based on its assessment, the Company determined that the software in the HAS and CMTS products is incidental, and therefore, the Company recognizes revenue on the HAS and CMTS products under SAB 101, as specifically amended by SAB 104. Additionally, based on its assessment of the DVS products, the Company determined that software was more than incidental, and therefore, the Company recognizes revenue on the DVS products under American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2), and SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1).

 

In order 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. Prior to 2006, for the DVS products, the Company determined that it did not establish VSOE of fair value for the undelivered element of PCS, which required the Company to recognize revenue and the cost of goods sold of both the hardware element and the PCS element ratably over the period of the customer support contract. Beginning in the first quarter of 2006, the Company determined that it established VSOE of fair value of the PCS element for the DVS product sales as a result of maintaining consistent pricing practices for PCS, including consistent pricing of renewal rates for PCS. For the DVS products sold beginning in the first quarter of 2006 that contain a multiple element arrangement, the Company recognizes revenue and cost of goods sold from the hardware component when all criteria of SAB 104 and SOP 97-2 have been met and revenue and cost of goods sold related to the PCS element ratably over the period of the PCS.

 

The Company sells its products directly to broadband service providers and, to a lesser extent, resellers. Revenue arrangements with resellers are recognized when product meets all criteria of SAB 104 and SOP 97-2.

 

Deferred Revenue, Deferred Cost of Goods Sold

 

Deferred revenue and deferred cost of goods sold are a result of the Company recognizing revenues on the DVS products under SOP 97-2. Under SOP 97-2, the Company must establish VSOE of fair value for each element of a multiple element arrangement. Until the first quarter of 2006, the Company did not establish VSOE of fair value for PCS when PCS was sold as part of a multiple element arrangement. As such, for the DVS products sold with PCS, revenue and the cost of goods sold related to the delivered element, the hardware component, were deferred and recognized ratably over the period of the PCS.

 

Stock-Based Compensation

 

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion (APB) 25, “Accounting for Stock Issued to Employees” (APB 25), for periods beginning January 1, 2006. In March 2005, the Commission issued SAB No. 107, “Share-based Payment” (SAB 107), relating to SFAS 123(R). SAB 107 provides guidance on the initial implementation of SFAS 123(R). In particular, the statement includes guidance related to share-based payment awards with non-employees, valuation methods and selecting underlying assumptions such as expected volatility and expected term. It also gives guidance on the classification of compensation expense associated with share-based payment awards and accounting for the income tax effects of share-based payment awards upon the adoption of SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Under the modified prospective method of adoption for SFAS 123(R), the compensation cost recognized by the Company beginning in 2006 includes (a) compensation cost for all equity incentive awards granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all equity incentive awards granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The Company uses the straight-line attribution method to recognize share-based compensation costs over the service period of the award. Upon exercise, cancellation, or expiration of stock options, deferred tax assets for options with multiple vesting dates are eliminated for each vesting period on a first-in, first-out basis as if each vesting period was a separate award.

 

Options currently granted by the Company generally expire six years from the grant date and vest over a three year period. Options granted prior to the second quarter of 2005 generally expire ten years from the grant date and vest over a four to five year period. The Company may use other types of equity incentives, such as restricted stock and stock appreciation rights. The Company’s equity incentive awards also allow for performance-based vesting.

 

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” (FAS 123(R)-3). The Company has elected to adopt the alternative transition method provided in FAS 123(R)-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC Pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC Pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).

 

Share-based compensation recognized in 2006 as a result of the adoption of SFAS 123(R) as well as pro forma disclosures according to the original provisions of SFAS 123 for periods prior to the adoption of SFAS 123(R) use the Black-Scholes valuation methodologies for estimating fair value of options granted under the Company’s equity incentive plans and rights to acquire stock granted under the Company’s stock participation plan.

 

Allowance for Doubtful Accounts

 

The Company performs ongoing credit evaluations of its customers and generally requires no collateral. The Company evaluates its trade receivables based upon a combination of factors. Credit losses have historically been within management’s expectations. When the Company becomes aware of a customer’s inability to pay, such as in the case of bankruptcy or a decline in the customer’s operating results or financial position, it records an allowance to reduce the related receivable to an amount it reasonably believes is collectible. The Company maintains an allowance for potentially uncollectible accounts receivable based on an estimate of collectibility. The Company assesses collectibility based on a number of factors, including history, the number of days an amount is past due (based on invoice due date), changes in credit ratings of customers, current events and circumstances regarding the business of its clients’ customers and other factors that it believes are relevant. If circumstances related to a specific customer change, the Company’s estimates of the recoverability of receivables could be further altered. In addition, the Company maintains an allowance for doubtful accounts to offset the accounts receivable and related reserve related to customers who were granted extended payment terms or who are experiencing financial difficulties, or where collectibility is not reasonably assured.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Inventory

 

Inventory is stated at the lower of cost (first-in, first-out) or market. The components of inventory are as follows (in thousands):

 

 

Purchase Obligations

 

The Company has purchase obligations to certain of its suppliers that support the Company’s ability to manufacture its products. The obligations consist of purchase orders placed with vendors for goods and services and require the Company to purchase minimum quantities of the suppliers’ products at a specified price. As of March 31, 2006, $4.9 million of purchase obligations were outstanding. The Company accrued vendor cancellation charges in an amount which represented management’s estimate of the Company’s exposure to vendors for its inventory commitments. As of March 31, 2006, accrued vendor cancellation charges were $0.3 million and the remaining $4.6 million was attributable to open purchase orders in the normal course of business. The remaining obligations become payable at various times throughout the remainder of 2006.

