TURNSTONE SYSTEMS INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 000-28843

TURNSTONE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE		77-0473640
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

2220 CENTRAL EXPRESSWAY, SANTA CLARA, CALIFORNIA 95050

(Address of principal executive offices, including zip code)

(408) 907-1400

(Registrant’s telephone number, including area code)

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

There were 65,841,815 shares of the Company’s Common Stock, par value $.001, outstanding on October 31, 2002.

TURNSTONE SYSTEMS, INC.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION		Page No.
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001	2
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2002 and 2001	3
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2002 and 2001	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35
Item 4.	Controls and Procedures	36

PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	37
Item 2.	Changes in Securities and Use of Proceeds	40
Item 3.	Defaults Upon Senior Securities	40
Item 4.	Submission of Matters to a Vote of Security Holders	40
Item 5.	Other Information	40
Item 6.	Exhibits and Reports on Form 8-K	40
Signatures		42
Certifications		43

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

	September 30, 2002			December 31, 2001
Assets
Current assets:
Cash and cash equivalents	$	110,076		$	92,633
Short-term investments		73,040			115,488
Accounts receivable, net		241			510
Inventories		5,796			6,208
Income tax receivable		10			527
Prepaid expenses and other current assets		1,205			1,146

Total current assets		190,368			216,512

Property and equipment, net		1,834			3,068
Long-term investments		34,876			26,562
Restricted cash		3,639			3,639
Other assets		—			24

Total assets	$	230,717		$	249,805

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	585		$	533
Accrued compensation and benefits		1,059			1,077
Other current liabilities and accrued expenses		2,632			3,512
Deferred revenue		395			177
Current obligations under capital leases		—			41

Total current liabilities		4,671			5,340

Accrual for loss on operating lease, long-term portion		901			1,576
Other long-term liabilities		—			68

Total liabilities		5,572			6,984

Stockholders’ equity:
Convertible preferred stock, $0.001 stated value, 5,000 shares authorized; none issued and outstanding at September 30, 2002 and December 31, 2001		—			—
Common stock, $0.001 stated value, 200,000 shares authorized; 65,757 and 65,643 shares issued and outstanding at September 30, 2002 and December 31, 2001, respectively		66			66
Treasury stock, at cost; 2,360 and 1,199 shares at September 30, 2002 and December 31, 2001, respectively		(7,946	)		(3,554	)
Additional paid-in capital		311,356			311,163
Deferred stock compensation		(763	)		(2,516	)
Accumulated other comprehensive income		495			842
Accumulated deficit		(78,063	)		(63,180	)

Total stockholders’ equity		225,145			242,821

Total liabilities and stockholders’ equity	$	230,717		$	249,805

See accompanying notes to condensed consolidated financial statements.

TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

	The Three Months Ended September 30,						The Nine Months Ended September 30,
	2002			2001			2002			2001
Net revenues:
Product revenue	$	707		$	287		$	1,565		$	9,077
Service revenue		351			431			1,129			2,821
Sales returns reserve adjustment		—			—			167			—

Total net revenues		1,058			718			2,861			11,898
Cost of revenues:
Cost of product revenue		388			103			855			5,146
Cost of service revenue		91			207			277			1,151
Write-down of inventory		75			—			75			35,019
Provision for purchase commitments		—			—			—			2,666

Total cost of revenues		554			310			1,207			43,982
Gross profit (loss)		504			408			1,654			(32,084	)
Operating expenses:
Research and development (exclusive of non-cash compensation expense of $184 and $356 for the three months ended September 30, 2002 and 2001 and $745 and $1,417 for the nine months ended September 30, 2002 and 2001, respectively)		3,947			5,331			11,062			18,821
Sales and marketing (exclusive of non-cash compensation expense of $104 and $142 for the three months ended September 30, 2002 and 2001 and $416 and $644 for the nine months ended September 30, 2002 and 2001, respectively)		1,866			3,606			6,183			13,268
General and administrative (exclusive of non-cash compensation expense of $137 and $217 for the three months ended September 30, 2002 and 2001 and $549 and $779 for the nine months ended September 30, 2002 and 2001, respectively)		640			1,127			2,100			3,809
Amortization and write-off of intangible assets		—			7,501			—			8,308
Amortization of deferred stock compensation		425			715			1,710			2,840
Provision for loss on operating lease		—			2,702			—			2,702

Total operating expenses		6,878			20,982			21,055			49,748

Operating loss		(6,374	)		(20,574	)		(19,401	)		(81,832	)
Interest income and other, net		1,507			2,334			4,596			9,421

Loss before income tax		(4,867	)		(18,240	)		(14,805	)		(72,411	)
Income tax expense		64			29			78			3,490

Net loss	$	(4,931	)	$	(18,269	)	$	(14,883	)	$	(75,901	)

Basic net loss per share of common stock	$	(.08	)	$	(.29	)	$	(.24	)	$	(1.23	)

Diluted net loss per share of common stock	$	(.08	)	$	(.29	)	$	(.24	)	$	(1.23	)

Weighted-average shares of common stock outstanding used in computing basic net loss per share		62,736			63,272			63,188			61,757

Weighted-average shares of common stock outstanding used in computing diluted net loss per share		62,736			63,272			63,188			61,757

See accompanying notes to condensed consolidated financial statements.

TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

	The Nine Months Ended September 30,
	2002			2001
Operating activities
Net loss	$	(14,883	)	$	(75,901	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,376			2,363
Write-off of intangible assets		—			7,501
Stock compensation expense		1,710			2,840
Common stock issued for services		1			7
Provision for doubtful accounts and sales returns		(664	)		(73	)
Loss on disposal of property and equipment		—			241
Provision for loss on operating lease		—			2,702
Effect of changes in foreign currency		(113	)		50
Changes in assets and liabilities:
Accounts receivable		933			720
Income tax receivable		533			4,175
Deferred tax asset		—			3,262
Inventory		412			22,446
Prepaid expenses and other assets		(32	)		690
Accounts payable		52			(7,529	)
Accrued compensation and benefits		(18	)		(38	)
Other current liabilities and accrued expenses		(887	)		(7,566	)
Accrual for loss on operating lease		(675	)		—
Income tax payable		—			408
Other long-term liabilities		(68	)		—
Deferred revenue		218			(1,343	)

Net cash used in operating activities		(12,105	)		(45,045	)
Investing activities
Acquisition of property and equipment		(153	)		(1,234	)
Acquisition of Paragon Solutions Limited		—			(5,000	)
Proceeds from disposal of property and equipment		11			—
Purchases of available-for-sale investments, net		(148,576	)		(179,001	)
Proceeds from sales and maturities of available-for-sale investments		182,363			146,729

Net cash provided by (used in) investing activities		33,645			(38,506	)
Financing activities
Net proceeds from issuance of common stock		236			1,390
Principal payments of capital lease obligations		(41	)		(170	)
Purchases of treasury stock		(4,392	)		—

Net cash provided by (used in) financing activities		(4,197	)		1,220
Effect of exchange rate changes on cash and cash equivalents		100			4
Increase (decrease) in cash and cash equivalents		17,443			(82,327	)
Cash and cash equivalents at beginning of period		92,633			199,091

Cash and cash equivalents at end of period	$	110,076		$	116,764

Supplemental disclosures of cash flow information:
Cash paid for interest	$	—		$	11
Cash paid for income tax	$	175		$	251
Noncash investing and financing activities:
Deferred stock compensation		—		$	1,776

See accompanying notes to condensed consolidated financial statements.

TURNSTONE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

SEPTEMBER 30, 2002

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Turnstone Systems, Inc. (the Company), pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company, the unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments, except as otherwise indicated) necessary for a fair presentation of the Company’s financial position at September 30, 2002 and December 31, 2001, its operating results for the three and nine months ended September 30, 2002 and 2001, and its cash flows for the nine months ended September 30, 2002 and 2001. These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto, included in the Company’s Annual Report on Form 10-K and filed with the SEC on March 20, 2002. The condensed consolidated balance sheet at December 31, 2001 has been derived from audited financial statements as of that date.

The interim financial statements are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending December 31, 2002.

2. Summary of Significant Accounting Policies

Short and Long-Term Investments

The Company has classified its investments as available-for-sale. Available-for-sale securities are carried at fair value. Unrealized gains and losses are included in other comprehensive loss. Realized gains and losses are computed using the specific identification method.

The Company’s short and long-term investments at September 30, 2002 consist primarily of U.S., state and municipal government and government agency obligations and corporate debt securities. Investments with remaining maturities of less than or equal to one year are considered short-term, and investments with maturities in excess of one year are considered long-term. Management determines the appropriate classification of securities at the time of purchase and evaluates such designation as of each balance sheet date.

Inventories

Inventories are stated at the lower of cost or market (on a first-in, first-out basis), and consist of the following (in thousands):

	September 30, 2002		December 31, 2001
Raw materials	$	955	$	750
Finished goods		4,841		5,458

	$	5,796	$	6,208

Recent Accounting Pronouncements

In July 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143, which is effective for fiscal years beginning after June 15, 2002, applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and the normal operation of a long-lived asset, except for certain obligations of lessees. Adoption of SFAS No. 143 is not expected to have a material impact on the Company’s financial position and results of operations.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which is effective for financial statements issued for fiscal years beginning after December 15, 2001. SFAS No. 144 develops one accounting model for long-lived assets that are to be disposed of by sale and requires that these assets be measured at the lower of book value or fair value less costs to sell. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and will be eliminated from the ongoing operations of the entity in a disposal transaction. The Company adopted SFAS No. 144 effective January 1, 2002 and the adoption did not have a material impact on the Company’s financial statements.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The principal difference between SFAS 146 and EITF 94-3 relates to SFAS 146’s timing for recognition of a liability for a cost associated with an exit or disposal activity. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3 a liability for an

exit cost as generally defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. Management does not expect that the adoption of SFAS No. 146 will have a material impact on the Company’s financial statements.

3. Net Loss Per Share

Basic net loss per share is computed using the weighted-average number of outstanding shares of common stock excluding the weighted-average number of shares of restricted stock subject to repurchase. Diluted net loss per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, shares of restricted common stock subject to repurchase, potential shares of common stock from options and warrants using the treasury stock method and from convertible securities using the “as-if converted basis”. The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Net loss	$	(4,931	)	$	(18,269	)	$	(14,883	)	$	(75,901	)

Basic and diluted:
Weighted average shares of common stock outstanding		63,429			64,947			63,995			65,030
Less: Weighted average shares subject to repurchase		(693	)		(1,675	)		(807	)		(3,273	)

Weighted average shares used in computing basic and diluted net loss per common share		62,736			63,272			63,188			61,757

Basic and diluted net loss per common share	$	(.08	)	$	(.29	)	$	(.24	)	$	(1.23	)

Options to purchase 10,074,000 shares of common stock and 648,000 shares of common stock subject to repurchase have been excluded from the computation of diluted net loss per share as of September 30, 2002, as their effect would have been antidilutive. Options to purchase 10,838,000 shares of common stock, 252,000 shares of common stock subject to repurchase issued to the Company’s founders, and 892,000 shares of common stock subject to repurchase issued to other employees have been excluded from the computation of diluted net loss per share as of September 30, 2001, as their effect would have been antidilutive.

