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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003

OR

FOR THE TRANSITION PERIOD FROM                                  TO                                     

COMMISSION FILE NUMBER 000-28843

TURNSTONE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes   x    No  ¨

There were 63,015,032 shares of the Registrant’s common stock, par value $0.001, outstanding on April 30, 2003, and the Registrant held an additional 3,286,379 shares as treasury stock on April 30, 2003.

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TURNSTONE SYSTEMS, INC.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Turnstone Systems, Inc. (the Company) is a provider of hardware and software products that enable local exchange carriers to deploy and maintain copper local loop services. The Company’s products include copper loop management and testing systems, signal splitters and remote line switching and service verification platforms.

On January 9, 2003, the Company announced that it was exploring various strategic alternatives, including possible merger and asset sale transactions, licensing arrangements and dissolution of the company and distribution of assets to stockholders. The Company also announced that it had engaged Goldman Sachs & Co. as its financial advisor. While a limited supply of the Company’s products remained available for sale, the Company generally ceased all direct sales efforts related to them, and the Company redirected its operating activities to focus primarily on in-process research and development related to the Company’s next generation copper automation products for incumbent local exchange carriers. In connection with those decisions, the Company reduced headcount by approximately 40%, or 29 employees, in January 2003.

On April 7, 2003, the Company entered into an agreement to restructure its lease agreement for its headquarters facility in Santa Clara, California. The previous lease covered approximately 62,500 square feet of facilities and expired in June 2010, and the Company had remaining rent obligations of approximately $32.0 million. The restructuring, effective May 1, 2003, reduced the Company’s facilities commitment to approximately 31,000 square feet and shortened the lease term to the end of 2003. Pursuant to the agreement, in April 2003, the Company made a lump sum cash payment of approximately $14.2 million, which included $3.6 million from its restricted cash and included prepaid rent through the end of 2003, the remaining facilities commitment under the restructured lease. Other than this restructured lease, the Company has no other material facilities lease commitments.

On April 24, 2003, the Company initiated actions to terminate most of its remaining employees except for a limited team of employees that will continue to handle matters related to its previously announced exploration of strategic alternatives. Associated with these actions, the Company expects to record severance-related charges of approximately $370,000 during the second quarter of 2003. Additionally, pursuant to retention agreements entered into with the affected employees in January 2003, the Company expects to make retention bonus payments to them of approximately $700,000 during the second quarter of 2003, of which approximately $530,000 had been accrued as of March 31,

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2003. As a result of these actions, the Company also anticipates recording a charge to reflect impairment in the carrying value of our property and equipment of approximately $800,000 in the second quarter of 2003.

The accompanying unaudited condensed consolidated financial statements have been prepared by 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 generally accepted accounting principles, 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 March 31, 2003 and December 31, 2002, its operating results for the three months ended March 31, 2003 and 2002 and its cash flows for the three months ended March 31, 2003 and 2002. 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 18, 2003. The condensed consolidated balance sheet at December 31, 2002 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, 2003.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with an original maturity of less than three months at the date of purchase to be cash equivalents. Cash equivalents at March 31, 2003 and December 31, 2002 consisted primarily of money market funds.

Short and Long-Term Investments

The Company’s short and long-term investments consist primarily of U.S., state and municipal government 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.

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Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and complies with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. Compensation expense on fixed stock options is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price of the option. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation (in thousands, except per share amounts):

The pro forma diluted net income per share for the three months ended March 31, 2003 and 2002 was calculated based on 63,018,000 and 63,568,000 weighted-average shares of common stock outstanding, respectively. During the three months ended March 31, 2003, adjustments to eliminate compensation cost previously recognized for options that were subsequently forfeited due to employee terminations exceeded compensation cost recognized during that same period resulting in a net recovery of stock-based compensation expense.

Recent Accounting Pronouncements

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,

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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. The requirements of SFAS 146 were effective prospectively for exit or disposal activities initiated after December 31, 2002. Adoption of SFAS 146 did not have a significant effect on the Company’s financial position, results of operations, or cash flows.

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which clarifies disclosure and recognition/measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition/measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The Company has determined that the requirements of FIN 45 apply to its accrued warranty and standard indemnification clauses contained within its various customer contracts (see Note 10); however the adoption of FIN No. 45 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002 (see Note 3). The adoption of SFAS No. 148 did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, which addresses consolidation by a business of variable interest entities in which it is the primary beneficiary. FIN 46 is effective immediately for certain disclosure requirements and variable interest entities created after January 31, 2003, and in the first interim or annual period beginning after June 15, 2003 for all other variable interest entities entered into prior to

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January 31, 2003. The company does not have any variable interest entities.