 

Net Loss Per Share

 

A reconciliation of the numerator and denominator of basic and diluted net loss per share is provided as follows (in thousands, except per share data) (unaudited):

 

 

Options to purchase 12,852,574 and 14,019,701 shares of common stock were outstanding at March 31, 2006 and March 31, 2005, respectively, and these common stock equivalents were not included in the computation of diluted net loss per share since the effect would have been anti-dilutive.

 

Comprehensive Loss

 

Comprehensive loss consists of net income (loss), net unrealized gain (loss) on short-term investments and net foreign currency translation gain (loss).

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following are the components of comprehensive loss during the three months ended March 31, 2006 and 2005 (in thousands) (unaudited):

 

 

The following are the components of accumulated other comprehensive loss (in thousands):

 

 

Impact of Recently Issued Accounting Standards

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (SFAS 155), which amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (SFAS 140). Specifically, SFAS 155 amends SFAS 133 to permit fair value remeasurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided the whole instrument is accounted for on a fair value basis. Additionally, SFAS 155 amends SFAS 140 to allow a qualifying special purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 applies to all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006, with early application allowed. The adoption of SFAS 155 is not expected to have a material impact on the Company’s results of operations or financial position.

 

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets” (SFAS 156), to simplify accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 amends SFAS 140. Additionally, SFAS 156 applies to all separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006, although early adoption is permitted. The adoption of SFAS 156 is not expected to have a material impact on the Company’s results of operations or financial position.

 

In July 2006, the FASB issued FASB Interpretation (FIN) 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) — an interpretation of FASB No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return, including a decision whether or not to file in a particular jurisdiction. FIN 48 is effective for years beginning after December 15, 2006. If there are changes in net assets as a result of application of FIN 48, these will be accounted for as an adjustment to retained earnings. The Company is currently assessing the impact of FIN 48 on its consolidated financial position and results of operations.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. Earlier adoption is permitted, provided the company has not yet issued financial statements, including for interim periods, for that fiscal year. The Company is currently evaluating the impact of SFAS 157, but does not expect the adoption of SFAS 157 to have a material impact on its consolidated financial position, results of operations or cash flows.

 

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” an amendment of FASB Statement Nos. 87, 88, 106 and 132(R) (SFAS 158). Under SFAS 158, companies must recognize a net liability or asset to report the funded status of their defined benefit pension and other postretirement benefit plans (collectively referred to herein as “benefit plans”) on their balance sheets, starting with balance sheets as of December 31, 2006 if they are calendar year-end public companies. SFAS 158 also changed certain disclosures related to benefit plans. The adoption of SFAS 158 is not expected to have a material impact on the Company’s results of operations or financial position.

 

In September 2006, the Commission released SAB No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 provides guidance on how the effects of prior-year uncorrected financial statement misstatements should be considered in quantifying a current year misstatement. SAB 108 requires registrants to quantify misstatements using both an income statement (rollover) and balance sheet (iron curtain) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial are now considered material based on either approach, no restatement is required as long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening retained earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006. The adoption of SAB 108 is not expected to have a material impact on the Company’s financial statements.

 

 

Litigation

 

Beginning in April 2000, several plaintiffs filed class action lawsuits in federal court against the Company and specific officers and directors of the Company. 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 the Company’s technology. On February 24, 2003, the Court certified a plaintiff class consisting of those who purchased or otherwise acquired the Company’s 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, the Company mediated the case with plaintiffs’ counsel. As part of the

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

mediation, the Company reached a settlement of $15.0 million. After this mediation, the Company’s insurance carriers agreed to tender their remaining limits of coverage, and the Company contributed approximately $2.2 million to the settlement. On March 17, 2006, the Company, along with plaintiffs’ counsel, submitted the settlement to the Court and the shareholder class for approval. The Company accrued $2.2 million to litigation expense settlement in the fourth quarter of 2005. 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 the Company 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 for the 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 the Company 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. The Company is 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, the Company 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, the Company 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, the Company paid $1.0 million in attorney’s fees and expenses to the derivative plaintiffs’ counsel and agreed to adopt certain corporate governance practices. The Company accrued $1.0 million to litigation expense settlement in the fourth quarter of 2005.