4. Comprehensive Loss

The components of comprehensive loss are as follows (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Net loss	$	(4,931	)	$	(18,269	)	$	(14,883	)	$	(75,901	)
Change in net unrealized gain (loss) on available-for-sale investments, net		(104	)		450			(347	)		579

Total comprehensive loss	$	(5,035	)	$	(17,819	)	$	(15,230	)	$	(75,322	)

5. Segment Information

SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information, establishes standards for the manner in which public companies report information about operating segments, products and services, geographic areas and major customers in annual and interim financial statements. The method of determining what information to report is based on the way that management organizes the operating segments within the enterprise for making operating decisions and assessing financial performance.

The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (CEO). The Company’s operations comprise one product line. The CEO reviews financial information on a single entity level basis for purposes of making operating decisions and assessing financial performance. The entity level financial information is the same as the information presented in the accompanying condensed consolidated statements of operations. Accordingly, the Company has determined that it is engaged in a single operating segment.

For the three months ended September 30, 2002 and 2001, approximately 58.0% and 0.8%, respectively, of revenues were derived from sales to customers located outside the United States. For the nine months ended September 30, 2002 and 2001, approximately 46.6% and 15.8%, respectively, of revenues were derived from sales to customers located outside the United States. Product revenues for the three and nine months ended September 30, 2002 and 2001 were derived from sales of our loop management products. Service revenues for the three and nine months ended September 30, 2002 and 2001 were derived primarily from the Company’s maintenance programs for loop management products.

6. Accrual for Loss on Operating Lease

In fiscal 2001, the Company recorded a $2.7 million provision for estimated losses, net of estimated sub-lease income, on an operating lease. The provision relates to the portion of the Company’s leased headquarter facility that it intends to sublease

at prevailing market rates, which are less than the rates that the Company is obligated to pay under a contractual lease commitment. The lease expires in June 2010.

For the three months ended September 30, 2002, activity for the accrual on operating lease was comprised of cash payments of $225,000 on the operating lease. The accrual for loss on operating lease for the quarter ended September 30, 2002, consisted of the following (in thousands):

	Accrual for Loss on Operating Lease
Current portion (included in other current liabilities and accrued expenses)	$	901
Long-term portion		901

Accrual balance at September 30, 2002	$	1,802

7. Litigation

A. Shareholder Litigation

On March 28, 2001, the Louisiana School Employees’ Retirement System filed a putative class action lawsuit against the Company, certain of its current and former officers and directors and the underwriters of the Company’s September 21, 2000 secondary offering of common stock in the United States District Court for the Northern District of California alleging that the defendants issued false and misleading statements in the Company’s prospectus issued in connection with the secondary offering. At or about the same time, four other purported class action lawsuits were filed against the Company and certain of its current and former officers and directors in the United States District Court for the Northern District of California alleging that the defendants made false or misleading statements during the class period of June 5, 2000 through January 2, 2001.

All five cases were consolidated on October 26, 2001, and by court order dated December 3, 2001, Radiant Advisors, LLC was designated as lead plaintiff and the law firms of Bernstein Litowitz Berger & Grossman LLP and Bernstein Liebhard & Lifshitz, LLP were designated as co-lead counsel for the consolidated actions. Plaintiff filed two separate consolidated amended complaints on March 19, 2002. On June 20, 2002, Judge Armstrong issued an order for plaintiff to show cause as to why the action should not be dismissed with prejudice for plaintiff’s failure to file one consolidated amended complaint. Plaintiff filed a certificate of counsel in response to the order on June 27, 2002. The Company filed its response on July 3, 2002. On August 30, 2002, Judge Armstrong struck the two separate amended complaints previously filed by plaintiff and ordered that a single amended complaint be filed. Plaintiff filed a single amended complaint on September 13, 2002. The Company filed a motion to dismiss the amended complaint on October 8, 2002.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit in state court in California, County of Santa Clara, against the Company and certain of the Company’s officers and directors, alleging that the individual defendants caused the Company harm by either making or permitting the Company to make

false and misleading statements between June 5, 2000 and January 2, 2001 and by permitting certain officers to profit from stock sales during that period. The complaint asserts claims against the individual defendants for breach of fiduciary duty, waste of corporate assets, abuse of control and gross mismanagement of the Company. The Company demurred to the complaint on July 9, 2001. On September 28, 2001, a court order was issued sustaining the demurrer and granting plaintiff limited discovery. On December 19, 2001, subsequent to the completion of the court-ordered discovery, plaintiff filed a first amended derivative complaint alleging the same causes of action asserted in the initial complaint. The Company filed a demurrer to the first amended derivative complaint on January 10, 2002. On February 22, 2002, Judge Jack Komar issued an order sustaining the demurrer and granting plaintiff leave to amend its complaint. Plaintiff filed an amended complaint on March 19, 2002. The Company filed a demurrer to the second amended derivative complaint on April 22, 2002. On May 28, 2002, Judge Komar issued an order sustaining the demurrer and dismissing the complaint with prejudice. Plaintiff filed a notice of appeal on August 1, 2002.

On November 9, 2001, Arthur Mendoza filed a securities class action lawsuit in the United States District Court for the Southern District of New York alleging claims against the Company, certain of its current and former officers and directors, and the underwriters of the Company’s initial public offering of stock. The complaint is purportedly brought on behalf of a class of individuals who purchased common stock in the initial public offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and commissions received by the underwriters. The case has been coordinated for pre-trial purposes with over 300 cases raising the same or similar issues and also currently pending in the Southern District of New York. On April 18, 2002, Michael Szymanowski was appointed lead plaintiff in the action. On April 22, 2002, an amended complaint was filed. On July 1, 2002, the underwriter defendants filed an omnibus motion to dismiss. On July 15, 2002, the Company, collectively with the other issuer defendants, also filed an omnibus motion to dismiss. Plaintiff filed an opposition to the underwriters’ motion to dismiss on August 15, 2002 and to the issuers’ motion to dismiss on August 27, 2002. Underwriters’ reply to the opposition was filed on September 13, 2002, and issuers’ reply to the opposition was filed on September 27, 2002.

Each of the Company’s current and former officers who were named in the New York securities class action lawsuit has entered into a tolling agreement, effective as of July 20, 2002, with the plaintiff. Pursuant to the tolling agreement, plaintiff agreed to dismiss the Company’s current and former officers from the lawsuit in exchange for a tolling of the statute of limitations with respect to any claims that may be asserted against them through the earlier of (i) thirty days after the termination of the tolling agreement or (ii) September 30, 2003. On October 9, 2002, the Court entered an order dismissing the Company’s current and former officers from the lawsuit.

Such matters are subject to many uncertainties and outcomes are not predictable with assurance. Consequently, management is unable to estimate the ultimate aggregate amount of monetary liability, amounts which may be covered by insurance, or the financial impact with respect to these matters as of September 30, 2002. However, management believes that the final resolution of these matters, individually and in the aggregate, will not have a material adverse impact upon the Company’s financial position, results of operations or cash flows.

B. In Re: Digital Broadband Communications, Inc. Bankruptcy

On August 12, 2002, the Official Committee of Unsecured Creditors of Digital Broadband Communications, Inc., a former customer of the Company which filed for Chapter 11 bankruptcy on December 27, 2000, filed a complaint in the United States Bankruptcy Court for the District of Delaware, seeking recovery of alleged preferential transfers to the Company in the aggregate amount of $3,522,714.85. The Company filed its answer on September 10, 2002.

This matter is subject to many uncertainties and the outcome is not predictable with assurance. Consequently, management is unable to estimate the ultimate aggregate amount of monetary liability or the financial impact with respect to this matter as of September 30, 2002. However, management believes that the final resolution of this matter will not have a material adverse impact upon the Company’s financial position, results of operations or cash flows.

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

In addition to the other information in this report, certain statements in the following Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A) are forward looking statements within the meaning of the safe harbor created by the Private Securities Litigation Reform Act of 1995 (the “PSLRA”). When used in this report, the words “expects,” “anticipates,” “estimates,” and similar expressions are intended to identify forward looking statements. Statements reflecting the Company’s expectations, beliefs, intentions and strategies regarding the Company’s future and the future of its business operations, including, without limitation, statements regarding the demand for local loop automation, worldwide growth of the DSL market, attractiveness of and demand for the Company’s products, timing and success of new product introductions, seasonal buying patterns of our customers, availability of key components necessary in the manufacture of our products and expected future financial operating results and trends, such as statements about future selling prices for our products, gross margins, revenues, expenses and capital resources, constitute forward looking statements within the meaning of the PSLRA. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward looking statements contained herein. Such risks and uncertainties are set forth below under the sections entitled “Overview” and “Risk Factors Affecting Future Results,” on pp. 12, and 17 to 34, of this document, respectively. The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report.

OVERVIEW

We design, engineer, market and support hardware and software products that enable local exchange carriers to rapidly deploy and efficiently maintain copper local loop services. Our CX loop management systems are designed to be deployed in central offices and remote terminals to assist with copper loop installation, qualification, service verification and maintenance. Our SX Smart Splitter^™ platform combines signal splitting capabilities with test access to assist in the delivery of asynchronous DSL, or ADSL, services. Our MX Copper CrossConnect^® solution is used to provide remote switching and service verification capabilities to facilitate the management of unbundled local loops. Our CrossWorks^™ and ONYX automation software suites enable service providers to remotely control our network equipment and seamlessly integrate loop management functions into their back-office operations support systems. Finally, a substantial portion of our operating activities and resources are dedicated to the development of next-generation copper automation and management products and to establishing customer relationships for these future products.

We market and sell our products to domestic and international local exchange carriers through our direct sales force, third-party resellers and through indirect original equipment manufacturer channels. A customer’s network planning and purchase decisions normally involve a significant commitment of its resources and a lengthy evaluation and product qualification process. Since the decision to purchase our products is made as part of this network planning process, our sales cycle is lengthy, typically as long as one year or more.

In the quarter ended September 30, 2002, pursuant to a first office application trial agreement, Bellsouth Telecommunications, Inc. purchased a single MX500 CrossConnect^® system, which included both hardware and a license for our ONYX automation software. Bellsouth does not have any further commitments to purchase our products. We will continue to work with Bellsouth and other incumbent local exchange carriers to establish and address their local loop management needs.

CRITICAL ACCOUNTING POLICIES

Management considers certain of our accounting policies to be critical because they are significant in the portrayal of the Company’s financial condition and results, or because their application requires significant reliance on management’s judgment. Critical accounting policies and judgments include revenue recognition, allowance for doubtful accounts and inventory valuation.

