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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the fiscal quarter ended March 31, 2004

OR

Commission file No. 000-28843

Turnstone Systems, Inc.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

77-0473640

(I.R.S. Employer Identification No.)

7650 MARATHON DRIVE, SUITE A, LIVERMORE, CALIFORNIA 94550

(Address of principal executive offices)

(408) 907-1400

(Issuer’s telephone number)

Indicate by check mark whether the issuer (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 issuer 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 Rule 12b-2 of the Exchange Act).    YES  x    NO  ¨

As of April 30, 2004, the Issuer had 63,417,130 shares of its Common Stock, par value $.001 per share, issued and outstanding.

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TURNSTONE SYSTEMS, INC.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF NET ASSETS IN LIQUIDATION

(IN THOUSANDS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS IN

LIQUIDATION

(IN THOUSANDS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENT 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 STATEMENT 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)

On August 6, 2003, our board of directors approved, subject to stockholder approval at our 2003 Annual Meeting of Stockholders, the liquidation and dissolution of Turnstone Systems, Inc. pursuant to a plan of complete liquidation and dissolution. The holders of a majority of our outstanding shares approved the plan of complete liquidation and dissolution on November 11, 2003. The key features of the plan are (1) file a certificate of dissolution with the Secretary of State of the State of Delaware; (2) cease conducting normal business operations, except as may be required to wind up our business affairs; (3) attempt to convert all of our remaining assets into cash or cash equivalents in an orderly fashion; (4) pay or attempt to adequately provide for the payment of all of our known obligations and liabilities; and (5) distribute pro rata in one or more liquidating distributions all of our remaining assets to our stockholders as of the applicable record date.

In connection with the adoption of the plan and the anticipated liquidation, we adopted the liquidation basis of accounting effective November 11, 2003, whereby assets are valued at their estimated net realizable cash values and liabilities are stated at their estimated settlement amounts. Uncertainties as to the precise net value of our non-cash assets, and the ultimate amount of our liabilities make it impracticable to predict the aggregate net value that may ultimately be distributable to stockholders. Claims, liabilities and future expenses for operations, although currently declining in the aggregate, will continue to be incurred with execution of the plan. These costs will reduce the amount of net assets available for ultimate distribution to stockholders. Although we do not believe that a precise estimate of those expenses can currently be made, we believe that available cash and amounts received from sales of non-cash assets will be adequate to provide for our obligations, liabilities, operating costs and claims, and to make cash distributions to stockholders. If available cash and amounts received from sales of non-cash assets are not adequate to provide for our obligations, liabilities, operating costs and claims, estimated future distributions of cash to our stockholders will be reduced.

We filed our certificate of dissolution with the Secretary of State of the State of Delaware effective December 4, 2003. Pursuant to Delaware law, Turnstone Systems, Inc. will continue in existence until at least December 4, 2006. During this period, we will continue to convert our estimated net assets to cash for future distribution to our stockholders. We are not permitted to continue our business as a going concern.

At the close of business on December 4, 2003, we closed our stock transfer books, discontinued recording transfers of our common

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stock, and our common stock was de-listed from the Nasdaq National Market. Any future distributions we make will be made solely to the stockholders of record as of the close of business on December 4, 2003. We intend, in the future, to seek relief from the Securities and Exchange Commission from the reporting requirements under the Exchange Act.

Since we were de-listed from Nasdaq and closed our stock records on December 4, 2003, our shares have continued to trade in the Over the Counter Market’s “pink sheets”. From time to time, trading volume in our shares has been relatively high, and our shares have traded at prices in excess of the highest price we have estimated for potential liquidation distributions. Traders in our shares are cautioned that our shares are highly speculative, and we cannot predict with any accuracy when, or if, additional liquidation distributions will be made.

We may at some point determine that the continued liquidation of Turnstone may be more efficiently handled by retaining a third party liquidator to manage the liquidation process. In particular, we may determine to do so at such time as our outstanding litigation and other significant creditor claims have been resolved. We cannot predict when or if these matters will be resolved, or when or if we will engage a third party liquidator.