 

On June 23, 2006, a putative class action lawsuit was filed against the Company 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 the Company’s 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 Company’s March 1, 2006 announcement of the restatement of financial statements for the year ended December 31, 2004, and for the four quarters of 2004 and the first two quarters of 2005. On November 8, 2006, Adrian G. Mongeli was appointed lead plaintiff in the case, replacing I.B.L. Investments Ltd. On January 8, 2007, Mongeli filed an amended complaint, purportedly on behalf of all persons who purchased the Company’s common stock between June 28, 2001 and March 1, 2006. The amended complaint adds Ernst & Young, Ray Fritz, Carol Lustenader, Matthew Miller, Shlomo Rakib, Doug Sabella, Christopher Schaepe, Mark Slaven, Lewis Solomon, Howard W. Speaks, Arthur T. Taylor and David Woodrow to the defendants named in the original complaint. The amended complaint incorporates the prior allegations and includes new allegations relating to the restatement of the Company’s consolidated historical financial statements as reported in the Company’s Form 10-K filed on December 29, 2006. 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 the Company’s results of operations.

 

On April 22, 2005, the Company 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). The Company sued Tom and Krause for breach of contract and RGB for

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

intentional interference with contractual relations based on breaches of the Noncompetition Agreements entered into between the Company 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 counterclaims against the Company 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, 2006, 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, the Company filed a demurrer to certain of those claims. The court granted the Company’s demurrer as to RGB’s request for declaratory judgment. On November 9, 2006, the Company filed its 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) 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 the Company and others supplying it with equipment indemnify Charter for these claims. The Company 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 the Company and a number of companies that supplied Charter with cable modems. 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 the Company 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 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 violates its patent rights. No trial date is known yet. To date, the Company has not been named as a party to the action. The MSOs have requested that the Company and others supplying them with cable modems and equipment indemnify the MSOs for these claims. The Company 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 the Company 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, the Company has not been named as a party in the action, but the Company has received a subpoena for documents and a deposition related to the products the Company sold to Comcast. The Company continues to comply with this subpoena. Comcast has made a request for indemnity related to the products that the Company and others have sold to them. The Company 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 the Company 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.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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, the Company has not been named as a party in the action, but Charter has made a request for indemnity related to the products that the Company and others have sold to them. The Company has not received an indemnity request from Cox, CSC and Cablevision but the Company expects that such request will be forthcoming shortly. To date, the Company 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 the Company 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, the Company has not been named as a party in the action, but TWC has made a request for indemnity related to the products that the Company and others have sold to them. The Company 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 the Company 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, the Company has not been named as a party in the action, but TWC has made a request for indemnity related to the products that the Company and others have sold to them. The Company 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 the Company 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.

 

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

 

Furthermore, the Company has in the past agreed to, and may from time to time in the future agree to, indemnify a customer of the Company’s technology or products for claims against the customer by a third party based on claims that the Company’s 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 the Company to enter into royalty arrangements, subject

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Company to damages or injunctions restricting the sale of its products, require the Company to indemnify its customers for the use of the allegedly infringing products, require the Company to refund payment of allegedly infringing products to its customers or to forgo future payments, require the Company to redesign certain of its products, or damage its reputation, any one of which could materially and adversely affect the Company’s business, results of operations and financial condition.

 

The Company has also provided an indemnity to ATI where the Company’s liability is set at $14.0 million for breaches of representations and warranties made by the Company and obligations assumed by the Company. This indemnity has been provided starting in March 2005 and continues for a period of three years for non-tax issues and six years for tax issues.

 

The Company may, in the future, take legal action to enforce its patents and other intellectual property rights, to protect its 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 the Company’s business, results of operation and financial condition.

 

In December 2005, the Commission issued a formal order of investigation in connection with the Company’s accounting review of a series of contractual arrangements with Thomson Broadcast (Thomson Contract). These matters were 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 Company is 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 the Company currently believes that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse effect on its financial position or overall results of operations, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur in any of the Company’s legal proceedings, there exists the possibility of a material adverse impact on the Company’s financial condition and results of operations for the period in which the ruling occurs. The estimate of the potential impact on the Company’s financial position and overall results of operations for any of the above legal proceedings could change in the future.

 

 

Stock Option Program Description

 

The Company’s 1995 Stock Option Plan (1995 Plan) and 1997 Equity Incentive Plan (1997 Plan) provide for incentive stock options and nonqualified stock options to be issued to employees, directors and consultants of the Company. Exercise prices of incentive stock options may not be less than the fair market value of the common stock at the date of grant. Exercise prices of nonqualified stock options may not be less than 85% of the fair market value of the common stock at the date of grant. Options generally vest and become exercisable over a period not to exceed five years from the date of grant. Any unvested stock issued is subject to repurchase by the Company at the original issuance price upon termination of the option holder’s employment. Unexercised options expire six to ten years after the date of grant. The 1997 Plan also provides for the sale of restricted shares of common stock to employees, directors and consultants, and the Company has provided such awards in prior years and may provide such awards in the future.

 

The Company’s 1997 Plan and 1998 Non-Employee Directors’ Stock Option Plan (1998 Plan) provide for non-discretionary nonqualified stock options to be issued to the Company’s non-employee directors automatically as of the effective date of their election to the Board of Directors and annually following each annual stockholder meeting. Exercise prices of nonqualified options may not be less than 100% and 85% of the fair market value of the common stock at the date of grant under the 1998 Plan and the 1997 Plan, respectively.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Options from the 1998 Plan and the 1997 Plan generally vest and become exercisable over a period not to exceed three or five years, respectively, from the date of grant. Unexercised options expire six to ten years after the date of grant.