We recognize revenue from product sales in accordance with SEC Staff Accounting Bulletin No. 101, based upon shipment of products pursuant to customer purchase orders, assuming that the price to the customer is fixed or determinable and that collectibility of the resulting receivable is reasonably assured. When the arrangement with the customer includes future obligations for which fair value does not exist or when customer acceptance is required, revenue is recognized when those obligations have been met or customer acceptance has been received. When an arrangement with the customer includes obligations to deliver unspecified additional products in the future, revenue is recognized ratably over the obligation period. When collectibility of the resulting receivable is not reasonably assured based on the company’s assessment of the customer’s financial condition, revenue is recognized upon customer payment. Our policy generally does not allow for product returns. We maintain a reserve for estimated potential returns based on our historical minimal level of returns. Revenue from services and support provided under our maintenance programs is deferred based upon the fair value of the program and recognized on a straight-line basis over the period of the contract. We generally provide a twelve month warranty for hardware products not covered under hardware maintenance programs. Costs associated with the warranty program are estimated and accrued for at the time of product shipment. Revenue from consulting and training is deferred based on the fair value of the services, and recognized when such services are completed.

Accounts receivable are recorded net of allowance for doubtful accounts. We regularly review the adequacy of our accounts receivable allowance after considering the age of each invoice, each customer’s expected ability to pay, and our collection history with each customer. Using these criteria, we establish an allowance for specific invoices deemed uncollectible. In addition, we maintain an unallocated reserve for invoices not specifically reserved. The allowance for doubtful accounts represents management’s best current estimate of the portion of all outstanding invoices deemed uncollectible. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, additional allowances may be required, increasing our operating expenses. Additionally, we may in some cases receive payment for an invoice for which an allowance had previously been established, resulting in a reduction of our operating expenses.

Inventory is stated at the lower of cost or market. If we determine that the utility of our inventory has been impaired, we reflect this impairment by recording a charge to cost of revenues in the current period. Such determinations are based on management’s estimates regarding future demand and recoverable cost for inventories in excess of foreseeable demand, requiring assumptions on highly uncertain matters. As such, a range of reasonable estimates exists. At September 30, 2002, inventory is recorded at the lower of cost or market in accordance with management’s best current estimates; however,

if a different estimate within the range were used, additional charges to cost of revenues of up to $5.8 million may be required in the current or future periods.

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001

NET REVENUES

Net revenues consist of product revenue and service revenue. Product revenue for the periods presented consists primarily of sales of our CX100 loop management products and, to a lesser extent, our MX500 Copper CrossConnect^® products and our Crossworks^™ and ONYX automation software licenses. Service revenue is derived primarily from our product maintenance programs.

Product revenue increased to $707,000 for the quarter ended September 30, 2002 from $287,000 for the comparable quarter in 2001. This increase in product revenue is primarily attributable to increased sales of our CX100 loop management products, and, to a lesser extent, sales of our MX500 unbundled network element management products. Product revenue decreased to $1.6 million for the nine months ended September 30, 2002 from $9.1 million for the comparable period in 2001. This decrease is due to reduced demand from competitive local exchange carrier customers, primarily attributable to their continued financial difficulties.

Service revenue for the three months ended September 30, 2002 was $351,000, or 33.2% of net revenues, compared to $431,000, or 60.0% of net revenues, for the comparable period in 2001. Service revenues decreased to $1.1 million, or 39.5% of net revenues for the nine months ended September 30, 2002, compared to $2.8 million, or 23.7% of net revenues for the comparable period in 2001. This decrease is due to reduced demand from competitive local exchange carrier customers.

Our revenue to date has been recognized from a small number of customers. We expect that the majority of our revenue will continue to depend on sales of our products to a small number of customers. Revenue from international customers totaled 58.0% of our net revenues for the three months ended September 30, 2002 compared to 0.8% for the comparable period in 2001. For the nine months ended September 30, 2002 and 2001, approximately 46.6% and 15.8%, respectively, of revenues were derived from sales to customers located outside the United States.

For the three months ended September 30, 2002 and 2001, four customers and one customer each contributed greater than 10% of total revenues, for combined totals of 70% and 50%, respectively. For the nine months ended September 30, 2002 and 2001, two customers and three customers, respectively, each contributed greater than 10% of total revenues, for combined totals of 46% and 57% of total revenues, respectively.

COST OF REVENUES

Cost of product revenue includes amounts paid to our third party contract manufacturer and related overhead expenses, consisting primarily of salary and other expenses for personnel engaged in procurement, vendor management and quality assurance. Cost of service revenue includes costs to maintain our customer support group, consisting primarily of salaries for customer support personnel and costs associated with technical support and training activities.

In the aggregate, cost of product revenue, write-down of inventory and provision for purchase commitments increased to $463,000 for the three months ended September 30, 2002 from $103,000 for the comparable period of 2001. This increase is primarily due to increased CX100 sales during the quarter ended September 30, 2002. In the aggregate, cost of product revenue, write-down of inventory and provision for purchase commitments decreased to $930,000 for the nine months ended September 30, 2002 from $42.8 million in the comparable period of 2001. This decrease is primarily due to a $37.7 million charge recorded during the three months ended June 30, 2001 to write down the value of component and product inventory, and to accrue for minimum required purchase commitments. The remaining decrease is due to the decrease in CX100 sales from the comparable periods in 2001.

Cost of service revenue for the three months ended September 30, 2002 was $91,000 compared to $207,000 for the three months ended September 30, 2001. Cost of service revenue decreased to $277,000 for the nine months ended September 30, 2002 from $1.2 million for the comparable period in 2001. This decrease is primarily attributable to headcount reductions in our customer support organization that were made in response to the decreased demand for our product maintenance services.

RESEARCH AND DEVELOPMENT

Research and development expenses, net of non-cash compensation expense, consist primarily of salaries and related expenses for personnel engaged in research and development, fees paid to consultants and outside service providers, cost of certification and compliance testing and material costs for prototype and test units. We expense all of our research and development costs as they are incurred. Non-cash compensation expense for the three months ended September 30, 2002 was $184,000 compared to $356,000 for the comparable period of 2001.

Research and development expenses decreased 26.0% to $3.9 million for the three months ended September 30, 2002 from $5.3 million in the comparable period of 2001. Research and development expenses decreased 41.2% to $11.1 million for the nine months ended September 30, 2002 from $18.8 million in the comparable period of 2001. This decrease is primarily attributable to the discontinuation of our research and development operations in New Zealand and overall headcount reductions as a result of our restructuring program in September 2001.

Development of new features and products is essential to our future success and we expect that research and development expenses will remain a substantial percentage of total operating expenses in future periods.

SALES AND MARKETING

Sales and marketing expenses, net of non-cash compensation expense, consist primarily of salaries and related costs, commissions, costs associated with trade shows, and promotional and public relations activities. Non-cash compensation expense for the three months ended September 30, 2002 was $104,000 compared to $142,000 for the comparable period of 2001.

Sales and marketing expenses decreased 48.3% to $1.9 million for the three months ended September 30, 2002 from $3.6 million in the comparable period of 2001. Sales and marketing expenses decreased 53.4% to $6.2 million for the nine months ended September 30, 2002 from

$13.3 million in the comparable period of 2001. This decrease was primarily due to a decrease in the number of sales and sales support personnel domestically and internationally in 2002 compared to 2001.

GENERAL AND ADMINISTRATIVE

General and administrative expenses, net of non-cash compensation expense, consist primarily of salaries and related expenses for executive, finance and accounting personnel, professional fees and costs associated with our information systems. Non-cash compensation expense for the three months ended September 30, 2002 was $137,000 compared to $217,000 in the comparable period of 2001.

General and administrative expenses decreased 43.2% to $640,000 for the three months ended September 30, 2002 from $1.1 million in the comparable period of 2001. General and administrative expenses decreased 44.9% to $2.1 million for the nine months ended September 30, 2002 from $3.8 million in the comparable period of 2001. This decrease was primarily due to a decrease in the number of accounting and finance personnel in 2002 compared to 2001, and to a lesser extent, decreased professional services fees.

AMORTIZATION OF DEFERRED STOCK COMPENSATION

As of September 30, 2002, deferred stock compensation for stock options granted at prices deemed to be below fair value on the date of grant totaled $763,000. We amortized deferred stock compensation of approximately $425,000 in the three months ended September 30, 2002 and $715,000 for the comparable period in 2001. Amortization of deferred stock compensation was $1.7 million for the nine months ended September 30, 2002 and $2.8 million for the comparable period in 2001.

INTEREST INCOME AND OTHER, NET

Interest income and other, net includes income from our cash investments net of expense related to our lease financing obligations. We had interest income and other, net of $1.5 million for the three months ended September 30, 2002 and interest income and other, net of $2.3 million for the comparable period in 2001. We had interest income and other, net of $4.6 million for the nine months ended September 30, 2002 and interest income and other, net of $9.4 million for the comparable period in 2001. Interest income decreased for the comparable three and nine-month periods primarily due to lower average rate of returns on our investments as well as lower total cash and investment balances. In future periods, we expect interest income and other, net to vary depending upon changes in interest rates and the amount and mix of interest-bearing investments and any future short and long-term debt outstanding during each period.

INCOME TAX EXPENSE

Income tax expense of $64,000 for the three months ended September 30, 2002 and $29,000 for the comparable period in 2001 was attributable to state and foreign income tax. Income tax expense decreased to $78,000 for the nine months ended September 30, 2002 from $3.5 million in the comparable period in 2001, primarily due to a $3.4 million valuation allowance recorded in 2001 for that portion of the deferred tax asset that more likely than not will not be realized.

LIQUIDITY AND CAPITAL RESOURCES

Our principal source of liquidity as of September 30, 2002 consisted of $110.1 million in cash and cash equivalents, $73.0 million in short-

term investments and $34.9 million in long-term investments. Since our inception, we have financed our operations through private and public sales of securities, cash generated from operations and, to a lesser extent, through equipment lease financing.

During the nine months ended September 30, 2002, we used $12.1 million in operating activities compared to the same period in 2001 in which we used $45.0 million in operating activities. The use of cash in operating activities for the nine months ended September 30, 2002 resulted primarily from the net loss for the period, and to a lesser extent, decreases in other current liabilities and accrued expenses, accrual for loss on operating lease and accounts payable. This use of cash in operating activities was partially offset by non-cash charges, decreases in accounts receivable, inventory and income taxes receivable, and an increase in deferred revenue.

Net cash provided by investing activities for the nine months ended September 30, 2002 was $33.6 million compared to net cash used in investing activities of $38.5 million in the same period in 2001. Cash provided by investing activities in the nine months ended September 30, 2002 consisted primarily of proceeds from sales and maturities of available for sale investments of $182.4 million, offset by purchases of similar investments in the amount of $148.6 million.

In addition, capital expenditures decreased to $153,000 for the nine months ended September 30, 2002 compared to $1.2 million for the same period in 2001. Capital expenditures for the nine months ended September 30, 2002 consisted primarily of test and lab equipment to support research and development activities.