In November 2002, the EITF published EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying this EITF Issue 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. This issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently evaluating the impact that the adoption of EITF Issue 00-21 will have on the Company’s financial position, results of operations, or cash flows.

In January 2003, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” EITF Issue No. 02-16 provides guidance regarding how a reseller of a vendor’s products should account for cash consideration received from a vendor. The provisions of EITF Issue No. 02-16 will apply to vendor arrangements entered into after December 31, 2002, including modifications of existing arrangements. The Company does not expect EITF 02-16 to have a material effect on the Company’s financial position, results of operations, or cash flows.

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”.

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The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

Options to purchase 8,280,000 shares of common stock and 23,000 shares of common stock subject to repurchase have been excluded from the computation of diluted net loss per share as of March 31, 2003, as their effect would have been antidilutive. Options to purchase 7,188,000 shares of common stock and 878,000 shares of common stock subject to repurchase have been excluded from the computation of diluted net loss per share as of March 31, 2002, as their effect would have been antidilutive.

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

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.

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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 March 31, 2003 and 2002, approximately 39% and 24%, respectively, of revenues were derived from sales to customers located outside the United States. Product revenues for the three months ended March 31, 2003 and 2002 were derived from sales of loop management products. Service revenues for the three months ended March 31, 2003 and 2002 were derived primarily from the Company’s maintenance programs for loop management products.

Other current liabilities and accrued expenses consisted of the following (in thousands):

In January 2003, the company reduced its headcount by approximately 40%, or 29 employees, and incurred related severance costs of $367,000, which are included in operating expenses for the three months ended March 31, 2003.

In January 2003, in an effort to retain key employees, the Company entered into agreements with its officers and employees which entitle such officers and employees to receive certain retention bonus payments upon the completion of providing employment services to the Company for a specified period of time. The time period, as specified in these agreements, may vary based on certain future events, and therefore, the total retention bonus payments from the Company to its officers and employees may vary. Retention bonus payments are accrued as earned.

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Restructuring and related costs consisted of the following (in thousands):

Accrued retention bonus is included in accrued compensation and benefits as of March 31, 2003.

Leases

The Company leased its headquarters facility under an operating lease agreement that previously expired in June 2010. In connection with this lease agreement, the Company was required to maintain a standby letter of credit totaling $3.6 million as security for the lease. This letter of credit required that the Company hold funds in the form of a certificate of deposit with a financial institution. While the letter of credit was maintained, the Company classified those funds as restricted cash on the balance sheet at March 31, 2003 and December 31, 2002. Future minimum lease payments under this non-cancelable operating lease as of March 31, 2003 were $32.4 million. In addition to base rent, the headquarters facility lease agreement requires that the Company pay a proportional share of the facility’s operating expenses.

In April 2003, the Company entered into an agreement, effective May 1, 2003, that restructures the operating lease associated with its headquarters facility. Pursuant to the agreement, the Company made a payment of $14.2 million, which included prepayment of rent through December 31, 2003, for approximately 31,000 square feet of the headquarters facility and a charge to terminate the remainder of the original lease commitment. The termination charge of $12.8 million will be included in operating expenses for the second fiscal quarter of 2003 and will be partially offset by reductions in accrual for loss on operating lease and deferred rent. Additionally, the Company will no longer be required to maintain the standby letter of credit.

Warranty

The Company provides limited warranties on certain of its products for periods of up to one year. The Company recognizes warranty reserves when products are shipped based upon an estimate of total warranty costs, and such reserves are included in accrued liabilities. The estimate of such costs is based upon

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historical and anticipated requirements. A reconciliation of the changes in accrued warranty for the quarter ended March 31, 2003 follows (in thousands):

Indemnification Agreements

The Company has standard indemnification clauses contained within its various customer contracts. To date, there have been no known events or circumstances that have resulted in an indemnification-related liability to the Company.

In fiscal 2001, the Company recorded a $2.7 million provision for estimated losses, net of estimated sub-lease income, on its headquarters facility operating lease, which had an original expiration date in June 2010. The provision relates to the portion of the Company’s headquarters facility that it intended to sublease at prevailing market rates, which were less than the rates that the Company was obligated to pay under its lease.