 

The Company’s 1999 Non-Officer Equity Incentive Plan (1999 Plan) provides for nonqualified stock options to be issued to non-officer employees and consultants of the Company. Prices for nonqualified stock options may not be less than 85% of the fair market value of the common stock at the date of the grant. Options generally vest and become exercisable over a period not to exceed five years from the date of grant. Unexercised options expire six to ten years after the date of grant. The 1999 Plan also provides for the sale of restricted shares of common stock to employees, directors and consultants and the Company has provided such awards in prior years and may provide such awards in the future.

 

General Option Information

 

The following table presents a summary of option activity during the three months ended March 31, 2006 (unaudited):

 

 

Valuation and Expense Information under SFAS 123(R)

 

Effective January 1, 2006, the Company adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to the Company’s employees and directors including employee stock options and employee stock purchases related to the stock option plans based on estimated fair values. The Company elected to adopt SFAS 123(R) using the modified prospective recognition method, which requires the Company to recognize compensation cost for new and unvested stock options, restricted stock, restricted stock units and employee stock purchase plan shares. The following table summarizes stock-based compensation expense related to employee stock options and employee stock

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

purchases under SFAS 123(R) for the three months ended March 31, 2006, which is allocated as follows (in thousands, except per share data) (unaudited):

 

 

At March 31, 2006, unamortized compensation expense related to outstanding unvested stock options that are expected to vest was approximately $4.8 million. This unamortized compensation expense is expected to be recognized over a weighted average period of approximately 2.0 years.

 

The following table presents pro forma information required under SFAS 123 for periods prior to 2006, which assumes the Company’s application of the fair value recognition provisions of SFAS 123 to options granted under the Company’s equity incentive plans (in thousands, except per share data) (unaudited):

 

 

The following table presents the weighted average estimated values of employee stock option grants, as well as the weighted average assumptions that were used in calculating such values during the three months

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

ended March 31, 2006 and 2005, respectively, based on the following estimates at the date of grant (unaudited):

 

 

The Company used its historical stock price volatility as the expected volatility assumption. The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding. The expected term is based on the observed and expected time to post-vesting exercise of options by employees. The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of the Company’s employee stock options.

 

Options outstanding that have vested and are expected to vest as of March 31, 2006 are as follows (unaudited):

 

 

 

 

 

The Company operates as one business segment. The following table presents revenues for groups of similar products (in thousands, except percentages) (unaudited):

 

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table is a breakdown of revenues by geographic region (in thousands, except percentages) (unaudited):

 

 

Three customers, Harmonic, Inc. (Harmonic), Comcast Corporation (Comcast) and CSC Holdings, Inc. (CSC), each accounted for 10% or more of total revenues (18%, 16% and 13%, respectively) for the three months ended March 31, 2006. One customer, Wharf T&T Limited, accounted for 12% of total revenues for the three months ended March 31, 2005. No other customer accounted for more than 10% of revenues for the three months ended March 31, 2006 and 2005.

 

Three customers, CSC, HOT Telecom and Comcast, each accounted for 10% or more of total accounts receivable (20%, 15% and 10%, respectively) as of March 31, 2006. One customer, Harmonic, accounted for 32% of accounts receivable as of March 31, 2005. No other customer accounted for more than 10% of accounts receivable at March 31, 2006 and 2005.

 

 

Restructuring

 

The Company accrues for termination costs in accordance with paragraph 3 of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and SFAS No. 112, “Employers’ Accounting for Post Employment Benefits.” Liabilities are initially measured at their fair value on the date in which they are incurred based on plans approved by the Company’s Board of Directors. Accrued employee termination costs principally consist of three components: (i) a lump-sum severance payment based upon the years of service (e.g., two weeks per year of service); (ii) COBRA insurance based on years of service and rounded up to the month; and (iii) an estimate of costs for outplacement services immediately provided to the affected employees. Substantially all employees were terminated on the date of notification, so there was no additional service period required to be included in the determination of accrued termination costs. Where such services were required for a period over 60 days, the Company amortized termination costs ratably over the required service period.

 

2004 Restructurings

 

During the quarter ended March 31, 2004, the Company initiated a restructuring plan to bring operating expenses in line with revenue levels and incurred restructuring plan charges related to employee termination costs, termination costs for an aircraft lease, and costs for excess leased facilities. In the quarter ended December 31, 2004, to further conform the Company’s expenses to its revenue and to cease investment in the CMTS product line, the Company’s Board of Directors approved a restructuring plan related to employee terminations. Additionally, in 2004, the Company re-evaluated and adjusted restructuring charges incurred in

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the first and second quarters of 2004 related to employee severance, excess facilities and the aircraft lease termination.

 

The Company anticipates the remaining restructuring accrual related to the aircraft lease to be substantially utilized for servicing operating lease payments through January 2007, and the remaining restructuring accrual related to excess leased facilities to be utilized for servicing operating lease payments through October 2009.