Basis Of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The unaudited interim financial statements, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation.

These financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2003 and footnotes thereto, included in the Company’s Annual Report on Form 10-K.

The condensed consolidated financial statements for the three months ended March 31, 2003 were prepared on the going concern basis of accounting, which contemplates realization of assets and satisfaction of liabilities in the normal course of business. As a result of the stockholders’ approval of the Plan and the imminent nature of the liquidation, the Company adopted the liquidation basis of accounting effective November 11, 2003. This basis of accounting is considered appropriate when, among other things, liquidation of a company is probable and the net realizable value of assets are reasonably determinable. Under

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this basis of accounting, assets are valued at their estimated net realizable values and liabilities are stated at their estimated settlement amounts.

The conversion from the going concern to liquidation basis of accounting required management to make significant estimates and judgments. In order to record assets at estimated net realizable value and liabilities at estimated settlement amounts under the liquidation basis of accounting, the Company recorded the following adjustments to record its assets and liabilities to fair value as of November 11, 2003, the date of adoption of the liquidation basis of accounting:

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, 2004 and December 31, 2003 consisted primarily of money market funds.

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Stock-Based Compensation

The Company accounted for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Beginning in fiscal 2003, the Company adopted the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment to SFAS No. 123, Accounting for Stock-Based Compensation. Compensation expense on fixed stock options was 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 accounted 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 was calculated based on 63,018,000 weighted-average shares of common stock outstanding. 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.

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Basic net loss per share was 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 was 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):

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.

There were no stock options outstanding or exercisable at March 31, 2004 since the Company had terminated its options plans, de-listed its stock and closed its transfer books.

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

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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). Prior to the adoption of the Complete Plan of Liquidation and Dissolution on November 11, 2003, the Company’s operations comprised one product line. The CEO reviewed financial information on a single entity level basis for purposes of making operating decisions and assessing financial performance. The entity level financial information was the same as the information presented in the accompanying condensed consolidated statement of operations. Accordingly, the Company determined that it was engaged in a single operating segment.

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

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 Company recorded retention bonuses of $816,000 to operating expenses in the three months ended March 31, 2003.

In October 2003, the retention agreements for the Company’s two remaining employees expired and the Company paid the earned retention bonuses to these employees. Concurrently, the Company entered into an employment agreement with the two remaining employees which provides that in the event the Company terminates the employees without cause, the employees will be entitled to receive a severance payment equal to six months annual base salary. These severance obligations are included in estimated net costs during liquidation as of March 31, 2004.

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Warranty Obligations

The Company has no warranty obligations remaining as of March 31, 2004. Accrued warranty was zero as of March 31, 2004 and December 31, 2003.

Indemnification Agreements

The Company and the underwriters of its September 2000 secondary stock offering previously entered into an underwriting agreement, whereby each party agreed, under certain specific circumstances applicable to such party, to indemnify and reimburse the other party for litigation costs and expenses related to claims arising out of the secondary offering. During the second fiscal quarter of 2003, the Company received a request for reimbursement of approximately $250,000 in legal fees purportedly incurred by those underwriters in connection with their defense of a class action lawsuit filed against the Company, certain of its current officers and directors, and those underwriters which alleged that the defendants made false and misleading statements in violation of the Securities Act of 1933 as part of the September 2000 secondary stock offering. In February 2004, in exchange for the Company’s payment of $150,000 of legal fees incurred by the underwriters, the Company and the underwriters agreed to mutually release each other from any further indemnification and reimbursement obligations related to the secondary offering class action lawsuit.

In addition to the indemnification provisions contained in our certificate of incorporation and bylaws, we have entered into separate indemnification agreements with each of our directors. These agreements require us, among other things, to indemnify such director against expenses (including attorneys’ fees), judgments, fines and settlements paid by such individual in connection with any action, suit or proceeding arising out of such individual’s status or service as our director or officer (other than such liabilities arising from willful misconduct or conduct that is knowingly fraudulent or deliberately dishonest) and to advance expenses incurred by such individual in connection with any proceeding against such individual with respect to which such individual may be entitled to indemnification by us. In September 2003, we purchased a six-year directors and officers run-off insurance policy.

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 pursuant to these customer contracts.

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

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offering of stock as well as the Company’s secondary offering of stock. The complaint is purportedly brought on behalf of a class of individuals who purchased common stock in the Company’s initial public offering and 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 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 us. Limited discovery is currently underway. A proposal has been made for the settlement and release of claims against the issuer defendants, including Turnstone. The settlement is subject to a number of conditions, including approval of the proposed settling parties and the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously. The Company does not estimate that there will be future costs associated with this case and has not included costs associated with this case in estimated litigation settlement costs at March 31, 2004.

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. Upon adoption of the liquidation basis of accounting, we accrued estimated litigation settlement costs of $500,000 related to this case. The estimate of litigation settlement costs is based on a settlement offer discussed and verbally agreed on March 4, 2004 by counsel for the Committee and the Company. The parties executed a formal stipulation of settlement in April 2004. The settlement is subject to the final approval of the United States Bankruptcy Court. If the formal settlement agreement is not approved by the bankruptcy court, and the Company is not successful in defending against this claim, the actual litigation settlement costs may exceed the Company’s estimates.

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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 our expectations, beliefs, intentions and strategies regarding our liquidation and dissolution, including, without limitation, statements regarding the execution, timing and expenses associated with our complete plan of liquidation and dissolution, disposition of our existing assets, the resolution of outstanding creditor claims and the ongoing litigation against us, and liquidating distributions, if any, to our stockholders, 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,” on pp. 15 to 16, and 20 to 24, 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

On August 6, 2003, our board of directors approved, subject to stockholder ratification at our 2003 Annual Meeting of Stockholders, a special cash distribution to stockholders of $2.77 per common share or such lesser amount as the board of directors might later determine to be appropriate. The board of directors also approved, subject to stockholder approval at our 2003 Annual Meeting of Stockholders, the liquidation and dissolution of Turnstone Systems, Inc. pursuant to a plan of complete liquidation and dissolution.

The special cash distribution was ratified by a majority of the shares present at the Annual Meeting on November 11, 2003. Following the Annual Meeting, our board of directors approved a special distribution of $2.77 per common share payable on November 28, 2003 to our stockholders of record as of November 21, 2003. The special cash distribution to stockholders, totaling $175.7 million, was paid on November 28, 2003.

On November 11, 2003, the holders of a majority of our outstanding shares approved the plan of dissolution. The key features of the plan are (1) file a certificate of dissolution with the Secretary of State of the State of Delaware; (2) cease conducting normal business operations, except as may be required to wind up our business affairs; (3) attempt to convert all of our remaining assets into cash or cash equivalents in an orderly fashion; (4) pay or attempt to adequately provide for the payment of all of our known obligations and

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liabilities; and (5) distribute pro rata in one or more liquidating distributions all of our remaining assets to our stockholders as of the applicable record date.

We filed our certificate of dissolution with the Secretary of State of the State of Delaware effective December 4, 2003. Pursuant to Delaware law, Turnstone Systems, Inc. will continue in existence until at least December 4, 2006. During this period, we will continue to convert our estimated net assets to cash for future distribution to our stockholders. We are not permitted to continue our business as a going concern.

At the close of business on December 4, 2003, we closed our stock transfer books, discontinued recording transfers of our common stock, and our common stock was de-listed from the Nasdaq National Market. Any future distributions we make will be made solely to our stockholders of record as of the close of business on December 4, 2003.

Under the plan of dissolution, we will liquidate our assets and make liquidating distributions to stockholders. We have not established a firm timetable for liquidating distributions to stockholders, but we intend, subject to contingencies inherent in winding up our business, to make such liquidating distributions as promptly as practicable and periodically as we convert our remaining assets to cash.

In March 2004, we licensed our Onyx software source code to a third party for $275,000 pursuant to a non-exclusive, perpetual software license agreement. Under the terms of the agreement, we received $69,000 upon execution of the agreement in March 2004. We received the remaining $206,000 in April 2004. We intend to continue to try to monetize our assets through direct sales and/or licensing arrangements, but we cannot assure you that we would be successful in consummating other transactions.

Prior to the decision to dissolve Turnstone Systems, Inc., we were a provider of hardware and software products that enabled local exchange carriers to deploy and maintain copper local loop services. Our products included copper loop management and testing systems, signal splitters and remote line switching and service verification platforms.

CRITICAL ACCOUNTING ESTIMATES

In connection with the adoption of the plan of dissolution and the anticipated liquidation, we adopted the liquidation basis of accounting effective November 11, 2003, whereby assets are valued at their estimated net realizable cash values and liabilities are stated at their estimated settlement amounts. The preparation of consolidated financial statements using the liquidation basis of accounting requires us to make assumptions, judgments and estimates that can have a significant impact on our reported net assets in liquidation. We base our assumptions, judgments and estimates on the most recent information available and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis we evaluate our assumptions, judgments and estimates and make changes accordingly. We believe that the assumptions, judgments and estimates involved in the accounting for the estimated litigation

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settlement costs, estimated costs to be incurred during liquidation, and estimated net realizable volume of intellectual property have the greatest potential impact on our consolidated financial statements, so we consider these estimates to be our critical accounting policies. We discuss below the critical accounting estimates associated with these policies.

Estimated Litigation Settlement Costs

Under the liquidation basis of accounting, we accrue for estimated litigation settlement costs. Estimated litigation settlement costs, which amounted to $500,000 as of March 31, 2004, represent the estimated future legal fees to be incurred and the estimated settlement amounts to be paid to 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. The Committee filed a complaint in the United States Bankruptcy Court seeking recovery of alleged preferential transfers to the Company in the aggregate amount of $3,522,715. In April 2004, we and the Committee entered into a stipulation of settlement, pursuant to which we agreed to make a payment of $500,000 to the Committee in exchange for a mutual release of all claims related to this matter. The stipulation of settlement is subject to the approval of the U.S. Bankruptcy Court, District of Delaware. The actual amount of litigation settlement cost may vary as the bankruptcy court may reject the settlement, in which case, if we are not successful in defending against this matter, the actual litigation settlement costs may exceed our estimate, ranging up to the full claim of $3,522,715, reducing net assets in liquidation. Conversely, our continued defense of the claim may result in a settlement for a lesser amount than our current estimate or a complete release of the claim, increasing net assets in liquidation. We are not aware of, and have not accrued for, any other outstanding litigation against us as of March 31, 2004.

Estimated Costs to be Incurred During Liquidation

Under the liquidation basis of accounting, we accrue for the remaining costs to be incurred during liquidation, including compensation and severance for the two remaining employees, board fees, fees of professional service providers and miscellaneous other costs, partially offset by estimated future interest earnings. Such costs were estimated at $654,000 at March 31, 2004. Our estimates are based on assumptions regarding our ability to settle outstanding obligations to creditors, resolve outstanding litigation, successfully petition the Securities and Exchange Commission for relief from public company reporting requirements, and the timing of distributions to stockholders. If there are delays, or we are not successful, in achieving these objectives, actual costs incurred during liquidation may increase, reducing net assets available in liquidation.

Estimated Net Realizable Value of Intellectual Property

At March 31, 2004, estimated net realizable value of intellectual property was $206,000. Our estimate is based on the remaining proceeds to be received pursuant to the licensing of Onyx software source code to a third-party. The proceeds were received in April 2004. Pursuant to our plan of dissolution, we continue to attempt to convert our intellectual property into cash and cash equivalents. Due to the significant uncertainties regarding our ability to sell and/or license our intellectual property, we generally estimate net realizable value to be zero until we have executed a license or purchase agreement and have received the related proceeds.

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LIQUIDITY AND CAPITAL RESOURCES

Our primary objectives are to liquidate our assets in the shortest time period possible while realizing the maximum values for such assets. The actual nature, amount and timing of all future distributions will be determined by the Board in its sole discretion, and will depend in part upon our ability to convert certain remaining assets into cash and settle certain obligations. At March 31, 2004, we had net assets in liquidation of $11,571,000, or $.182 per common share.

As of March 31, 2004, our total assets were $12,818,000, consisting of $12,583,000 of cash and cash equivalents, $206,000 of estimated net realizable value of intellectual property, and $29,000 of receivables and other current assets. The following table summarizes the activity related to receivables and other current assets for the three months ended March 31, 2004 (in thousands):

At March 31, 2004, we estimate that there are $654,000 of costs to be incurred during liquidation, $500,000 of estimated litigation settlement costs and $93,000 of other current liabilities and accrued expenses. Estimated costs to be incurred during liquidation decreased to $654,000 from $810,000 due to net cash disbursements of $75,000 and an adjustment to decrease estimated costs to be incurred during liquidation of $81,000.

Net assets in liquidation increased to $11,571,000 as of March 31, 2004 from $11,215,000 at December 31, 2003. This increase is due to an $81,000 adjustment to decrease estimated costs of liquidation resulting primarily from insurance proceeds received related to an equipment loss experienced at our former headquarter facility, and estimated proceeds of $275,000 related to the third-party licensing of our Onyx software source code.

On November 28, we paid $175,665,000, or $2.77 per common share, to stockholders as a return-of-capital distribution.

THREE MONTHS ENDED MARCH 31, 2003

NET REVENUES

In connection with the adoption of the plan of dissolution, we will not generate revenues from our products or services in the future. We have ceased all sales and marketing efforts related to our products, and have no supply of product available for sale.

Net revenues for the three months ended March 31, 2003 consisted of product revenue and service revenue. Product revenue of $268,000 consisted primarily of sales of our CX100 loop management products and,

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to a lesser extent, our MX500 Copper CrossConnect^® and SX Smart Splitter^® products and our Crossworks^™ and ONYX automation software licenses. Service revenue of $122,000 was derived primarily from our product maintenance programs.

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. Revenue from international customers totaled 39.3% of our net revenues for the quarter ended March 31, 2003.

COST OF REVENUES

In connection with the adoption of our plan of dissolution, we will not generate revenues from our products and services in the future, and, therefore, will not incur cost of revenues in the future.

During the three months ended March 31, 2003, we utilized written-down inventory to fulfill demand, resulting in minimal cost of product revenue of $2,000, or 1% of product revenue.

RESEARCH AND DEVELOPMENT

We will not incur research and development expenses in the future. Research and development expenses of $4.4 million for the three months ended March 31, 2003 consisted 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.

SALES AND MARKETING

We will not incur sales and marketing expenses in the future. Sales and marketing expenses of $1.2 million for the three months ended March 31, 2003 consisted primarily of salaries, retention bonuses, and related expenses for personnel engaged in marketing and sales activities.

GENERAL AND ADMINISTRATIVE

In connection with the adoption of the liquidation basis of accounting on November 11, 2003, we accrued estimated costs to be incurred during liquidation. Included in estimated costs to be incurred during liquidation are future expenditures that, prior to the adoption of the liquidation basis of accounting, would have been included in general and administrative expenses in future periods. As such, no general and administrative expenses will be incurred in future periods. Future adjustments in estimated costs to be incurred in liquidation will be reflected as changes in net assets in liquidation.

General and administrative expenses of $1.7 million for the three months ended March 31, 2003 consisted primarily of salaries, retention bonuses and related expenses for executive, finance and administrative personnel, financial advisory fees, legal fees, and other general corporate expenses.

AMORTIZATION OF DEFERRED STOCK COMPENSATION

In connection with the adoption of the liquidation basis of accounting, deferred stock compensation was written down to its net realizable value of zero. There will be no deferred stock compensation in future periods. We amortized deferred stock compensation of approximately $124,000 in the three months ended March 31, 2003.

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INTEREST INCOME AND OTHER, NET

Interest income and other, net of $1.0 million for the three months ended March 31, 2003 consisted primarily of income from our cash investments.

INCOME TAX EXPENSE

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

RISK FACTORS

In addition to other information in this Form 10-Q, the following risk factors should be carefully considered in evaluating us and our liquidation and dissolution because such factors may have a significant impact on the execution of our plan of dissolution and the timing and mount of liquidating distributions, if any, to our stockholders. As a result of the risk factors set forth below and elsewhere in this Form 10-Q, and the risks discussed in our other Securities and Exchange Commission Filings, actual results could differ materially from those projected in any forward-looking statements.

We cannot assure you of the exact amount or timing of any future distribution to our stockholders under the plan of dissolution.

The liquidation and dissolution process is subject to numerous uncertainties and may not result in any remaining capital for future distribution to our stockholders. The precise nature, amount and timing of any future distribution to our stockholders will depend on and could be delayed by, among other things, sales of our non-cash assets, claim settlements with creditors, resolution of outstanding litigation matters, and unexpected or greater than expected expenses. Furthermore, we cannot provide any assurances that we will actually make additional distributions. The estimates we have provided are based on currently available information, and actual payments, if any, could be substantially less than the range we have estimated. Any amounts to be distributed to our stockholders may be less than the price or prices at which our common stock has recently traded or may trade in the future.

Our common stock is continuing to trade even though we are in the process of liquidation and liquidating distributions, if any, may be below any trading price.

Until December 4, 2003, when our certificate of dissolution became effective and we voluntarily de-listed our common stock and closed our transfer books, our common stock was traded on the Nasdaq National Market under the symbol “TSTN.” Since the de-listing, our common stock has been trading in the Over the Counter Market’s “pink sheets” under the symbol “TSTN.PK.” It has been trading under “due-bill” contractual obligations between the seller and purchaser of the stock, who negotiate and rely on themselves with respect to the allocation of stockholder proceeds arising from ownership of the shares. No assignments or transfers of our common stock were recorded or will be recorded after December 4, 2003. Trading in our stock is highly speculative and the market for our stock is highly illiquid. The only value associated with our shares is the right to receive further distributions as part of the liquidation process. Because of the

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difficulty in estimating the amount and timing of the liquidating distributions, and due to the other risk factors discussed herein, our common stock may be subject to significant volatility and may trade above the amount of any liquidating distribution that is made.

We may not be able to settle all of our obligations to creditors and resolve all of our outstanding litigation.

If we do not settle all of our obligations to creditors and resolve all of our outstanding litigation, we may be prevented from completing our plan of dissolution. Our obligations to creditors include, among other things, long-term contractual obligations to certain customers, including certain product warranties, and contractual obligations to certain of our vendors. Our outstanding litigation includes federal securities class action litigation and litigation arising out of our ordinary course of business. As part of the wind down process, we will attempt to settle our obligations with our creditors and resolve all of the outstanding litigation. In particular, we have reached a tentative settlement of the federal securities class action lawsuit related to our initial public offering that we believe will not require any contribution from us. The proposed settlement is still subject to a number of conditions, including final court approval. Plaintiffs in the class action lawsuit have claimed damages in the hundreds of millions of dollars. Our inability to reach settlement with our creditors and resolve outstanding litigation could delay or even prevent us from completing the plan of dissolution. Moreover, amounts required to settle our obligations to creditors and resolve any outstanding litigation will reduce the amount of remaining capital available for future distribution to stockholders.

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 received 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 $3,522,714.85. In April 2004, we entered into a stipulation of settlement with the Committee, pursuant to which we would make a payment of $500,000 to the Committee in exchange for a mutual release of all claims related to the matter. 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.