For the three months ended March 31, 2003, 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 March 31, 2003, consisted of the following (in thousands):

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, 2001 secondary offering of common stock in the United States District Court for the Northern District of California. The complaint alleged that the defendants made 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

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District Court for the Northern District of California alleging that the defendants made false or misleading statements regarding the Company 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 a single amended complaint on September 13, 2002. The Company filed a motion to dismiss the amended complaint on October 8, 2002. On February 7, 2003, the court issued an order denying in part and granting in part, with leave to amend, the Company’s motion to dismiss. On March 10, 2003, plaintiff filed a Second Amended Complaint (“SAC”) against the Company, certain of its current officers and directors, and the underwriters of the Company’s September 21, 2000 secondary offering of stock alleging that the defendants made false and misleading statements in connection with the Company’s secondary offering in violation of Sections 11, 12 and 15 of the Securities Act of 1933.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit in the Santa Clara County Superior Court, against the Company and certain of its 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, the 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, the Court issued an order sustaining the demurrer and granting plaintiff leave to amend its complaint. The 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, the Court issued an order sustaining the demurrer and dismissing the complaint with prejudice. The 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 as well as its secondary offering of stock. The complaint is purportedly brought on behalf of a class of individuals who purchased common stock in the initial public offering and the secondary stock offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectuses 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

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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. The lead 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. The underwriters’ reply to the opposition was filed on September 13, 2002, and the Company’s reply to the opposition was filed on September 27, 2002. On February 19, 2003, the court issued an order denying the motions to dismiss with respect to substantially all of the plaintiffs’ claims, including those against the Company. Limited discovery is currently underway.

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 March 31, 2003. 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.

In Re: Digital Broadband Communications, Inc. Bankruptcy

On August 12, 2002, the Official Committee of Unsecured Creditors of Digital Broadband Communications, Inc., one of the Company’s 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 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 March 31, 2003. 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.

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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 anticipated headcount reductions, estimated payments to affected employees, estimated impairment charges, exploration of possible strategic alternatives, business outlook or expected performance or developments 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. 16 to 17, and 24 to 29, 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 are a provider of hardware and software products that enable local exchange carriers to deploy and maintain copper local loop services. Our products include copper loop management and testing systems, signal splitters and remote line switching and service verification platforms.

On January 9, 2003, we announced that we were exploring various strategic alternatives, including possible merger and asset sale transactions, licensing arrangements and dissolution of the company and distribution of assets to stockholders. We also announced that we had engaged Goldman Sachs & Co. as our financial advisor. While we explored our strategic alternatives, our operating activities were focused primarily on in-process research and development related to our next generation copper automation products for incumbent local exchange carriers. While a limited supply of our products remained available for sale, we generally ceased all direct sales efforts related to them, and did not expect to generate material revenues from them for the foreseeable future. In connection with those decisions, we reduced headcount by approximately 40%, or 29 employees, in January 2003.

On April 7, 2003, we entered into an agreement to restructure our lease agreement for our headquarters facility located at 2220 Central Expressway, Santa Clara, California. The previous lease covered approximately 62,500 square feet of facilities and expired in June 2010, and we had remaining rent obligations of approximately $32.0 million. The restructuring, effective May 1, 2003, reduced our

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facilities commitment to approximately 31,000 square feet and shortened the lease term to December 31, 2003. Pursuant to the agreement, in April 2003 we made a lump sum cash payment of approximately $14.2 million, which included $3.6 million from our restricted cash and was inclusive of prepaid rent through the end of 2003 for our remaining facilities commitment under the restructured lease. Other than this restructured lease, we have no other material facilities lease commitments.

On April 24, 2003, we terminated most of our remaining employees except for a limited team of employees that will continue to handle matters related to our previously announced exploration of strategic alternatives. Associated with these actions, we expect to record severance-related charges of approximately $370,000 during the second quarter of 2003. Additionally, pursuant to retention agreements entered into with the affected employees in January 2003, we expect to make retention bonus payments to them of approximately $700,000, of which approximately $530,000 was accrued as of March 31, 2003. As a result of these actions, we also anticipate recording a charge to reflect impairment in the carrying value of our property and equipment of approximately $800,000 in the second quarter of 2003.