 

The reserve for the aircraft lease approximates the difference between the Company’s current costs for the aircraft lease and the estimated income derived from subleasing.

 

The amount of net charges accrued under the 2004 restructuring plans assumes that the Company will successfully sublease excess leased facilities. The reserve for the excess leased facilities includes the estimated income derived from subleasing, which is based on information from the Company’s real estate brokers, who estimated it based on assumptions relevant to the real estate market conditions as of the date of the Company’s implementation of the restructuring plan and the time it would likely take to sublease the excess leased facility. The Company sub-subleased its former principal executive offices in August 2006.

 

The following table summarizes the accrued restructuring balances related to the 2004 restructurings as of March 31, 2006 (in thousands) (unaudited):

 

 

2001 Restructuring

 

As part of the restructuring plan initiated in 2001 (2001 Plan), the Company incurred restructuring charges in the amount of $12.7 million. In 2005, the Company decreased the restructuring reserve by $0.3 million to reflect a decrease for improving tenant sublease conditions in Israel that was partially offset by an increase in the reserve for excess leased facilities due to the use of the wrong lease term in its initial estimate. At December 31, 2005, $0.1 million remained accrued for excess leased facilities. The Company applied the remaining $0.1 million against the reserve in the first quarter of 2006.

 

Asset Write-offs

 

In the three months ended March 31, 2006 and 2005, asset write-offs were $41,000 and $0.5 million, respectively.

 

 

The Company provides a standard warranty for most of its products, ranging from one to five years from the date of purchase. The Company estimates product warranty expenses at the time revenue is recognized. The Company’s warranty obligations are affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. The estimate of costs to service its warranty obligations is based on historical experience and the Company’s expectation of future conditions. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revision to the warranty liability would be required.

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

On March 9, 2005, the Company sold certain of its cable modem semiconductor assets to ATI Technologies, Inc. (ATI). Under the agreement, ATI acquired the Company’s cable modem silicon intellectual property and related software, entered into a sublease and hired approximately 25 employees from the Company’s design team. Under the terms of the agreement, ATI was required to pay the Company $7.0 million at the closing, with a balance of $7.0 million subject to its achieving milestones for certain conditions, services and deliverables up to June 9, 2006. Upon closing, the Company received $8.6 million in cash, which was comprised of the $7.0 million for the initial payment and $1.9 million for having met the first milestone, minus $0.3 million to pay for Company funded retention bonuses for employees that accepted employment with ATI. In June 2005, ATI paid the Company $2.5 million for delivering certain documentation and validation deliverables. On September 9, 2005, the Company forfeited $0.8 million for failing to obtain vendor author status for ATI with CableLabs. In June 2006, ATI paid the Company $1.1 million from the amount that was released from escrow and the Company forfeited $0.8 million, the remaining amount that was held in escrow, for failing to obtain vendor author status for ATI with CableLabs by June 9, 2006. Additionally, in June 2006, the Company and ATI amended the agreement to (i) transfer assets related to the manufacture of the semiconductors to ATI and (ii) engage ATI to provide technical assistance to the Company. The Company’s maximum liability is set at $14.0 million for breaches of representations and warranties made by the Company and obligations assumed by the Company. In June 2006, the Company recognized a $9.9 million gain from the sale of assets to ATI, which represented the purchase price of $12.5 million, less transaction related costs of $2.6 million. Despite receiving cash payments for the sale of assets to ATI, the Company did not recognize the gain on the ATI transaction until the quarter ended June 30, 2006 based upon the completion of milestones and the termination of the supply arrangement between ATI and the Company.

 

 

On November 7, 2005, the Company announced that the filing of its periodic report on Form 10-Q for the quarter ended September 30, 2005 would be delayed pending completion of the accounting review. The Company was required under its Indenture, dated July 26, 2000 (Indenture), to file with the Commission and the trustee of the Company’s 5% convertible subordinated notes (Notes) all reports, information and other documents required pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act). On January 12, 2006, holders of more than 25% of the aggregate principal amount of the Notes, in accordance with the terms of the Indenture, provided written notice to the Company that it was in default under the Indenture based on the Company’s failure to file its Form 10-Q for the quarter ended September 30, 2005. The Company was unable to cure the default within 60 days of the written notice, March 13, 2006, which triggered an Event of Default under the Indenture. The Event of Default enabled the holders of at least 25% in aggregate principal amount of Notes outstanding to accelerate the maturity of the Notes by written notice and declare the entire principal amount of the Notes, together with all accrued and unpaid interest thereon, to be due and payable immediately. On March 16, 2006, the Company received a notice of acceleration from holders of more than 25% of the aggregate principal amount of the Notes. On March 21, 2006, the Company paid in full the entire principal amount of the outstanding Notes, including all accrued and unpaid interest thereon and related fees, for a total of $65.6 million. In addition, as of March 31, 2006, the Company amortized the remaining bond premium of $0.3 million into interest income and expensed $0.5 million related to the bond issuance costs to other income.