We will continue to incur claims, liabilities and expenses that will reduce the amount available for distribution out of the liquidation to stockholders.

Claims, liabilities and expenses from operations, such as operating costs, salaries, directors’ and officers’ insurance, payroll and local

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taxes, legal, accounting and consulting fees and miscellaneous office expenses, will continue to be incurred as we wind down. These expenses will reduce the amount of assets available for future distribution out of the liquidation to stockholders. If available cash and amounts received on the sale of non-cash assets are not adequate to provide for our obligations, liabilities, expenses and claims, we may not be able to distribute out of the liquidation meaningful cash, or any cash at all, to our stockholders.

Distribution of assets out of the liquidation, if any, to our stockholders could be delayed.

Although our board of directors has not established a firm timetable for distributions to our stockholders out of the liquidation, the board of directors intends, subject to contingencies inherent in winding down our business, to make such distributions as promptly as practicable as creditor and litigant claims are paid or settled. However, we are currently unable to predict the precise timing of any such distributions. The timing of such distributions will depend on and could be delayed by, among other things, the timing of sales of our non-cash assets, claim settlements with creditors and the settlement of any outstanding litigation matters. Additionally, a creditor could seek an injunction against the making of such distributions to our stockholders on the ground that the amounts to be distributed were needed to provide for the payment of our liabilities and expenses. Any action of this type could delay or substantially diminish the amount available for such distribution to our stockholders.

If we fail to create an adequate contingency reserve for payment of our expenses and liabilities, each stockholder could be held liable for payment to our creditors of his or her pro rata share of amounts owed to creditors in excess of the contingency reserve, up to the amount actually distributed to such stockholder.

We filed our certificate of dissolution with the Secretary of State of the State of Delaware effective December 4, 2003. Pursuant to the Delaware General Corporation Law, we will continue to exist for three years after the certificate of dissolution is filed or for such longer period as the Delaware Court of Chancery shall direct, for the purpose of prosecuting and defending suits against us and enabling us gradually to close our business, to dispose of our property, to discharge our liabilities and to distribute to our stockholders any remaining assets. Under the Delaware General Corporation Law, in the event we fail to create during this three-year period an adequate contingency reserve for payment of our expenses and liabilities, each stockholder could be held liable for payment to our creditors of such stockholder’s pro rata share of amounts owed to creditors in excess of the contingency reserve, up to the amount actually distributed to such stockholder.

Although the liability of any stockholder is limited to the amounts previously received by such stockholder from us (and from any liquidating trust or trusts) in the dissolution, this means that a stockholder could be required to return all distributions previously made to such stockholder and receive nothing from us under the plan of dissolution. Moreover, in the event a stockholder has paid taxes on amounts previously received, a repayment of all or a portion of such amount could result in a stockholder incurring a net tax cost if the stockholder’s repayment of an amount previously distributed does not

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cause a commensurate reduction in taxes payable. While we will endeavor to make adequate reserves for all known, contingent, and unknown liabilities, there is no guarantee that the reserves established by us will be adequate to cover all such expenses and liabilities.

We will continue to incur the expenses of complying with public company reporting requirements.

We have an obligation to continue to comply with the applicable reporting requirements of the Securities Exchange Act of 1934, as amended, referred to as the “Exchange Act,” even though compliance with such reporting requirements is economically burdensome. We intend to seek relief from the Securities and Exchange Commission from the reporting requirements under the Exchange Act at such time in the future as active trading in our shares has ceased. We anticipate that, if such relief were granted, we would continue to file current reports on Form 8-K to disclose material events relating to our liquidation and dissolution along with any other reports that the Securities and Exchange Commission might require. However, the Securities and Exchange Commission may not grant any such relief, and we do not anticipate we will be able to request relief while active trading of our shares is continuing.

If we fail to retain the services of certain key personnel, the plan of dissolution may not succeed.

The success of the plan of dissolution depends in large part upon our ability to retain the services of certain of our current officers. The retention of Eric S. Yeaman, our Chief Executive Officer and Chief Financial Officer, and Albert Y. Liu, our General Counsel and Director of Human Resources, is particularly important under our current circumstances. Failure to retain these personnel could harm the implementation of the plan of dissolution, particularly during the current period while we are trying to resolve outstanding litigation and creditor claims.

Our board of directors may at any time turn management of the liquidation of Turnstone Systems over to a third party, and some or all of our directors may resign from our board at that time.

Our board of directors may at any time turn our management over to a third party to complete the liquidation of our remaining assets and distribute the available proceeds to our stockholders, and some or all of our directors may resign from our board at that time. On December 2, 2003, five directors resigned from the board and two directors were added to the board. If management is turned over to a third party and all of our directors resign from our board, the third party would have sole control over the liquidation process, including the sale or distribution of any remaining assets.

If we are deemed to be an investment company, we may be subject to substantial regulation that would cause us to incur additional expenses and reduce the amount of assets available for distribution.

If we invest our cash and/or cash equivalents in investment securities, we may be subject to regulation under the Investment Company Act of 1940. If we are deemed to be an investment company under the Investment Company Act because of our investment securities

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holdings, we must register as an investment company under the Investment Company Act. As a registered investment company, we would be subject to the further regulatory oversight of the Division of Investment Management of the Securities and Exchange Commission, and our activities would be subject to substantial regulation under the Investment Company Act. Compliance with these regulations would cause us to incur additional expenses, which would reduce the amount of assets available for distribution to our stockholders. To avoid these compliance costs, we intend to invest our cash proceeds in money market funds and government securities, which are exempt from the Investment Company Act but which currently provide a very modest return.

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 and reduce assets available for distribution in liquidation. 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.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK

At March 31, 2004 and December 31, 2003, we held our entire portfolio in money market funds, which are not subject to market risk.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

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Our significant personnel reductions during 2003 have affected the overall control environment. As of March 31, 2004, there are only two remaining employees. One employee, Eric S. Yeaman, is the Chief Executive Officer and Chief Financial Officer. 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.

Changes in Internal Controls Over Financial Reporting

There has been no change in our internal controls over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected or is reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

We dispute, but cannot assure you that we will be successful in our defense of, the outstanding lawsuits against us described below. If we are unsuccessful, these lawsuits could have a material adverse effect on our financial condition and on the amount of assets available for distribution to stockholders. Even if we are successful in defending against these claims, the litigation could result in substantial costs.

IPO 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. 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, 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

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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. A proposal has been made for the settlement and release of claims against the issuer defendants, including Turnstone. The settlement is subject to a number of conditions, including approval of the proposed settling parties and the court. If the settlement does not occur, and litigation against us continues, we believe we have meritorious defenses and intend to defend the case vigorously. We did not estimate that there will be future costs associated with this case and have not included costs associated with this case in estimated litigation settlement costs at March 31, 2004.

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.

In March 2004, we and counsel for the Committee discussed and verbally agreed on a settlement proposal pursuant to which we would make a payment of $500,000 to the Committee in exchange for a mutual release of all claims related to this matter. The parties executed a formal stipulation of settlement in April 2004, which is still subject to the final approval of the United States Bankruptcy Court, District of Delaware. If the Court does not approve the stipulation of settlement, then we believe we have meritorious defenses and intend to defend the case vigorously. At March 31, 2004, accrued estimated litigation settlement costs were $500,000 related to this case.

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.

In November 2003, we made a special cash distribution to stockholders totaling $175.7 million. In December 2003, we filed our certificate of dissolution with the Secretary of State of the State of Delaware. Pursuant to our plan of

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dissolution, we anticipate that we will distribute all of our remaining assets, including any remaining net proceeds from our offerings, to our stockholders.

Not applicable.

Not applicable.

None.

(a)    Exhibits

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(b)    Reports on Form 8-K

None.

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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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EXHIBIT INDEX

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