CRITICAL ACCOUNTING POLICIES

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventory, income taxes, and lease losses. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

The methods, estimates, and judgments we use in applying our most critical accounting policies have a significant impact on the results that we report in our consolidated financial statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a company’s financial condition and results of operations, and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain at the time of estimation. We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our consolidated financial statements:

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Revenue Recognition

We recognize revenues from product sales in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, 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, we recognize revenues 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, we recognize revenues 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, we recognize revenues 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. We defer revenues from services and support provided under our maintenance programs based upon the fair value of the program and recognize those revenues 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. We estimate costs associated with the warranty program based on historical warranty program costs and accrue for those costs at the time of product shipment. We defer revenues from consulting and training based on the fair value of the services, and recognize those revenues when such services are completed.

Allowance for doubtful accounts

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 a minimal unallocated reserve for invoices not specifically reserved. The allowance for doubtful accounts represents our best current estimate of the portion of all outstanding invoices deemed uncollectible. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required, increasing our operating expenses.

Accounting for income taxes

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We make an assessment of the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not believed to be likely, a valuation allowance is established. At March 31, 2003 and December 31, 2002, a full valuation allowance has been established against the net deferred tax assets.

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THREE MONTHS ENDED MARCH 31, 2003 AND 2002

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^® and SX Smart Splitter^® products and our Crossworks^™ and ONYX automation software licenses. Service revenue is derived primarily from our product maintenance programs.

While a limited supply of our products remains available for sale, we have generally ceased all direct sales efforts related to them, and do not expect to generate material revenues from them for the foreseeable future.

Product revenue increased to $268,000 for the quarter ended March 31, 2003 from $266,000 for the comparable quarter in 2002. Service revenue for the three months ended March 31, 2003 was $122,000 compared to $397,000 for the comparable period in 2002.

Sales returns reserve adjustment of $167,000 for the quarter ended March 31, 2002 represents a reduction in the sales returns reserve based on revised estimates of potential product returns.

Our revenue to date has been recognized from a small number of customers. For the quarter ended March 31, 2003, four customers each contributed greater than 10% of total revenues, for a combined total of 74.9% of total revenues. For the quarter ended March 31, 2002, three customers each contributed greater than 10% of total revenues, for a combined total of 50.6% of total revenues. Revenue from international customers totaled 39.3% of our net revenues for the quarter ended March 31, 2003, compared to 24.1% for the comparable period in 2002.

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.

Cost of product revenue decreased to $2,000, or 1% of product revenue, for the quarter ended March 31, 2003 from $182,000, or 68% of product revenue for the comparable period of 2002. During the three months ended March 31, 2003, we utilized written-down inventory to fulfill customer demand, resulting in a decrease of cost of product revenue as a percentage of product revenue. We had previously written inventory down in its entirety due to our decreased sales and marketing efforts associated with these products and the lack of estimated future demand. We have generally ceased all direct sales and marketing efforts related to our products, and do not expect material revenues from them in the foreseeable future. We may experience limited demand from existing customers who desire to purchase additional product before such products become unavailable. Any such demand will generally be fulfilled from existing quantities of written-off inventory and we would expect cost of product revenue to remain low as a percentage of product revenue.

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Cost of service revenue for the three months ended March 31, 2003 was zero compared to $100,000 for the three months ended March 31, 2002. This decrease was attributable to headcount reductions in our customer support organization that were made during January 2003.

We have generally ceased all direct sales efforts related to our products. However, if we are successful in selling any products in future periods, we expect that our existing quantities of finished goods and raw materials inventories that have been written down in their entirety would be sufficient to substantially fulfill potential customer demand for the foreseeable future.

RESEARCH AND DEVELOPMENT

Research and development expenses, net of non-cash compensation expense, consist primarily of salaries and related personnel expenses, retention bonuses, fees paid to consultants and outside service providers, and material costs related to the design, development, testing and enhancement of our products. Non-cash compensation expense for the three months ended March 31, 2003 was $54,000, compared to $316,000 for the comparable period in 2002.

Research and development expenses increased 23.7% to $4.4 million for the three months ended March 31, 2003, from $3.5 million in the comparable period in 2002. This increase is primarily attributable to retention bonus compensation associated with agreements entered into between the Company and its employees in January 2003 of $519,000 and increased materials costs associated with continued in-process research and development related to our next generation copper automation products for incumbent local exchange carriers of $255,000.