 

 

Delisting by The NASDAQ Stock Market

 

The Company received a letter from The NASDAQ Stock Market (NASDAQ), dated November 17, 2005, notifying the Company that its common stock was subject to delisting based on its failure to file its Form 10-Q

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

for the quarter ending September 30, 2005 as required by NASDAQ Marketplace Rule 4310(c)(14). On November 25, 2005, the Company requested a hearing before a NASDAQ Listing Qualifications Panel (Panel) to request an extension to comply with the periodic filing requirements. NASDAQ stayed the delisting process and a hearing was held on December 15, 2005. The Company received a second letter from NASDAQ on January 4, 2006, notifying the Company that its common stock was subject to delisting based on its failure to satisfy NASDAQ Marketplace Rules 4350(e) and 4350(g), which required the Company to solicit proxies and hold an annual meeting of shareholders before December 31, 2005. The Company held its 2004 annual shareholder meeting in December 2004 and its 2005 annual shareholder meeting was originally planned for December 2005, but the Company was unable to hold its 2005 annual shareholder meeting due in part to its ongoing accounting review. On January 17, 2006, the Panel granted the Company’s request for continued listing subject to certain conditions. On March 28, 2006, the Company announced that it had concluded that the restatement will not be completed by the March 31, 2006 deadline, and had communicated this information to the Panel.

 

On March 31, 2006, the Company received a letter from NASDAQ notifying it that the Panel had determined to delist the Company’s securities from The NASDAQ National Market effective as of the opening of business on Tuesday, April 4, 2006. Upon delisting, the quotations for the Company’s common stock appeared in the Pink Sheets, a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time, under the trading symbol TERN.PK.

 

Reliance Settlement

 

In 2001, the insurer of the second layer of the Company’s directors and officers insurance, Reliance Insurance Company (Reliance), filed for liquidation under the laws of the Commonwealth of Pennsylvania. Because of Reliance’s filing for liquidation, the Company self-insured the Reliance layer of $2.5 million and paid the $2.5 million as part of the securities class action lawsuit filed against the Company and certain of its officers and directors in 2000. The Company filed a claim for $2.5 million against Reliance with its liquidator. In April 2005, the liquidator for Reliance provided the Company with a notice of determination that allowed its claim against Reliance. In June 2006, the Company sold its claim against Reliance to Prime Shares World Market LLC and recognized other income of $1.0 million.

 

Changes in Membership and Reduction in Size of the Board of Directors

 

On June 19, 2006, the Company announced that two members of the Board of Directors resigned, and that the Board of Directors approved a reduction in size from nine to seven members. Mark Slaven, Chair of the Audit Committee and member of the Board of Directors of the Company, resigned effective August 2, 2006 as a result of the increased demands on his time from his duties as Senior Vice President, Chief Financial Officer and Treasurer of Cross Match Technologies Inc. in Palm Beach Garden, Florida, and not as a result of any matter concerning the Company. Aleksander Krstajic resigned, effective June 19, 2006, as a result of the increased travel and demands on his time from his duties as President and Chief Executive Officer of Bell Vanguard Inc., and not as a result of any matter concerning the Company. The Company appointed Lewis Solomon, currently a member of the Board of Directors, to be a member of the Audit Committee effective August 2, 2006. With four independent directors on the seven member board, the Board of Directors is currently comprised of a majority of independent directors.

 

Commitments and Obligations

 

Effective in August 2006, the Company entered into an agreement to sub-sublease its then current principal executive offices located in Santa Clara, California and consisting of approximately 141,000 square feet of office space. The sublease agreement expires on October 31, 2009, which is the same day the Company’s agreement to sub-sublease the premises expires. Concurrently, the Company entered into a lease

 

TERAYON COMMUNICATION SYSTEMS, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

agreement to lease approximately 63,069 square feet of office space through September 2009 at another location in Santa Clara, California to serve as the Company’s new principal executive offices.

 

Settlement of Derivative Lawsuit

 

On September 15, 2006, the Company entered into a Stipulation of Settlement of Derivative Claims with respect to the derivative litigation entitled In re Terayon Communication Systems, Inc. Derivative Litigation, Case No. CV 807650, pending in the Superior Court of California, County of Santa Clara. On September 18, 2006, the court approved the final settlement of the derivative litigation. In connection with the settlement, the Company paid $1.0 million in attorney’s fees and expenses to the derivative plaintiffs’ counsel and agreed to adopt certain corporate governance practices. The Company accrued $1.0 million to litigation settlement expense in the fourth quarter of 2005. For a description of the derivative litigation and settlement, see Note 4, “Contingencies,” to Condensed Consolidated Financial Statements.