Net cash used in financing activities for the nine months ended September 30, 2002 was $4.2 million compared to net cash provided by financing activities of $1.2 million for the comparable period in 2001. Cash used in financing activities for the nine months ended September 30, 2002 consisted primarily of purchases of treasury stock totaling $4.4 million, partially offset by the net proceeds from stock option exercises and employee stock purchases.

We expect to continue to devote capital and operating resources to continue our research and development efforts, to strategically grow our sales, support, marketing and product development organizations, to expand marketing programs, and for other general corporate activities. Additionally, we may use capital resources to repurchase our common stock. Although we believe that current cash and investment balances will be sufficient to fund operations for at least the next 12 months, there can be no assurance that we will not require additional financing within this time frame or that such additional funding, if needed, will be available on acceptable terms. Any additional issuance of equity or equity-related securities may be dilutive to our stockholders.

RISK FACTORS AFFECTING FUTURE RESULTS

Investing in our common stock involves a high degree of risk. The risks described below are not exhaustive of the risks that might affect our business. Other risks, including those we currently deem immaterial, may also impact our business. Any of the following risks could materially adversely affect our business operations, results of

operations and financial condition and could result in a complete loss of your investment.

WE HAVE LOST MONEY IN THE PAST, ARE CURRENTLY EXPERIENCING LOSSES AND MAY NOT ACHIEVE PROFITABILITY IN THE FUTURE, WHICH COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO DECLINE FURTHER.

We have experienced losses in the past, are currently incurring net operating losses and expect to record net losses and generate negative cash flow for the foreseeable future. As of September 30, 2002, we had an accumulated deficit of approximately $78.1 million. Our stock price has declined substantially since our initial public offering in February 2000. If we do not succeed in generating significant revenue growth, we will not be able to achieve profitability and the market price of our common stock may decline further. We expect to continue to incur significant research, product development and sales and marketing expenses as we continue to:

•

focus our sales and marketing activities on penetrating the incumbent local exchange carriers; and

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develop our technology, expand our existing product lines and add new product features.

Our operating expenses are largely based on currently anticipated revenue trends, which may not be realized, and a high percentage of our expenses are and will continue to be fixed in the short term. We will need to generate significant revenues to offset these expenses and achieve profitability.

IF WE FAIL TO PENETRATE THE INCUMBENT LOCAL EXCHANGE CARRIER MARKET, OUR ABILITY TO GROW OUR BUSINESS WILL BE JEOPARDIZED.

If we cannot overcome the challenges inherent in penetrating the incumbent local exchange carrier market, our growth will be slowed and we may not achieve profitability. Previously, our sales efforts were primarily focused on competitive local exchange carriers, which have generally experienced substantial financial problems in recent periods. We have shifted our focus to penetrating the incumbent local exchange carrier market and face a number of new challenges, including our inexperience in selling to incumbent carriers, a very long sales cycle, cutbacks in carrier capital spending, competition from established suppliers and stringent customer service and support requirements. In addition, the incumbent carriers recently have also delayed or reduced their network maintenance and buildout plans and may be reluctant to make additional infrastructure investments or to purchase products from a supplier with whom they have not previously worked.

IF INCUMBENT LOCAL EXCHANGE CARRIERS DECIDE NOT TO AUTOMATE THEIR EXISTING LOCAL LOOP MANAGEMENT SYSTEMS AND PROCESSES, WE WILL NOT BE SUCCESSFUL IN SELLING OUR PRODUCTS TO THEM.

If incumbent carriers decide not to upgrade their existing local loop management systems, we will not be successful in selling our products to them. We believe the local loop management systems and processes currently implemented by the incumbent local exchange carriers are inefficient, labor-intensive and error prone. Our products are designed to automate these processes and allow incumbent carriers to more rapidly and effectively deploy and maintain copper local loop

services. Incumbent carriers may consider a number of different factors when deciding whether or not to upgrade and automate their systems, including the cost of purchasing new systems and replacing existing infrastructure, issues arising from displaced union laborers, risks associated with the installation and deployment of a new generation of products and potential disruptions in copper local loop services.

CHANGES TO REGULATIONS AFFECTING, OR THE LACK OF DEMAND FROM COMPETITIVE CARRIERS FOR, UNBUNDLED NETWORK ELEMENTS MAY SIGNIFICANTLY REDUCE OR ELIMINATE THE NEED FOR OUR UNBUNDLED NETWORK ELEMENT MANAGEMENT PRODUCTS.

Adjustments to the Federal Communications Commission (FCC) regulations regarding unbundled network elements, new FCC regulations or regulations set forth by other regulatory bodies or new congressional legislation may reduce or eliminate the demand for our unbundled network element management products. If the FCC should decide that incumbent carriers are no longer required to lease unbundled lines to competitive carriers, our unbundled network element management products would be made obsolete.

Demand for our unbundled network element management products may also be reduced or eliminated if competitive carriers fail to order unbundled lines in large volumes from incumbent carriers. Competitive carriers have experienced financial difficulties and have either reduced or delayed the buildout of their networks. In addition, some competitive carriers have chosen to utilize UNE-P, a form of resale, instead of deploying their own facilities, thus eliminating their need for the physical unbundled lines that create demand for our unbundled network element management products. If, as a result, such competitive carriers stop or delay or reduce their orders for physical unbundled lines, the incumbent carriers may have no incentive to purchase and install our unbundled network element management products.

EVEN IF WE SUCCEED IN OBTAINING PRODUCT DEPLOYMENT APPROVAL FROM THE INCUMBENT LOCAL EXCHANGE CARRIERS, THEY MAY NOT ALLOCATE CAPITAL BUDGET TO PURCHASE AND DEPLOY OUR PRODUCTS.

If the incumbent carriers do not or cannot allocate enough capital spending for the purchase and deployment of our products, our business will suffer. As a result of the current downturn in the telecommunications market and reduced demand for their services, incumbent carriers have repeatedly lowered their capital spending budgets for the foreseeable future and delayed or canceled infrastructure investments. These carriers may decide not to or may simply lack the capital necessary to make the substantial investments required to deploy our products, regardless of the quality, performance and functionality of our products.

OUR LIMITED OPERATING HISTORY AND THE LIMITED VISIBILITY WE ARE EXPERIENCING WITH OUR TARGET CUSTOMERS MAKE FORECASTING DIFFICULT, AND IF OUR OPERATING RESULTS ARE BELOW EXPECTATIONS, THE PRICE OF OUR COMMON STOCK COULD DECLINE FURTHER.

As a result of our limited operating history and the limited visibility we are experiencing with our target customers, it is difficult to forecast accurately our revenues and operating expenses. Specifically, we began operations in January 1998, began shipping the CX100 in the first quarter of 1999 and introduced the SX500 in November

2000, the CX40 in June 2001 and the MX500 in November 2001. The revenue and income potential of our newer products is unproven and the market that we are addressing is rapidly evolving. Prior to the fourth quarter of 2001, we derived substantially all of our revenues from new and emerging competitive local exchange carriers. Substantially all of these competitive carriers have experienced financial difficulties and have either reduced or discontinued their purchases of our products. Our target incumbent carrier customers have recently announced cutbacks in capital spending, and we have limited visibility as to if or when they may purchase our products. Even if a target incumbent carrier customer decides to purchase our products, it may deploy our products more slowly than we or our investors or market analysts expect. As a result of these various factors, our operating results have declined in the past and may fall below our expectations and the expectations of investors and market analysts in the future, and the price of our common stock could decline further.

OUR FUTURE GROWTH DEPENDS UPON OUR ABILITY TO TIMELY DESIGN, BUILD AND MARKET OUR NEXT-GENERATION COPPER AUTOMATION AND MANAGEMENT PRODUCTS.

If we fail to timely design, build and market our next-generation copper automation and management products, we will not be able to grow our business. We have in the past devoted, and expect to continue to devote, substantial research and development resources toward designing and building our next-generation products. Our product designs incorporate new and untested technologies currently under development, and we cannot assure you that we will be successful in perfecting these new technologies. Furthermore, even if we are able to perfect these new technologies, incorporating them into our new products may be cost prohibitive. In addition, we utilize third-party design firms and foundries to develop the components needed for our next-generation products. Several of these companies have recently experienced financial difficulties. If these companies were to go out of business, our development efforts could be delayed as we transition to new vendors. If we experience delay with the introduction of our next-generation products as a result of technology challenges, cost, vendor difficulties or otherwise, our revenues may not be sufficient to offset the increased development expense and our earnings would suffer.

BECAUSE OUR PRODUCTS ARE DEPLOYED IN COMPLEX ENVIRONMENTS, THEY MAY HAVE ERRORS OR DEFECTS THAT ARE FOUND ONLY AFTER FULL DEPLOYMENT, WHICH COULD RESULT IN LIABILITY CLAIMS AGAINST US.

Errors or other problems in our products could result in:

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loss of or delay in revenues and loss of customers or market share;

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failure of our products to achieve market acceptance;

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diversion of development resources;

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increased service and warranty costs;

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legal actions by our customers; and

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increased insurance costs.

Because our products are designed to provide critical services, if errors, defects or failures are discovered in our current or future products, or as new versions are released, we may be exposed to significant legal claims. Any claims, with or without merit, could damage our reputation and our business, increase our expenses and impair our operating results. Although we maintain product liability insurance covering some damages arising from implementation and use of our products, our insurance may not fully cover claims brought against us. Liability claims could require us to spend significant time and money in litigation or to pay significant damages.

Our products are designed for large and complex networks and have only been deployed on a limited basis. Consequently, our customers may discover errors or defects in our hardware or software only after it has been fully deployed and operated as part of their infrastructure in connection with products from other vendors.

Our products incorporate numerous component parts designed and manufactured by third parties. We cannot assure you that these third party parts are free of defects or errors. Given the complex nature of our products and our dependence on a large number of highly intricate third-party component parts, our products may contain defects or errors not detectable during our quality assurance and testing procedures. Any such defects or errors could delay or cost us market acceptance of our products or result in legal claims against us.

WE OFFER A SMALL NUMBER OF PRODUCTS, AND IF THEY FAIL TO ACHIEVE MARKET ACCEPTANCE, WE WILL NOT BE ABLE TO INCREASE OUR REVENUES IN THE NEAR FUTURE.

Our future growth and a significant portion of our future revenue depend on the success of our copper automation platforms. Accordingly, failure of these or future products to achieve meaningful levels of market acceptance and customer satisfaction would limit our sales and our revenue growth. Many potential customers who have evaluated our products have not yet deployed them in production network environments and may choose not to deploy them or any of our future products. Other potential customers may have already deployed another technology and may therefore be unwilling to purchase our products.

Even when customers do purchase and deploy our products, due to the variety and complexity of environments in which they are installed, the installed product may not operate as expected. Failure of our products to operate as expected could delay or prevent their volume deployment, which could decrease our revenues and increase our expenses as we devote additional development resources to improving product performance. The success and deployment into our customers’ networks of our products will also depend on customer satisfaction with our products and numerous other factors, including:

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the realization of operating cost efficiencies for our customers when our products are deployed and our customers’ ability to quantify these operational efficiencies;

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our successful development of systems and software that address customer infrastructure requirements; and

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our customers’ successful integration of our management software into their operational support systems.

WE DERIVE A MAJORITY OF OUR REVENUES FROM A SMALL NUMBER OF CUSTOMERS, AND ANY DECREASE IN REVENUES FROM A MAJOR CUSTOMER COULD PREVENT US FROM MEETING OUR EXPECTATIONS OR SECURITIES ANALYSTS’ EXPECTATIONS AND CAUSE OUR STOCK PRICE TO FALL.

The majority of our revenues to date have been recognized from a small number of customers. Purchases by large customers and, therefore, our revenues, may vary significantly from quarter to quarter. The loss of any one or more of our major customers or a reduction or delay in purchases of our products from any one or more of these customers may cause our revenues to decline and could cause our stock price to decline if our revenues are below our expectations or analysts’ expectations. Revenues from significant customers as a percentage of our total revenues for the nine-month periods ended September 30, 2002 and 2001 were as follows:

	September 30,
	2002	2001
Ericsson	27%	Less than 10%
Qwest	19%	17%
McLeodUSA	Less than 10%	27%
XO Communications	Less than 10%	13%

Ericsson resold our products to one end-user, BT Ignite, during the nine months ended September 30, 2002, which represented 27% of our total revenues during that period.

We expect that the majority of our revenues will continue to depend on sales of our products to a small number of customers. In addition, a small number of customers may account for substantially all of our revenues in any particular quarter, and these customers may change from quarter to quarter. We have no long-term contracts with any customers for the purchase of our products, and customers may reduce or discontinue purchases at any time. Customers may also delay or cancel purchase orders without penalty.

There is a limited number of local exchange carriers that are potential customers, and this number may not increase in the future. Consolidation among local exchange carriers may increase our reliance on a small number of customers in future periods. Accordingly, our future revenues will depend significantly upon the timing and size of future purchase orders from our largest customers.

Some of our customers are significantly larger than we are and therefore have significant bargaining power to demand low prices and other terms and conditions that may negatively affect our business and results of operations.

THE LONG SALES CYCLE FOR OUR PRODUCTS MAY CAUSE OUR REVENUES AND OPERATING RESULTS TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER.

Because the sales cycle for our products is long, our revenues in a given quarter may not meet market expectations if we experience delays in or cancellations of customer orders. In addition, we may have

incurred substantial sales and marketing expenses during a quarter without realizing offsetting revenues. As a result, delays resulting from our lengthy sales cycle could reduce our revenues and result in continuing losses. Specifically, our customers’ network planning and purchase decisions normally involve a significant commitment of resources and a lengthy evaluation and product qualification process. The decision to purchase our products is made as part of this network planning process, and our sales cycle can be as long as one year or more. Throughout the sales cycle, we often spend considerable time and resources educating and providing information to prospective customers regarding the use and benefits of our products. Even after making the decision to purchase our products, our customers may delay or cancel the deployment of our products. Timing of deployment is unpredictable, can vary widely and depends on a number of factors, many of which are beyond our control, including:

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customers’ current financial condition and budget constraints;

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customers’ current network deployment procedures;

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demand for our customers’ products and services;

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customers’ level of expertise;

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status and performance of customers’ other network equipment;

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degree of software development and integration necessary for customers to deploy our products;

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turnover in customers’ personnel with whom we have established relationships; and

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customers’ financial and administrative resources.

INTENSE COMPETITION IN OUR INDUSTRY COULD RESULT IN OUR LOSING CUSTOMERS OR BEING UNABLE TO ATTRACT NEW CUSTOMERS. AS A RESULT, WE MAY NOT BE ABLE TO ACHIEVE PROFITABILITY.

The market for telecommunications equipment is highly competitive. If we are unable to compete effectively, we may not be able to achieve profitability. A number of companies produce products that compete with our DSL loop management products, including Harris Corporation; Spirent plc; Nortel Networks; Sunrise Telecom; Teradyne Corporation; Marconi; ADC and Tollgrade Communications. Our primary competitors in the copper switching and unbundled network management market include NHC Communications, Avaya, Simpler Networks and Con-X Corporation. Many of our current and potential competitors have significantly greater sales and marketing, technical, manufacturing, financial and other resources than we do. Due to the rapidly evolving market in which we compete, additional competitors with significant market presence and financial resources, including other large telecommunications equipment manufacturers, may enter the market, thereby further intensifying competition.

We also compete with DSL equipment providers, including Alcatel, Lucent and Nokia, which have each announced plans to incorporate competitive features and functionality into their DSL access

multiplexers. A DSL access multiplexer is a network device, usually located at a telephone company’s central office, that receives signals from multiple DSL connections and puts the signal on a larger, high-speed transmission line. Lucent has introduced a DSL access multiplexer that includes some of the same features and functions as our CX100 product. If our current and potential customers choose to deploy DSL access multiplexers that include features and functions that are competitive with those provided by our products, or delay purchases of our products to evaluate these DSL access multiplexers, our business could be materially impacted. To the extent we expand the capabilities of our products to incorporate functionality traditionally contained in other equipment, we may also face increased competition from other vendors.

OUR OPERATING RESULTS MAY FLUCTUATE DUE TO SEASONAL BUYING PATTERNS OF OUR TARGET INCUMBENT CARRIER CUSTOMERS.

We believe that as a general industry trend, capital spending for telecommunications equipment by the incumbent carriers tends to be higher in the fourth calendar quarter on a relative basis. Recently, however, their ordering patterns have been affected by a number of other business factors, including capital availability, inventory levels and competition, which we believe have caused them to substantially alter their expected seasonal buying patterns. Therefore, we cannot be certain that any seasonal trend will continue or that additional patterns of seasonality will not occur either domestically or in international markets. The volatility associated with the seasonal buying patterns of our target incumbent carrier customers or any other reductions in capital expenditures by them could adversely affect our expected revenue or operating results in any given future quarter, and cause the price of our common stock to fall.

WE EXPECT AVERAGE SELLING PRICES AND GROSS MARGINS OF OUR PRODUCTS TO DECREASE, AND WE MAY NOT BE SUCCESSFUL IN REDUCING OUR COSTS OR REDESIGNING OUR PRODUCTS TO REMAIN COMPETITIVE.

The market for telecommunications equipment is characterized by declining prices due to increased competition, new products and increasing unit volumes. Due to competition and potential pricing pressures from large customers in the future, we expect that the average selling price and gross margins for our products will decline over time. If we fail to reduce our production costs, our gross margins will decline rapidly. We may not be successful in redesigning our products or achieving cost reductions in a timely manner, particularly as we introduce new products. In addition, redesigns may not provide sufficient cost reductions to allow us to remain competitive.

OUR CUSTOMERS HAVE MADE AND MAY CONTINUE TO MAKE AVAILABLE FOR SALE LARGE QUANTITIES OF OUR PRODUCTS IN THE PUBLIC MARKETPLACE AT DISCOUNTED PRICES, WHICH COULD RESULT IN LOST SALES AND LOWER GROSS MARGINS FOR US.

To date, a number of our customers have decided to scale back or discontinue their network buildouts or have filed for bankruptcy. As a result, these customers have made and may continue to make available for sale large quantities of our products in the public marketplace, often at substantially discounted prices. Some of our bankrupt customers have sold substantially all of their assets, including our products, to third party purchasers. If our prospective customers

choose to purchase our products other than directly from us or from our authorized resellers, our sales could decline. In addition, we may experience pricing pressures as a result of the excess supply of our products in the marketplace, which could force us to lower our average selling prices and reduce our gross margins.

IF OUR CUSTOMERS FILE FOR BANKRUPTCY PROTECTION, WE MAY BE REQUIRED TO RETURN SOME OR ALL OF THE PAYMENTS WE RECEIVE FROM THEM AS PART OF THE BANKRUPTCY PROCEEDINGS.

Because of their inability to obtain additional financing or generate sufficient revenues to fund their operations, a number of our customers have filed or may file for bankruptcy protection. The bankruptcy court may require us to return some or all of the payments we received from such customers prior to their initiation of bankruptcy proceedings, which would negatively affect our financial results.

WE COULD INCUR SUBSTANTIAL COSTS AND OUR MANAGEMENT’S ATTENTION AND RESOURCES COULD BE DIVERTED AS A RESULT OF THE OUTSTANDING SECURITIES CLASS ACTIONS AND SHAREHOLDER DERIVATIVE LITIGATION AGAINST US.

We dispute, but cannot assure you that we will be successful in our defense of, the outstanding shareholder lawsuits against us. If we are unsuccessful, these lawsuits could have a material adverse effect on our business, financial condition and results of operations. Even if we are successful in defending against these claims, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect the results and profitability of our business.

On March 28, 2001, the Louisiana School Employees’ Retirement System filed a putative class action lawsuit against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California alleging claims under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The case, which also names as defendants the underwriters of the Company’s September 21, 2000 secondary offering of common stock, is encaptioned Louisiana School Employees’ Retirement System v. Turnstone Systems, Inc. et al. (formerly CV-01-1256 JL). The complaint alleges that the defendants issued false and misleading statements in our prospectus issued in connection with our secondary offering. At or about the same time, four other purported class action lawsuits were filed against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California, encaptioned as follows: Huang v. Turnstone Systems, Inc., et al. (formerly C-01-1342-CW) (filing date 4/04/01); Riskin v. Turnstone Systems, Inc., et al. (formerly C-01-1355-CW) (filing date 4/05/01); Bojsza v. Turnstone Systems, Inc., et al. (formerly C-01-1411-CW) (filing date 4/10/01); and Greenberg, et al. v. Turnstone Systems, Inc. et al. (formerly C-01-1454-CW) (filing date 4/12/01). These latter complaints allege that the defendants made false or misleading statements during the class period of June 5, 2000 through January 2, 2001, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder.

No. CV 01-1256 SBA. By order dated December 3, 2001, Judge Armstrong designated Radiant Advisors, LLC as lead plaintiff and the law firms of Bernstein Litowitz Berger & Grossman LLP and Bernstein Liebhard & Lifshitz, LLP as co-lead counsel for the consolidated actions. Plaintiff filed two separate consolidated amended complaints on March 19, 2002. On June 20, 2002, Judge Armstrong issued an order for plaintiff to show cause as to why the action should not be dismissed with prejudice for plaintiff’s failure to file one consolidated amended complaint. Plaintiff filed a certificate of counsel in response to the order on June 27, 2002. We filed a response on July 3, 2002. On August 30, 2002, Judge Armstrong struck the two separate amended complaints previously filed by plaintiff and ordered that a single amended complaint be filed. Plaintiff filed a single amended complaint on September 13, 2002. We filed a motion to dismiss the amended complaint on October 8, 2002.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit in state court in California, County of Santa Clara, alleging claims against us, a nominal defendant in the action, and certain of our officers and directors. The lawsuit is encaptioned Okino v. Tinsley, et al., Case No. CV 798814. The complaint alleges that the individual defendants caused us harm by either making or permitting the corporation to make false and misleading statements between June 5, 2000 and January 2, 2001 and by permitting certain officers to profit from stock sales during that period. It asserts claims against the individual defendants for breach of fiduciary duty, waste of corporate assets, abuse of control and gross mismanagement.