We expect research and development expenses to decrease in future periods as a result of our April 2003 termination of substantially all research and development personnel and discontinuation of substantially all research and development activities associated with our next generation copper automation products.

SALES AND MARKETING

Sales and marketing expenses, net of non-cash compensation expense, consist primarily of salaries, retention bonuses, commissions and related expenses for personnel engaged in marketing, sales and customer support functions, as well as trade shows and promotional expenses. Non-cash compensation expense for the three months ended March 31, 2003 was $16,000 compared to $183,000 for the comparable period in 2002.

Sales and marketing expenses decreased 43.7% to $1.2 million for the three months ended March 31, 2003 from $2.2 million in the comparable period of 2002. This decrease is primarily due to a decrease in the number of sales, sales support and marketing personnel domestically and internationally in 2003 compared to 2002.

We expect sales and marketing expenses to decrease in future periods as a result of our April 2003 termination of substantially all sales, sales support and marketing personnel.

GENERAL AND ADMINISTRATIVE

General and administrative expenses, net of non-cash compensation expense, consist primarily of salaries, retention bonuses and related

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expenses for executive, finance and administrative personnel, financial advisory fees, legal fees, and other general corporate expenses. Non-cash compensation expense for the three months ended March 31, 2003 was $54,000 compared to $236,000 for the comparable period in 2002.

General and administrative expenses increased 150.3% to $1.7 million for the three months ended March 31, 2003 from $694,000 in the comparable period in 2002. This increase is primarily attributable to increased financial advisory fees related to the exploration of strategic alternatives of $807,000 and accrual for retention bonuses earned by general and administrative personnel pursuant to agreements entered into in January 2003 of $182,000.

We expect to incur significant financial advisory fees, legal fees and other general and administrative expenses associated with the exploration and possible execution of various strategic alternatives, which may cause general and administrative expenses to increase further in future periods.

AMORTIZATION OF DEFERRED STOCK COMPENSATION

As of March 31, 2003, deferred stock compensation totaled $127,000. We amortized deferred stock compensation of approximately $124,000 in the three months ended March 31, 2003 compared to $735,000 in the comparable period in 2002.

INTEREST INCOME AND OTHER, NET

Interest income and other, net consists primarily of income from our cash investments, and to a lesser extent the net gain or loss from foreign currency translation gains and losses, net gains or losses on disposal of property and equipment, and expenses related to our lease financing obligations. We had interest income and other, net of $1.0 million for the three months ended March 31, 2003 and interest income and other, net of $1.6 million in the comparable period of 2002. The decrease in interest income and other, net is 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.

INCOME TAX EXPENSE

Income tax expense was $25,000 for the three months ended March 31, 2003 and consisted primarily of state income taxes.

LIQUIDITY AND CAPITAL RESOURCES

Our principal source of liquidity as of March 31, 2003 consisted of $195.2 million in cash and cash equivalents and $10.3 million in short-term investments. Additional capital resources as of March 31, 2003 included restricted cash of $3.6 million in the form of a stand-by letter of credit required by our headquarters lease.

During the three months ended March 31, 2003, we used $5.8 million in operating activities, primarily from our net loss of $6.1 million, and to a lesser extent, increases in prepaid expenses and other assets and decreases in accrual for loss on operating lease and accounts payable. The use of cash in operating activities was partially offset by increases in accrued compensation and benefits and non-cash charges. Non-cash charges consisted principally of depreciation expense and amortization of deferred stock compensation.

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Net cash provided by investing activities for the three months ended March 31, 2003 was $97.5 million, primarily due to proceeds from sales and maturities of available-for-sale investments of $98.8 million, partially offset by purchases of similar investments in the amount of $1.3 million.

Net cash provided by financing activities for the three months ended March 31, 2003 was $43,000, primarily due to proceeds of $185,000 from stock option exercises, partially offset by purchases of treasury stock totaling $142,000. Our purchases of treasury stock were made pursuant to a stock repurchase program approved by the board of directors in October 2001. This program permitted the purchase of up to $15.0 million of our common stock over the subsequent twelve-month period. In October 2002, the stock repurchase program was extended for an additional twelve-month period. As of March 31, 2003, we were authorized under the program to purchase up to an additional $5.0 million of our common stock.

We expect to devote capital and operating resources to continue to explore and consummate strategic alternatives and to repurchase our common stock.