 

Forward-Looking Statements

 

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto. This discussion and analysis may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties, including those discussed under Risk Factors in Part II, Item 1A in this Quarterly Report on Form 10-Q and Item 1A of the Annual Report on Form 10-K for the year ended December 31, 2005 (2005 Form 10-K). The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “plan” and other expressions, that are predictions or indicate future events, identify forward-looking statements, which are based on the current expectations, estimates, forecasts and projections of future Company or industry performance based on management’s judgment, beliefs, current trends and market conditions. The forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause our actual outcomes and results to differ materially from what is expressed, expected, anticipated, or implied in any forward-looking statement. These statements include those related to our products, product sales, expenses, our revenue recognition policies, and material weaknesses or deficiencies in internal control over financial reporting. For example, there can be no assurance that our product sales efforts or recognized revenues or expenses will meet any expectations or follow any trend(s), that our internal controls over financial reporting will be effective or produce reliable financial information on a timely basis, or that our ability to compete effectively and maximize stockholder value will be successful or yield preferred results. Our ongoing or future litigation may have an adverse effect on our results of operations and financial results. In addition, our financial results, liquidity and stock price may suffer as a result of the restatements, the cost of completing the restatements and the audit and review of our financial statements, our ability to control operating expenses and maintain adequate cash balances for operating the business going forward, any adverse response of our vendors, customers, stockholders, media and others relating to the delay or restatements of our financial statements, the review and application of our accounting processes, policies and procedures, and additional uncertainties related to accounting. We undertake no intent or obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events or otherwise. This caution is made under the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act).

 

Executive Overview

 

We currently develop, market and sell digital video equipment to network 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.

 

In 2004, we refocused the Company to make digital video 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) products, including cable modems, embedded multimedia terminal adapters (eMTA) and home networking devices, but ceased future investment in our cable modem termination systems (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 charges and asset impairment charges. Additionally, in March 2005, we eliminated our in-house semiconductor group in connection with the sale of certain modem semiconductor assets to ATI Technologies, Inc.

We announced in January 2006 that we were focusing our business solely on digital video, 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 product line increasingly irrelevant given our core business of digital video. We discontinued our HAS product line in January 2006 and have engaged in the sale of remaining inventories, the collection of subsequent receivables and a global reduction in headcount. 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 transactions and other alternatives in order to maintain market position and maximize shareholder value.

 

We have not been profitable since our inception, and we may remain unprofitable in future periods. Our ability to grow our business, as well as attaining and sustaining profitability, is dependent on our ability to effectively compete in the marketplace with our current products and services, the development, introduction and acceptance of new products and services, containing operating expenses and improving gross margins.

 

A more detailed description of the risks to our business can be found in the sections captioned “Risk Factors” in this Quarterly Report on Form 10-Q and the 2005 Form 10-K.

 

Critical Accounting Policies and Estimates

 

The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires our management to make judgments and estimates that affect the amounts reported in our financial statements and accompanying notes. Our management believes that we consistently apply these judgments and estimates and the financial statements and accompanying notes fairly represent all periods presented. However, any differences between these judgments and estimates and actual results could have a material impact on our statement of income and financial condition. Critical accounting estimates, as defined by the Securities and Exchange Commission (Commission), are those that are most important to the portrayal of our financial condition and results of operations and require our management’s most difficult and subjective judgments and estimates of matters that are inherently uncertain.

 

We describe our critical accounting policies regarding revenue recognition, deferred revenue and deferred cost of goods sold, critical accounting estimates regarding stock-based compensation and allowance for doubtful accounts below. For a discussion of our remaining critical accounting policies, see Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — “Critical Accounting Policies” in our 2005 Form 10-K.

 

Revenue Recognition

 

In accordance with Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition” (SAB 101), as amended by SAB 104, for all products and services, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services were rendered, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is not recognized until all acceptance criteria have been met. Contracts and customer purchase orders are used to determine the existence of an arrangement. Delivery occurs when product is delivered to a common carrier. Certain products are delivered on a free-on-board (FOB) destination basis and we do not recognize revenue associated with these transactions until the delivery has occurred to the customers’ premises. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

 

In establishing our revenue recognition policies for our products, we assess software development efforts, marketing and the nature of post contract support (PCS). Based on our assessment, we determined that the software in the HAS and CMTS products is incidental, and therefore, we recognize revenue on the HAS and CMTS products under SAB 101, as specifically amended by SAB 104. Additionally, based on our assessment of the digital video solutions (DVS) products, we determined that software was more than incidental, and therefore, we recognize revenue on the DVS products under American Institute of Certified Public Accountants

Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2), and SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1).

 

In order to recognize revenue from individual elements within a multiple element arrangement under SOP 97-2, we must establish vendor specific objective evidence (VSOE) of fair value for each element. Prior to 2006, for the DVS products, we determined that we did not establish VSOE of fair value for the undelivered element of PCS, which required us to recognize revenue and the cost of goods sold of both the hardware element and the PCS element ratably over the period of the customer support contract. Beginning in the first quarter of 2006, we determined that we established VSOE of fair value of the PCS element for the DVS product sales as a result of maintaining consistent pricing practices for PCS, including consistent pricing of renewal rates for PCS. For the DVS products sold beginning in the first quarter of 2006 that contain a multiple element arrangement, we recognize revenue and cost of goods sold from the hardware component when all criteria of SAB 104 and SOP 97-2 have been met and revenue and cost of goods sold related to the PCS element ratably over the period of the PCS.

 

We sell our products directly to broadband service providers and, to a lesser extent, resellers. Revenue arrangements with resellers are recognized when product meets all criteria of SAB 104 and SOP 97-2.

 

Deferred Revenue, Deferred Cost of Goods Sold

 

Deferred revenue and deferred cost of goods sold are a result of our recognizing revenues on the DVS products under SOP 97-2. Under SOP 97-2, we must establish VSOE of fair value for each element of a multiple element arrangement. Until the first quarter of 2006, we did not establish VSOE of fair value for PCS when PCS was sold as part of a multiple element arrangement. As such, for the DVS products sold with PCS, revenue and the cost of goods sold related to the delivered element, the hardware component, were deferred and recognized ratably over the period of the PCS.

 

Stock-Based Compensation

 

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan based on estimated fair values. SFAS 123(R) supersedes our previous accounting under Accounting Principles Board Opinion (APB) 25, “Accounting for Stock Issued to Employees” (APB 25), for periods beginning January 1, 2006. In March 2005, the Commission issued SAB No. 107, “Share-based Payment” (SAB 107), relating to SFAS 123(R). SAB 107 provides guidance on the initial implementation of SFAS 123(R). In particular, the statement includes guidance related to share-based payment awards with non-employees, valuation methods and selecting underlying assumptions such as expected volatility and expected term. It also gives guidance on the classification of compensation expense associated with share-based payment awards and accounting for the income tax effects of share-based payment awards upon the adoption of SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).

 

Under the modified prospective method of adoption for SFAS 123(R), the compensation cost recognized by us beginning in 2006 includes (a) compensation cost for all equity incentive awards granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all equity incentive awards granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). We use the straight-line attribution method to recognize share-based compensation costs over the service period of the award. Upon exercise, cancellation, or expiration of stock options, deferred tax assets for options with multiple vesting dates are eliminated for each vesting period on a first-in, first-out basis as if each vesting period was a separate award.

 

Options currently granted by us generally expire six years from the grant date and vest over a three year period. Options granted prior to the second quarter of 2005 generally expire ten years from the grant date and

vest over a four to five year period. We may use other types of equity incentives, such as restricted stock and stock appreciation rights. Our equity incentive awards also allow for performance-based vesting.

 

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” (FAS 123(R)-3). We have elected to adopt the alternative transition method provided in FAS 123(R)-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC Pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC Pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).

 

Share-based compensation recognized in 2006 as a result of the adoption of SFAS 123(R) as well as pro forma disclosures according to the original provisions of SFAS 123 for periods prior to the adoption of SFAS 123(R) use the Black-Scholes valuation methodologies for estimating fair value of options granted under our equity incentive plans and rights to acquire stock granted under our stock participation plan.

 

Allowance for Doubtful Accounts

 

We perform ongoing credit evaluations of our customers and generally require no collateral. We evaluate our trade receivables based upon a combination of factors. Credit losses have historically been within management’s expectations. When we become aware of a customer’s inability to pay, such as in the case of bankruptcy or a decline in the customer’s operating results or financial position, we record an allowance to reduce the related receivable to an amount we reasonably believe is collectible. We maintain an allowance for potentially uncollectible accounts receivable based on an estimate of collectibility. We assess collectibility based on a number of factors, including history, the number of days an amount is past due (based on invoice due date), changes in credit ratings of customers, current events and circumstances regarding the business of our clients’ customers and other factors that we believe are relevant. If circumstances related to a specific customer change, our estimates of the recoverability of receivables could be further altered. In addition, we maintain an allowance for doubtful accounts to offset the accounts receivable and related reserve related to customers who were granted extended payment terms or who are experiencing financial difficulties, or where collectibility is not reasonably assured.

 

Results of Operations

 

Comparison of Three Months Ended March 31, 2006 and March 31, 2005 (as restated)

 

Revenues

 

Our revenues increased 21% to $21.5 million for the three months ended March 31, 2006, compared to $17.8 million for the three months ended March 31, 2005, primarily due to increased revenue from our DVS products. Additionally, in the three months ended March 31, 2006 compared to the same period in 2005, our HAS revenues decreased while CMTS revenues increased slightly. We expect both overall revenues and revenue invoiced and recognized in 2006 to be lower than in 2005.

Revenues by Groups of Similar Products

 

The following table presents revenues for groups of similar products (in thousands, except percentages) (unaudited):

 

 

Revenues from the sale of HAS products decreased to $5.0 million for the three months ended March 31, 2006, compared to $11.7 million for the three months ended March 31, 2005. In January 2006, we announced that we were discontinuing the HAS product line to focus solely on digital video. As a result, we continue to sell our remaining HAS inventory and collect the remaining receivables with respect to our HAS products, and we expect revenue from the sale of our HAS products to continue to decline over the remainder of 2006. We anticipate that all remaining HAS inventories will be sold during the first quarter of 2007. CMTS revenues were relatively unchanged at $1.7 million and $1.6 million for the three months ended March 31, 2006 and March 31, 2005, respectively, as we continued to sell our remaining CMTS inventory. We do not believe that sales of CMTS products will be material for the remainder of 2006 and in future periods.

 

Revenues from the sale of DVS products increased to $14.8 million for the three months ended March 31, 2006, compared to $4.5 million for the three months ended March 31, 2005.

 

The following is a breakdown of DVS product revenue by period invoiced (in millions, except percentages) (unaudited):