We demurred to the complaint on July 9, 2001. On September 28, 2001, Judge Conrad L. Rushing issued an order sustaining the demurrer and granting plaintiff limited discovery. On December 19, 2001, subsequent to the completion of the court-ordered discovery, plaintiff filed a first amended derivative complaint alleging the same causes of action asserted in the initial complaint. We filed a demurrer to the first amended derivative complaint on January 10, 2002. On February 22, 2002, Judge Jack Komar issued an order sustaining the demurrer and granting plaintiff leave to amend its complaint. Plaintiff filed an amended complaint on March 19, 2002. We filed a demurrer to the second amended derivative complaint on April 22, 2002. On May 28, 2002, Judge Komar issued an order sustaining the demurrer and dismissing the complaint with prejudice. Plaintiff filed a notice of appeal on August 1, 2002.

On November 9, 2001, Arthur Mendoza filed a securities class action lawsuit in the United States District Court for the Southern District of New York alleging claims against us, certain of our current and former officers and directors, and the underwriters of our initial public offering of stock. The complaint is encaptioned Mendoza v. Turnstone Systems, Inc. et al., Case No. 01 CV 9981, and is purportedly brought on behalf of a class of individuals who purchased common stock in the initial public offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and commissions received by the underwriters and asserts claims against the defendants under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, and Section 10(b) of the Exchange Act of 1934. The case has been coordinated for pre-trial purposes with over 300 cases raising the same or similar issues and also currently pending in the Southern District of New York. On April 18, 2002, Michael

Szymanowski was appointed lead plaintiff in the action. On April 22, 2002, an amended complaint was filed. On July 1, 2002, the underwriter defendants filed an omnibus motion to dismiss. On July 15, 2002, we, collectively with the other issuer defendants, also filed an omnibus motion to dismiss. Plaintiff filed an opposition to the underwriters’ motion to dismiss on August 15, 2002 and to the issuers’ motion to dismiss on August 27, 2002. Underwriters’ reply to the opposition was filed on September 13, 2002, and issuers’ reply to the opposition was filed on September 27, 2002.

Each of our current and former officers who were named in the New York securities class action lawsuit has entered into a tolling agreement, effective as of July 20, 2002, with the plaintiff. Pursuant to the tolling agreement, plaintiff agreed to dismiss our current and former officers from the lawsuit in exchange for a tolling of the statute of limitations with respect to any claims that may be asserted against them through the earlier of (i) thirty days after the termination of the tolling agreement or (ii) September 30, 2003. On October 9, 2002, the court entered an order dismissing our current and former officers from the lawsuit.

SOME KEY COMPONENTS IN OUR PRODUCTS COME FROM SOLE OR LIMITED SOURCES OF SUPPLY, WHICH EXPOSES US TO POTENTIAL SUPPLY INTERRUPTIONS THAT COULD PREVENT OR DELAY THE MANUFACTURE AND SALE OF OUR PRODUCTS AND COULD REDUCE GROSS MARGINS OF OUR PRODUCTS.

A number of key components used in the manufacture of our products are from sole or limited sources of supply for which alternative sources are not currently qualified and may not be available. In most cases we and our contract manufacturer have no guaranteed supply arrangement with these suppliers, and we or our contract manufacturer may fail to obtain these supplies in a timely or cost-effective manner. Financial or other difficulties faced by these suppliers or significant changes in market demand for, or supply of, these components could limit the availability to us of these components. We have experienced supply delays in the past and may experience delays in the future. Such delays could:

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significantly increase the cost of manufacturing our products and reduce gross margins of our products;

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adversely affect our ability to meet scheduled product deliveries to our customers; and

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cause us to lose sales to existing and future customers.

In addition, the purchase of these components on a sole source basis subjects us to risks of price increases and potential quality assurance problems.

Our contract manufacturer currently purchases key components from approximately eight suppliers for which no substitutes presently exist. All of these components are critical to the production of our products, and competition exists with other manufacturers for these key components. We might not be able to qualify or identify alternative suppliers in a timely fashion, or at all. Consolidations involving suppliers could further reduce the number of alternatives for us and affect the cost of components. An increase in the cost of components could make our products less competitive and result in lower margins.

IF WE FAIL TO ACCURATELY PREDICT OUR MANUFACTURING REQUIREMENTS, WE COULD INCUR ADDITIONAL COSTS AND ACCUMULATE EXCESS INVENTORY OR EXPERIENCE MANUFACTURING DELAYS AND A SHORTAGE OF INVENTORY.

We have a supply contract with Fine Pitch, a subsidiary of Solectron Corporation, to build our products. We provide product demand forecasts to Fine Pitch no less than six months prior to scheduled delivery of products to our customers. If we overestimate our requirements or if our customers cancel or delay their orders on short notice, Fine Pitch may have excess inventory, which we have had to purchase in the past, and may be obligated to purchase in the future. If we underestimate our requirements, Fine Pitch may have inadequate inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues, or add additional costs to our products to expedite delivery of certain long lead time components.

In addition, lead times for some of the materials and components used in our products are very long and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. If we fail or Fine Pitch fails to carry a sufficient inventory of long lead time items, if lead times increase or if demand for our products increases unexpectedly, we may have insufficient access to components necessary to meet demand for our products on a timely basis. Long lead times for some materials and components have in the past, and may in the future, cause us to purchase inventories of, or enter into supply contracts for, some parts ourselves. This may increase our costs and the risks of the parts’ obsolescence, excess inventory, and incurring supply contract cancellation fees if we overestimate our component requirements.

IF OUR SALES DO NOT INCREASE IN THE FORESEEABLE FUTURE, WE MAY HAVE TO RECORD ADDITIONAL CHARGES TO FURTHER WRITE DOWN OUR INVENTORY BALANCES.

Recently, we experienced excess inventory and incurred purchase commitments as a result of customer order cancellations, reductions and delays. As a result, during 2001 we recorded charges to write down our excess inventory and to accrue for our estimated purchase commitments. These charges reflect the impairment to the value of our finished goods and raw materials inventories that were in excess of our sales forecast in the foreseeable future. If our customers continue to cancel, reduce or delay their orders or we fail to attract new customers, we may in the future have to record additional charges to further write down our inventory balances.

WE DEPEND ON A SINGLE CONTRACT MANUFACTURER THAT HAS NO OBLIGATION TO PROVIDE US WITH FIXED PRICING OR QUANTITIES. IF WE ARE UNABLE TO OBTAIN SUFFICIENT PRODUCTS FROM OUR CONTRACT MANUFACTURER ON ECONOMICAL TERMS, WE MAY NOT BE ABLE TO TIMELY FILL CUSTOMER ORDERS.

If for any reason Fine Pitch, our only contract manufacturer, is unable to provide us with adequate supplies of high-quality products, or terminates its relationship with us, we may be unable to fulfill customer orders on a timely basis, which may delay the deployment schedules of our customers and strain our relationships with them. Because we currently do not have a long-term supply contract with Fine Pitch, it is not obligated to supply products to us for any specific period, in any specific quantity or at any certain price, except as may be specified in a particular purchase order. Our current supply

contract with Fine Pitch can be terminated by either party with 120 days notice for any reason. If the contract is terminated, we would be required to purchase any excess inventory held by Fine Pitch, it would no longer be obligated to manufacture products for us and our ability to supply products to our customers could be materially impaired. We may be unable to develop alternative manufacturing arrangements on a timely basis, or at all. In addition, Fine Pitch may not meet our future requirements for product quality or timely delivery.

IF WE FAIL TO ENHANCE EXISTING PRODUCTS OR DEVELOP AND SELL NEW PRODUCTS THAT MEET CUSTOMER REQUIREMENTS, OUR SALES MAY SUFFER.

Our failure to develop products or offer services that satisfy customer requirements could reduce our sales and harm our operating results. Many of our current and potential customers may require product features that our products do not have. In addition, some potential customers have sought to use our products for functions we have not anticipated, and we have been required to determine whether the requested functionality could be integrated into our product. The inability to integrate the requested functionality into our existing products could result in the loss of sales to such potential customers. In addition, to the extent we are required to add features to our products in order to achieve a sale, our sales cycle will lengthen, and we will incur increased development costs for our products. To increase our sales, we must effectively anticipate and adapt to customer requirements and offer products and services that meet customer demands.

IF WE DO NOT MANAGE NEW PRODUCT INTRODUCTIONS EFFECTIVELY, WE COULD EXPERIENCE CANCELLED ORDERS OR PRODUCT RETURN REQUESTS OR BE REQUIRED TO PURCHASE OBSOLETE INVENTORY FROM OUR CONTRACT MANUFACTURER.

The introduction of new or enhanced products requires that we manage the transition from older products in order to minimize disruption in customer ordering patterns and ensure that adequate supplies of new products can be delivered to meet anticipated customer demand. Our inability to effectively manage a product transition may cause material delays in the deployment of copper local loop services by our customers, which could cause our customers to defer or cancel orders or request returns or exchanges of our older products. In addition, the development of new or enhanced products could cause inventory held by our contract manufacturer, Fine Pitch, to become obsolete.

WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE FAIL TO DEVELOP AND MAINTAIN RELATIONSHIPS WITH THIRD PARTIES TO MARKET AND SELL OUR PRODUCTS.

Our growth will largely be dependent upon relationships with third parties who market and sell our products. In particular, we have entered into an original equipment manufacturer agreement with Alcatel. Under the terms of the agreement, Alcatel will market, sell and support our products in conjunction with its own suite of broadband access solutions. Our agreement with Alcatel does not require them to sell specified volumes of our products or exclusively sell our loop management products. Alcatel may choose to sell other competing products instead of our products. If Alcatel fails to successfully

market and sell our products or breaches or terminates its agreement with us, our business could be harmed.

IF WE CANNOT ATTRACT EXPERIENCED SALES PERSONNEL, SPECIALIZED ENGINEERS AND HIGHLY-TRAINED CUSTOMER SERVICE PERSONNEL, WE WILL NOT BE ABLE TO SELL AND SUPPORT OUR PRODUCTS.

Our products and services require a sophisticated selling effort targeted at several key people within our prospective customers’ organizations. This process requires the efforts of experienced sales personnel as well as specialized systems and consulting engineers. In addition, the complexity of our products and the difficulty of configuring and maintaining them require highly trained customer service and support personnel. If demand for our products increases, we may need to hire a significant number of engineering, sales, marketing and customer service and support personnel. We believe our success will depend, in large part, upon our ability to attract and retain these key employees. We may not be successful in attracting and retaining these individuals.

IF WE FAIL TO MANAGE OUR PERSONNEL LEVELS EFFECTIVELY, OUR CUSTOMER RELATIONSHIPS COULD BE STRAINED.

Our customer relationships could be strained if we fail to manage our personnel levels effectively. Specifically, prospective customers often request from us individualized product demonstrations and trials, training and support services and systems and software integration services, which place significant strain on our operational resources. If we are unable to devote sufficient resources to current and future customers, our business will suffer.

WE FACE RISKS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS THAT COULD LIMIT OUR SALES AND ADD TO OUR COST OF OPERATIONS.

We market and sell our products in the United States and internationally. Penetrating new international markets will require significant management attention and financial resources. We may not be able to maintain or increase international market demand for our products.

We have limited experience in marketing and distributing our products internationally. International operations are subject to inherent risks, including:

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tariffs, export controls and other trade barriers;

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longer accounts receivable payment cycles, difficulties in collecting accounts receivable and foreign currency exchange exposures;

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difficulties and costs of staffing and managing foreign operations;

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limited experience with developing relationships with foreign customers;

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potential technological issues associated with the existing copper wire infrastructure in foreign markets;

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certification and regulatory requirements with which we may be unfamiliar; and

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reduced protection of intellectual property rights in some countries.

IF DSL TECHNOLOGY FAILS TO ACHIEVE SIGNIFICANT AND CONSISTENT SUBSCRIBER GROWTH, THERE WILL BE LITTLE OR NO DEMAND FOR OUR DSL LOOP MANAGEMENT PRODUCTS.

If DSL technology fails to achieve significant and consistent subscriber growth, we will not be able to successfully market and sell our DSL loop management products. Our DSL loop management products are designed to be used by local exchange carriers who offer DSL-based services. A number of these carriers have ceased doing business or declared bankruptcy, in part because they could not achieve the subscriber growth necessary to support their operations. Future demand for our DSL loop management products is dependent upon the rate at which DSL technology is rolled out by local exchange carriers, of which there is a limited number, and by the adoption rate of the end users of their services. Local exchange carriers are continually evaluating alternative high-speed data access technologies and may at any time deploy technologies other than DSL. Numerous other high-speed access technologies, including cable modems, wireless technologies and satellite technologies compete with DSL-based services. Cable modem service can theoretically provide faster download speeds than DSL. Both satellite and wireless services receive information using radio frequencies at speeds close or comparable to DSL transmission speeds. These competing technologies may ultimately prove to be superior to DSL-based services and reduce or eliminate the demand for our products.

RAPID TECHNOLOGICAL CHANGE IN THE TELECOMMUNICATIONS INDUSTRY COULD RENDER OUR PRODUCTS OBSOLETE.

The markets for high-speed telecommunications products are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, changes in customer requirements and evolving industry standards. Intense competition among numerous high-speed access technologies has further driven innovation and increasingly complex product requirements. We may be unable to improve the performance and features of our products as needed to respond to these developments. The introduction or market acceptance of products incorporating superior technologies or the emergence of alternative technologies or new industry standards could render our existing or potential future products less economical, obsolete and unmarketable. For example, if semiconductor, robotic or other technologies become effective alternatives for our product architecture, our products may become obsolete.

WE COULD LOSE OUR COMPETITIVE ADVANTAGE IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY.

If we fail to adequately protect our intellectual property, our competitors could offer similar products relying on technologies developed by us, potentially harming our competitive position and

decreasing our revenues. We have filed seventeen patent applications to date from which three patents have been issued. Our existing and future patent applications, if any, may not be approved, any issued patents may not protect our intellectual property and any issued patents could be challenged by third parties. Furthermore, other parties may independently develop similar or competing technology or design around any patents that may be issued to us.

Attempts may be made to copy aspects of our products or to obtain and use information that we regard as proprietary. We attempt to protect our intellectual property by limiting access to the distribution of our software, documentation and other proprietary information and by relying on a combination of copyright, patent, trademark, trade secret and other intellectual property laws. In addition, we enter into confidentiality agreements with our employees and certain customers, vendors and strategic partners. These steps may fail to prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our intellectual property as fully as in the United States.

IF WE BECOME INVOLVED IN A PROTRACTED INTELLECTUAL PROPERTY DISPUTE, OR ONE WITH A SIGNIFICANT DAMAGES AWARD, OR WHICH REQUIRES US TO CEASE SELLING OUR PRODUCTS, WE COULD BE SUBJECT TO SIGNIFICANT LIABILITY AND THE TIME AND ATTENTION OF OUR MANAGEMENT COULD BE DIVERTED.

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights, including among companies in telecommunications and Internet industries. Intellectual property claims against us, and any resulting lawsuit, if successful, could subject us to temporary or permanent injunctions and significant liability for damages and could invalidate our intellectual property rights. These lawsuits, regardless of their merit, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

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cease selling, incorporating or using products or services that incorporate the infringed intellectual property;

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obtain from the holder of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on acceptable terms, if at all; or

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redesign those products or services that incorporate the disputed technology.

If we are subject to a successful claim of infringement against us and fail to develop non-infringing technology or license the infringed technology on acceptable terms and on a timely basis, our revenues may decline or our expenses may increase.

We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could result in costly litigation and the diversion of our technical and management personnel.

CONTROL BY OUR EXISTING STOCKHOLDERS MAY LIMIT YOUR ABILITY TO INFLUENCE MATTERS REQUIRING STOCKHOLDER APPROVAL AND COULD DELAY OR PREVENT A CHANGE IN CONTROL, WHICH COULD PREVENT YOU FROM REALIZING A PREMIUM IN THE MARKET PRICE OF OUR COMMON STOCK.

The concentration of ownership of our common stock by existing stockholders could delay or prevent a change in our control or discourage a potential acquirer from attempting to obtain control of us, which could cause the market price of our common stock to fall or prevent our stockholders from realizing a premium in the market price associated with an acquisition. As of September 30, 2002, our executive officers, directors and principal stockholders and their affiliates owned 30,617,530 shares, or approximately 46.5%, of the outstanding shares of common stock. These stockholders, acting together, would be able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions.

WE EXPECT TO EXPERIENCE VOLATILITY IN OUR STOCK PRICE, WHICH COULD NEGATIVELY AFFECT YOUR INVESTMENT.

Prior to February 2000, you could not buy or sell our common stock publicly. An active public market for our common stock may not be sustained in the future. The market for technology stocks has been extremely volatile. The following factors could cause the market price of our common stock to fluctuate significantly from the original purchase prices paid by investors:

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announcements by us or our competitors of significant contracts, new products or technological innovations, acquisitions, strategic relationships, joint ventures or capital commitments;

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announcements about the status of securities class action and shareholder derivative lawsuits against us;

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changes in financial estimates by us or by securities analysts;

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release of transfer restrictions on our outstanding shares of common stock or sales of additional shares of common stock;

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changes in market valuations of networking and telecommunications companies; and

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fluctuations in stock market prices and volumes.

SHOULD OUR STOCKHOLDERS SELL A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK IN THE PUBLIC MARKET, THE PRICE OF OUR COMMON STOCK COULD FALL.

Our executive officers, directors and principal stockholders and their affiliates hold a substantial number of shares, which they are able to sell in the public market, subject to certain restrictions under federal securities laws. Sales of a substantial number of shares of our common stock at any time could reduce the market price of our common stock. In addition, the sale of these shares could impair our

ability to raise capital through the sale of additional equity securities.

WE RELY ON A CONTINUOUS POWER SUPPLY TO CONDUCT OUR OPERATIONS, AND A CALIFORNIA ENERGY CRISIS COULD DISRUPT OUR OPERATIONS AND INCREASE OUR EXPENSES.

California has in the recent past experienced, and could in the future experience, an energy crisis that could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when power reserves for the State of California fall below 1.5%, California has on some occasions implemented, and may in the future implement, rolling blackouts throughout California. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we or our customers may suffer as a result of any interruption in our power supply. If blackouts interrupt our power supply, we would be temporarily unable to continue operations at our facilities. Blackouts may also impair the operations of Fine Pitch, upon whom we depend for all our manufacturing needs. Any such interruption in our ability to continue our operations could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations.

Furthermore, the deregulation of the energy industry instituted in 1996 by the California government has caused power prices to increase. Under deregulation, utilities were encouraged to sell their plants, which traditionally had produced most of California’s power, to independent energy companies that were expected to compete aggressively on price. Instead, wholesale prices have increased, particularly during the recent energy crisis. If wholesale prices continue to increase, our operating expenses will likely increase, as substantially all of our facilities are located in California.

THE LOSS OF FINE PITCH, OUR SOLE MANUFACTURER, DUE TO INTERRUPTION IN CALIFORNIA’S ELECTRIC POWER SUPPLY, WOULD NEGATIVELY IMPACT OUR ABILITY TO MANUFACTURE AND SELL OUR PRODUCTS.

We rely on Fine Pitch as our sole contract manufacturer. The locations of Fine Pitch that are responsible for manufacture of our products are exclusively in Northern California. California has in the recent past experienced, and may in the future experience, a shortage of electric power supply that results in intermittent loss of power in the form of rolling blackouts. While Fine Pitch has not experienced any power failures to date that have prevented its ability to manufacture our products, the continuance of blackouts may affect Fine Pitch’s ability to manufacture our products, meet our requirements for product quality and meet scheduled delivery needs.

Furthermore, because we currently do not have a long-term supply contract with Fine Pitch, it is not obligated to supply products to us for any specific period, in any specific quantity or at any certain price, except as may be specified in a particular purchase order. If wholesale prices for electricity continue to increase, Fine Pitch may increase the prices they charge us for manufacturing our products. An increase in the cost of our products could make our products less competitive and result in lower margins.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK

The primary objective of our investment activities is to preserve principal. We attempt to maximize the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the value of the investment will probably decline. To mitigate this risk, we maintain our portfolio of cash equivalents and investments in a variety of securities, including money market funds, commercial paper and government and non-government debt securities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate. In addition, the majority of our investment portfolio is invested in securities maturing within one year.

The following table presents the amounts of cash equivalents, short-term investments and long-term investments that are subject to market risk by range of expected maturity and weighted-average interest rates as of September 30, 2002 and December 31, 2001. This table does not include money market funds because those funds are not subject to market risk.

	MATURING IN THREE MONTHS OR LESS			MATURING BETWEEN THREE MONTHS AND ONE YEAR			MATURING GREATER THAN ONE YEAR			TOTAL
	(in thousands, except for percentages)
AT SEPTEMBER 30, 2002
Included in cash and cash equivalents	$	65,745		$	—		$	—		$	65,745
Weighted average interest rate		1.93	%		—			—			1.93	%
Included in short-term investments	$	26,703		$	46,337		$	—		$	73,040
Weighted average interest rate		3.68	%		2.89	%		—			3.18	%
Included in long-term investments	$	—		$	—		$	34,876		$	34,876
Weighted average interest rate		—			—			3.15	%		3.15	%
Total portfolio	$	92,448		$	46,337		$	34,876		$	173,661
Weighted average interest rate		2.44	%		2.89	%		3.15	%		2.68	%
AT DECEMBER 31, 2001
Included in cash and cash equivalents	$	57,042		$	—		$	—		$	57,042
Weighted average interest rate		2.22	%		—			—			2.22	%
Included in short-term investments	$	20,757		$	94,731		$	—		$	115,488
Weighted average interest rate		3.86	%		3.15	%		—			3.28	%
Included in long-term investments	$	—		$	—		$	26,562		$	26,562
Weighted average interest rate		—			—			5.34	%		5.34	%
Total portfolio	$	77,799		$	94,731		$	26,562		$	199,092
Weighted average interest rate		2.66	%		3.15	%		5.34	%		3.25	%

EXCHANGE RATE SENSITIVITY

We develop our products in the United States and market our products in the United States, Canada, Europe, Asia, and Asia Pacific.

Substantially all of our sales and expenses are denominated in United States dollars. As a result, a strengthening of the dollar could make our products less competitive in foreign markets. We have not engaged in any foreign exchange hedging activities to date. We may conduct transactions in foreign currencies in the future as we expand our international operations and may engage in foreign exchange hedging activities at that time. Currencies held in other than the US dollar in our subsidiaries have been insignificant. As such, we have not had any material exposure to foreign currency rate fluctuations.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures.

The Company’s Chief Executive Officer, Richard N. Tinsley, and Chief Financial Officer, Eric S. Yeaman, have reviewed the Company’s disclosure controls and procedures within 90 days prior to the filing of this report. Based upon this review, these officers believe that the Company’s disclosure controls and procedures are effective in ensuring that material information related to the Company is made known to them by others within the Company.

(b) Changes in Internal Controls.

There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls during the quarter covered by this report or from the end of the reporting period to the date of this Form 10-Q.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We dispute, but cannot assure you that we will be successful in our defense of, the outstanding lawsuits against us, which are described below. If we are unsuccessful, these lawsuits could have a material adverse effect on our business, financial condition and results of operations. Even if we are successful in defending against these claims, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect the results and profitability of our business.

A. Shareholder Litigation

All five cases were consolidated before Judge Saundra B. Armstrong in the United States District Court for the Northern District of California on October 26, 2001. The consolidated complaint is encaptioned In re Turnstone Systems, Inc. Securities Litigation, Case No. CV 01-1256 SBA. By order dated December 3, 2001, Judge Armstrong designated Radiant Advisors, LLC as lead plaintiff and the law firms of Bernstein Litowitz Berger & Grossman LLP and Bernstein Liebhard & Lifshitz, LLP as co-lead counsel for the consolidated actions. Plaintiff filed two separate consolidated amended complaints on March 19, 2002. On June 20, 2002, Judge Armstrong issued an order for plaintiff to show cause as to why the action should not be dismissed with

prejudice for plaintiff’s failure to file one consolidated amended complaint. Plaintiff filed a certificate of counsel in response to the order on June 27, 2002. We filed our response on July 3, 2002. On August 30, 2002, Judge Armstrong struck the two separate amended complaints previously filed by plaintiff and ordered that a single amended complaint be filed. Plaintiff filed a single amended complaint on September 13, 2002. We filed a motion to dismiss the amended complaint on October 8, 2002.

New York. On April 18, 2002, Michael Szymanowski was appointed lead plaintiff in the action. On April 22, 2002, an amended complaint was filed. On July 1, 2002, the underwriter defendants filed an omnibus motion to dismiss. On July 15, 2002, we, collectively with the other issuer defendants, also filed an omnibus motion to dismiss. Plaintiff filed an opposition to the underwriters’ motion to dismiss on August 15, 2002 and to the issuers’ motion to dismiss on August 27, 2002. Underwriters’ reply to the opposition was filed on September 13, 2002, and issuers’ reply to the opposition was filed on September 27, 2002.

B. In Re: Digital Broadband Communications, Inc. Bankruptcy

On August 12, 2002, the Official Committee of Unsecured Creditors of Digital Broadband Communications, Inc., one of our former customers that filed for Chapter 11 bankruptcy on December 27, 2000, filed a complaint in the United States Bankruptcy Court for the District of Delaware, seeking recovery of alleged preferential transfers to us in the aggregate amount of $3,522,714.85. We filed our answer on September 10, 2002.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

Use of Proceeds

On February 1, 2000, we completed our initial public offering and on September 26, 2000, we completed our secondary offering, which resulted in total net proceeds of approximately $257.6 million. To date, we have used a portion of the net proceeds from our offerings to fund general business operations. Amounts not used to fund operations have been invested in money market funds, certificates of deposit, and other investment grade securities. We may use a portion of the net proceeds to acquire or invest in businesses, technologies, products or services, repurchase Company stock in the open market, and for general corporate purposes.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

EXHIBIT NO.		DESCRIPTION
3.1*		Amended and Restated Certificate of Incorporation of Turnstone Systems
3.2*		Amended and Restated Bylaws of Turnstone Systems
4.1*		Form of Common Stock certificate
4.2*		Registration Rights Agreement, dated January 12, 1998, by and among Turnstone Systems and certain stockholders of Turnstone Systems named herein, as amended as of January 12, 1999 and November 21, 1999
4.3**		Form of Founder’s Restricted Stock Purchase Agreement entered into as of January 2, 1998, between Turnstone Systems and each of P. Kingston Duffie, M. Denise Savoie and Richard N. Tinsley
10.1*		Form of Indemnification Agreement entered into by Turnstone Systems with each of its directors and executive officers
10.2*		1998 Stock Plan and forms of agreement thereunder

10.3***		Amended and Restated 2000 Stock Plan
10.4*		2000 Nonstatutory Stock Plan and forms of agreement thereunder
10.5****		Amended and Restated 2000 Employee Stock Purchase Plan
10.6**		Manufacturing Agreement dated as of October 16, 1998, between Turnstone Systems and A-Plus Manufacturing Corporation
10.7**		OEM Purchase Agreement, dated effective as of September 1, 1999, between Turnstone Systems and Lucent Technologies Inc., as amended as of September 28, 1999 and December 9, 1999
10.8*		Lease dated April 28, 2000, between Turnstone Systems and South Bay/San Tomas Associates
10.11*****		OEM Purchase Agreement, dated effective as of June 1, 2001, between Turnstone Systems, Inc. and Alcatel.

Incorporated herein by reference to the Registration Statement on Form S-1 and all amendments thereto filed on November 22, 1999 with the Securities and Exchange Commission (No. 333-45130).

Confidential treatment requested and received as to certain portions. These exhibits are incorporated herein by reference to the Registration Statement on Form S-1 and all amendments thereto filed on November 22, 1999 with the Securities and Exchange Commission (No. 333-45130).

***

Incorporated herein by reference to Appendix A of our 2002 Definitive Proxy Statement on Schedule 14A, filed on April 16, 2002 with the Securities and Exchange Commission.

****

Incorporated herein by reference to Exhibit 10.5 of our Quarterly Report on Form 10-Q filed on November 13, 2001 with the Securities and Exchange Commission.

*****

Confidential treatment requested as to certain portions. This exhibit is incorporated herein by reference to Exhibit 10.11 of our Quarterly Report on Form 10-Q filed on August 13, 2001 with the Securities and Exchange Commission.

(b) No reports on Form 8-K have been filed by the Company during the quarter for which this report was filed.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned.

		TURNSTONE SYSTEMS, INC.

Date:	November 6, 2002	By:	/S/ RICHARD N. TINSLEY
			Richard N. Tinsley President and Chief Executive Officer (Principal Executive Officer)


Date:	November 6, 2002	By:	/S/ ERIC S. YEAMAN
			Eric S. Yeaman Chief Financial Officer (Principal Financial and Accounting Officer)

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO SECTION 302(A) OF SARBANES-OXLEY ACT

I, Richard N. Tinsley, certify that:

I have reviewed this quarterly report on Form 10-Q of Turnstone Systems, Inc.

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 12a-14 and 15d-14) for the registrant and we have:

(a)

designated such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(b)

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

(c)

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

(a)

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

(b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



Date: November 6, 2002								/S/ RICHARD N. TINSLEY
								Richard N. Tinsley President & CEO

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO SECTION 302(A) OF SARBANES-OXLEY ACT

I, Eric S. Yeaman, certify that:

I have reviewed this quarterly report on Form 10-Q of Turnstone Systems, Inc.

(a)

(b)

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

(c)

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

(a)

(b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Date: November 6, 2002				/s/ ERIC S. YEAMAN
				Eric S. Yeaman Chief Financial Officer

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Turnstone Systems, Inc. (the “Company”) on Form 10-Q for the period ending September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Richard N. Tinsley, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: November 6, 2002				/s/ RICHARD N. TINSLEY
				Richard N. Tinsley President & CEO

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Turnstone Systems, Inc. (the “Company”) on Form 10-Q for the period ending September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Eric S. Yeaman, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: November 6, 2002				/s/ ERIC S. YEAMAN
				Eric S. Yeaman Chief Financial Officer

EXHIBIT INDEX

Exhibit No.		Description
3.1*		Amended and Restated Certificate of Incorporation of Turnstone Systems
3.2*		Amended and Restated Bylaws of Turnstone Systems
4.1*		Form of Common Stock certificate
4.2*		Registration Rights Agreement, dated January 12, 1998, by and among Turnstone Systems and certain stockholders of Turnstone Systems named herein, as amended as of January 12, 1999 and November 21, 1999
4.3**		Form of Founder’s Restricted Stock Purchase Agreement entered into as of January 2, 1998, between Turnstone Systems and each of P. Kingston Duffie, M. Denise Savoie and Richard N. Tinsley
10.1*		Form of Indemnification Agreement entered into by Turnstone Systems with each of its directors and executive officers
10.2*		1998 Stock Plan and forms of agreement thereunder
10.3***		Amended and Restated 2000 Stock Plan
10.4*		2000 Nonstatutory Stock Plan and forms of agreement thereunder
10.5****		Amended and Restated 2000 Employee Stock Purchase Plan
10.6**		Manufacturing Agreement dated as of October 16, 1998, between Turnstone Systems and A-Plus Manufacturing Corporation
10.7**		OEM Purchase Agreement, dated effective as of September 1, 1999, between Turnstone Systems and Lucent Technologies Inc., as amended as of September 28, 1999 and December 9, 1999
10.8*		Lease dated April 28, 2000, between Turnstone Systems and South Bay/San Tomas Associates
10.11*****		OEM Purchase Agreement, dated effective as of June 1, 2001, between Turnstone Systems, Inc. and Alcatel.

Incorporated herein by reference to the Registration Statement on Form S-1 and all amendments thereto filed on November 22, 1999 with the Securities and Exchange Commission (No. 333-45130).

***

Incorporated herein by reference to Appendix A of our 2002 Definitive Proxy Statement on Schedule 14A, filed on April 16, 2002 with the Securities and Exchange Commission.

****

Incorporated herein by reference to Exhibit 10.5 of our Quarterly Report on Form 10-Q filed on November 13, 2001 with the Securities and Exchange Commission.

*****