RECENT ACCOUNTING PRONOUNCEMENTS

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. The requirements of SFAS 146 were effective prospectively for exit or disposal activities initiated after December 31, 2002. Adoption of SFAS 146 did not have a significant effect on the Company’s financial position, results of operations, or cash flows.

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which clarifies disclosure and recognition/measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition/measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The Company has determined that the requirements of FIN 45 apply to its accrued warranty and standard indemnification clauses contained within its various customer contracts (see Note 10); however the adoption of FIN No. 45 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

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In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002 (see Note 3). The adoption of SFAS No. 148 did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, which addresses consolidation by a business of variable interest entities in which it is the primary beneficiary. FIN 46 is effective immediately for certain disclosure requirements and variable interest entities created after January 31, 2003, and in the first interim or annual period beginning after June 15, 2003 for all other variable interest entities entered into prior to January 31, 2003. The company does not have any variable interest entities.

In November 2002, the EITF published EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying this EITF Issue 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. This issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently evaluating the impact that the adoption of EITF Issue 00-21 will have on the Company’s financial position, results of operations, or cash flows.

In January 2003, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” EITF Issue No. 02-16 provides guidance regarding how a reseller of a vendor’s products should account for cash consideration received from a vendor. The provisions of EITF Issue No. 02-16 will apply to vendor arrangements entered into after December 31, 2002, including modifications of existing arrangements. The Company does not expect EITF 02-16 to have a material effect on the Company’s financial position, results of operations, or cash flows.

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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.

Our exploration of strategic alternatives may be unsuccessful and may have an adverse effect on our operating results and stock price.

In January 2003, we engaged Goldman, Sachs & Co. as our financial advisor to explore various strategic alternatives to maximize our stockholder value, including possible merger and asset sale transactions, licensing arrangements, and dissolution of the company and distribution of assets to our stockholders. We are uncertain as to what strategic alternatives may be available to us or what impact any particular strategic alternative will have on our stock price if accomplished. Uncertainties and risks relating to our exploration of strategic alternatives include:

Even if interested third parties are willing to explore strategic transactions with us, we may not be successful in executing and consummating any transactions because of the risks and uncertainties associated with our business.

We have a number of risks and uncertainties associated with our business that may prevent the consummation of a strategic transaction, including but not limited to:

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These and other risks and uncertainties may prevent us and interested third parties from exploring and consummating mutually acceptable strategic alternatives.

We may elect to dissolve and distribute assets to our stockholders if our board of directors determines that such action is in the best interest of our stockholders.

As a result of our exploration of strategic alternatives, our board of directors may deem it advisable to dissolve the company and distribute assets to stockholders. Liquidation and dissolution may not create value for our stockholders or result in any remaining capital for distribution to our stockholders. The precise nature, amount and timing of any distribution to our stockholders would depend on and could be delayed by, among other things, sales of our non-cash assets, claim settlements with creditors and resolution of outstanding litigation matters or new litigation matters arising from the liquidation or dissolution proceedings. Our stockholders may also experience adverse tax consequences to the extent they receive any distributions from us.

We do not expect any significant revenue to offset the expenses that we will incur during the strategic alternatives exploration and consummation process, which could cause the amount of assets available to stockholders to be reduced and the market price of our common stock to decline further.

We have generally ceased all sales, marketing and research and development activities related to our products and do not expect any significant revenue from them for the foreseeable future. As we expect to continue to incur expenses during the strategic alternatives exploration and consummation process, the amount of assets available to stockholders may be reduced, which could cause the market price of our common stock to decline further.

We could incur substantial costs and our management’s attention and resources could be diverted as a result of the outstanding securities class action lawsuits 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 our results of operations.

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. The complaint alleged 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

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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 regarding the Company 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.

All five cases were consolidated before Judge Saundra B. Armstrong 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 a consolidated First Amended Complaint (“FAC”) on September 13, 2002. The FAC alleges that we and the other defendants made false and misleading statements in connection with the Company’s secondary offering in violation of Sections 11, 12 and 15 of the Securities Act of 1933, and also that we and the other defendants made false and misleading statements during the class period in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder. We and the other defendants moved to dismiss the FAC on October 8, 2002. On February 7, 2003, the court issued an order denying in part and granting in part, with leave to amend, our motion to dismiss.

On March 10, 2003, plaintiff filed a Second Amended Complaint (“SAC”) against us, certain of our current officers and directors, and the underwriters of our September 21, 2000 secondary offering of stock alleging that we and the other defendants made false and misleading statements in connection with our secondary offering in violation of Sections 11, 12 and 15 of the Securities Act of 1933. By agreement of the parties, our answer to the SAC is due on June 13, 2003.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit the Santa Clara County Superior Court, 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, the Court issued an order sustaining the demurrer and granting plaintiff leave to amend its complaint. The 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, the Court

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issued an order sustaining the demurrer and dismissing the complaint with prejudice. The plaintiff filed a notice of appeal on August 1, 2002. On April 4, 2003, the parties stipulated to the dismissal of plaintiff’s appeal, and on April 8, 2003, the court entered an order terminating the litigation.

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 as well as our secondary 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 our initial public offering and our secondary stock offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectuses 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. The lead 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. The underwriters’ reply to the opposition was filed on September 13, 2002, and our reply to the opposition was filed on September 27, 2002. On February 19, 2003, the court issued an order denying the motions to dismiss with respect to substantially all of the plaintiffs’ claims, including those against us. Limited discovery is currently underway.

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, the 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 of our customers have filed or may file for bankruptcy protection, and as a result, 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 that previously purchased loop management products from us have filed or may file for bankruptcy protection. For example, in August 2002 the Official Committee of Unsecured Creditors of Digital Broadband Communications, Inc., one of our former customers that filed for Chapter 11 bankruptcy, 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

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$3,522,714.85. The bankruptcy court may require us, or we may agree as part of a settlement, to return some or all of the payments we have received or will receive in the future from such customers prior to their initiation of bankruptcy proceedings, which would negatively affect our financial results.

Because our products have been deployed in complex environments, they may have errors or defects that are found only after they have been fully deployed, which could result in liability claims against us.

Because our products are designed to provide critical services in large and complex networks, if errors, defects or failures are discovered in our products, we may be exposed to significant legal claims. Any claims, with or without merit, could increase our expenses, impair our operating results and prevent us from consummating strategic alternatives. 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 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 result in legal claims against us.

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 March 31, 2003, our executive officers, directors and principal stockholders and their affiliates owned 29,116,158 shares, or approximately 46.4%, 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 or disapproval of any strategic business transactions.

We expect to experience volatility in our stock price, which could negatively affect your investment.

An active public market for our common stock may not be sustained in the future. The market for technology stocks has been extremely volatile. In 2002 the per-share closing market price of our common stock on the Nasdaq National Market reached a high of $5.55 and a low of $2.00. 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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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 in which we have invested 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 March 31, 2003 and December 31, 2002. This table does not include money market funds because those funds are not subject to market risk.

EXCHANGE RATE SENSITIVITY

Currencies held in other than the U.S. dollar in our subsidiaries have been insignificant. As such, we have not had any material exposure to foreign currency rate fluctuations.

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ITEM 4.    CONTROLS AND PROCEDURES

Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

The Company’s significant personnel reductions in January 2003 and April 2003 have affected the overall control environment. However, management does not believe that these personnel reductions have had a significant impact on the effectiveness of the design and operation of the Company’s disclosure controls and procedures.

There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date that the Company completed its evaluation.

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PART II.    OTHER INFORMATION

All five cases were consolidated before Judge Saundra B. Armstrong 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 a consolidated First Amended Complaint (“FAC”) on September 13, 2002. The FAC alleges that we and the other defendants made false and misleading statements in connection with the Company’s secondary offering in violation of Sections 11, 12 and 15 of the Securities Act of 1933, and also that we and the other defendants made false and misleading statements during the class period in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder. We and the other defendants moved to dismiss the FAC on October 8, 2002. On February 7, 2003, the court issued an order denying in part and granting in part, with leave to amend, our motion to dismiss.

On March 10, 2003, plaintiff filed a Second Amended Complaint (“SAC”) against us, certain of our current officers and directors, and the underwriters of our September 21, 2000 secondary offering of stock alleging that we and the other defendants made false and misleading statements in connection with our secondary offering in violation of Sections 11, 12 and 15 of the Securities Act of 1933. By agreement of the parties, our answer to the SAC is due on June 13, 2003.

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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.

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Certification of Chief Executive Officer

pursuant to Section 302(a) of Sarbanes-Oxley Act

I, Richard N. Tinsley, certify that:

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Certification of Chief Financial Officer

pursuant to Section 302(a) of Sarbanes-Oxley Act

I, Eric S. Yeaman, certify that: