Annual Reports

 
Quarterly Reports

  • 10-Q (May 9, 2011)
  • 10-Q (Nov 8, 2010)
  • 10-Q (Aug 6, 2010)
  • 10-Q (May 10, 2010)
  • 10-Q (Nov 9, 2009)
  • 10-Q (Aug 7, 2009)

 
8-K

 
Other

UTStarcom 10-Q 2006

QuickLinks -- Click here to rapidly navigate through this document



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)  

ý

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



For the quarterly period ended June 30, 2006



OR



o


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



For the transition period from                             to                              

COMMISSION FILE NUMBER 000-29661

UTSTARCOM, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
(State of Incorporation)
  52-1782500
(I.R.S. Employer Identification No.)

1275 HARBOR BAY PARKWAY
ALAMEDA, CALIFORNIA

(Address of principal executive offices)

 

94502
(zip code)

Registrant's telephone number, including area code:
(510) 864-8800

        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 ý No o

        Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer ý    Accelerated filer o    Non-accelerated filer o

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

        As of August 1, 2006 there were 120,839,532 shares of the registrant's common stock outstanding, par value $0.00125.




TABLE OF CONTENTS

PART I—FINANCIAL INFORMATION   3
 
ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

3
 
ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

43
 
ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

 

67
 
ITEM 4—CONTROLS AND PROCEDURES

 

68

PART II—OTHER INFORMATION

 

78
 
ITEM 1—LEGAL PROCEEDINGS

 

78
 
ITEM 1A—RISK FACTORS

 

82
 
ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

101
 
ITEM 3—DEFAULTS UPON SENIOR SECURITIES

 

101
 
ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

102
 
ITEM 5—OTHER INFORMATION

 

102
 
ITEM 6—EXHIBITS

 

102
 
SIGNATURES

 

103
 
EXHIBIT INDEX

 

 

2



PART I—FINANCIAL INFORMATION

ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


UTSTARCOM, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands, except share and per share data)

 
  June 30,
2006

  December 31,
2005

 
ASSETS              
Current assets:              
  Cash and cash equivalents   $ 647,274   $ 645,571  
  Short-term investments     10,339     13,266  
  Accounts receivable, net of allowances for doubtful accounts of $71,619 and $67,789 at June 30, 2006 and December 31, 2005, respectively     383,507     453,671  
  Accounts receivable, related parties, net of allowancec for doubtful accounts of $16 and $5 at June 30, 2006 and December 31, 2005, respectively     41,110     69,293  
  Notes receivable     11,593     2,065  
  Inventories     455,015     425,955  
  Deferred costs/Inventories at customer sites under contracts     256,812     239,876  
  Prepaids     60,085     61,795  
  Short-term restricted cash and investments     71,119     53,680  
  Other current assets     34,092     37,267  
   
 
 
    Total current assets     1,970,946     2,002,439  
Property, plant and equipment, net     216,325     233,403  
Long-term investments     29,824     26,023  
Goodwill     3,063     3,063  
Intangible assets, net     65,568     75,313  
Other long-term assets     31,092     25,811  
   
 
 
    Total assets   $ 2,316,818   $ 2,366,052  
   
 
 

LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 

 
Current liabilities:              
  Accounts payable   $ 363,097   $ 320,677  
  Short-term debt     122,587     198,826  
  Income taxes payable     37,101     33,608  
  Customer advances     291,964     221,301  
  Deferred revenue     66,776     69,030  
  Other current liabilities     218,194     289,867  
   
 
 
    Total current liabilities     1,099,719     1,133,309  

Long-term debt

 

 

274,900

 

 

274,900

 
Other long-term liabilities     27,470     20,958  
   
 
 
    Total liabilities     1,402,089     1,429,167  

Commitments and contingencies (Note 16)

 

 

 

 

 

 

 
Minority interest in consolidated subsidiaries     7,593     8,338  
   
 
 
Stockholders' equity:              
  Common stock: $0.00125 par value; authorized: 750,000,000 shares; issued and outstanding: 120,618,764 and 120,585,158 at June 30, 2006 and December 31, 2005, respectively     152     152  
  Additional paid-in capital     1,171,175     1,168,166  
  Deferred stock compensation         (3,493 )
  Accumulated deficit     (285,252 )   (253,174 )
  Accumulated other comprehensive income     21,061     16,896  
   
 
 
Total stockholders' equity     907,136     928,547  
   
 
 
    Total liabilities, minority interest and stockholders' equity   $ 2,316,818   $ 2,366,052  
   
 
 

See accompanying notes to the condensed consolidated financial statements.

3



UTSTARCOM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share data)

 
  Three months ended June 30,
  Six months ended
June 30,

 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
Net sales                          
  Unrelated party   $ 515,733   $ 691,431   $ 1,076,094   $ 1,295,362  
  Related party     33,413     28,328     69,623     326,281  
   
 
 
 
 
      549,146     719,759     1,145,717     1,621,643  
Cost of net sales                          
  Unrelated party     414,364     591,892     873,744     1,128,844  
  Related party     25,496     15,729     40,233     143,237  
   
 
 
 
 
Gross profit     109,286     112,138     231,740     349,562  
   
 
 
 
 
Operating expenses:                          
  Selling, general and administrative     82,423     103,009     165,593     212,020  
  Research and development     46,743     65,621     93,052     131,881  
  Amortization of intangible assets     4,821     6,776     9,746     13,748  
  In-process research and development         660         660  
  Restructuring         15,127         15,127  
   
 
 
 
 
Total operating expenses     133,987     191,193     268,391     373,436  
   
 
 
 
 
Operating loss     (24,701 )   (79,055 )   (36,651 )   (23,874 )
   
 
 
 
 
Interest income     3,947     1,452     7,479     2,801  
Interest expense     (3,166 )   (4,711 )   (6,667 )   (8,989 )
Other income, net     6,887     8,867     10,454     2,020  
   
 
 
 
 
Loss before income taxes, minority interest and equity in loss of affiliated companies     (17,033 )   (73,447 )   (25,385 )   (28,042 )
Income tax expense     (4,669 )   (240 )   (7,508 )   (7,920 )
Minority interest in losses of consolidated subsidiaries     259     313     815     91  
Equity in loss of affiliated companies         (574 )       (1,033 )
   
 
 
 
 
Net loss   $ (21,443 ) $ (73,948 ) $ (32,078 ) $ (36,904 )
   
 
 
 
 
Loss per share—Basic and diluted   $ (0.18 ) $ (0.64 ) $ (0.27 ) $ (0.32 )

Weighted average shares used in per-share calculation:

 

 

 

 

 

 

 

 

 

 

 

 

 
  —Basic and diluted     120,608     114,880     120,604     114,702  
   
 
 
 
 

See accompanying notes to the condensed consolidated financial statements.

4



UTSTARCOM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)

 
  Six months ended June 30,
 
 
  2006
  2005
 
 
   
  As restated

 
CASH FLOWS FROM OPERATING ACTIVITIES:              
Net loss   $ (32,078 ) $ (36,904 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:              
  Depreciation and amortization     34,653     51,411  
  Loss on sale and disposal of assets     2,169     3,684  
  Loss on asset impairment         6,739  
  Stock compensation expense     8,769     1,153  
  Provision for doubtful accounts     3,133     33,609  
  Provision for inventory     5,978     28,241  
  Deferred income taxes         97,466  
  Gain on extinguishment of debt         (11,094 )
  Other     (2,930 )   2,768  
  Changes in operating assets and liabilities, net of effects of acquisition:              
    Accounts receivable     97,596     (74,915 )
    Inventories     (36,916 )   41,929  
    Deferred costs/Inventories at customer sites under contracts     (13,677 )   (31,966 )
    Other current and non-current assets     (7,784 )   58,378  
    Accounts payable     39,693     24,830  
    Income taxes payable     3,438     (140,379 )
    Customer advances     69,280     (225,238 )
    Deferred revenue     (2,699 )   19,892  
    Other current liabilities     (89,469 )   11,035  
   
 
 
Net cash provided by (used in) operating activities     79,156     (139,361 )
   
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:              
Additions to property, plant and equipment     (12,288 )   (46,325 )
Investment in affiliates, net of cash acquired     (302 )   (2,550 )
Purchase of business, net of cash acquired         (23,806 )
Proceeds from sale of business     19,965      
Proceeds from disposal of property         663  
Change in restricted cash and investments     (19,994 )   2,708  
Purchase of short-term investments     (21,810 )   (123,768 )
Proceeds from sale of short-term investments     25,588     228,649  
Other     1,672     (750 )
   
 
 
Net cash (used in) provided by investing activities     (7,169 )   34,821  
   
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:              
Proceeds from borrowing     62,545     278,381  
Payments on borrowings     (140,053 )   (373,081 )
Cash paid to extinguish debt         (15,781 )
Other     1,967     4,579  
   
 
 
Net cash used in financing activities     (75,541 )   (105,902 )
Effect of exchange rate changes on cash and cash equivalents     5,257     (1,766 )
   
 
 
Net increase (decrease) in cash and cash equivalents     1,703     (212,208 )
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD     645,571     562,532  
   
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD   $ 647,274   $ 350,324  
   
 
 
Supplemental disclosure of cash flow information:              
  Cash paid:              
    Interest   $ 4,596   $ 8,179  
    Income taxes   $ 3,529   $ 11,387  
  Non-cash operating activity              
    Accounts receivable transferred to notes receivable   $ 15,376   $ 34,551  
    Property, plant and equipment exchanged for long-term investment   $ 5,500   $  

See accompanying notes to the condensed consolidated financial statements.

5


UTSTARCOM, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1.     BASIS OF PRESENTATION

        The accompanying unaudited condensed consolidated financial statements include the accounts of UTStarcom, Inc. (the "Company") and its wholly and majority owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the preparation of the condensed consolidated financial statements. The minority interests in consolidated subsidiaries and equity in affiliated companies are shown separately in the condensed consolidated financial statements.

        The accompanying financial statements as of June 30, 2006 and for the three and six months ended June 30, 2006 and 2005 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Certain information and footnote 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. The December 31, 2005 balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. These condensed consolidated financial statements should be read in conjunction with the Company's audited December 31, 2005 financial statements, including the notes thereto, and other information set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2005, as amended.

        In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) considered necessary for a fair statement of the Company's financial condition, the results of its operations and its cash flows for the periods indicated. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of the operating results for the full year.

2.     RESTATEMENT OF FINANCIAL STATEMENTS

        The Company has restated its previously issued consolidated financial statements for the years ended December 31, 2004 and 2003. Accordingly, the consolidated balance sheets at December 31, 2004 and 2003, and consolidated statements of operations, stockholders' equity and cash flows for the years then ended were restated from amounts previously reported, and are included in the Form 10-K for the year ended December 31, 2005, as amended. In addition, the unaudited quarterly condensed consolidated financial statements for the interim reporting periods during the years ended December 31, 2005, 2004 and 2003 are also restated and are included in the "Quarterly Financial Data (unaudited)" in the Form 10-K for the year ended December 31, 2005, as amended, following the Notes to the Consolidated Financial Statements therein.

        The restatement follows completion of an investigation by independent legal counsel with the assistance of forensic accountants that was ordered by and under the direction of the Audit Committee of the Company's Board of Directors. The genesis for this independent investigation was the discovery, in December 2005, of two previously unknown side letter agreements provided to a customer in India in 2004 and 2005. The side letter agreements obligated the Company to deliver a variety of software bug fixes, features, updates and upgrades for no additional consideration, and, contrary to Company policy, these side letter agreements were withheld from the Company's financial management and the Company's independent registered public accounting firm. Therefore, neither management nor the Company's independent registered public accounting firm was able to properly evaluate their effect on the recognition of revenue under contracts with this customer.

        The independent investigation's initial focus was on the potential existence of other unknown side letter agreements with customers, but the investigation was broadened to encompass other areas

6



involving revenue recognition and some non-revenue related areas to ensure completeness of the investigation. The Audit Committee did not restrict the scope of the independent investigation.

        Upon completion of the independent investigation, the investigation team shared its final findings with the Audit Committee and with the Company's independent registered public accounting firm. Financial management conducted follow-up procedures to ensure the information provided by the investigation team was complete, attempted to locate any additional relevant information, and then evaluated the initial accounting for these transactions given the newly available additional information to determine whether the initial accounting was appropriate. Based on the evaluation of available information, management concluded that the original amount of the revenue recognized under contracts with certain customers and other matters discovered as part of the investigation constituted accounting errors. In making a decision regarding whether a restatement of the previously issued financial statements was required, consideration was given to the individual and aggregate effect of all potential restatement adjustments as well as qualitative issues that enter into materiality decisions.

        The restatement consists primarily of adjustments for errors in the timing of when revenues, cost and expenses should have been recognized in accordance with generally accepted accounting principles. It resulted in no change to the reported cash balances at the end of the restatement period or as of December 31, 2005. Revenues, contract costs and profits deferred at the end of the restatement period will be recognized in the Company's consolidated statements of operations of future periods when conditions that permit revenue recognition in accordance with generally accepted accounting principles are met.

7



        The following tables summarize the impact of the restatement adjustments on the consolidated statement of operations for the three and six months ended June 30, 2005:

 
  Three months ended June 30, 2005
 
 
  As previously
reported

  Adjustments
  As restated
 
 
  (in thousands, except per share amounts)

 
Net sales                    
  Unrelated party   $ 692,315   $ (884 ) $ 691,431  
  Related party     30,646     (2,318 )   28,328  
   
 
 
 
      722,961     (3,202 )   719,759  

Cost of net sales

 

 

 

 

 

 

 

 

 

 
  Unrelated party     596,785     (4,893 )   591,892  
  Related party     16,729     (1,000 )   15,729  
   
 
 
 
Gross profit     109,447     2,691     112,138  
   
 
 
 
Operating expenses:                    
  Selling, general and administrative     102,808     201     103,009  
  Research and development     65,621         65,621  
  In-process research and development     660         660  
  Amortization of intangible assets     6,776         6,776  
  Restructuring costs     15,127         15,127  
   
 
 
 
Total operating expenses     190,992     201     191,193  
   
 
 
 
Operating loss     (81,545 )   2,490     (79,055 )
   
 
 
 
Interest income     1,452         1,452  
Interest expense     (4,711 )       (4,711 )
Other income, net     8,867         8,867  
   
 
 
 
Income before income taxes, minority interest and equity in loss of affiliated companies     (75,937 )   2,490     (73,447 )
Income tax expense (benefit)     (1,485 )   1,725     240  
Minority interest in losses of consolidated subsidiaries     313         313  
Equity in loss of affiliated companies     (574 )       (574 )
   
 
 
 
Net loss   $ (74,713 ) $ 765   $ (73,948 )
   
 
 
 
Earnings per share—Basic and diluted   $ (0.65 ) $ 0.01   $ (0.64 )

Weighted average shares used in per-share calculation:

 

 

 

 

 

 

 

 

 

 
  —Basic and diluted     114,880     114,880     114,880  

8


 
  Six months ended June 30, 2005
 
 
  As previously
reported

  Adjustments
  As restated
 
 
  (in thousands, except per share amounts)

 
Net sales                    
  Unrelated party   $ 1,298,475   $ (3,113 ) $ 1,295,362  
  Related party     326,281         326,281  
   
 
 
 
      1,624,756     (3,113 )   1,621,643  

Cost of net sales

 

 

 

 

 

 

 

 

 

 
  Unrelated party     1,134,423     (5,579 )   1,128,844  
  Related party     142,697     540     143,237  
   
 
 
 
Gross profit     347,636     1,926     349,562  
   
 
 
 
Operating expenses:                    
  Selling, general and administrative     211,018     1,002     212,020  
  Research and development     132,281     (400 )   131,881  
  In-process research and development     660         660  
  Amortization of intangible assets     13,748         13,748  
  Restructuring costs     15,127         15,127  
   
 
 
 
Total operating expenses     372,834     602     373,436  
   
 
 
 
Operating loss     (25,198 )   1,324     (23,874 )
   
 
 
 
Interest income     2,801         2,801  
Interest expense     (8,989 )       (8,989 )
Other income, net     2,020         2,020  
   
 
 
 
Income before income taxes, minority interest and equity in loss of affiliated companies     (29,366 )   1,324     (28,042 )
Income tax expense (benefit)     6,399     1,521     7,920  
Minority interest in losses of consolidated subsidiaries     91         91  
Equity in loss of affiliated companies     (1,033 )       (1,033 )
   
 
 
 
Net loss   $ (36,707 ) $ (197 ) $ (36,904 )
   
 
 
 
Earnings per share—Basic and diluted   $ (0.32 ) $   $ (0.32 )

Weighted average shares used in per-share calculation:

 

 

 

 

 

 

 

 

 

 
  —Basic and diluted     114,702     114,702     114,702  

3.     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates:

        The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates are used for revenue recognition, allowance for doubtful accounts and sales returns, reserves for inventory, deferred costs and accrued product warranty costs, tax valuation allowances, goodwill impairments and loss contingencies, among others. Actual results could differ from those estimates.

9



Revenue Recognition:

        Revenues from sales of telecommunications equipment and handsets are recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, customer acceptance has been obtained, the fee is fixed or determinable and collectibility is reasonably assured. If the payment due from the customer is not fixed or determinable due to extended payment terms, revenue is recognized as payments become due from the customer, assuming all other criteria for revenue recognition are met. Any payments received prior to revenue recognition are recorded as customer advances. Normal payment terms differ for various reasons amongst different customer regions, depending upon common business practices for customers within a region. Shipping and handling costs are recorded as revenues and costs of revenues. Any expected losses on contracts are recognized when identified.

        Sales may be generated from complex contractual arrangements that require significant revenue recognition judgments, particularly in the area of contracts with multiple deliverable elements (multiple element arrangements). Where multiple elements exist in an arrangement, contract revenue is allocated to the different elements based upon and in proportion to verifiable objective evidence of the fair value of the various elements, as governed under Emerging Issues Task Force Issue ("EITF") No. 00-21 ("Accounting for Revenue Arrangements with Multiple Deliverables") and SEC Staff Accounting Bulletin No. 104 ("Revenue Recognition"). Multiple element arrangements primarily involve the sale of equipment, installation, training and the provision of such equipment to different locations for the same customer. Revenue is recognized as each element is earned, namely upon installation and acceptance of equipment or delivery of handsets, provided that the fair value of the undelivered element(s) has been determined, the delivered element(s) has stand-alone value, there is no right of return on delivered element(s), and the Company is in control of the undelivered element(s). For arrangements that include service elements, including promotional support and installation, for which verifiable objective evidence of fair value does not exist, revenue is deferred until such services are deemed complete, or until the time the Company can establish verifiable objective evidence.

        Final acceptance is required for revenue recognition when installation services are not considered perfunctory. Final acceptance indicates that the customer has fully accepted delivery of equipment and the Company is entitled to full payment. The Company will not recognize revenue before final acceptance is granted by the customer if acceptance is considered substantive to the transaction. Additionally, the Company does not recognize revenue when cash payments are received from customers for transactions that do not have the customer's final acceptance. The Company records these cash receipts as customer advances, and defers revenue recognition until final acceptance is received.

        Where multiple elements exist in an arrangement that includes software, and the software is considered more than incidental to the equipment or services in the arrangement, software and software related elements are recognized under the provisions of Statement of Position 97-2 ("Software Revenue Recognition") as amended, and EITF No. 03-05 ("Applicability of SOP 97-2 to non-software deliverables containing more than incidental software.") The Company allocates revenues to each element of software arrangements based on vendor specific objective evidence ("VSOE"). VSOE of each element is based on the price charged when the same element is sold separately. The Company uses the residual method to recognize revenue when an arrangement includes one or more elements to be delivered at a future date and VSOE of the fair value of all the undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the contract revenue is recognized as revenue. If evidence of fair value of one or more undelivered elements does not exist, all revenue for delivered and undelivered elements is deferred and recognized when delivery of all elements occurs or when VSOE can be established.

        The Company recognizes revenue for system integration, installation and training upon completion of performance and if all other revenue recognition criteria are met. Other service revenue, principally

10



related to maintenance and support contracts, is recognized ratably over the contract term. Revenues from services were less than 10% of revenues for all periods present.

        The Company also sells products through resellers. Revenue is generally recognized when the standard price protection period, which ranges from 30 to 90 days, has lapsed. If collectibility cannot be reasonably assured in a reseller arrangement, revenue is recognized upon sell through to the end customer and receipt of cash. There may be additional obligations in reseller arrangements such as inventory rotation, or stock exchange rights on the product. As such, revenue is recognized in accordance with Statement of Financial Accounting Standards ("SFAS") No. 48, "Revenue Recognition When Right of Return Exists." In most cases, the Company has developed reasonable estimates for stock exchanges based on historical experience with similar types of sales of similar products.

        The Company has sales agreements with certain wireless customers that provide for a rebate of the selling price to such customers if the particular product is subsequently sold at a lower price to such customers or to a different customer. The rebate period extends for a relatively short period of time. Historically, the amounts of such rebates paid to customers have not been material. The Company estimates the amount of the rebate based upon the terms of each individual arrangement, historical experience and future expectations of price reductions and then records its estimate of the rebate amount at the time of the sale. The Company also enters into sales incentive programs, such as co-marketing arrangements, with certain wireless and handset customers. The Company records the incurred incentive as a reduction of revenue when the sales revenue is recognized.

        The assessment of collectibility is also a factor in determining whether revenue should be recognized. The Company assesses collectibility based on a number of factors, including payment history and the credit-worthiness of the customer. The Company does not request collateral from its customers. In international sales, the Company often requires letters of credit from its customers that can be drawn on demand if the customer defaults on its payment. If the Company determines that collection of a payment is not reasonably assured, the Company defers revenue recognition until collection becomes reasonably assured, which is generally upon receipt of cash.

        Occasionally, the Company enters into revenue sharing arrangements. Under these arrangements, the Company collects revenues only after its customer, the telecommunications service provider, collects service revenues. When the Company enters a revenue sharing arrangement, the Company does not recognize revenue until collection is reasonably assured.

        Because of the nature of doing business in China and other emerging markets, the Company's billings and/or customer payments may not correlate with the contractual payment terms and the Company generally does not enforce contractual payment terms prior to final acceptance. Accordingly, accounts receivable are not booked until the Company recognizes the related customer revenue. Advances from customers are recognized when the Company has collected cash from the customer, prior to recognizing revenue. Deferred revenue is recorded if there are undelivered elements after final acceptance has been obtained.

Stock-Based Compensation

        On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan based on estimated fair values. SFAS 123(R) supersedes the Company's previous accounting under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") for periods beginning in the fiscal year 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 ("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

11



        The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company's fiscal year 2006. The Company's Consolidated Financial Statements as of and for the three and six months ended June 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company's Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

        Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Stock-based compensation expense recognized in the Company's Consolidated Statement of Operations for the three and six months ended June 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Compensation expense for all share-based payment awards granted on or prior to December 31, 2005 was recognized using the straight-line single-option method, and the Company will continue to use the straight-line single option method for all share-based payment awards granted subsequent to December 31, 2005. The stock-based compensation expense recognized in the Consolidated Statement of Operations for the three and six months ended June 30, 2006 is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company's pro forma information required under SFAS 123 for the periods prior to the fiscal year 2006, the Company accounted for forfeitures as they occurred.

        The Company has used the Black-Scholes option-pricing model ("Black-Scholes model") method of valuation for share-based awards granted on or prior to December 31, 2005, and has continued to use the Black-Scholes model for subsequent share-based payment awards. The Company's determination of fair value of share-based payment awards on the date of grant using the Black-Scholes model is affected by the Company's stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. The Company uses historical volatility as management believes it is more representative of future stock price trends than implied volatility due to the relatively small number of actively traded options on our common stock available to determine implied volatility. The Company estimates an expected term of options granted based upon the Company's historical exercise and cancellation data for vested options. In addition, separate groups of employees that have similar exercise behavior are considered separately. The expected term of employee stock purchase plan shares is the average of the remaining purchase periods under each offering period. The Company bases the risk free interest rate used in the option valuation model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option valuation model. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. All stock based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.

        Because the Company's employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management's opinion, the existing valuation models may not provide an accurate measure of the fair value of the Company's employee stock options. Although the fair value of

12



employee stock options is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

        On November 10, 2005, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position No. FAS 123(R)-3 "Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards." The Company has not yet chosen a transition method to establish the beginning balance of the additional paid-in capital pool ("APIC pool") related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).

        Prior to the adoption of SFAS 123(R), the Company applied APB 25 and related interpretations to account for employee stock-based compensation. As such, compensation expense was recorded only if on the date of the grant, the current fair value of the underlying stock exceeded the exercise price of the stock option. The Company recorded deferred compensation in connection with stock options granted, as well as stock options issued in acquisitions, with exercise prices less than the fair market value of common stock on the date of the grant. The amount of such deferred compensation per share was equal to the excess of the fair market value over the exercise price on the grant date. The Company also recorded deferred compensation in connection with the restricted stock units granted, the amount of which equaled the fair market value of common stock on the date of the grant. Recorded deferred compensation was recognized as stock-based compensation expense ratably over the vesting periods. In accordance with SFAS 123(R), all deferred compensation, totaling $3.5 million that had previously been recorded, has been eliminated with a corresponding reduction in additional paid-in capital. In accordance with SFAS 123, Company provided pro forma information to illustrate the effect on net income and earnings per share if the Company had applied the fair value recognition provision of SFAS 123 to stock-based employee compensation.

4.     STOCK-BASED COMPENSATION

Stock Option Plans

The 1997 Stock Plan:

        Prior to the adoption of the 2006 Equity Incentive Plan (the "2006 Plan") by the Company's stockholders on July 21, 2006, officers, employees and consultants of the Company and its affiliates were eligible to receive options to purchase shares of common stock and stock purchase rights under the 1997 Stock Plan (the "1997 Plan"). On January 31, 1997, the Board of Directors adopted, and the Company's stockholders approved, the 1997 Plan. In December 1999, the Board of Directors amended the 1997 Plan, which the Company's stockholders approved in February 2000. As of June 30, 2006, the Company was authorized to issue up to 36,353,183 shares subject to options under the plan. As of June 30, 2006, there were options to purchase 21,509,230 shares of common stock outstanding under the 1997 Plan.

        The 1997 Plan was terminated upon adoption of the 2006 Plan by the Company's stockholders on July 21, 2006. Beginning on July 21, 2006, any shares (i) reserved but not issued under the 1997 Plan or (ii) subject to outstanding options or other equity awards granted under the 1997 Plan which terminate, expire or are forfeited or repurchased by the Company will be added to the 2006 Plan for future issuance thereunder. For more discussion on the 2006 Plan, please see Note 25 to Condensed Consolidated Financial Statements in this Form 10-Q. The 1997 Plan will continue to govern all options and other equity awards issued and outstanding under the 1997 Plan.

        Options granted under the 1997 Plan prior to July 21, 2006 were either incentive stock options ("ISOs") intended to qualify for favorable federal income tax treatment under the provisions of Section 422 of the Internal Revenue Code of 1986, as amended, or non-qualified stock options

13


("NSOs"), which did not so qualify. The Compensation Committee of the Board of Directors ("Compensation Committee") oversaw the selection of eligible persons for option grants and determined the grant date, amounts, exercise prices, vesting periods and other relevant terms of the options, including whether the options would be ISOs or NSOs. The exercise price of ISOs granted under the 1997 Plan could not be less than 100% of the fair market value of common stock on the grant date, while the exercise price of NSOs could be determined by the Compensation Committee in its discretion. Options granted under the 1997 Plan were generally not transferable during the life of the optionee.

        Under the 1997 Plan, options vest and become exercisable as determined by the Compensation Committee, generally over four years. Options may generally be exercised at any time after they vest and before their expiration date as determined by the Compensation Committee. However, no option may be exercised more than ten years after the grant date. Options will generally terminate (i) 12 months after the death or permanent disability of an optionee and (ii) 90 days after termination of employment for any other reason. The aggregate fair market value of the shares of common stock represented by ISOs that become exercisable in any calendar year by any one option holder may not exceed $100,000. Options in excess of this limit are treated as NSOs.

        In the event the Company is merged with or into another corporation, or all or substantially all of the Company's assets are sold, each outstanding option will be assumed or an equivalent option or right will be substituted by the successor corporation or its parent or subsidiary. If the successor corporation refuses to assume or substitute for the option or right, the option or right will automatically vest and become exercisable in full for a period of at least fifteen days, after which time the option or right will terminate.

        Prior to the adoption of the 2006 Plan, the Company could also grant restricted stock purchase rights to eligible participants under the 1997 Plan. Under the 1997 Plan, any shares purchased pursuant to restricted stock purchase rights were subject to a restricted stock purchase agreement. Unless the Compensation Committee determined otherwise, this agreement granted the Company a right to repurchase the restricted stock upon the voluntary or involuntary termination of the employee for any reason, including death or disability prior to vesting. The purchase price for repurchased shares was the original price paid and could be paid by cancellation of any indebtedness owed to the Company.

        The shares of restricted stock are subject to the Company's right of repurchase, which lapse over a period of four years. 50,000 shares of restricted stock subject to such repurchase right of the Company were purchased by employees and outstanding during the six months ended June 30, 2006, with a fair value of $0.4 million. The Company also granted rights to purchase 346,017 shares of restricted stock to employees and directors during the six months ended June 30, 2006, of which the rights to purchase 301,133 shares of restricted stock were allowed to lapse unexercised in March 2006.

2001 Director Option Plan:

        Prior to the adoption of the 2006 Plan on July 21, 2006, those directors who were not employees of the Company ("Outside Directors") were eligible to receive options to purchase shares of common stock under the 2001 Director Option Plan (the "2001 Plan"). The 2001 Plan was adopted by the Board of Directors on March 2, 2001 and was approved by the Company's stockholders in May 2001. In July 2001, the Board of Directors amended the 2001 Plan. As of June 30, 2006, the Company was authorized to issue up to 1,200,000 shares pursuant to options under the 2001 Plan. As of June 30, 2006, there were options to purchase 360,000 shares of common stock outstanding under the 2001 Plan. The Compensation Committee has been the administrator of the 2001 Plan. As of June 30, 2006, Directors Horner, Lenzmeier, Clarke and Toy were Outside Directors. Under the 2001 Plan, all grants of options to Outside Directors were automatic and nondiscretionary. On April 27, 2006, the Board of Directors suspended until further action all future grants of stock options to our Outside Directors under the 2001 Plan.

14



        The 2001 Plan was terminated upon adoption of the 2006 Plan by the Company's stockholders on July 21, 2006. Beginning on July 21, 2006, any shares (i) reserved but not issued under the 2001 Plan or (ii) subject to outstanding options granted under the 2001 Plan which terminate, expire or are forfeited will be added to the 2006 Plan for future issuance thereunder. For more discussion on the 2006 Plan, please see Note 25 to Condensed Consolidated Financial Statements in this Form 10-Q. The 2001 Plan will continue to govern all options issued and outstanding under the 2001 Plan.

        Under the terms of the 2001 Plan, each Outside Director was automatically granted an option to purchase eighty thousand shares of common stock (the "First Option") on the date on which such person first became an Outside Director (the "Anniversary Date"). A director who was an employee of the Company and ceased employment with the Company to become an Outside Director could receive an option to purchase twenty thousand shares of common stock (a "Subsequent Option") at the Company's first annual meeting of stockholders following such conversion to an Outside Director and at each subsequent annual stockholder meeting thereafter, provided that he or she was serving as an Outside Director on each such date. As such time as each Outside Director's First Option was fully vested, each Outside Director was automatically granted a Subsequent Option on the Anniversary Date of each year provided that he or she was then an Outside Director.

        Under the terms of the 2001 Plan, the exercise price of each option granted equaled the market value of the common stock on the date of grant. Such options have terms of ten years, but terminate earlier if the individual ceases to serve as a director. The First Option grants vest as to 25% of shares subject to the First Option on each of the first four anniversaries of its date of grant. The Subsequent Option grants vest as to 100% of the shares subject to the Subsequent Option on the first anniversary of its date of grant.

Issanni Communications, Inc. Incentive Program:

        The Issanni plan was established for the issuance of up to a total of 39,876 shares of UTStarcom's common stock to specified former employees of Issanni Communications, Inc. ("Issanni") who became UTStarcom's employees in connection with UTStarcom's acquisition of Issanni. The Issanni plan is administered by the Board of Directors or the Compensation Committee. A participant in the Issanni plan is eligible to earn and vest in a designated number of shares that are subject to the award of shares made to a participant under the plan, based upon the attainment of one of six milestones related to the amount of revenue generated from Issanni products in 2002 and 2003 and subject to the participant's continued employment with Issanni, the Company or one of their subsidiaries through the day of the determination that the applicable milestone has been satisfied. In addition, each participant is entitled to receive the unearned shares, if any, on the fifth anniversary of the acquisition of Issanni if the employee continues to be employed with Issanni, the Company or any of their subsidiaries on such date regardless of whether any milestone is attained. The shares subject to an award will in any event become issuable, whether or not the milestones were achieved and whether or not the five-year vesting schedule has elapsed, upon (i) the sale or the discontinuation of the Company or UTStarcom International Products Inc., (ii) the sale of substantially all or any of the technology acquired by UTStarcom International Products Inc. in connection with the acquisition of Issanni, or (iii) the employment termination of certain Issanni principals.

        If, prior to the date on which all of a participant's shares are earned, the participant's service with Issanni, the Company or one of their subsidiaries is terminated (i) voluntarily or for cause, the Company may exercise its repurchase option with respect to any of the participant's unearned shares, (ii) other than voluntarily or for cause, death or disability, the participant will be entitled to receive the shares that the participant would have otherwise earned with respect to milestones achieved within 24 months of the participant's termination, or (iii) as a result of death or disability, the participant (or his estate) will be entitled to receive the unearned portion of his shares with respect to all milestones.

15



The 2003 Non-Statutory Stock Option Plan:

        Prior to the adoption of the 2006 Plan on July 21, 2006, directors, officers, employees and consultants of the Company and its affiliates were eligible to receive options to purchase shares of the Company's common stock under the 2003 Nonstatutory Stock Option Plan (the "2003 Plan"). The 2003 Plan was adopted by the Board of Directors on April 15, 2003. Only nonstatutory stock options, which would not qualify for favorable federal income tax treatment under the provisions of Section 422 of the Internal Revenue Code of 1986, as amended, could be granted under the 2003 Plan. As of June 30, 2006, the Company was authorized to issue up to 1,500,000 shares pursuant to options granted under the 2003 Plan, subject to adjustment in certain instances (including stock splits, stock dividends, business combinations or other changes in capitalization). As of June 30, 2006, options to purchase 979,535 shares of common stock were outstanding under the 2003 Plan.

        The 2003 Plan was terminated upon adoption of the 2006 Plan by the Company's stockholders on July 21, 2006. Beginning on July 21, 2006, any shares (i) reserved but not issued under the 2003 Plan or (ii) subject to outstanding options granted under the 2003 Plan which terminate, expire or are forfeited will be added to the 2006 Plan for future issuance thereunder. For more discussion on the 2006 Plan, please see Note 25 to Condensed Consolidated Financial Statements in this Form 10-Q. The 2003 Plan will continue to govern all options issued and outstanding under the 2003 Plan.

        The 2003 Plan has been administered by the Compensation Committee. The Compensation Committee oversaw the selection of the eligible persons to whom options would be granted and determined the number of shares subject to the option, exercise prices, vesting periods and other terms applicable to each option.

        Options granted under the 2003 Plan generally vest and become exercisable over four years, and may be exercised at any time after they vest but before their expiration date. Options will generally terminate (i) 12 months after the death or employment termination due to disability of an option holder and (ii) 90 days after termination of an option holder's service for any other reason other than for disability or due to the option holder's death. No option, however, may be exercised more than ten years after the grant date.

        In the event the Company is merged with or into another corporation, or all or substantially all of the Company's assets are sold, the 2003 Plan provides for each outstanding option to be assumed or an equivalent option or right to be substituted by the successor corporation or its parent or subsidiary. If the successor corporation refuses to assume or substitute for the option, the option will automatically vest and become exercisable in full for a period determined by the compensation committee, after which time the option will terminate.

        A summary of activity under all Plans follows:

 
  Number of
options

  Weighted average
exercise price

  Shares available
for grant

 
Options outstanding, December 31, 2005   19,908,010   $ 18.34   6,495,767  
Options authorized in 2006         400,000  
Options granted   5,171,650     6.32   (5,171,650 )
Options exercised   (33,606 )   3.79    
Options forfeited or expired   (2,179,455 )   17.84   2,179,455  
   
 
 
 
Options outstanding, June 30, 2006   22,866,599   $ 15.69   3,903,572  
   
 
 
 

Stock Award Activity

        During the six months ended June 30, 2006, the Company granted restricted stock awards to its employees under the 1997 Stock Option Plan. Such awards generally vest over a period of four years from the date of grant. The restricted stock awards have the voting rights of common stock and the

16



shares underlying the restricted are considered issued and outstanding. The Company expenses the cost of the restricted stock awards, which is determined to be the fair market value of the shares at the date of grant, ratably over the period during which the restrictions lapse. The grant of restricted stock awards is deducted from the shares available for grant under the Company's stock option plan. Restricted stock activity under the Company's stock option plans for the six months ended June 30, 2006 is summarized below:

 
  Restricted stock
outstanding

  Weighted
average grant
date fair value

Balance at December 31, 2005   150,000   $ 8.15
  Restricted stock purchased as of June 30, 2006   50,000     8.33
  Restricted stock forfeited as of June 30, 2006      
  Restricted stock vested as of June 30, 2006      
   
 
Balance at June 30, 2006*   200,000   $ 8.19
   
 

*
As of June 30, 2006, rights to purchase an additional 44,884 shares of restricted stock were outstanding

        Information regarding the stock options outstanding at June 30, 2006 is summarized below:

 
  Options Outstanding
  Options Exercisable
Range of exercise price

  Outstanding
at
June 30,
2006

  Weighted
average
exercise
price

  Intrinsic
value

  Weighted
average
remaining
contractual
life

  Exercisable
at
June 30,
2006

  Weighted
average
exercise
price

  Intrinsic
value

 
   
   
  (in thousands)

  (in years)

   
   
  (in thousands)

$  0.06 - $  0.07   28,321   $ 0.06   $ 219   2.4   28,321   $ 0.06   $ 219
    0.25 -    0.25   16,781     0.25     127   2.2   16,781     0.25     127
    1.57 -    2.28   169,474     2.23     942   1.4   169,474     2.23     942
    2.50 -    3.65   118,254     3.47     511   2.4   118,254     3.47     511
    4.00 -    5.99   643,009     4.67     2,006   3.8   567,459     4.50     1,867
    6.06 -    8.87   7,544,729     6.63     8,752   9.5   172,778     7.68     19
    9.38 -  13.61   2,883,681     11.45       6.6   1,677,632     11.64    
  14.23 -  21.32   5,566,676     18.17       5.2   4,892,894     18.24    
  21.53 -  32.05   4,636,824     26.58       6.5   4,584,141     26.63    
  32.65 -  45.21   1,258,850     37.72       5.1   1,258,850     37.72    
   
 
 
 
 
 
 
$  0.06 - $45.21   22,866,599   $ 15.69   $ 12,557   7.0   13,486,584   $ 20.99   $ 3,685
   
       
     
       
Options exercisable and expected to vest June 30, 2006   20,717,139   $ 15.69   $ 11,376                    
   
 
 
                   

The intrinsic value is calculated as the difference between the market value as reported by NASDAQ on June 30, 2006 and the exercise price of the in-the-money shares. The total intrinsic value of options exercised and the amount of cash received for the exercise of options during the six months ended June 30, 2006 were not significant. The weighted average remaining contractual life of options exercisable was 6.3 years, and the weighted average remaining contractual life of options expected to vest was 7.0 years as of June 30, 2006.

2000 Employee Stock Purchase Plan:

        In February 2000, the Company's stockholders approved the 2000 Employee Stock Purchase Plan. The purchase plan is intended to qualify as an "employee stock purchase plan" under Section 423 of the Internal Revenue Code.

17



        The Company has reserved 1,914,934 shares of common stock for sale under the stock purchase plan at June 30, 2006. The number of shares reserved for sale under the plan will be increased annually on the first day of each fiscal year beginning in 2001 by an amount equal to 2.0 million shares, or 2% of the outstanding shares of the Company's common stock on that date, or a lesser amount determined by the Board of Directors. The stock purchase plan is administered by the Board or a committee appointed by the Board.

        The stock purchase plan is implemented by offering periods, the duration of which may not exceed 24 months. Offering periods may contain interim purchase periods. Shares purchased under the stock purchase plan will be held in separate accounts for each participant. The first offering period began in March 2000 and ended on the last trading day before April 30, 2002. There were no shares issued in May 2006 as the Company was not current with the filings of its annual report on Form 10-K for the year ended December 31, 2005 and quarterly report on Form 10-Q for the quarter ended March 31, 2006. The May 2006 offering period commenced on June 29, 2006, and terminates on May 14, 2008. Subsequent consecutive overlapping offering periods begin on May 15 and November 15 annually. These offering periods end twenty-four months thereafter.

        Employees will be eligible to participate in the stock purchase plan if they are employed by the Company for more than 20 hours per week and more than five months in a calendar year. The stock purchase plan permits eligible employees to purchase the Company's common stock through payroll deductions, which may not exceed 15% of the employee's total compensation. Stock may be purchased under the plan at a price equal to 85% of the fair market value of the Company's stock on either the date of purchase or the first day of the offering period, whichever is lower. However, the Board of Directors may in its discretion provide that the price at which shares of common stock are purchased under the plan shall be 85% of the fair market value of the Company's shares on the date of purchase. Participants may not purchase shares of common stock having a value greater than $25,000 during any calendar year.

        Participants may increase or decrease their payroll deductions at any time during an offering period, subject to limits imposed by the Board of Directors. If a participant withdraws from the stock purchase plan, any contributions that have not been used to purchase shares shall be refunded. A participant who has withdrawn may not participate in the stock purchase plan again until the next offering period. In the event of retirement or cessation of employment for any reason, any contributions that have not yet been used to purchase shares will be refunded to the participant, or to the participant's designated beneficiary in the case of death, and a certificate will be issued for the full shares in the participant's account.

        The Board of Directors may terminate or amend the stock purchase plan, subject to stockholder approval in some circumstances. Unless terminated earlier by the Board, the stock purchase plan will have a term of ten years.

Stock-Based Compensation

        The assumptions used to value option grants for the periods ended June 30, 2006 and 2005 are as follows:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  as restated
   
  as restated
 
Expected remaining term in years   4.0   4.0   4.0   4.0  
Weighted average risk-free interest rate   4.95 % 3.77 % 4.67 % 3.71 %
Expected dividend rate   0.00 % 0.00 % 0.00 % 0.00 %
Volatility   55.89 % 71.00 % 56.44 % 67.16 %

18


        The assumptions used to value employee stock purchase plan shares for the periods ended June 30, 2006 and 2005 are as follows:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
Expected remaining term in years   1.5   0.5   1.5   0.5  
Weighted average risk-free interest rate   4.64 % 2.69 % 4.64 % 2.69 %
Expected dividend rate   0.00 % 0.00 % 0.00 % 0.00 %
Volatility   60.89 % 52.00 % 60.89 % 52.00 %

        At June 30, 2006, there was $36.4 million of total unrecognized compensation cost related to non-vested stock options and restricted stock, which is expected to be recognized over a weighted-average period of 3.0 years. The weighted average fair value (computed using the Black-Scholes option pricing model) of options granted under the stock option plans during the six months ended June 30, 2006 was $3.00 per share.

        The total stock-based compensation cost recognized in income for the three and six month periods ended June 30, 2006 was as follows:

 
  Three months
ended June 30,
2006

  Six months
ended June 30,
2006

 
  (in thousands, except per share data)

Stock-based compensation expense by type of award:            
  Employee stock options   $ 3,707   $ 6,882
  Employee stock purchase plan     367     734
  Restricted stock     536     1,153
  Tax effect        
   
 
Total   $ 4,610   $ 8,769
   
 

        Adopting SFAS 123(R) increased pre-tax loss by $4.1 million and $7.6 million during the three and six months ended June 30, 2006, respectively, and decreased basic and diluted earnings per share by $0.03 and $0.06 during the three and six months ended June 30, 2006, respectively.

19



Prior to the adoption of SFAS 123(R)

        The pro forma information required under SFAS 123 for the three and six months ended June 30, 2005 was as follows:

 
  Three months
ended June 30,
2005

  Six months
ended June 30,
2005

 
 
  As restated

  As restated

 
 
  (in thousands, except per share data)

 
Basic and diluted              
Net loss:              
  As reported   $ (73,948 ) $ (36,904 )
  Add: Stock-based employee compensation expense included in reported net income, net of related tax effects     412     822  
  Deduct: Total compensation expense determined under fair value based method for all awards, net of related tax effects     (5,739 )   (12,017 )
   
 
 
Pro forma net loss   $ (79,275 ) $ (48,099 )
   
 
 
Basic and diluted loss per share:              
  As reported   $ (0.64 ) $ (0.32 )
  Pro forma   $ (0.70 ) $ (0.42 )

5.     (LOSS) EARNINGS PER SHARE

        Basic earnings per share is computed by dividing net income available to holders of common stock by the weighted average number of shares of the Company's common stock outstanding during the period. Diluted earnings per share is determined by adjusting net income as reported by the effect of dilutive securities and increasing the number of shares by potentially dilutive shares of common stock outstanding during the period. Potentially dilutive shares of common stock consist of employee stock options, a written call option, unvested restricted stock, warrants, convertible subordinated notes and unvested acquisition-related stock options.

        The following is a summary of the calculation of basic and diluted earnings per share:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands, except per share data)

 
Numerator:                          
Net loss for basic EPS computation   $ (21,443 ) $ (73,948 ) $ (32,078 ) $ (36,904 )

Effect of dilutive securities 7/8% convertible subordinated notes

 

 


 

 


 

 


 

 


 
   
 
 
 
 
Net loss adjusted for dilutive securities   $ (21,443 ) $ (73,948 ) $ (32,078 ) $ (36,904 )
   
 
 
 
 
Denominator:                          
Shares used to compute basic EPS     120,608     114,880     120,604     114,702  
Dilutive common stock equivalent shares                  
   
 
 
 
 
Shares used to compute diluted EPS     120,608     114,880     120,604     114,702  
   
 
 
 
 
Loss per share—basic and diluted   $ (0.18 ) $ (0.64 ) $ (0.27 ) $ (0.32 )
   
 
 
 
 

20


        Potentially dilutive shares are excluded from the computation of diluted net loss per share in which their effect would be anti-dilutive for the three and six months ended June 30, 2006 and 2005. These shares included 7.3 million stock options with exercise prices below market, 15.6 million stock options with exercise prices above market, 0.8 million restricted shares, and conversion of subordinated notes of 11.5 million as of June 30, 2006, included 1.2 million stock options with exercise prices below market, 17.6 million stock options with exercise prices above market, and conversion of subordinated notes of 16.9 million as of June 30, 2005.

        At June 30, 2006, the Company's 7/8% convertible subordinated notes ("Notes") outstanding were ineligible for conversion into shares of common stock. For each $1,000 of aggregate principal amount of notes converted, the Company will deliver 42.0345 shares of common stock, if the Company's closing stock price exceeds $26.17 as of the last trading day of the immediately preceding fiscal quarter. At March 31, 2006, the closing price of the Company's common stock was below $26.17. In September 2004, the EITF reached a consensus related to EITF No. 04-8 "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" which requires contingently convertible debt instruments to be treated as "if converted" for the purpose of computing the earnings per share.

        The Company entered into convertible bond hedge and call option transactions to reduce the potential dilution from conversion of the notes. Both the bond hedge and call option transactions may be settled at the Company's option either in cash or net shares and expire on March 1, 2008. Using the treasury stock method, under Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS128"), during periods when the average price of the Company's stock is above the specified strike prices of the bond hedge and call option transaction, the effect to the diluted earnings per share calculation would be a decrease to the denominator for the bond hedge transaction, and an increase to the denominator for the call option transaction. However, only the potential dilutive effect with respect to the call option transaction is included in the Company's diluted earnings per share calculations. The convertible bond hedge, under SFAS 128, is always anti-dilutive.

        During the three and six months ended June 30, 2006 and 2005, the average price of the Company's stock was below the specified strike prices of both the convertible bond hedge and call option transactions and, therefore, there was no dilutive effect.

6.     COMPREHENSIVE LOSS

        The reconciliation of net loss to comprehensive loss for the three and six months ended June 30, 2006 and 2005 is as follows:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands)

 
Net loss   $ (21,443 ) $ (73,948 ) $ (32,078 ) $ (36,904 )
Unrealized gain (loss) on investments     (21 )   (8 )   2     (8 )
Foreign currency translation     1,766     (81 )   4,163     (556 )
   
 
 
 
 
Total comprehensive loss   $ (19,698 ) $ (74,037 ) $ (27,913 ) $ (37,468 )
   
 
 
 
 

7.     CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

        Cash and cash equivalents consist of instruments with maturities of three months or less at the date of purchase. There were no available for sale securities included in cash and cash equivalents at June 30, 2006 or December 31, 2005. Short-term investments, consisting entirely of available-for-sale securities, were $10.3 million and $13.3 million at June 30, 2006 and December 31, 2005, respectively.

21



These available for sale securities consist of government-backed notes, commercial paper, floating rate corporate bonds and fixed income corporate bonds. These investments are recorded at fair value. Any unrealized holding gains or losses are reported as a component of comprehensive other income. Realized gains and losses are reported in earnings.

        The Company accepts bank notes receivable with maturity dates of between three and six months from its customers in China in the normal course of business. The Company may discount these notes with banking institutions in China. A sale of these notes is reflected as a reduction of cash and cash equivalents or short-term investments and the proceeds of the settlement of these notes are included in cash flows from operating activities in the consolidated statement of cash flows. There were no bank notes sold during the three and six months ended June 30, 2006.

        Any notes that have been sold are not included in the Company's consolidated balance sheets as the criteria for sale treatment established by Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140"), have been met. Under SFAS 140, upon a transfer, the transferor or entity must de-recognize financial assets when control has been surrendered and the transferee obtains control over the assets. In addition, the transferred assets have been isolated from the transferor, beyond the reach of its creditors, and the transferee has the right, without conditions or constraints, to pledge or exchange the assets it has received.

8.     RESTRICTED CASH AND INVESTMENTS

        At June 30, 2006 the Company had short-term restricted cash and investments of $71.1 million and long-term restricted cash of $2.9 million. At December 31, 2005 the Company had short-term restricted cash and investments of $53.7 million, and long-term restricted cash of $0.3 million. These amounts are primarily comprised of restricted cash held to collateralize commercial and standby letters of credit.

        The Company issues standby letters of credit primarily to support international sales activities outside of China. When the Company submits a bid for a sale, often the potential customer will require that the Company issue a bid bond or a standby letter of credit to demonstrate its commitment through the bid process. In addition, the Company may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to twelve months from date of issuance without being drawn by the beneficiary thereof. Finally, the Company may issue commercial letters of credit in support of purchase commitments.

9.     ACCOUNTS AND NOTES RECEIVABLE

        The Company accepts bank notes and commercial notes receivable from its customers in China in the normal course of business. The notes are typically non-interest bearing, with maturity dates between three and six months. Bank notes are included in short-term investments. Commercial notes receivable available for sale were $11.6 million and $2.1 million at June 30, 2006 and December 31, 2005, respectively. The Company may discount these notes with banking institutions in China. A sale of these notes is reflected as a reduction of notes receivable and the proceeds of the settlement of these notes are included in cash flows from operating activities in the consolidated statement of cash flows. Any notes that have been sold are not included in the Company's consolidated balance sheets as the criteria for sale treatment established by SFAS No. 140, "Accounting for Transfers and Services of Financial Assets and Extinguishment of Liabilities," has been met. There were no notes receivable sold during the three and six months ended June 30, 2006 and 2005.

        In August 2005, the Company entered into a Committed Receivables Purchase Agreement ("Agreement") with a commercial bank, whereby the Company may sell up to $100.0 million of its eligible accounts receivable, as defined in the Agreement. The Agreement contains provisions

22



customary in transactions of this nature including certain commitment fees. During the three and six months ended June 30, 2006, no receivables have been sold pursuant to provisions of the Agreement, and the Company recorded commitment fees of $0.3 million.

10.   INVENTORIES

        As of June 30, 2006 and December 31, 2005, total inventories consisted of the following:

 
  June 30,
2006

  December 31,
2005

 
  (in thousands)


Raw materials

 

$

72,554

 

$

70,608
Work-in-process     38,898     27,582
Finished goods     296,038     270,374
Inventories at customer sites without contracts     47,525     57,391
   
 
Total inventories   $ 455,015   $ 425,955
   
 

11.   SALE OF BUSINESS

Marvell Technology Group Ltd.:

        In February 2006, the Company sold substantially all of the assets and selected liabilities of its semiconductor design business division to Marvell Technology Group Ltd. ("Marvell"). The Company received $20.0 million in cash and an additional $4.0 million in cash was paid by Marvell to an escrow account and will be received by the Company in August 2007 in the absence of a material breach of the original contractual terms. The Company may also receive an additional $16.0 million from Marvell if certain defined milestones are achieved before September 30, 2006.

        The assets sold include the assets related to the prior acquisition of Advanced Communications Devices Corporation in 2001, and other system-on-chip semiconductors. The net book value of assets sold was $2.9 million, and the Company incurred transaction costs of approximately $0.6 million.

        In connection with the sale of assets, the Company has entered into a supply agreement with Marvell. Pursuant to the supply agreement, the Company has agreed to purchase chipsets supplied by Marvell for a period of five years. These chipsets will be included in certain handset products designed and manufactured by the Company.

        As of June 30, 2006, the $4.0 million in cash held in escrow was recorded in other assets. The net proceeds received of $23.4 million were allocated between the assets sold and the supply agreement, in the amounts of $2.9 million and $20.5 million, respectively. The value allocated to the supply agreement is included in other current and long-term liabilities, and will be amortized in proportion to the quantities of chipsets purchased under the supply agreement over the next five years. As of June 30, 2006, approximately $1.0 million has been amortized against cost of sales.

        The Company considered whether or not the sale of the semiconductor design business constituted a discontinued operation, as defined by Statement of Financial Accounting Standard No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). Due to the Company's continuing involvement with the disposed business, as it has committed to purchase product from Marvell and assist in the development of future products, the requirements for presentation as a discontinued operation have not been met.

23


12.   GOODWILL AND INTANGIBLE ASSETS

        As of June 30, 2006 and December 31, 2005, goodwill was $3.1 million, the entire amount of which was allocated to the service operating segment. As of June 30, 2006 and December 31, 2005, intangible assets consisted of the following:

 
  June 30,
2006

  December 31,
2005

 
 
  (in thousands)

 
Intangible assets:              
Existing technology   $ 39,530   $ 39,530  
  Less accumulated amortization     (24,815 )   (21,702 )
   
 
 
    $ 14,715   $ 17,828  
   
 
 
Customer relationships   $ 57,220   $ 57,220  
  Less accumulated amortization     (15,328 )   (12,037 )
   
 
 
    $ 41,892   $ 45,183  
   
 
 
Supplier relationships   $ 5,300   $ 5,300  
  Less accumulated amortization     (4,417 )   (3,092 )
   
 
 
    $ 883   $ 2,208  
   
 
 
Trade names   $ 4,940   $ 4,940  
  Less accumulated amortization     (3,162 )   (2,496 )
   
 
 
    $ 1,778   $ 2,444  
   
 
 
Non-compete agreement   $ 10,800   $ 10,800  
  Less accumulated amortization     (4,500 )   (3,150 )
   
 
 
    $ 6,300   $ 7,650  
   
 
 
Total intangible assets   $ 65,568   $ 75,313  
   
 
 

        Amortization expense was $4.8 million and $6.8 million for the three months ended June 30, 2006 and 2005, respectively, and was $9.7 million and $13.7 million for the six months ended June 30, 2006 and 2005, respectively. The estimated aggregate amortization expense for intangibles for each of the five years from the year ended December 31, 2007 through the year ended December 31, 2011 is $16.0 million, $12.7 million, $6.9 million, $5.1 million and $5.1 million, and is $10.6 million thereafter.

        The weighted average amortization period for each class of unamortized identifiable intangible assets include the following:

 
  Weighted Average Life
 
  (in years)

Technology   2.4
Customer relationships   6.4
Supplier relationships   0.3
Trade names   1.3
Non-compete   2.3
   
Total   3.4

24


13.   LONG-TERM INVESTMENTS

        The Company's investments are as follows:

 
  June 30,
2006

  December 31,
2005

 
  (in thousands)

Cellon International   $ 13,500   $ 8,000
Restructuring Fund No. 1         1,538
Global Asia Partners L.P.     1,700     1,700
Fiberxon Inc.     3,000     3,000
Immenstar     2,000     2,000
Matsushita Joint Venture         465
GCT SemiConductor     3,000     3,000
Xalted Networks     3,302     3,000
Infinera     1,902     1,902
Others     1,420     1,418
   
 
Total   $ 29,824   $ 26,023
   
 

Cellon International

        In September 2001, the Company invested $2.0 million in Cellon International Holdings Corporation ("Cellon") with additional investments of $3.0 million each in April and December 2002. Cellon designs wireless terminals and related technology for handset manufacturers and private distributors. In November 2005, the Company and Cellon entered into an agreement under which the Company received consideration in the form of preferred stock and warrants of Cellon valued at $5.5 million in exchange for the transfer of fixed assets with a net book value of $3.0 million, a facilities lease and a workforce in place consisting of 156 employees. This transaction was completed on May 31, 2006 and a gain on sale of assets of $2.5 million was recorded in other income. As of June 30, 2006, with the additional shares obtained in the purchase transaction, the Company had an 11% ownership interest in Cellon. This investment is accounted for under the cost method, and its carrying value has been evaluated for possible impairment based on the achievement of business objectives and milestones, the financial condition and prospects of the Company and other relevant factors.

        In May 2006, the Company has also entered into a Development Service Agreement with Cellon in which $5.0 million was prepaid in exchange for future product development. Cellon will pay the Company a royalty if certain technology shared by the Company to Cellon is used in products developed and sold through November 2007. Approximately $1.3 million of the prepaid has been consumed in the three months ended June 30, 2006.

Matsushita Joint Venture

        In December 2005 the parties agreed to dissolve the partnership. A final distribution was made in April, 2006 that did not materially exceed the carrying value of the investment.

Restructuring Fund No. 1

        During the first quarter of fiscal 2002, the Company invested $2.0 million in Restructuring Fund No. 1, a venture capital investment limited partnership established by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANK CORP. SOFTBANK America Inc., an entity affiliated with SOFTBANK CORP., is a significant stockholder of the Company. The fund focuses on leveraged buyout investments in companies in Asia undergoing restructuring or bankruptcy procedures. The fund has a separate management team, and none of the Company's employees are employed by the fund. The Company accounts for this investment under the equity method of accounting. The Company received a cash distribution of approximately $0.7 million in March 2006 and an additional cash

25



distribution of $1.5 million in May, 2006 and reduced the carrying value of the investment accordingly. Income of $0.7 million in excess of our carrying value has been recognized in other income. There were no cash distributions during the three or six months ended June 30, 2005. The fund is in the process of dissolving and will make a final cash distribution, if any, during the second half of 2006.

Xalted Networks

        In May 2005 and August 2005, the Company invested $2.0 million and $1.0 million, respectively, in Xalted Networks ("Xalted"). In March 2006 the Company invested an additional $0.3 million in Xalted. Xalted is a development stage company providing telecommunication operator customers with a comprehensive set of network systems, software solutions and service offerings. The Company has a 10% ownership interest in Xalted and accounts for the investment under the cost method. As of June 30, 2006, the Company has not recorded any impairment of this investment.

14.   DEBT

        The following represents the outstanding borrowings at June 30, 2006 and December 31, 2005:

 
  June 30,
2006

  December 31,
2005

 
  (in thousands)

Bank loans   $ 122,587   $ 198,826
Long-term debt     274,900     274,900
   
 
Total debt     397,487     473,726
Long-term debt     274,900     274,900
   
 
Short-term debt   $ 122,587   $ 198,826
   
 

        Occasionally, the Company issues short-term notes payable to its vendors, in lieu of trade accounts payable. None were issued during the six months ended June 30, 2006. The payment terms are normally three to nine months and are typically non-interest bearing. At June 30, 2006, the Company had loans with various banks totaling $122.6 million with interest rates of 5.02% per annum. These bank loans mature during 2006 and 2007, and are included in short-term debt. There are no significant covenants associated with these loans.

        On March 12, 2003, the Company completed an offering of convertible subordinated notes due March 1, 2008 to qualified buyers pursuant to Rule 144A under the Securities Act of 1933. During 2005, a portion of the notes was extinguished. As of June 30, 2006 and December 31, 2005, $274.6 million of these notes were outstanding. The notes bear interest at a rate of 7/8% per annum and are convertible into the Company's common stock at a conversion price of $23.79 per share and are subordinated to all present and future senior debt of the Company. Holders of the notes may convert their notes only if: (i) the price of the Company's common stock issuable upon conversion of a note reaches a specified threshold, (ii) specified corporate transactions occur, or (iii) the trading price for the notes falls below certain thresholds. At the initial conversion price, each $1,000 principal amount of notes will be convertible into 42.0345 shares of common stock. Expenses associated with the convertible subordinated notes issuance have been recorded in other long-term assets and are being amortized over the life of the notes.

        The Company has entered into a convertible bond hedge and call option transaction. The convertible bond hedge allows the Company to purchase 11.5 million shares of its common stock at $23.79 per share from the other party to the agreement. The written call option allows the holder to purchase 11.5 million shares of the Company's common stock from the Company at $32.025 per share. Both the bond hedge and call option transactions may be settled at the Company's option either in cash or net shares and expire on March 1, 2008.

26



        The Company recorded these instruments at cost, and their carrying value at June 30, 2006 equaled their original cost as adjusted for amendments related to the early extinguishment of debt. The convertible bond hedge and call option transactions are expected to reduce the potential dilution from conversion of the notes. The options have been included in stockholders' equity in accordance with the guidance in EITF No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock."

        From March 15, 2006 until June 1, 2006, the Company was in technical non-compliance with loan covenants of the convertible subordinated notes due to the untimely filing of the annual report on Form 10-K for the year ended December 31, 2005. The Company is currently in compliance with all covenants.

15.   WARRANTY OBLIGATIONS AND OTHER GUARANTEES

        The Company provides a warranty on its equipment and handset sales for a period generally ranging from one to three years from the time of final acceptance. Very rarely, the Company has entered into arrangements to provide limited warranty services for periods longer than three years. The longest of such warranty periods is ten years. The Company provides for the expected cost of product warranties at the time that revenue is recognized based on an assessment of past warranty experience.

        Warranty obligations are as follows:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
  (in thousands)

 
Beginning of period   $ 68,702   $ 57,862   $ 76,720   $ 46,596  
Accruals for warranties issued during the period     2,821     9,479     11,769     32,568  
Settlements made during the period     (7,415 )   (8,755 )   (24,381 )   (20,578 )
   
 
 
 
 
Balance at end of period   $ 64,108   $ 58,586   $ 64,108   $ 58,586  
   
 
 
 
 

        During 2005, the Company incurred a special warranty charge for equipment sold to Softbank during 2003 and 2004. Since the agreement to repair these parts exceeds the Company's normal warranty terms, the Company has recorded an additional special warranty charge of $11.7 million for certain asynchronous digital subscriber line ("ADSL") products, $4.0 million primarily related to NetRing equipment and $14.9 million for GEPON equipment. As of June 30, 2006, the repairs have been completed for the ADSL products only.

        Certain of the Company's sales contracts include provisions under which customers would be indemnified by the Company in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to the Company's products. There are no limitations on the maximum potential future payments under these guarantees. The Company has not accrued any amount in relation to these provisions as no such claims have been made and the Company believes it has valid, enforceable rights to the intellectual property embedded in its products.

        The Company issues standby letters of credit primarily to support international sales activities outside of China. When the Company submits a bid for a sale, often the potential customer will require that the Company issue a bid bond or a standby letter of credit to demonstrate its commitment through the bid process. In addition, the Company may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to twelve months from the date of issuance without being drawn by the beneficiary thereof. The Company may issue commercial letters of credit in support of purchase commitments.

27



16.   COMMITMENTS AND CONTINGENCIES

Leases:

        The Company leases certain facilities under non-cancelable operating leases that expire at various dates through 2011. The minimum future lease payments under the leases at June 30, 2006 were as follows:

 
  June 30,
2006

 
  (in thousands)

1 year   $ 15,579
2 year     10,028
3 year     6,623
4 year     4,479
5 year and after     787
   
Total minimum lease payments   $ 37,496
   

        Rent expense for the three and six months ended June 30, 2006 were $4.9 million and $10.1 million, respectively. Rent expense for the three and six months ended June 30, 2005 were $5.4 million and $11.0 million, respectively.

        In connection with the sale of assets to Marvell, the Company has entered into a supply agreement with Marvell. Pursuant to the supply agreement, the Company has agreed to purchase chipsets supplied by Marvell for a period of five years. These chipsets will be included in certain handset products designed and manufactured by the Company.

Investment commitments:

        As of June 30, 2006, the Company had invested a total of $2.6 million in Global Asia Partners L.P., a fund anticipated to grow to $10 million. The fund was formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. The Company has a commitment to invest up to a maximum of $5.0 million. The remaining amount is due at such times and in such amounts as shall be specified in one or more future capital calls to be issued by the general partner.

        The Company has also entered into various earnout agreements related to certain acquisitions, which are subject to the completion of performance milestones.

Contractual obligations and commercial commitments:

        As of June 30, 2006 the Company's obligations under contractual obligations and commercial commitments are as follows:

 
  June 30, 2006
Payments Due by Period

 
  Total
  Less than
1 year

  1-3 years
  3-5 years
 
  (in thousands)

Bank loans   $ 122,587   $ 122,587   $   $
Convertible subordinated notes   $ 274,600   $   $ 274,600   $
Interest payable on subordinated notes   $ 4,806   $ 2,403   $ 2,403   $
Standby letters of credit   $ 91,935   $ 89,048   $ 2,887   $
Purchase commitments   $ 791,947   $ 786,359   $ 5,588   $

28


Bank loans

        At June 30, 2006, the Company had loans with various banks totaling $122.6 million each with an interest rate of 5.02% per annum. These bank loans mature during 2006 and first quarter of 2007 and are included in short-term debt.

Convertible subordinated notes

        The Company's convertible subordinated notes, due March 1, 2008, bear interest at a rate of 7/8% per annum, payable semiannually on May 1 and September 1, are convertible into the Company's common stock at a conversion price of $23.79 per share and are subordinated to all the Company's present and future senior debt. The principal amount of the notes is due only at maturity of the notes.

Standby letters of credit:

        The Company issues standby letters of credit primarily to support international sales activities outside of China. When the Company submits a bid for a sale, often the potential customer will require that the Company issue a bid bond or a standby letter of credit to demonstrate its commitment through the bid process. In addition, the Company may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to twelve months from the date of issuance without being drawn by the beneficiary thereof. The Company may issue commercial letters of credit in support of purchase commitments.

Purchase commitments

        The Company is obligated to purchase raw materials and work-in-process inventory under various orders from various suppliers, all of which should be fulfilled without adverse consequences material to its operations or financial condition. As of June 30, 2006, total open commitments under these purchase orders extending beyond one year were approximately $5.6 million. Additionally, the Company has agreed to purchase from Marvell certain chip-sets that will be included in the Company's PAS handsets through 2011.

Intellectual property:

        Certain sales contracts include provisions under which customers would be indemnified by us in the event of, among other things, a third party claim against the customer for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. The Company has not accrued any amounts in relation to these provisions as no such claims have been made and the Company believes it has valid enforceable rights to the intellectual property embedded in its products.

Litigation:

Securities Class Action Litigation

        Beginning in October 2004, several shareholder class actions alleging federal securities violations were filed against the Company and various officers and directors. The actions have been consolidated in United States District Court for the Northern District of California. The lead plaintiffs in the case filed a First Amended Consolidated Complaint on July 26, 2005. The First Amended Complaint alleged violations of the Securities Exchange Act of 1934, and was brought on behalf of a putative class of shareholders who purchased the Company's stock after April 16, 2003 and before September 20, 2004. On April 13, 2006, the lead plaintiffs filed a Second Amended Complaint adding new allegations and extending the end of the class period to October 6, 2005. In addition to the Company defendants, the plaintiffs are also suing Softbank. Plaintiffs' complaint seeks recovery of damages in an unspecified amount.

29



        This litigation is in its preliminary stage, and its outcome cannot be predicted. Management of the Company believes that the claims are not meritorious. Nevertheless, an adverse outcome in the litigation, if it occurred, could have a material adverse effect on the Company's results of operations, financial position and cash flows.

Governmental Investigations

        The Company has received notice of a formal inquiry by the staff of the Securities & Exchange Commission ("SEC") into certain aspects of the Company's financial disclosures during prior reporting periods and certain other issues. In addition, in December 2005, the U.S. Embassy in Mongolia informed the Company that it had forwarded to the Department of Justice ("DOJ") allegations that an agent of the Company's Mongolia joint venture had offered payments to a Mongolian government official in possible violation of the Foreign Corrupt Practices Act (the "FCPA"). In April 2006, the Company became aware that an agent of the Company may have made an offer to pay an Indian government official in possible violation of the FCPA. In June 2006, the Company became aware that a former employee of the Company may have made a payment to a Thailand government official in possible violation of the FCPA. The Company, through its Audit Committee, authorized an independent investigation into these matters, and the Company has been in contact with the DOJ and SEC regarding the investigation. At this time, the Company cannot predict when any governmental inquiry will be completed or what the outcome of any governmental inquiry will be.

IPO Allocation

        On October 31, 2001, a complaint was filed in United States District Court for the Southern District of New York against the Company, some of the Company's directors and officers and various underwriters for our initial public offering. Substantially similar actions were filed concerning the initial public offerings for more than 300 different issuers, and the cases were coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92 for pretrial purposes. In April 2002, a consolidated amended complaint was filed in the matter against the Company, captioned In re UTStarcom, Initial Public Offering Securities Litigation, Civil Action No. 01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 through undisclosed improper underwriting practices concerning the allocation of IPO shares in exchange for excessive brokerage commissions, agreements to purchase shares at higher prices in the aftermarket and misleading analyst reports. Plaintiffs seek unspecified damages on behalf of a purported class of purchasers of the Company's common stock between March 2, 2000 and December 6, 2000. The Company's directors and officers have been dismissed without prejudice pursuant to a stipulation. On February 19, 2003, the Court granted in part and denied in part a motion to dismiss brought by defendants including the Company. The order dismisses all claims against the Company except for a claim brought under Section 11 of the Securities Act of 1933, which alleges that the registration statement filed in accordance with the IPO was misleading. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including the Company, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including the Company). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On February 15, 2005, the Court issued an order granting conditional preliminary approval of the settlement. On August 31, 2005, the Court entered an order confirming its preliminary approval of the settlement. On April 24, 2006, the Court conducted a fairness hearing in connection with the motion for final approval of the settlement. The Court did not issue a ruling on the motion for final approval at the fairness hearing. The settlement remains subject to a number of conditions, including final court approval. The total amount of the loss associated with the above litigation is not determinable at this time. Therefore, the Company is unable to currently estimate the loss, if any, associated with the litigation.

30



Starent Patent Infringement Litigation

        We have sued Starent Networks Corporation ("Starent") for patent infringement in the U.S. District Court for the Northern District of California. On March 22, 2004, we filed our Complaint. On June 3, 2004, we served our Complaint on Starent. On July 30, 2004, Starent filed and served its answer and counterclaims. On August 30, 2004, we served and filed our Amended Complaint. In our Amended Complaint, we assert that Starent infringes a UTStarcom patent through the manufacture, use, offer for sale, and sale of Starent's ST-16 Intelligent Mobile Gateway. We seek, inter alia, compensatory damages and injunctive relief. Starent filed its answer to the Amended Complaint and counterclaims on September 17, 2004. In its answer and counterclaims, Starent denies our allegations and seeks a declaration that the patent-in-suit is not infringed, is invalid, and is unenforceable. The Court held an initial case management conference on November 2, 2004. On February 17, 2005, we filed a motion for a preliminary injunction against Starent's use, sale, and offer for sale of products having the infringing feature. The Court held a hearing on our motion on May 11, 2005 and denied our motion on June 17, 2005. On June 30, 2005, the Court held a hearing on the proper meaning or construction of the claims of the patent-in-suit and entered an order construing these claims on August 11, 2005. On September 20, 2005, Starent filed a motion for summary judgment of non-infringement and UTStarcom filed a motion for summary judgment that Starent is estopped from asserting invalidity and unenforceability. On October 4, 2005, Starent filed a motion to strike UTStarcom's final infringement contentions. On November 7, 2005, Starent's motion to strike was denied. Oral argument on UTStarcom's estoppel motion and Starent's non-infringement motion was held on November 8, 2005. On December 6, 2005, the Court granted Starent's motion for summary judgment of non-infringement. On December 12, 2005, the Court dismissed as moot Starent's counterclaims for declaratory relief based on invalidity or unenforceability of the asserted patent. On February 2, 2006, the Court entered judgment in favor of Starent. On March 2, 2006, UTStarcom filed a notice of appeal. The case is currently pending at the Court of Appeals for the Federal Circuit. UTStarcom believes that the appeal will be successful, nonetheless, UTStarcom has indicated that it believes that an adverse judgment will not have a material adverse effect on the business, financial condition, or results of its operations.

        On February 16, 2005, we filed a second suit against Starent for patent infringement in the U.S. District Court for the Northern District of California. On May 6, 2005, we served the Complaint on Starent. In the Complaint, we assert that Starent infringes a UTStarcom patent through Starent's development and testing of a software upgrade for its customer's installed ST-16 Intelligent Mobile Gateways. We seek, inter alia, declaratory and injunctive relief. Starent filed its answer and counterclaims on May 31, 2005, denying our allegations and seeking a declaration that the patent-in-suit is not infringed, is invalid, and is unenforceable. On June 16, 2005, we filed a motion to strike Starent's affirmative defense and dismiss Starent's counterclaim alleging inequitable conduct. Pursuant to the parties' stipulation, we withdrew our motion to strike and, on July 27, 2005, Starent filed an amended answer and counterclaims, which pleaded its inequitable conduct allegations with more specificity. UTStarcom filed its answer to the amended counterclaims on August 10, 2005. The initial case conference was scheduled for March 31, 2006, but was vacated by the Judge, who instead issued a scheduling order and referred the case to the Magistrate on March 29, 2006. On May 17, 2006, the Magistrate issued a new scheduling order to accommodate the parties' request. On June 30, 2006, the Magistrate amended the earlier order and issued second new scheduling order to accommodate the parties' request. The litigation is in the preliminary stage and its outcome cannot be predicted. However, UTStarcom believes that its claims are meritorious. Nonetheless, UTStarcom has indicated that it believes that any adverse judgment on Starent's counterclaims will not have a material adverse effect on the business, financial condition, or results of its operations.

31


Fenner Investments Patent Infringement Litigation

        On January 6, 2005, Fenner Investments, Ltd. ("Fenner") filed suit against the Company and co-defendants Juniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., Lucent Technologies, Inc., and Cisco Systems, Inc. in the U.S. District Court for the Eastern District of Texas. On May 17, 2005, Fenner amended its complaint to add as defendants Ericsson Inc., Ericsson AB, Telefonaktiebolaget LM Ericsson, and Alcatel USA Inc. The suit alleged that certain products infringe two Fenner patents, U.S. Patent Nos. 5,561,706 and 6,819,670, for which Fenner sought compensatory and injunctive relief. On March 20, 2006, the Company agreed to settle Fenner's claims against it for $1.4 million. As part of this settlement, Fenner agreed to dismiss with prejudice its claims against the Company. On April 27, 2006, the court ordered the dismissal with prejudice of Fenner's claims against the Company as a result of the settlement.

Telos Technology, Inc. Arbitration

        On November 22, 2005, Telos Technology, Inc. ("Telos") filed a formal Demand for Arbitration against the Company with JAMS/Endispute in San Jose, California. The Demand for Arbitration seeks the release of $2.4 million from an escrow fund. Pursuant to the terms of an Asset Purchase Agreement dated April 21, 2004 and an Escrow Agreement dated May 19, 2004 between the parties, the escrow fund was created to indemnify the Company from certain losses associated with the Company's purchase of assets from Telos. Telos asserts that the Company's refusal to release the escrowed funds constitutes a breach of its contractual obligations under the agreements. Telos also seeks attorneys' fees, costs and prejudgment interest in the amount of $500,000. In its response to the Demand for Arbitration, the Company denied that it had breached its contractual obligations. In January 2006, Telos moved for summary judgment on its claim and the Company opposed the motion. On March 6, 2006, the Arbitrator issued a ruling denying Telos' motion. In light of the ruling on summary judgment, Telos dismissed its claim for arbitration without prejudice, subject to its contractual right to dispute any future disbursement from escrow.

Telos Technology, Inc. Litigation

        On November 22, 2005, plaintiffs Telos Technology, Inc., Telos Technology (Canada), Inc., Telos Technology (Bermuda) Ltd., and Telos Engineering Limited (collectively, the "Telos Plaintiffs") filed a Complaint against the Company in the Superior Court of California, County of Santa Clara. The Complaint alleges five causes of action, including breach of contract, breach of the implied covenant of good faith and fair dealing, fraudulent inducement, intentional misrepresentation and negligent misrepresentation, all of which arise from the Asset Purchase Agreement between the parties dated April 21, 2004. The Telos Plaintiffs assert that the Company breached the express and implied terms of the Asset Purchase Agreement and made representations to the Telos Plaintiffs during negotiations that it never intended to fulfill. The Telos Plaintiffs seek at least $19 million in damages, unspecified punitive damages and attorneys' fees. On December 28, 2005, the Telos plaintiffs filed a First Amended Complaint, alleging substantially the same facts and seeking the same relief. On January 26, 2006, the Company filed a demurrer with respect Telos' three tort causes of action. On March 23, 2006, the Court sustained the Company's demurrer to all three tort causes of action and allowed Telos thirty days to amend its complaint. On April 12, 2006, Telos filed a Second Amended Complaint, alleging substantially the same facts and seeking the same relief as in the First Amended Complaint. On May 12, 2006, the Company filed an Answer to the Second Amended Complaint, denying all material factual allegations asserted by the Telos Plaintiffs. Discovery is underway, and no trial date has been set.

32



Cell Communication Ltd. Arbitration

        On October 27, 2005, the Company received notice of a demand for arbitration filed against it by Cell Communication Ltd. of Nigeria. The demand was filed in the London Court of International Arbitration ("LCIA"). In its Amended Claim, Cell Communication claims 'general' damages of $26.6 million and 'special' damages of $15 million (alternatively $41 million general damages) in connection with alleged failures of products purchased from Telos Technology, whose assets have been acquired by the Company.

        An arbitrator has been selected by the LCIA. The arbitrator ordered the determination of certain preliminary issues as to whether the claims made by Cell Communication are irrecoverable as a matter of English law. There was a hearing on May 26, 2006 in respect of these preliminary issues. On June 13, 2006, the arbitrator issued a partial award in which he addressed several issues. Among them, the arbitrator adopted the Company's position that liability in this matter is limited to the amount of the purchase price paid by Cell Communication. The purchase price is not agreed but the Company believes it is less than $5 million. Cell Communication is also required to replead its 'general' damages claim. No further directions have been given nor has a date for the substantive hearing been scheduled. The Company intends to deny all liability, and believes it has meritorious defenses.

Other

        The Company is a party to other litigation matters and claims that are normal in the course of operations, and while the results of such litigation matters and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material adverse impact on its financial position or results of operations.

17.   SEGMENT REPORTING

        The Company has organized its business into five operating units, (i) Broadband Infrastructure, (ii) Wireless Infrastructure, (iii) Handsets, (iv) Personal Communications Division ("PCD"), and (v) Service. Each operating unit represents its own reporting segment and each operating unit is responsible for its own worldwide production and sales management.

        Effective July 1, 2006, the Company combined the Broadband Infrastructure and the Wireless Infrastructure segments into a newly created Network Solutions segment, as that is the basis on which management will manage the business going forward.

        The Company currently evaluates operating performance of and allocates resources to the reporting segments based on segment gross profit. Cost of sales and direct expenses in relation to productions are assigned to the reporting segments. Corporate headquarters expenses and non-operating items are not allocated to the segments. The accounting policies used in measuring segment assets and operating performance are the same as those used by corporate and are consistently applied across all segments.

33



        Summarized below are the Company's segment sales revenue and gross profit for the three and six months ended June 30, 2006 and 2005, respectively.

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
          
  2005
          
  2006
          
  2005
          
 
 
   
   
  As restated

   
   
   
  As restated

   
 
 
  (in thousands)

 
Sales by Segment                                          
  Broadband Infrastructure   $ 44,674   8 % $ 56,644   8 % $ 101,830   9 % $ 382,951   24 %
  Wireless Infrastructure     113,680   21 %   152,925   21 %   214,113   19 %   262,362   16 %
  PCD     266,247   49 %   342,263   48 %   589,242   52 %   657,815   40 %
  Handsets     107,069   19 %   143,879   20 %   206,088   17 %   271,962   17 %
  Service     17,476   3 %   24,048   3 %   34,444   3 %   46,553   3 %
   
 
 
 
 
 
 
 
 
    $ 549,146   100 % $ 719,759   100 % $ 1,145,717   100 % $ 1,621,643   100 %
   
 
 
 
 
 
 
 
 
 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  Gross
Profit %

  2005
  Gross
Profit %

  2006
  Gross
Profit %

  2005
  Gross
Profit %

 
 
   
   
  As restated

   
   
   
  As restated

   
 
 
  (in thousands)

 
Gross profit by Segment                                          
  Broadband Infrastructure   $ 4,852   11 % $ 16,739   30 % $ 27,809   27 % $ 180,796   47 %
  Wireless Infrastructure     54,240   48 %   45,964   30 %   103,757   48 %   75,634   29 %
  PCD     12,322   5 %   15,990   5 %   26,755   5 %   29,682   5 %
  Handsets     32,894   31 %   20,800   14 %   64,493   31 %   35,339   13 %
  Service     4,978   28 %   12,645   53 %   8,926   26 %   28,111   60 %
   
 
 
 
 
 
 
 
 
    $ 109,286   20 % $ 112,138   16 % $ 231,740   20 % $ 349,562   22 %
   
 
 
 
 
 
 
 
 

        Assets by segment are as follows:

 
  June 30,
2006

  December 31,
2005

 
  (in thousands)

Long-lived assets            
  Broadband Infrastructure   $ 44,040   $ 47,480
  Wireless Infrastructure     44,488     87,673
  PCD     81,322     1,512
  Handsets     1,234     47,963
  Service     45,241     48,775
   
 
    $ 216,325   $ 233,403
   
 
 
  June 30,
2006

  December 31,
2005

 
  (in thousands)

Total assets            
  Broadband Infrastructure   $ 426,735   $ 471,783
  Wireless Infrastructure     833,040     831,944
  PCD     431,236     420,191
  Handsets     529,526     546,788
  Service     96,281     95,346
   
 
    $ 2,316,818   $ 2,366,052
   
 

34


        Sales data by geographical areas are as follows:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  % of net
sales

  2005
  % of net
sales

  2006
  % of net
sales

  2005
  % of net
sales

 
 
   
   
  As restated

   
   
   
  As restated

   
 
 
  (in thousands)

 
United States   $ 266,319   48 % $ 326,217   45 % $ 591,579   52 % $ 627,993   39 %
China     202,970   37 %   287,330   39 %   397,404   35 %   514,539   31 %
Japan     38,071   7 %   53,033   8 %   85,731   7 %   385,059   24 %
Other     41,786   8 %   53,179   8 %   71,003   6 %   94,052   6 %
   
 
 
 
 
 
 
 
 
Total net sales   $ 549,146   100 % $ 719,759   100 % $ 1,145,717   100 % $ 1,621,643   100 %
   
 
 
 
 
 
 
 
 

        Long-lived assets by geographical areas are as follows:

 
  June 30,
2006

  December 31,
2005

 
  (in thousands)

U.S.   $ 14,961   $ 16,676
China     196,684     204,630
Other     7,680     12,097
   
 
Total long-lived assets   $ 216,325   $ 233,403
   
 

18.   RELATED PARTY TRANSACTIONS

Softbank

        The Company recognized revenue of $33.3 million and $69.4 million for the three and six months ended June 30, 2006, respectively, and revenue of $28.2 million and $326.1 million during the three and six months ended June 30, 2005, as restated, respectively, with respect to sales of telecommunications equipment to affiliates of SOFTBANK CORP. ("Softbank"), a significant stockholder of the Company. Softbank offers asynchronous digital subscriber line ("ADSL") coverage throughout Japan, which is marketed under the name "YAHOO! BB." The Company supports Softbank's fiber-to-the-home service through sales of our carrier class Gigabit Ethernet Passive Optical Network ("GEPON") product as well as the Company's multi-service optical transport product ("NetRing™"). In addition, the Company supports Softbank's new internet protocol television ("IPTV"), through sales of our RollingStream™ product. Included in revenue for the three months ended June 30, 2006 is a fee of $10.0 million charged for the cancellation of orders for wireless infrastructure products. Included in revenue for the six months ended June 30, 2006 is a fee of $17.0 million charged for the cancellation of orders for broadband products and $10.0 million charged for the cancellation of orders for wireless infrastructure products.

        Included in accounts receivable at June 30, 2006 and December 31, 2005 were $39.8 million and $69.3 million, respectively, related to these agreements. Sales to Softbank include a three year service period and a penalty clause if product failure rates exceed a certain level over a seven year period. There were $12.2 million and $16.3 million included in long term deferred revenue with respect to these agreements at June 30, 2006 and December 31, 2005, respectively. Additionally, there were $9.1 million and $6.3 million included in current deferred revenue at June 30, 2006 and December 31, 2005, respectively. As of June 30, 2006 and December 31, 2005, there were $0.3 million and $5.4 million, respectively, included in customer advances related to Softbank agreements.

        During August 2004, the Company entered into several agreements with Japan Telecom Co., Ltd ("JT"), a wholly owned subsidiary of Softbank. These agreements relate to the sale of iAN-8000

35



equipment with specified value and delivery dates, as well as an oral agreement which subsequently converted into specific service contracts to manage a sales promotional program for JT. The Company has determined that the service activities revenue should be recorded net of expected promotional spending.

        Because the Company had not provided these activities in the past and could not estimate the fair value of these services, the Company determined under the guidance of SAB 104 that all revenue related to these agreements could not be recognized until all goods and services were delivered. The Company had delivered and received final acceptance for all equipment contemplated under these agreements in the quarter ended March 31, 2005.

        The promotional services discussed above involved contracting with third party promotional vendors, who in turn, facilitated the marketing and subscriber recruitment for the JT fiber-to-the-home program. During the fourth quarter of 2004, the Company determined that it would end its involvement with the JT promotional program after completion of the contract discussed above. Accordingly, late in the fourth quarter of 2004 and during the first quarter of 2005, the Company either cancelled or assigned to another party all third party contracts with promotional vendors related to the JT contract. Such termination or assignment of all third party promotional agreements, as well as effective satisfaction of the Company's obligations with JT under such agreements, satisfied the revenue recognition criteria for these agreements and as such, the net value of the promotional services and the value of equipment delivered, which totaled $205.4 million, was reported in the quarter ended March 31, 2005.

        The Company also entered into an agreement with JT during the third quarter of 2004 to supply chassis equipment. The equipment shipped under this agreement is considered linked to the iAN-8000 sale noted above and as such, was also deferred until the completion of the above-mentioned promotional activities. The revenue recognition criteria related to the sale of the iAN-8000 equipment was satisfied in the first quarter of 2005 and as such, the revenue related to the chassis sale of $66.5 million was reported in the quarter ended March 31, 2005.

        During the three and six months ended June 30, 2006, sales to Softbank included $1.5 million and $3.3 million, respectively, with regards to telecommunications equipment and services sold to JT. During the three and six months ended June 30, 2005, sales to Softbank included $4.1 million and $276.0 million, respectively, with regards to telecommunications equipment and services sold to JT.

        In June 2006, the Company purchased advertising space and season tickets totaling $0.2 million from a sports franchise owned by Softbank.

        On July 17, 2003, the Company entered into a Mezzanine Loan Agreement with BB Modem Rental PLC ("BB Modem"), an affiliate of SOFTBANK CORP. Under the terms of the agreement, the Company loaned BB Modem $10.1 million at an effective interest rate of 12.01% per annum, for the purpose of investing in a portfolio of ADSL modems and associated modem rental agreements, from Softbank. Softbank will continue to service such modems and modem rental agreements. The Company's loan is subordinated to certain senior lenders of BB Modem, and repayments are payable to the Company over a 42-month period through January 31, 2007, with a substantial portion of the principal amount of the loan schedule to be repaid during the last 16 months of this period. The Company's recourse for nonpayment of the loan is limited to the assets of BB Modem, the account into which subscriber payments are made and its rights under the securitization transaction documents. The value of BB Modem's modems that serve as collateral for the loan may decrease over time and may not be sufficient upon sale to pay the outstanding amounts on the loans. The Company assesses the loan for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company periodically reviews the underlying quality of the asset pool securing the loan to assess whether impairment has incurred and needs to be recorded. During the three and six months ended June 30, 2006, the Company recorded $0.2 million, $0.4 million,

36



respectively, in interest income in respect to this loan. The loan receivable at June 30, 2006 and December 31, 2005 was approximately $5.3 million and $9.0 million, respectively and is included in other current assets.

        As of June 30, 2006, Softbank beneficially owned approximately 12.1% of the Company's outstanding stock.

Acoustek Int'l Corp.

        The Company obtains consulting services from Acoustek Int'l Corp. ("Acoustek"), which employs an individual related to one of the Company's officers. The Company paid to Acoustek $0.1 million during each of the six months ended June 30, 2006 and 2005 for consulting services, and none during the three months ended June 30, 2006 or 2005.

Audiovox

        One of the Company's officers also serves as a director for Audiovox Corporation ("Audiovox"). During the three and six months ended June 30, 2006, the Company purchased approximately $0.2 million and $0.7 million, respectively, of IT services from Audiovox.

Cellon

        In September 2001, the Company invested $2.0 million in Cellon International Holdings Corporation ("Cellon") with additional investments of $3.0 million each in April and December 2002. Cellon designs wireless terminals and related technology for handset manufacturers and private distributors. In November 2005, the Company and Cellon entered into an agreement under which the Company received consideration in the form of preferred stock and warrants of Cellon valued at $5.5 million in exchange for the transfer of fixed assets with a net book value of $3.0 million, a facilities lease and a workforce in place consisting of 156 employees. This transaction was completed on May 31, 2006 and a gain on sale of assets of $2.5 million was recorded in other income. As of June 30, 2006, with the additional shares obtained in the purchase transaction, the Company had an 11% ownership interest in Cellon. This investment is accounted for under the cost method, and its carrying value has been evaluated for possible impairment based on the achievement of business objectives and milestones, the financial condition and prospects of the Company and other relevant factors.

        In May 2006, the Company has also entered into a Development Service Agreement with Cellon in which $5.0 million was prepaid in exchange for future product development. Cellon will pay the Company a royalty if certain technology shared by the Company to Cellon is used in products developed and sold through November 2007. Approximately $1.3 million of the prepaid has been consumed in the three months ended June 30, 2006.

        As of June 30, 2006 the Company had an accounts payable balance of $0.3 million, and an account receivable balance of $0.5 million with Cellon.

Fiberxon

        The Company has an outstanding purchase commitment with Fiberxon, in which the Company has a 7% ownership interest, to purchase component parts for optical networking products. Purchases from Fiberxon totaled $0.2 million and $0.4 million during the three and six months ended June 30, 2006, respectively. Purchases from Fiberxon totaled $3.1 million and $8.1 million during the three and six months ended June 30, 2005, respectively and the Company had $0.4 million and $0.3 million in accounts payable to Fiberxon at June 30, 2006 and December 31, 2005, respectively.

37



Immenstar

        The Company has an outstanding purchase commitment with Immenstar, in which the Company owns Series A preferred stock, to purchase component parts. Purchases from Immenstar totaled $0.5 million during the three and six months ended June 30, 2006. The Company had $0.2 million accounts payable balance at June 30, 2006.

Matsushita Joint Venture

        In July 2002, the Company entered into a joint venture agreement with Matsushita Communication Industrial Co., Ltd. to jointly design and develop, manufacture and sell telecommunication products. The Company had a 49% ownership interest in the joint venture company. In December 2005, the partners agreed to dissolve the joint venture, which was completed by June 30, 2006. As of December 31, 2005, the Company had a receivable of $0.1 million.

Global Asia Partners L.P.

        Global Asia Partners L.P. is a venture capital fund formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. The general partner of this fund is also a sales agent of the Company. Between June 2002 and April 2005, the Company has invested a total of $2.6 million in the fund. As of June 30, 2006 and December 31, 2005, the Company has 49% of the outstanding partnership units.

Org, Inc.

        As of June 30, 2006, the Company had a 49% ownership in Global Asia Partners L.P. which in turn was a significant shareholder in Org, Inc. During the three and six months ended June 30, 2006, the Company had sales of $0.1 million and $0.3 million to Org, Inc. During the three and six months ended June 30, 2005 the Company had sales of $0.2 million to Org, Inc. As of December 31, 2005, the Company had $0.2 million receivable, and $0.1 million deferred revenue. As of June 30, 2006 there was no receivable or deferred revenue with Org, Inc.

Spacetime

        In January, 2005 the Company formed a joint venture with two other parties to provide mobile communication, broadband and IP related value added services in Mongolia. The operations of the joint venture are consolidated into the financial statements of the Company. In the first quarter of 2006, the Company decided to terminate the joint venture arrangement and wrote off the remaining net assets, of approximately $4.7 million. (See Note 23) As of June 30, 2006 and December 31, 2005, the Company has $0.3 million included in related party receivables and $0.3 million in long term debt related to one of the joint venture partners, Spacetime Golden Communication Technology USA, Inc.

Xalted Networks

        The Company received purchase orders from Xalted Networks, in which the Company owns preferred stock, totaling approximately $1.3 million for telecommunications equipment that is for product not typically sold by the Company to other customers. The Company is charging a ten percent procurement fee to Xalted for obtaining and reselling these products. The equipment was delivered but revenue has not been recognized as the revenue recognition process had not been completed.

19.   RESTRUCTURING COSTS

        In 2005 the Company incurred $35.3 million in expenses in relation to the restructuring plan actions, primarily consisting of (i) $15.2 million related to severance payments (ii) $14.5 million in asset

38



impairments primarily related to the write-off of equipment and licenses associated with discontinued products, which are included in operating expenses and (iii) $5.6 million in inventory write-down associated with discontinued products. Included in severance is a $1.8 million non-cash reversal of a housing allowance accrual in China. As of June 30, 2006 and December 31, 2005, a total of 1,595 employees were terminated or placed in the workforce reduction programs pursuant to the plan.

        A summary of the restructuring accrual related to the 2005 charge during the six months ended June 30, 2006, is as follows:

 
  December 31,
2005
Balance

  Cash
payment

  Non-cash
settlement

  June 30,
2006
Balance

 
  (in thousands)

Broadband                        
  Severance payments   $ 50   $ (50 ) $   $

Handsets

 

 

 

 

 

 

 

 

 

 

 

 
  Severance payments     29     (29 )      
  Exit cost     350             350

Corporate

 

 

 

 

 

 

 

 

 

 

 

 
  Severance payments     207     (207 )      
  Exit cost     579         (183 )   396

Summary Totals

 

 

 

 

 

 

 

 

 

 

 

 
  Severance payments     286     (286 )      
  Exit cost     929         (183 )   746
   
 
 
 
Total   $ 1,215   $ (286 ) $ (183 ) $ 746
   
 
 
 

20.   OTHER INCOME AND EXPENSES:

        The other income (expense) balances in the three and six months ended June 30, 2006 and 2005 are comprised of the following items:

 
  Three months
ended
June 30,

  Six months
ended
June 30,

 
 
  2006
  2005
  2006
  2005
 
 
  (in millions)

 
Foreign exchange gains (losses)   $ 2.9   $ (6.8 ) $ 5.7   $ (14.6 )
Japan consumption tax refund         4.8         6.0  
Chinese government financial subsidy     0.2         0.8     0.5  
Dividend income     0.7         0.7      
Gain of sale of asset     2.5         2.5      
Gain on debt extinguishment         11.1         11.1  
Other     0.6     (0.2 )   0.8     (1.0 )
   
 
 
 
 
Total   $ 6.9   $ 8.9   $ 10.5   $ 2.0  
   
 
 
 
 

21.   CREDIT RISK AND CONCENTRATION

        During the three months ended June 30, 2006 and 2005 no customer accounted for greater than 10% of net sales. In the six months ended June 30, 2006 one customer accounted for approximately 13% of net sales. For the six months ended June 30, 2005 one customer accounted for approximately

39



20% of net sales. As of June 30, 2006 no customer accounted for greater than 10% of accounts receivable, while one customer accounted for 13% of accounts receivable as of December 31, 2005.

        Approximately 28% and 33% of the Company's net sales during the three months ended June 30, 2006 and 2005, respectively, and approximately 27% and 33% of the Company's net sales during the six months ended June 30, 2006 and 2005, respectively, were to entities affiliated with the government of China. Accounts receivable balances from these China government affiliated entities or state owned enterprises were $232.0 million and $268.8 million, respectively, as of June 30, 2006 and December 31, 2005. The Company extends credit to its customers in China generally without requiring collateral. In global sales outside of China, the Company often requires letters of credit from its customers. The Company monitors its exposure for credit losses and maintains allowances for doubtful accounts.

        Approximately 37% and 39% of the Company's sales for the three months ended June 30, 2006 and 2005, respectively, and approximately 35% and 31% of the Company's sales for the six months ended June 30, 2006 and 2005, respectively, were made in China. Accordingly, the political, economic and legal environment, as well as the general state of China's economy, may influence the Company's business, financial condition and results of operations. The Company's operations in China are subject to special considerations and significant risks not typically associated with companies in the United States. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected by, among other things, changes in the political, economic and social conditions in China, and by changes in governmental policies with respect to laws and regulations, changes in China's telecommunications industry and regulatory rules and policies, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation.

        Approximately 7% and 8% of the Company's sales for the three months ended June 30, 2006 and 2005, respectively, and approximately 7% and 24% of the Company's sales for the six months ended June 30, 2006 and 2005, respectively, were made in Japan. Accordingly, the political, economic and legal environment and the general state of Japan's economy may influence the Company's business, financial condition and results of operations.

22.   INCOME TAX ASSETS AND LIABILITIES

        In establishing its deferred income tax assets and liabilities, the Company makes judgments and interpretations based on the enacted tax laws and published tax guidance applicable to its operations as well as the amount and jurisdiction of future taxable income. The Company records deferred tax assets and liabilities and evaluates the need for valuation allowances to reduce the deferred tax assets to realizable amounts. We expect to maintain a full valuation allowance on our net deferred tax assets in China, the United States, and other countries until an appropriate level of profitability that generates taxable income is sustained or until we are able to develop tax strategies that would enable us to conclude that it is more likely than not that a portion of our deferred tax assets will be realizable. Any reversal of valuation allowances will favorably impact our results of operations in the period of the reversal.

        Income tax expense was $4.7 million and $0.2 million for the three months ended June 30, 2006 and 2005, respectively. Income tax expense was $7.5 million and $7.9 million for the six months ended June 30, 2006 and 2005, respectively. The Company's 2006 annual effective tax rate is estimated to be negative 17%. There are two primary reasons for the negative 17% effective tax rate. First, the Company has not provided any tax benefit on the forecasted current year losses incurred and tax credits generated in the United States and other countries, because management believes that it is more likely than not that the tax benefit associated with these losses will not be realized. Also, the Company continues to accrue tax expense in jurisdictions where the Company has been historically profitable. Estimates of the annual effective tax rate at the end of the interim periods are based on

40



evaluations of possible future events and transactions and may be subject to subsequent refinement or revision.

        As of December 31, 2005, the U.S. net operating loss carryforwards ("NOLs") were $12.2 million and expire in varying amounts between 2015 and 2025. As of December 31, 2005, state NOL carryforwards were $73.3 million and expire in varying amounts between 2015 and 2025. As of December 31, 2005 the Company also had NOL carryforwards in China of approximately $65.6 million that will expire in 2010.

        The company's income tax return for the 2003 tax year is currently under audit by the Internal Revenue Service. The Company is also under audit by China tax authorities for the 2003 to 2005 tax years.

23.   VARIABLE INTEREST ENTITIES

        The Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46 ("FIN 46"). FIN 46 requires that if an entity is the primary beneficiary of a variable interest entity ("VIE"), the assets, liabilities, and results of operations of the VIE should be included in the consolidated financial statements of the entity.

        During the fourth quarter of 2005, the Company provided an interest free, $12.4 million loan to a party in China as seed capital for a venture organized to participate in providing technical service, networking technology, and equipment to the emerging market for IPTV products in China. The loan is partially secured by an indirect ownership interest in the venture, is payable in 10 years and may be called early without penalty. As a result of the foregoing, and the fact that the venture's continuing viability is heavily dependent on the further provision of network and terminal equipment by the Company, the Company has determined that the venture is a VIE and that the Company is the primary beneficiary of the venture. Therefore, this venture is consolidated into the Company's results as of June 30, 2006. This VIE had insignificant revenue during the three and six months ended June 30, 2006, and had net losses of $0.7 million and $1.4 million during the three and six months ended June 30, 2006. The consolidation of this VIE represented $17.7 million and $18.9 million of the total assets of the Company as of June 30, 2006 and December 31, 2005. The creditors of this VIE have no recourse to the Company.

        In the first quarter of 2005, the Company invested in an additional entity, which is considered a VIE where the Company is the primary beneficiary and does not hold a majority voting interest. The company was established to install, develop and operate a PAS network in Mongolia. The creditors of this VIE have no recourse to the Company. In December 2005, the U.S. Embassy in Mongolia informed the Company that it had forwarded to the Department of Justice allegations that an agent of the joint venture had offered payments to a Mongolian government official, in possible violation of the Foreign Corrupt Practices Act. The Audit Committee authorized an independent investigation into the matter. As a result of the investigation, the Company wrote off $1.2 million of intangibles and established a $2.6 million VAT liability at December 31, 2005. The investigation is still ongoing. The consolidation of this entity resulted in a $6.0 million increase in both total assets and total liabilities and equity as of December 31, 2005. In the first quarter of 2006, the Company decided to terminate the joint venture arrangement and wrote off the remaining net assets, of approximately $4.7 million.

24.   RECENT ACCOUNTING PRONOUNCEMENTS

        In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109" (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that the Company recognize in the financial statements the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The

41



provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect, if any, of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on our consolidated financial statements.

25.   SUBSEQUENT EVENT

The 2006 Equity Incentive Plan

        The 2006 Equity Incentive Plan (the "2006 Plan") was adopted by the Board of Directors on June 6, 2006 and was approved by the Company's stockholders on July 21, 2006. The 2006 Plan provides for the grant of the following types of incentive awards: (i) stock options, (ii) stock appreciation rights, (iii) restricted stock, (iv) restricted stock units, (v) performance shares and performance units, and (vi) and other stock or cash awards (each, an "Award," collectively, "Awards"). Those who are eligible for Awards under the 2006 Plan include employees, directors and consultants who provide services to the Company and its affiliates.

        The maximum aggregate number of shares that may be awarded and sold under the 2006 Plan is 4,500,000 shares plus (i) any shares that have been reserved but remain unissued under the 1997 Plan, 2001 Plan, and 2003 Plan (the "Prior Plans") as of July 21, 2006, and (ii) any shares subject to stock options or similar awards granted under the Prior Plans that expire or become exercisable without having been exercised in full and shares issued pursuant to awards granted under the Prior Plans that are forfeited to or repurchased by the Company. As of July 31, 2006, 4,055,214 shares that had been reserved but remain unissued under the Prior Plans, may be issued under the 2006 Plan. The 2006 Plan replaces the 1997 Plan, the 2001 Plan, and the 2003 Plan, and no further awards will be granted pursuant to the Prior Plans.

        The Board of Directors or the Compensation Committee of the Board administers the 2006 Plan (the "Administrator"). Subject to the terms of the 2006 Plan, the Administrator has the sole discretion to select the employees, consultants, and directors who will receive Awards, determine the terms and conditions of Awards, and to interpret the provisions of the 2006 Plan and outstanding Awards.

        Awards granted under the 2006 Plan are generally not transferable, and all rights with respect to an Award granted to a participant generally may be exercised during a participant's lifetime only by the participant; provided, however, that with the Administrator's approval, a participant may (i) transfer an Award to a participant's spouse or former spouse pursuant to a court-approved domestic relations order which relates to the provision of child support, alimony payments or marital property rights, or (ii) transfer an Award by gift to or for the benefit of the participant's immediate family.

        In the event of a change of control of the Company, each outstanding Award will be assumed or an equivalent option or right substituted by the successor corporation or a parent or subsidiary of the successor corporation. In the event that the successor corporation, or the parent or subsidiary of the successor corporation, refuses to assume or substitute for the Award, the participant will fully vest in and have the right to exercise all of his or her outstanding options or stock appreciation rights, including shares as to which such Awards would not otherwise be vested or exercisable, all restrictions on restricted stock will lapse, and, with respect to restricted stock units, performance shares and performance units, all performance goals or other vesting criteria will be deemed achieved at target levels and all other terms and conditions met. In addition, if an option or stock appreciation right is not assumed or substituted for in the event of a change of control, the Administrator will notify the participant in writing or electronically that the option or stock appreciation right will be fully vested and exercisable for a period of time determined by the Administrator in its sole discretion, and the option or stock appreciation right will terminate upon the expiration of such period.

42



ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

        This Report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These statements are based on information that is currently available to management. We intend such forward-looking statements to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of complying with those provisions. The forward-looking statements include, without limitation, those concerning the following: our expectations as to the nature of possible trends; our expectations regarding continued growth in our business and operations; our expectations regarding fluctuations in gross profit; our plans regarding payment of cash dividends; our expectations regarding recognition of certain compensation costs; our expectations regarding receipt of funds associated with the Marvell transaction; our plans regarding legal proceedings; our expectations regarding the effect of legal proceedings; our expectations regarding the functionality, performance and features of our products; our expectation regarding Softbank's continued service of certain modems and modem rental agreements; our expectations regarding the vacancy of the offices of Chief Executive Officer and Chairman of the Board and planned replacements thereto; our plans and expectations regarding relationships with vendors and suppliers, including Marvell and Cellon; our expectations regarding the future source and costs of integrated circuits; our plans regarding the use of financial instruments to hedge against certain foreign currency exchange rate risks; our plans regarding the use of derivative financial instruments for speculative trading purposes; our plans regarding the discounting of certain bank notes and commercial notes; our expectations regarding our ability to raise funds; our plan regarding the sale of accounts receivable to Citibank, N.A.; our expectations regarding our right to intellectual property embedded in our products; our expectations regarding the effect of market risks on our operating results; our plans to implement measures to remediate material weaknesses; our expectations regarding the effectiveness of remediation measures; our plans to continue to review internal controls; our expectations regarding competition and the competitive advantages of our competitors; our expectations regarding consolidation of the telecommunications industry; our expectations regarding the development and introduction of new products; our plans and expectations regarding growth management; our plans to reinvest cost savings derived from employee terminations; our expectations regarding the importance of hiring and retaining of key personnel and qualified employees; our expectation regarding the adoption of environmental, health and safety laws by countries world-wide; our expectations regarding the effect of the Sarbanes-Oxley Act on our corporate governance and disclosure practices; our expectation regarding the expenses associated with compliance with the Sarbanes-Oxley Act; our expectations regarding the maturation of the PAS market and corresponding decrease in PAS subscriber growth; our expectations regarding our ability to offset the decline in PAS sales through pursuing other products; our expectations regarding our annual effective tax rate; our expectations regarding the sufficiency of credit facilities, short-term investments, lines of credit, cash and cash equivalents to meet our needs for our operations and planned restructuring activities for the next twelve months; our expectations regarding our ability to receive licenses for our products; our expectation that our business, financial condition and results of operations will continue to be significantly influenced by the political, economic, legal and social environment in China and other international markets, including Japan; our expectations regarding the nature of political, economic and legal reform in China; our expectations regarding the continued importance of the Chinese market for our technologies and development; our expectations regarding the impact of our receiving the license to sell GSM and CDMA handsets in China on our ability to meet future market demands; our expectations regarding subscriber growth; our expectations regarding global expansion of sales outside of China; our plans regarding improvement of our internal supply chain and inventory management processes; our expectations regarding the reliability of stock-based compensation valuation models and the impact of SFAS 123R; our expectations regarding the importance of sales in China to

43



our operating results; and our expectations regarding our ability to implement and enhance our administrative infrastructure. Additional forward-looking statements may be identified by the words "anticipate," "expect," "believe," "intend," "will," and similar expressions, as they relate to us or our management, or by the words "designed," "intended" and similar expressions, as they relate to our products and services. Investors are cautioned that these forward-looking statements are inherently uncertain. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the "Factors Affecting Future Operating Results" section of this Form 10-Q. We do not guarantee future results and undertake no obligation to update the forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-Q.

RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS

        In December 2005, we discovered two previously unknown side letter agreements that were provided to a customer in India. The side letter agreements obligated us to deliver a variety of software bug fixes, features, updates and upgrades for no additional consideration, and, contrary to our policy, these side letter agreements were withheld from our financial management and the Company's independent registered public accounting firm. As a result, neither management nor our independent registered public accounting firm was able to properly evaluate their effect on the recognition of revenue under contracts with this customer. The discovery of these side letter agreements prompted an investigation by independent legal counsel that was ordered by and under the direction of the Audit Committee of the Company's Board of Directors.

        As a result of the independent review conducted for the Audit Committee of the Board of Directors, we identified accounting errors that impacted certain of our previously issued financial statements. We have determined that our previously issued financial statements and related financial information for the years ended December 31, 2004 and 2003, the corresponding quarterly periods therein, and the first three quarterly periods of 2005 should be restated to correct accounting errors identified in those periods. The restated financial statements include a number of restatement adjustments, relating to errors in the accounting for revenue, rebate accrual, inventory reserves, and other miscellaneous items. The financial statements for each restated period has been presented in our Annual Report on Form 10-K for the year ended December 31, 2005, as amended. For additional information regarding the restatement adjustments for the three and six months ended June 30, 2005, see Note 2, "Restatement of Financial Statements," of the Notes to the Condensed Consolidated Financial Statements.

EXECUTIVE SUMMARY

        We design, manufacture and sell telecommunications infrastructure, handsets and customer premise equipment and provide services associated with their installation, operation, and maintenance. Our products are sold primarily to telecommunications service providers or operators. We sell an extensive range of products that are designed to enable voice, data and video services for our operator customers and consumers around the world. While historically the vast majority of our sales have been to service providers in China, we have expanded our focus to build a global presence and currently sell our products in several other established and emerging growth markets, which include North America, Japan, India, Central and Latin America, Europe, the Middle East, Africa and Southeast and North Asia.

        We differentiate ourselves with products designed to reduce network complexity, integrate high performance capabilities and allow a simple transition to next generation networks. We design our products to facilitate cost-effective and efficient deployment, maintenance and upgrades.

44



        As of June 30, 2006 we structured the Company across five key business segments:

    1.
    Wireless Infrastructure: Our Wireless Infrastructure segment designs, builds and sells software and hardware products that enable end users, or subscribers, to send and receive voice and data communication in either a fixed or mobile environment by using wireless devices;

    2.
    Broadband Infrastructure: Our Broadband Infrastructure segment designs, builds and sells software and hardware products that enable end users to access high-speed, cost effective fixed data, voice and media communication;

    3.
    Personal Communications Division: Our Personal Communications Division ("PCD") markets, sells and supports handsets other than PAS handsets for markets other than China. Most of our handset sales in 2005 and 2004 were designed and built by other manufacturers, but we anticipate that during 2006 and beyond future sales will include more products built by our Handsets segment;

    4.
    Handsets: Our Handsets segment designs, builds and sells consumer devices that allow customers to access wireless services. Revenues from worldwide PAS handsets and all handset revenues within China are included in this segment; and

    5.
    Services: Our Services segment provides service and support for Wireless Infrastructure and Broadband Infrastructure customers in the areas of planning, deployment, operations and ongoing maintenance.

        Effective July 1, 2006 the Company combined the Broadband Infrastructure and the Wireless Infrastructure segments into a newly created Network Solutions segment.

        Our products within each of these categories, excluding services, include multiple hardware and software subsystems that can be offered in various combinations to suit individual carrier needs. Our system products are based on widely adopted global communications standards and are designed to allow service providers to quickly and cost-efficiently integrate our systems into their existing networks and deploy our systems in new broadband, IP and wireless network rollouts. Our products are also designed for quick and cost-effective transition to future network technologies, enabling our customers to make the best use of their existing infrastructure.

        Our largest market for the six months ended June 30, 2006 and the year ended December 31, 2005 was the United States of America representing 52% and 46% of sales, respectively, for the periods. Prior to 2005, the majority of our sales were to service providers in China. This shift in market concentration and revenue is due to the combination of China's continued slow-down in its economy since the fourth quarter of 2004 and our ability to capture growth opportunities internationally as well as the incremental sales contributed by PCD subsequent to its acquisition in November 2004.

        China has been one of our largest markets and we believe that it will continue to be an important market for our current and future technologies and development for the foreseeable future. However, we have also experienced a maturation of our PAS market in China resulting in our need to have a more diversified product and customer base. We also believe sales generated from China, as a percentage of total sales, may continue to decline as we continue to grow internationally.

        We use subscriber growth statistics to gauge future inventory purchasing requirements as well as to forecast our anticipated revenue growth. We expect this subscriber growth to continue throughout 2006 as China's teledensity rates, or the number of telephones per person in a region, remain low in comparison to that of developed countries.

        The number of competitors for communications access and switching systems and handsets in China has grown in line with China's telecommunications market expansion. This growth has led to competitive pricing pressure, causing average selling prices to decrease during the six months ended

45



June 30, 2006 relative to those in the comparative period in 2005. Our gross profit as a percentage of sales in both our wireless infrastructure and handset product lines have improved despite the decline in sales prices as a result of improved product cost management. We expect gross profit as a percentage of sales to decline during the remainder of the year as cost reduction measures is not likely to keep pace with price reductions.

        We strive to develop products with more advanced features and to enhance the features of our existing products, which, we believe, will enable us to offer our customers more advanced products at higher average selling prices than otherwise would be possible in the future.

        Over the past few years, we have undertaken a significant globalization program and we intend to continue to expand our global sales outside of China in the current year. As we expand, we will continue to improve our internal supply chain and inventory management processes to ensure timely deliveries. We will also continue to implement and enhance our administrative infrastructure to assist with our growth and globalization transformation.

KEY TRANSACTIONS

Marvell Technology Group Ltd.

        In February 2006, we sold substantially all of the assets and selected liabilities of our semiconductor design business division, including the assets related to the prior acquisition of Advanced Communications Devices Corporation ("ACD"), to Marvell Technology Group Ltd. ("Marvell"). We received $20.0 million in cash in February 2006 and will receive an additional $4.0 million in cash in August 2007 currently held in an escrow account in the absence of a material breach of the original contractual terms. We may also receive up to an additional $16.0 million from Marvell if certain defined milestones are achieved before September 30, 2006.

        In connection with the sale of assets, we have entered into a supply agreement with Marvell to purchase chipsets for our handset products over the next five years. The total consideration received of $24.0 million was allocated between the assets sold and the supply agreement, in the amounts of $3 and $21 million, respectively. The value allocated to the supply agreement is included in other current and long-term liabilities, and will be amortized in proportion to the quantities of chipsets purchased under the supply agreement over the next five years. As of June 30, 2006, approximately $1.0 million has been amortized against cost of sales.

        We considered whether or not the sale of the semiconductor design business constituted a discontinued operation, as defined by Statement of Financial Accounting Standard No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). Due to our continuing involvement with the disposed business, as we have committed to purchase product from Marvell and assist in the development of future products, the requirements for presentation as a discontinued operation have not been met.

Stock-based Compensation

        On January 1, 2006, we adopted the provisions of, and account for stock-based compensation in accordance with, Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards No. 123—revised 2004 ("SFAS 123R"), "Share-Based Payment." We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.

        We currently use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of stock-based

46



payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

        We estimate the expected term of options granted by taking the average of the vesting term and the contractual term of the option. We estimate the volatility of our common stock by using implied volatility in market traded options in accordance with SAB 107. We base the risk free interest rate that we use in the option pricing model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. We do not anticipate paying any cash dividends in the foreseeable future and therefore use an expected dividend yield of zero in the option pricing model. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from these estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. All share based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.

        If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods or if we decide to use a different valuation model, the future periods may differ significantly from what we have recorded in the current period and could materially affect our operating income, net income and net income per share.

        The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and employee stock purchase plan shares. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our stock based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. There is not currently a market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.

        The guidance in SFAS 123R is relatively new. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimate of stock-based payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.

Change in Management

        On May 5, 2006, Hong Liang Lu notified us of his resignation as our President, Chief Executive Officer and Chairman of the Board, effective December 31, 2006. Ying Wu, Chief Executive Officer of our China operations and Vice Chairman of the Board, will assume the position of Chief Executive Officer effective January 1, 2007. Thomas Toy, currently an independent director of the Company, will assume the position of Chairman of the Board effective January 1, 2007.

47



RELATED PARTY TRANSACTIONS

Softbank

        We recognized revenue of $33.3 million and $69.4 million for the three and six months ended June 30, 2006, respectively, and revenue of $28.2 million and $326.1 million during the three and six months ended June 30, 2005, as restated, respectively, with respect to sales of telecommunications equipment to affiliates of SOFTBANK CORP. ("Softbank"), a significant stockholder of the Company. Softbank offers asynchronous digital subscriber line ("ADSL") coverage throughout Japan, which is marketed under the name "YAHOO! BB." We support Softbank's fiber-to-the-home service through sales of our carrier class Gigabit Ethernet Passive Optical Network ("GEPON") product as well as our multi-service optical transport product ("NetRing™"). In addition, we support Softbank's new internet protocol television ("IPTV"), through sales of our RollingStream™ product. Included in revenue for the three months ended June 30, 2006 is a fee of $10.0 million charged for the cancellation of order for the wireless infrastructure products. Included in revenue for the six months ended June 30, 2006 is a fee of $17.0 million charged for the cancellation of orders for broadband products and $10.0 million charged for the cancellation of orders for wireless infrastructure products.

        Included in accounts receivable at June 30, 2006 and December 31, 2005 were $39.8 million and $69.3 million, respectively, related to these agreements. Sales to Softbank include a three year service period and a penalty clause if product failure rates exceed a certain level over a seven year period. There were $12.2 million revenue included and $16.3 million included in long term deferred revenue with respect to these agreements at June 30, 2006 and December 31, 2005, respectively. Additionally, there were $9.1 million and $6.3 million included in current deferred revenue at June 30, 2006 and December 31, 2005, respectively. As of June 30, 2006 and December 31, 2005, there were $0.3 million and $5.4 million, respectively, included in customer advance related to Softbank agreements.

        During August 2004, we entered into several agreements with Japan Telecom Co., Ltd ("JT"), a wholly owned subsidiary of Softbank. These agreements relate to the sale of iAN-8000 equipment with specified value and delivery dates, as well as an oral agreement which subsequently converted into specific service contracts to manage a sales promotional program for JT. We have determined that the service activities revenue should be recorded net of expected promotional spending.

        Because we had not provided these activities in the past and could not estimate the fair value of these services, we determined under the guidance of SAB 104 that all revenue related to these agreements could not be recognized until all goods and services were delivered. We had delivered and received final acceptance for all equipment contemplated under these agreements in the quarter ended March 31, 2005.

        The promotional services discussed above involved contracting with third party promotional vendors, who in turn, facilitated the marketing and subscriber recruitment for the JT fiber-to-the-home program. During the fourth quarter of 2004, we determined that we would end our involvement with the JT promotional program after completion of the contract discussed above. Accordingly, late in the fourth quarter of 2004 and during the first quarter of 2005, we either cancelled or assigned to another party all third party contracts with promotional vendors related to the JT contract. Such termination or assignment of all third party promotional agreements, as well as effective satisfaction of our obligations with JT under such agreements, satisfied the revenue recognition criteria for these agreements and as such, the net value of the promotional services and the value of equipment delivered, which totaled $205.4 million, was reported in the quarter ended March 31, 2005.

        We also entered into an agreement with JT during the third quarter of 2004 to supply chassis equipment. The equipment shipped under this agreement is considered linked to the iAN-8000 sale noted above and as such, was also deferred until the completion of the abovementioned promotional activities. The revenue recognition criteria related to the sale of the iAN-8000 equipment was satisfied

48



in the first quarter of 2005 and as such, the revenue related to the chassis sale of $66.5 million was reported in the quarter ended March 31, 2005.

        During the three and six months ended June 30, 2006, sales to Softbank included $1.5 million and $3.3 million, respectively, and during the three and six months ended June 30, 2005, sales to Softbank included $4.1 million and $276.0 million, respectively, with regards to telecommunications equipment and services sold to JT.

        On July 17, 2003, we entered into a Mezzanine Loan Agreement with BB Modem Rental PLC ("BB Modem"), an affiliate of SOFTBANK CORP. Under the terms of the agreement, we loaned BB Modem $10.1 million at an effective interest rate of 12.01% per annum, for the purpose of investing in a portfolio of ADSL modems and associated modem rental agreements, from Softbank. Softbank will continue to service such modems and modem rental agreements. Our loan is subordinated to certain senior lenders of BB Modem, and repayments are payable to us over a 42-month period through January 31, 2007, with a substantial portion of the principal amount of the loan schedule to be repaid during the last 16 months of this period. Our recourse for nonpayment of the loan is limited to the assets of BB Modem, the account into which subscriber payments are made and its rights under the securitization transaction documents. The value of BB Modem's modems that serve as collateral for the loan may decrease over time and may not be sufficient upon sale to pay the outstanding amounts on the loans. We assess the loan for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We periodically review the underlying quality of the asset pool securing the loan to assess whether impairment has incurred and needs to be recorded. During the three and six months ended June 30, 2006, we recorded $0.2 million and $0.4 million, respectively, in interest income in respect to this loan. The loan receivable at June 30, 2006 and December 31, 2005 was approximately $5.3 million and $9.0 million, respectively and is included in other current assets.

        As of June 30, 2006, Softbank beneficially owned approximately 12.1% of our outstanding stock.

Acoustek Int'l Corp.

        We obtain consulting services from Acoustek Int'l Corp. ("Acoustek"), which employs an individual related to one of our officers. We paid to Acoustek $0.1 million during each of the six months ended June 30, 2006 and 2005 for consulting services, and none during the three months ended June 30, 2006 and 2005.

Audiovox

        One of our officers also serves as a director for Audiovox Corporation ("Audiovox"). During the three and six months ended June 30, 2006, we purchased approximately $0.2 million and $0.7 million, respectively, of IT services from Audiovox.

Cellon

        In September 2001, we invested $2.0 million in Cellon International Holdings Corporation ("Cellon") with additional investments of $3.0 million each in April and December 2002. Cellon designs wireless terminals and related technology for handset manufacturers and private distributors. In November 2005, we entered into an agreement with Cellon under which we received consideration in the form of preferred stock and warrants of Cellon valued at $5.5 million in exchange for the transfer of fixed assets with a net book value of $3.0 million, a facilities lease and a workforce in place consisting of 156 employees. This transaction was completed on May 31, 2006 and a gain on sale of assets of $2.5 million was recorded in other income. As of June 30, 2006, with the additional shares obtained in the purchase transaction, we had an 11% ownership interest in Cellon. This investment is accounted for under the cost method, and its carrying value has been evaluated for possible impairment

49



based on the achievement of business objectives and milestones, the financial condition and prospects of the Company and other relevant factors.

        In May 2006, we also entered into a Development Service Agreement with Cellon in which $5.0 million was prepaid in exchange for future product development. Cellon will pay us a royalty if certain technology shared by us to Cellon is used in products developed and sold through November 2007. Approximately $1.3 million of the prepaid has been consumed in the three months ended June 30, 2006.

        As of June 30, 2006 we had an accounts payable balance of $0.3 million, and an account receivable balance of $0.5 million.

Fiberxon

        We have an outstanding purchase commitment with Fiberxon, in which we have a 7% ownership interest, to purchase component parts for optical networking products. Purchases from Fiberxon totaled $0.2 million and $0.4 during the three and six ended June 30, 2006, respectively. Purchases from Fiberxon totaled $3.1 million and $8.1 million during the three and six months ended June 30, 2005, respectively, we had $0.4 million and $0.3 million in accounts payable to Fiberxon at June 30, 2006 and December 31, 2005, respectively.

Global Asia Partners L.P.

        Global Asia Partners L.P. is a venture capital fund formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. The general partner of this fund is also one of our sales agents. Between June 2002 and April 2005, we have invested a total of $2.6 million in the fund. As of June 30, 2006 and December 31, 2005, we have 49% of the outstanding partnership units.

Immenstar

        We have an outstanding purchase commitment with Immenstar, in which we own Series A preferred stock, to purchase component parts. Purchases from Immenstar totaled $0.5 million during the three and six months ended June 30, 2006. We had a $0.2 million accounts payable balance at June 30, 2006.

Matsushita Joint Venture

        In July 2002, we entered into a joint venture agreement with Matsushita Communication Industrial Co., Ltd. to jointly design and develop, manufacture and sell telecommunication products. We had a 49% ownership interest in the joint venture company. In December 2005, the partners agreed to dissolve the joint venture, which was completed by June 30, 2006. As of December 31, 2005, we had a receivable of $0.1 million.

Org, Inc.

        We have a 49% ownership in Global Asia Partners L.P. which in turn is a significant shareholder in Org, Inc. During the three and six months ended June, 2006, we had sales of $0.1 million and $0.3 million to Org, Inc. During the three and six months ended June 30, 2005 we had sales of $0.2 million to Org, Inc. As of December 31, 2005, we had a $0.2 million receivable, and $0.1 million deferred revenue. As of June 30, 2006 there was no receivable or deferred revenue with Org, Inc.

50


Spacetime

        In January 2005, we formed a joint venture with two other parties to provide mobile communication, broadband and IP related value added services in Mongolia. The operations of the joint venture are consolidated into our financial statements. In the first quarter of 2006, we decided to terminate the joint venture arrangement and wrote off the remaining net assets, of approximately $4.7 million. (See Note 23 to the Condensed Consolidated Financial Statements) As of June 30, 2006 and December 31, 2005, we had $0.3 million included in related party receivables, and $0.3 million in long term debt related to one of the joint venture partners, Spacetime Golden Communication Technology USA, Inc.

Xalted Networks

        We received purchase orders from Xalted Networks, in which the Company owns preferred stock, totaling approximately $1.3 million for telecommunications equipment that is for product not typically sold by us to other customers. We are charging a ten percent procurement fee to Xalted for obtaining and reselling these products. The equipment was delivered but revenue has not been recognized as the revenue recognition process had not been completed.

RESULTS OF OPERATIONS

        We manage our business based principally upon product families of five operating segments, (i) Broadband Infrastructure, (ii) Wireless Infrastructure, (iii) PCD, (iv) Handsets, and (v) Service. Broadband infrastructure is primarily comprised of digital subscriber line products, multi-service access node products, fiber optics products and IP-based television. Wireless infrastructure is primarily comprised of the PAS family of core infrastructure equipment and Code Division Multiple Access ("CDMA") family of infrastructure equipment. Our PCD segment markets wireless handsets through international wireless carriers and their agents. The Handsets segment includes global PAS handset sales and sales of CDMA, Wireless Fidelity ("WiFi") and CDMA handset sales in China. We also provide installation and certain maintenance services. For each of the periods presented, total services sales accounted for less than 10% of net sales.

        Effective July 1, 2006 the Company combined the Broadband Infrastructure and the Wireless Infrastructure segments into a newly created Network Solutions segment.

NET SALES

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
          
  2005
          
  2006
          
  2005
          
 
 
   
   
  As restated

   
   
   
  As restated

   
 
 
  (in thousands)

 
Sales by Segment                                          
  Broadband Infrastructure   $ 44,674   8 % $ 56,644   8 % $ 101,830   9 % $ 382,951   24 %
  Wireless Infrastructure     113,680   21 %   152,925   21 %   214,113   19 %   262,362   16 %
  PCD     266,247   49 %   342,263   48 %   589,242   52 %   657,815   40 %
  Handsets     107,069   19 %   143,879   20 %   206,088   17 %   271,962   17 %
  Service     17,476   3 %   24,048   3 %   34,444   3 %   46,553   3 %
   
 
 
 
 
 
 
 
 
    $ 549,146   100 % $ 719,759   100 % $ 1,145,717   100 % $ 1,621,643   100 %
   
 
 
 
 
 
 
 
 

Three months ended June 30, 2006 and 2005

        Net sales decreased by 24% to $549.1 million during the quarter ended June 30, 2006 compared to the same period in 2005. The decline in sales occurred across each operating segment equally, as each segment reported sales were between 21% and 27% lower during the three months June 30, 2006 than

51



the same period in the prior year. Broadband segment sales are concentrated with one customer, Softbank in Japan, and as such fluctuate based upon the magnitude and timing of revenue recognition on certain contracts. The decline in Broadband segment revenue is the result of a decline in sales to Softbank during the three months ended June 30, 2006 as compared to the same period in the prior year. As we have been experiencing in the recent quarters, our PAS/iPAS wireless infrastructure products as well as our PAS/iPAS based handsets in the China market continued to mature which resulted in lower unit demand. In our PCD operating segment, our unit sales during the three months ended June 30, 2006 have remained substantially unchanged from the comparable period in the prior year, but our average price per unit has declined from the prior year. For additional discussion see "Segment Reporting."

Six months ended June 30, 2006 and 2005

        Net sales were $1,145.7 million in the six months ended June 30, 2006, a decrease of 29% from $1,621.6 million in the corresponding period of 2005. The overall decrease in net sales was largely due to a decrease in sales in the Broadband segment of 73%, from June 30, 2005 to June 30, 2006. Broadband segment sales during the six months ended June 30, 2005 included one large transaction with Softbank totaling $271.9 million of revenue on certain agreements entered into with Japan Telecom primarily for iAN8000 product. As we have been experiencing in the recent quarters, our PAS/iPAS wireless infrastructure products and our PAS/iPAS based handsets in the China market continued to mature, which resulted in lower unit demand. This led to a decrease in our wireless infrastructure and handset segment sales of 18% and 24%, respectively, from June 30, 2005 to June 30, 2006. In our PCD operating segment, our unit sales during the six months ended June 30, 2006 did not change significantly from the comparable period in the prior year, but our average price per unit has declined leading to a 10% decline in segment revenue. For additional discussion of our business segments see "Segment Reporting."

        Net sales revenue by geography shifted in comparison to the corresponding period of 2005. Revenue derived from China accounted for approximately 35% of our net sales revenue in the six months ended June 30, 2006, in comparison to approximately 31% in the corresponding period last year. Similarly, revenue derived from the United States accounted for approximately 52% of our net sales revenue in the six months ended June 30, 2006, in comparison to approximately 39% in the corresponding period last year. Due to the completion of a large contract during 2005, revenue from Japan accounted for approximately 7% of our net sales revenue in the six months ended June 30, 2006, in comparison to approximately 24% in the prior year.

GROSS PROFIT

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  Gross
Profit %

  2005
  Gross
Profit %

  2006
  Gross
Profit %

  2005
  Gross
Profit %

 
 
   
   
  As restated

   
   
   
  As restated

   
 
 
  (in thousands)

 
Gross profit by Segment                                          
  Broadband Infrastructure   $ 4,852   11 % $ 16,739   30 % $ 27,809   27 % $ 180,796   47 %
  Wireless Infrastructure     54,240   48 %   45,964   30 %   103,757   48 %   75,634   29 %
  PCD     12,322   5 %   15,990   5 %   26,755   5 %   29,682   5 %
  Handsets     32,894   31 %   20,800   14 %   64,493   31 %   35,339   13 %
  Service     4,978   28 %   12,645   53 %   8,926   26 %   28,111   60 %
   
 
 
 
 
 
 
 
 
    $ 109,286   20 % $ 112,138   16 % $ 231,740   20 % $ 349,562   22 %
   
 
 
 
 
 
 
 
 

        Cost of sales consists primarily of material and labor costs associated with manufacturing, assembly and testing of products, costs associated with installation and customer training, warranty costs, fees to

52



agents, inventory provision and overhead. Cost of sales also includes import taxes and tariffs on components and assemblies. Some components and materials used in our products are purchased from a single supplier or a limited group of suppliers and, in some cases, are subject to our obtaining Chinese import permits and approvals. We also rely on third party manufacturers to manufacture and assemble most of our CDMA handsets.

        Our gross profit has been affected by average selling prices, material costs, product mix and the impact of warranty charges as well as inventory reserves. Our gross profit, as a percentage of net sales, varies among our product families. We expect that our overall gross profit, as a percentage of net sales, will fluctuate from period to period as a result of shifts in product mix, stage of product life cycle, anticipated decreases in average selling prices and our ability to reduce cost of sales.

Three months ended June 30, 2006 and 2005

        Gross profit was $109.3 million, or 20% of net sales, in the three months ended June 30, 2006, compared to $112.1 million, or 16% of net sales as restated, in the corresponding quarter of 2005. The overall gross profit declined in real terms due to a decline in sales and lower gross profit percentages in our Broadband Infrastructure and Service segments, partially offset by improved gross profit percentages in the Wireless Infrastructure and Handset segments. For additional discussion of our business segments see "Segment Reporting."

Six months ended June 30, 2006 and 2005

        Gross profit was $231.7 million, or 20% of net sales, in the six months ended June 30, 2006, compared to $349.6 million, or 22% of net sales as restated, in the corresponding period of 2005. The decline in gross profit dollars primarily reflects an 84% decrease in the Broadband Infrastructure segment. As mentioned previously, revenue from the Broadband Infrastructure segment is concentrated with one customer in Japan and a significant contract was recognized as revenue during the first quarter of 2005. There was no similar-sized transaction in the Broadband Infrastructure segment during the six months ended June 30, 2006. Gross profit percentages improved in the Wireless and Handset segments, declined in the Broadband Infrastructure and Service segments and remained the same in PCD. For additional discussion of our business segments see "Segment Reporting."

OPERATING EXPENSES

        The following table summarizes our operating expenses:

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  % of net
sales

  2005
  % of net
sales

  2006
  % of net
sales

  2005
  % of net
sales

 
 
   
   
  As restated

   
   
   
  As restated

   
 
 
  (in thousands)

 
Selling, general and administrative   $ 82,423   15 % $ 103,009   15 % $ 165,593   14 % $ 212,020   13 %
Research and development     46,743   8 %   65,621   9 %   93,052   8 %   131,881   8 %
In-process research and development       0 %   660   0 %     0 %   660   0 %
Amortization of intangible assets     4,821   1 %   6,776   1 %   9,746   1 %   13,748   1 %
Restructuring costs       0 %   15,127   2 %     0 %   15,127   1 %
   
 
 
 
 
 
 
 
 
Total operating expenses   $ 133,987   24 % $ 191,193   27 % $ 268,391   23 % $ 373,436   23 %
   
 
 
 
 
 
 
 
 

53


SELLING, GENERAL AND ADMINISTRATIVE

Three months ended June 30, 2006 and 2005

        Selling, general and administrative expenses decreased $20.6 million but remained constant as a percentage of net sales during the three months ended June 30, 2006 compared to the same period in 2005, as restated. The decrease in SG&A expenses was primarily due to a $13.7 million decrease in our provision for doubtful accounts compared to the same period in 2005, as restated. In addition, there were reductions in expenses across all entities due to expense controls. Days sales outstanding was 70 days at June 30, 2006 as compared to 106 days at June 30, 2005. The shorter days sales outstanding and resulting decrease in provision for doubtful accounts was the result of improved cash collections in the three months ended June 30, 2006 relative to the comparable period in 2005.

Six months ended June 30, 2006 and 2005.

        SG&A expenses were $165.6 million and $212.0 million in the six months ended June 30, 2006 and 2005, as restated, respectively. SG&A expenses as a percentage of net sales were 14% and 13% the six months ended June 30, 2006 and 2005, as restated, respectively. The decrease in SG&A expenses was primarily due to a $30.5 million decrease in our provision for doubtful accounts compared to the same period in 2005, as restated. In addition, there were reductions in expenses across all entities due to expense controls. Days sales outstanding was 70 days at June 30, 2006 as compared to 106 days at June 30, 2005. The shorter days sales outstanding and resulting decrease in provision for doubtful accounts was the result of improved cash collections in the three months ended June 30, 2006 relative to the comparable period in 2005.

RESEARCH AND DEVELOPMENT

Three months ended June 30, 2006 and 2005

        Research and development ("R&D") expenses were $46.7 million, or 8% of net sales, in the three months ended June 30, 2006, compared to $65.6 million, or 9% of net sales, as restated, in the corresponding period of 2005. The decrease of $18.9 million in absolute dollars of R&D expenses can be primarily attributed to the decreased headcount of approximately 778 employees resulting from restructuring activities and the transfer of engineers as part of the sale of ACD. Personnel related expenses decreased by $5.5 million and facility and depreciation cost decreased by $6.2 million as a result of restructuring and write down of R&D equipment. Additionally, professional services costs decreased by $2.5 million due to a decreased use of consultants.

Six months ended June 30, 2006, and 2005

        R&D expenses were $93.1 million and $131.9 million as restated, or 8% and 8% of net sales, in the six months ended June 30, 2006 and 2005, respectively. In absolute dollars, R&D expenses decreased by $38.8 million, primarily due to a decrease in facility and depreciation costs of $11.8 million as a result of restructuring and write-down of R & D equipment. Also, there was a decrease in personnel expenses, including payroll, payroll taxes and benefits totaling $10.2 million resulting from the decreased headcount as described above. In addition, the decrease in R&D expenses also can be attributed to decreased a professional costs of $6.0 million associated with decreased use of consultants.

IN-PROCESS RESEARCH AND DEVELOPMENT

Three and six months ended June 30, 2006 and 2005

        The $0.7 million charges to in-process research and development ("IPR&D") for the three months ended June 30, 2005, as restated, were related to our acquisition of Pedestal Networks. All charges to

54



IPR&D were based, in part, upon independent valuations. In assessing IPR&D projects, we considered key product characteristics including each product's development stage at the acquisition date, each product's life cycle and each product's future prospects. We also considered the rate at which technology changes in the relevant industry, the industry's competitive environment and the economic market outlook. There have been no IPR&D costs in 2006.

AMORTIZATION OF INTANGIBLE ASSETS

Three and six months ended June 30, 2006 and 2005

        Amortization of intangible assets expenses was $4.8 million and $6.8 million, or 1% and 1% of net sales in the three months ended June 30, 2006 and 2005, as restated, respectively. Amortization of intangible assets expenses were $9.7 million and $13.7 million, or 1% and 1% of net sales in the six months ended June 30, 2006 and 2005, as restated, respectively. The decrease in the amortization of intangible assets for the three and six months ended June 30, 2006 was due to several intangible assets being fully amortized during the preceding twelve months.

RESTRUCTURING COSTS

Three and six months ended June 30, 2006 and 2005

        In the second quarter of the fiscal year 2005, we announced and initiated a restructuring plan to rationalize our cost structure in response to the decline in demand for certain of our products. In addition, the restructuring plan was designed to allow us to reduce break-even revenues for each product line, align investments with key growth opportunities and facilitate the process of globalization.

        During the three and six months ended June 30, 2005, we incurred approximately $15.1 million in operating expenses relating to the restructuring plan actions, primarily consisting of $7.6 million in severance payments, $7.5 million in asset impairments primarily related to the impairment of equipment and licenses associated with discontinued products. Included in the restructuring costs of $15.1 million are non-cash charges of $6.9 million in asset impairments. We made cash payments of $6.3 million for severance and other benefits, and $2.7 million of accrued expenses. As part of the restructuring plan, during the three and six months ended June 30, 2005 we recorded $5.5 million in inventory write-off which was associated with discontinued products. Restructuring expense related to the inventory write-off was included in cost of sales in the Consolidated Statements of Operations.

        During the second half of 2005, we incurred an additional $14.6 million in operating expenses in relation to the restructuring plans. As of December 31, 2005, approximately $1.2 million remained unpaid in accrued expenses, and as of June 30, 2006, approximately $0.7 million remained, primarily relating to remaining lease termination expenses.

INTEREST INCOME

Three months ended June 30, 2006 and 2005

        Interest income was $3.9 million and $1.5 million for the three months ended June 30, 2006 and 2005, respectively. Interest income was generated from cash and short-term investment balances which increased in the three months ended June 30, 2006 as compared to the corresponding period of 2005. The effective interest rate doubled between the two time periods.

Six months ended June 30, 2006 and 2005

        Interest income was $7.5 million and $2.8 million for the six months ended June 30, 2006 and 2005, respectively. Interest income was generated from cash and short-term investment balances which

55



increased in the six months ended June 30, 2006 as compared to the corresponding period of 2005. The effective interest rate doubled between the two time periods.

INTEREST EXPENSE

Three months ended June 30, 2006 and 2005

        Interest expense was $3.2 million and $4.7 million for the three months ended June 30, 2006 and 2005, respectively. The decrease in interest expense for the three months ended June 30, 2006 was attributable to the decrease in short-term debt, which declined from approximately $265.2 million as of June 30, 2005 to approximately $122.6 million as of June 30, 2006.

Six months ended June 30, 2006 and 2005

        Interest expense was $6.7 million and $9.0 million for the six months ended June 30, 2006 and 2005, respectively. The decrease in interest expense for the six months ended June 30, 2006 was attributable to a decrease in short-term borrowings.

OTHER INCOME (EXPENSES)

Three months ended June 30, 2006 and 2005

        Net other income was $6.9 million and $8.9 million for the three months ended June 30, 2006 and 2005, respectively. Net other income for the three months ended June 30, 2006 primarily consisted of $2.9 million of currency exchange and $2.5 million for a gain on sales of assets. For the three months ended June 30, 2005, net other income primarily consisted of an $11.1 million gain recognized on early debt extinguishment and $4.8 million Japan consumption tax refund offset by foreign exchange losses of $6.8 million.

Six months ended June 30, 2006 and 2005

        Net other income was $10.5 million and $2.0 million for the six months ended June 30, 2006 and 2005, respectively. Net other income for the six months ended June 30, 2006 primarily consisted of gains from foreign exchange of $5.7 million and a gain on the sale of an asset of $2.5 million. Net other income for the six months ended June 30, 2005 primarily consisted of an $11.1 million gain recognized on early debt extinguishment and a $6.0 million consumption tax refund in Japan offset by a foreign exchange loss of $14.6 million. Yen-denominated sales and accounts receivable were significantly higher during the six months ended June 30, 2005 as compared to the same period last year. As such, we incurred a $14.6 million unrealized loss in foreign exchange due to the weakened Japanese Yen against the US dollar for the six months ended June 30, 2005.

INCOME TAX EXPENSE

        Income tax expense is based upon a blended effective tax rate based upon our expectation of the amount of income to be earned in each tax jurisdiction and is accounted under the liability method. Deferred income taxes are recognized for the differences between the tax bases of assets and liabilities and their financial statement amounts based on enacted tax rates. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. We expect to maintain a full valuation allowance on our net deferred tax assets in China, the United States, and other countries until an appropriate level of profitability that generates taxable income is sustained or until we are able to develop tax strategies that would enable us to conclude that it is more likely than not that a portion of our deferred tax assets will be realizable. Any reversal of valuation allowances will favorably impact our results of operations in the period of the reversal.

56



        As of December 31, 2005, the U.S. net operating loss carryforwards ("NOLs") were $12.2 million and expire in varying amounts between 2015 and 2025. As of December 31, 2005, state NOL carryforwards were $73.3 million and expire in varying amounts between 2015 and 2025. As of December 31, 2005 the Company also had NOL carryforwards in China of approximately $65.6 million that will expire in 2010.

        Our income tax return for the 2003 tax year is currently under audit by the Internal Revenue Service. The Company is also under audit by China tax authorities for the 2003 to 2005 tax years. The Company provides tax reserves for federal, state and international exposures relating to audit results, tax planning initiatives and compliance responsibilities. The development of these reserves requires judgements about tax issues, potential outcomes and timing, and is a subjective critical estimate. Although the outcome of these tax audits is uncertain, in management's opinion, adequate provisions for income taxes have been made as a result of these reviews. If actual outcomes differ materially from these estimates, they could have a material impact on the Company's results of operations.

Three months ended June 30, 2006 and 2005

        Income tax expense was $4.7 million and $0.2 million for the three months ended June 30, 2006 and 2005, respectively. Our 2006 annual effective tax rate is estimated to be negative 17%. There are two primary reasons for the negative 17% effective tax rate. First, we have not provided any tax benefit on the forecasted current year losses incurred and tax credits generated in the United States and other countries, because management believes that it is more likely than not that the tax benefit associated with these losses will not be realized. Also, we continue to accrue tax expense in jurisdictions where we have been historically profitable. Estimates of the annual effective tax rate at the end of the interim periods are based on evaluations of possible future events and transactions and may be subject to subsequent refinement or revision.

Six months ended June 30, 2006 and 2005

        Income tax expense was $7.5 million and $7.9 million for the six months ended June 30, 2006 and 2005, respectively. In the six months ended June 30, 2005, we recorded an additional tax expense of $9.0 million primarily relating to the valuation of our deferred tax assets in China.

EQUITY IN NET LOSS OF AFFILIATED COMPANIES

Three and six months ended June 30, 2006 and 2005

        Equity in net loss of affiliated companies was $0.6 million and $1.0 million for the three and six months ended June 30, 2005, respectively. The loss in both periods was primarily attributable to the loss recognized from our joint venture investments with Matsushita Communication Industrial Co., Ltd., and Matsushita Electronic Industrial Co., Ltd. There was no equity net loss of affiliated companies during the three and six months ended June 30, 2006 as business operations have been terminated.

SEGMENT REPORTING

        As of June 30, 2006, we managed our business on the basis of our five operating segments, namely Broadband Infrastructure, Wireless Infrastructure, Handsets, PCD, and Service. Each operating segment represents its own reporting segment and each operating segment is responsible for its own production and sales management.

        We currently evaluate operating performance of and allocate resources to the reporting segments based on segment gross profit. Cost of sales and direct expenses in relation to production are assigned to the reporting segments. Corporate headquarters expenses and non-operating items are not allocated

57



to the segments. The accounting policies used in measuring segment assets and operating performance are the same as those used by corporate and are consistently applied across all segments.

        Effective July 1, 2006 we combined the Broadband Infrastructure and the Wireless Infrastructure segments into a newly created Network Solutions segment.

        Summarized below are our segment sales revenue and gross profit for the three and six months ended June 30, 2006 and 2005, respectively.

Broadband Infrastructure

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands)

 
Sales   $ 44,674   $ 56,644   $ 101,830   $ 382,951  
Gross profit   $ 4,852   $ 16,739   $ 27,809   $ 180,796  
Gross profit as a percentage of sales     11 %   30 %   27 %   47 %

        Our largest Broadband Infrastructure customer is Softbank in Japan, representing approximately 44% and 38% of total broadband sales during the three months ended June 30, 2006 and 2005, respectively, and 53% and 80% during the six months ended June 30, 2006 and 2005, respectively. Due to the customer concentration in this segment, revenues fluctuate based upon the magnitude and timing of revenue recognition on certain contracts.

        Broadband Infrastructure net sales during the six months ended June 30, 2005, as restated, included one large transaction with Softbank totaling $271.9 million of revenue on certain agreements entered into with Japan Telecom primarily for the iAN8000 product in 2005. Included in Broadband Infrastructure sales for the six months ended June 30, 2006 are order cancellation fees of $22.6 million and included in cost of sales is a $3.1 million inventory write-down. During the three and six months ended June 30, 2006 we incurred a negative gross profit in China of $0.6 million and $2.7 million, respectively, primarily as a result of a reduction in the realizable value of inventory at customer sites without contracts for products in the RollingStream and GEPON product lines.

Wireless Infrastructure

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands)

 
Sales   $ 113,680   $ 152,925   $ 214,113   $ 262,362  
Gross profit   $ 54,240   $ 45,964   $ 103,757   $ 75,634  
Gross profit as a percentage of sales     48 %   30 %   48 %   29 %

        During the three months ended June 30, 2006, sales of Wireless Infrastructure products declined by 26% compared to the same period in 2005. PAS systems sales declined 41% and now comprise approximately 76% of our Wireless Infrastructure sales compared to 96% during the same period in 2005. The decrease in PAS systems sales was primarily the result of our customers in China transitioning from new system installations to system expansions as PAS/iPAS systems reach product maturity. Included in Wireless Infrastructure sales for the three months ended June 30, 2006, is an order cancellation fee of $10.0 million and included in cost of sales is a $5.0 million prepaid license fee write-down. Sales of products other than PAS systems, including our Moving Media 2000 and Moving Media 6000 products comprised the remaining 17% of sales.

58



        During the six months ended June 30, 2006, Wireless Infrastructure sales declined by 18% compared to the same period in 2005. Sales in China, which is predominately a PAS market for us, decreased by 24% while sales elsewhere increased by 32%. The decline in sales in China has continued since late 2004 as carriers have transitioned from new system installations to system expansions as PAS/iPAS systems reach product maturity.

        We anticipate moderate declines in PAS system spending. We plan to aggressively pursue opportunities for our other technology products in multiple markets, though we do not anticipate that these sales will fully offset the decline in PAS sales through the remainder of 2006.

        Gross profit increased by 18 percentage points in the three months ended June 30, 2006, as compared to the corresponding quarter in 2005 due to a number of factors including: (i) the margins on PAS infrastructure improved due to a shift in product mix towards higher margin cell sites as well as a reduction in product discounts given; (ii) an improvement in inventory management and product quality resulting in a decrease in excess/slow moving inventory write-downs and scrap; and (iii) a decrease in component material costs.

        Gross profit increased by 19 percentage points in the six months ended June 30, 2006, as compared to the corresponding six months in 2005 due to a number of factors, including: (i) the margins on PAS infrastructure improved due to a shift in product mix towards higher margin cell sites as well as a reduction in product discounts given; (ii) an improvement in inventory management and product quality resulting in a decrease in excess inventory write-downs and scrap; and (iii) sales of voice and data networks software totaling $8.6 million which has nearly 100% gross margins.

PCD

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands)

 
Sales   $ 266,247   $ 342,263   $ 589,242   $ 657,815  
Gross profit   $ 12,322   $ 15,990   $ 26,755   $ 29,682  
Gross profit as a percentage of sales     5 %   5 %   5 %   5 %

        Revenue from external customers for the segment decreased 22% during the three months ended June 30, 2006 as compared to the same quarter in 2005. The number of units sold during the three months ended June 30, 2006 was substantially unchanged from the comparable period in the prior year at 1.7 million units. The average sales price per unit declined by approximately 22%, accounting for the decline in sales. During the three months ended June 30, 2006, the sales activities of the PCD division were expanded to include sales of handsets other than PAS in countries other than China that were previously included in the Handset division. This resulted in additional sales of $9.5 million for the segment, and did not have an appreciable effect on total sales or gross profit.

        Historically, PCD has relied upon a limited number of manufacturers to supply its handset products. During the three and six months ended June 30, 2006, one vendor accounted for approximately 26% and 39%, respectively, of PCD purchases. This vendor will continue to supply PCD existing handset models but is selling new models directly to some of our customers. We plan to replace this supplier by introducing more models of our own design and expanding our relationship with other manufacturers, but we still expect to see flat or declining sales during the remainder of 2006 while we make this transition. The percentage of product sourced from this vendor has already declined from the 63% of PCD purchases during 2005. During the three and six months ended June 30, 2006, sales of UTStarcom branded devices increased to approximately 20% and 13%, respectively, from zero in the same periods last year. In addition, two other vendors combined to account for approximately 54% and 47% during the three and six months ended June 30, 2006, respectively.

59



        Gross profit as a percentage of sales was consistent for the three and six month periods ending June 30, 2006 compared to the prior year.

Handsets

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands)

 
Sales   $ 107,069   $ 143,879   $ 206,088   $ 271,962  
Gross profit   $ 32,894   $ 20,800   $ 64,493   $ 35,339  
Gross profit as a percentage of sales     31 %   14 %   31 %   13 %

        Handsets sales declined 26% for the three months ended June 30, 2006 compared to the same period in 2005. Nearly all our handset sales are in China, where we have experienced a decline in volume for our PAS handsets, partially offset by an increase in the per-unit average price. The units sold declined to 2.2 million compared to 3.4 million in the comparable period last year. We believe that the 35% volume decline was primarily attributed to lower demand for our PAS handsets resulting from slower subscriber growth. During the three months ended June 30, 2006, the PAS net subscriber growth in China slowed to 3.0 million from 4.5 million during the comparable period in the prior year as service providers reduced marketing efforts for PAS handsets in anticipation of next generation technology networks.

        We believe the average selling price per unit improved due to a shift in product mix to sales of higher-end models, including our new PAS/GSM dual mode model. This shift in product mix more than offset declining prices of other models due to competitive pricing pressures in the PAS market, which we have experienced in the China telecommunications market since the latter part of 2003. We expect to see cumulative PAS subscriber growth at lower rates in future periods.

        Handset sales declined 24% for the six months ended June 30, 2006 compared to the six months ended June 30, 2005. As noted above, the decrease in net sales was primarily attributable to declining volume in the China telecommunications market. Unit sales declined to 4.4 million for the six months ended June 30, 2006 compared to 6.0 million units in the prior year. The average selling price per unit remained relatively stable due to the offset of competitive pricing pressures in the PAS market with a shift in product mix to sales of higher end models including our new dual mode model.

        Gross profit as a percentage of sales for our handsets segment increased by 17% in the three months ended June 30, 2006, as compared to the corresponding quarter in 2005. A significant portion of the improvement in the gross profit percentage relates to shifting most of our products to the use of chip-sets with greater functionality in PAS handsets that reduce the overall component costs of each unit. Additionally, we have had a shift in product mix towards higher margin products such as our PAS/GSM dual mode and ultra-thin high-end PAS handsets. Additional factors leading to the improvement in gross profit is a reduction in scrap, variances and warranty costs.

        Gross profit as a percentage of sales for our handsets segment increased by 18% in the six months ended June 30, 2006, as compared to the corresponding six months in 2005. A portion of the improvement in the gross profit percentage relates to shifting most of our products to the use of chip-sets with greater functionality in PAS handsets that reduce the overall component costs of each unit. Additionally, we have had a shift in product mix towards higher margin products such as our PAS/GSM dual mode and ultra-thin high-end PAS handsets. Additional factors leading to the improvement in gross profit are a reduction in scrap, variances and warranty costs.

        We believe our Handset segment is positioned to meet future market demand as we were awarded a license to sell both GSM and CDMA handsets in China in July 2005. Additionally, we are focusing on expanding our handset product offering outside of China. However, we do not expect gross profit as a percentage of sales to continue at this level over the remainder of the year as the decline of the price per unit will likely exceed our ability to continue to reduce per-unit costs.

60


Service

 
  Three months ended June 30,
  Six months ended June 30,
 
 
  2006
  2005
  2006
  2005
 
 
   
  As restated

   
  As restated

 
 
  (in thousands)

 
Sales   $ 17,476   $ 24,048   $ 34,444   $ 46,553  
Gross profit   $ 4,978   $ 12,645   $ 8,926   $ 28,111  
Gross profit as a percentage of sales     28 %   53 %   26 %   60 %

        Our Service segment's revenue from external customers decreased by $6.5 million for the three months ended June 30, 2006 as compared to the corresponding quarter last year. Included in service revenue during the three months ended June 30, 2006 is revenue of $3.3 million related to support and service performed for Softbank affiliates compared to $6.4 million during the same period in 2005.

        During the first half of 2006, we focused on the revenue opportunities with respect to support in China. Approximately 477 employees previously providing sales and support services were shifted towards generating revenue from support arrangements, resulting in additional cost of goods sold for the three and six months ended June 30, 2006 of $3.5 million and $6.9 million, respectively, and a corresponding decrease to operating expenses. Additionally, revenues of $2.7 million and $5.3 million from Wireless Infrastructure and $0.2 million and $0.4 million from Broadband segment sales in China were allocated to the Service segment during the three and six months ended June 30, 2006, respectively. The allocation was made on certain completed contracts for which the service element was not separately priced.

        Our Service segment revenue from external customers declined by $12.0 million, or 26%, for the six months ended June 30, 2006 as compared to the corresponding period last year. The Service segments revenue for the six months ended June 30, 2006 included $5.8 million of revenue and gross profit associated with services performed for Softbank and affiliates compared to $19.0 million during the same period in 2005.

LIQUIDITY AND CAPITAL RESOURCES

OPERATING ACTIVITIES

2006

        Net cash provided by operating activities for the six months ended June 30, 2006 was $79.2 million. Operating cash was affected by changes in accounts receivable, customer advances, and accounts payable, and offset by the net loss as well as changes in other current liabilities and inventories.

        The $97.6 million decrease in accounts receivable was attributable to a decline in sales preceding the end of the June 30, 2006 quarter as compared to sales preceding December 31, 2005. Days sales outstanding, when calculated using the preceding quarterly sales, remained constant at 70 days at June 30, 2006 and December 31, 2005. Days sales outstanding lengthened in the Broadband and PCD segments and shortened in the Handset and wireless segments.

        Customer advances increased by $69.3 million for the six months ended June 30, 2006. Customer advances represent cash deposits we have received from our customers for orders that have not yet received final acceptance. Upon subsequent receipt of final acceptances and revenue recognition, customer advances are reduced and revenue and cost of sales is recorded.

        Accounts payable increased by $39.7 million, other current liabilities decreased by $89.5 million and inventory increased by $36.9 million. The decrease in other current liabilities is primarily the result of a decrease in other taxes payable of approximately $19.1 million, a decrease in compensation related

61



costs of approximately $10.2 million, a decrease in accrued warranty costs of approximately $12.6 million, a decrease in accrued contract costs, which relate to purchase of goods and services for which invoices have not been received of approximately $13.5 million and a decrease of approximately $34.1 million in other liabilities.

        Non-cash charges for the six months ended June 30, 2006 included $34.7 million of depreciation and amortization, an $8.8 million of stock compensation expense and a $6.0 million provision for inventory.

2005

        Net cash used in operating activities for the six months ended June 30, 2005 was $139.4 million. Operating cash was primarily affected by changes in accounts receivable, income tax payable and customer advances, offset by changes in payables, inventory, and current and non-current assets.

        The $74.9 million increase, as restated, in accounts receivable was primarily attributable to two factors: (i) incremental sales derived from PCD sales and (ii) longer collection cycles in China which we have been experiencing since late 2004. Days sales outstanding was 170 days, excluding PCD, at June 30, 2005 as compared to 70 days at June 30, 2004. Days sales outstanding was 106 days including PCD at June 30, 2005. The longer days sales outstanding is a direct result of longer collection cycles in China due to the slow-down in the telecommunication industry which has necessitated in a corresponding increase in the provision for doubtful accounts.

        Income tax payable decreased by $140.4 million and customer advances decreased by $225.2 million for the six months ended June 30, 2005, as restated, as compared to December 31, 2004. Customer advances represent cash deposits we have received from our customers for orders that have not yet received final acceptance. Upon subsequent receipt of final acceptances and revenue recognition, customer advances are reduced and revenue and cost of sales are recorded.

        The reduction of customer advances in the six months ended June 30, 2005 was primarily due to the completion of the revenue earning process for most of the agreements with Japan Telecom, Inc. ("JT"), an affiliate of Softbank Corp. as well as the decline in sales and the corresponding cash advances for product sold in China. All cash received from JT in advance of revenue recognition and in advance of spending for promotional activities was reflected as a customer advance in prior periods. Revenue for certain of these agreements has been recognized in the six months ended June 30, 2005, as restated. For additional information, refer to Note 18, "Related Party Transactions," to our condensed consolidated financial statements.

        The decreases in inventory balance of $41.9 million and other current and non-current assets of $58.4 million, as restated, have contributed to our increase in operating cash. In addition, accounts payable increased by $24.8 million, and deferred revenue increased by $19.9 million, as restated, both contributing to the increase in operating cash.

        Non-cash charges for the six months ended June 30, 2005, as restated, included $51.4 million of depreciation and amortization, a $6.7 million loss on asset impairment, a $33.6 million provision for doubtful accounts and a $28.2 million inventory provision excluding $5.5 million write-off of inventory associated with the Restructuring. In the six months ended June 30, 2005, as restated, we recorded an $11.1 million non-cash gain on extinguishment of debt which offsets activities that increase operating cash.

62



INVESTING ACTIVITIES

2006

        Net cash used in investing activities for the six months ended June 30, 2006 totaled $7.2 million. Cash outflows for investing activities, including $12.3 million of additions to property, plant and equipment, $21.8 million of purchases of short-term investments, and $20.0 million in changes to restricted cash. Cash inflows from investing activities included $20.0 million received from the sale of the semiconductor design business division to Marvell Technology Group, Ltd., and $25.6 of proceeds of the sale of short-term investments.

2005

        Net cash provided by investing activities for the six months ended June 30, 2005, as restated, totaling $34.8 million was primarily due to $104.9 million of net proceeds from the purchase and sale of short-term investments. The cash outflow was principally attributable to $23.8 million related to our acquisitions of Giga Telecom, Inc. in the first quarter of 2005, as restated, and Pedestal Networks in the second quarter 2005, as restated, and $46.3 million in purchases of property, plant and equipment.

FINANCING ACTIVITIES

2006

        Net cash used in financing activities was $75.5 million, primarily consisting of a net repayment of short-term borrowings in excess of new borrowings of $77.5 million.

2005

        Net cash used in financing activities was $105.9 million for the six months ended June 30, 2005, as restated. This was primarily due to the net repayment of borrowing of $94.7 million and $15.8 million cash payment in conjunction with an early debt extinguishment.

LIQUIDITY

        Our working capital was $0.9 billion and $1.1 billion at June 30, 2006, and 2005, respectively. This decrease in working capital was primarily due to decrease in accounts receivable, and increases in customer advances and deferred revenue. These are partially offset by smaller accounts payable and short-term debt. Cash and cash equivalents increased to $647.3 million at June 30, 2006 from $350.3 million at June 30, 2005 while short-term investments decreased to $10.3 million at June 30, 2006 from $31.4 million at June 30, 2005.

        Our China sales are generally denominated in local currency. Due to the limitations on converting Renminbi, we are limited in our ability to engage in foreign currency hedging activities in China. We cannot guarantee that fluctuations in foreign currency exchange rates in the future will not have a material adverse effect on revenues from international sales and, correspondingly, on our business, financial condition and results of operations. We have contracts negotiated in Japanese Yen and we maintain a bank account in Japanese Yen for purchasing portions of our inventories and supplies. The balance of this Japanese Yen account at June 30, 2006 was approximately $35.4 million. We may hedge certain Japanese Yen-denominated balance sheet exposures against future movements in foreign currency exchange rates by using foreign currency forward contracts. Gains and losses on these fair value hedges are intended to offset gains and losses from the revaluation of our Japanese Yen-denominated recognized assets and liabilities. In accordance with Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities," we recognize derivative instruments and hedging activities as either assets or liabilities on

63



the balance sheet and measure them at fair value. We do not intend to utilize derivative financial instruments for speculative trading purposes.

        We accept bank notes receivable and commercial notes receivable with maturity dates of between three and six months from our customers in China in the normal course of business. Notes receivable available for sale was $11.6 million and $2.1 million at June 30, 2006 and December 31, 2005, as restated, respectively. We may discount these notes with banking institutions in China. Any notes that have been sold are not included in our consolidated balance sheets as the criteria for sale treatment established by Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140"), have been met.

        In March 2003, we completed an offering of $402.5 million of convertible subordinated notes due March 1, 2008 to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. The notes bear interest at a rate of 7/8% per annum, are convertible into our common stock at a conversion price of $23.79 per share and are subordinated to all of our present and future senior debt. Concurrent with the issuance of the convertible notes, we entered into a convertible bond hedge and a call option transaction with respect to our common stock. Both the bond hedge and call option transactions may be settled at our option either in cash or net shares and expire on March 1, 2008.

        During 2005, we completed exchanges of approximately 5.0 million shares of our common stock and approximately $57.1 million in cash for $127.9 million aggregate principal amount of outstanding notes. As a result of the early extinguishment, we also amended the above convertible bond hedge and call option transactions to reflect the change in principal amount of the underlying notes.

        On August 1, 2005, we entered into a 364-day $100.0 million committed receivables purchase facility with a financial institution. In July 2006 the agreement was extended to the earlier of (i) July 31, 2007, (ii) upon 90 days written notice by the financial institution, or (iii) the occurrence of an event of default. Pursuant to the terms of the receivable purchase facility, we may sell certain receivables arising from the sale of telecommunications equipment to this financial institution. No receivables had been sold, pursuant to this arrangement.

        We believe that our existing credit facilities and cash and cash equivalents, short-term investments and cash from operations will be sufficient to finance our operations and any cash used for planned restructuring activities through at least the next 12 months. As of June 30, 2006, we had cash, restricted cash, short-term investments and restricted short-term investments of $728.7 million and lines of credit totaling $705.5 million, with $565.0 million available for future borrowings. $664.2 million of these facilities expire in 2006 and $61.3 million of these facilities expire in 2007. We are proceeding with the extension or renewal of these credit facilities, however, such renewal is not certain. Of our total cash and short-term investment balance, $504.0 million is held in China where currency exchange controls exist. As a result, our ability to make payments in other jurisdictions could be limited by our ability to move money from China to the other jurisdictions.

        In the event that our current cash balances, future cash flows from operations and current lines of credit are not sufficient to meet our obligations or strategic needs or in the event that market conditions are favorable, we would consider raising additional funds in the capital or equity markets. If additional financing is needed, there can be no assurance that such financing will be available to us on commercially reasonable terms, or at all.

INCOME TAXES

        Certain subsidiaries and joint ventures located in China enjoy tax benefits in China which are generally available to foreign investment enterprises, including full exemption from national enterprise income tax for two years starting from the first profit-making year and/or a 50% reduction in national

64



income tax rate for the following three years. In addition, local enterprise income tax is often waived or reduced during this tax holiday/incentive period. Under current regulations in China, foreign investment enterprises that have been accredited as technologically advanced enterprises are entitled to additional tax incentives. These tax incentives vary in different locales and could include preferential national enterprise income tax treatment at 50% of the usual rates for different periods of time. The tax holidays discussed above are applicable or potentially applicable to CUTS, HUTS, Hangzhou UTStarcom Telecom Co., Ltd. ("HSTC") and UTStarcom China Co., Ltd. ("UTSC"), our active subsidiaries in China, as those entities may qualify as accredited technologically advanced enterprises.

OFF BALANCE SHEET ARRANGEMENTS

        On August 1, 2005, we entered into a committed receivables purchase facility with Citibank, N.A., which provides for the sale of up to $100.0 million of trade accounts receivable of our PCD segment. Sales of the accounts receivables to Citibank, N.A. under this program will result in a reduction of total accounts receivable in our consolidated balance sheet. The remaining accounts receivables not sold to Citibank, N.A. will be carried at their net realizable value, including an allowance for doubtful accounts. We have not sold any receivables pursuant to this facility during 2005 or the first six months of 2006. We believe that available funding under our accounts receivable financing program provides us increased flexibility to manage working capital requirements, and that there are sufficient trade accounts receivable to support the U.S. financing programs. Under the program, we will continue to service the accounts receivable.

CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS

        Our obligations under contractual obligations and commercial commitments are as follows:

 
  June 30, 2006
Payments due by period

 
  Total
  Less than
1 year

  1-3 years
  3-5 years
  over 5 years
 
  (in thousands)

Contractual Obligations                              
  Bank loans   $ 122,587   $ 122,587   $   $   $
  Convertible subordinated notes   $ 274,600   $   $ 274,600   $   $
  Interest payable on subordinated notes   $ 4,806   $ 2,403   $ 2,403   $   $
  Lease obligations   $ 37,496   $ 15,579   $ 16,651   $ 4,479   $ 787

Other Commercial Commitments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Standby letters of credit   $ 91,935   $ 89,048   $ 2,887   $   $
  Purchase commitments   $ 791,947   $ 786,359   $ 5,588   $   $

Notes Payable

        Occasionally, we issue short-term notes payable to our vendors in lieu of trade accounts payable. The payment terms are normally three to nine months and are typically non-interest bearing.

Bank Loans

        At June 30, 2006, we had loans with various banks totaling $122.6 million and each with interest rate 5.02% per annum. These bank loans mature within twelve months and are included in short-term debt.

65



Convertible Subordinated Notes

        Our convertible subordinated notes, due March 1, 2008, bear interest at a rate of 7/8% per annum, payable semiannually on May 1 and September 1, are convertible into our common stock at a conversion price of $23.79 per share and are subordinated to all our present and future senior debt. The principal amount of the notes is due only at maturity of the notes.

Operating Leases

        We lease certain facilities under non-cancelable operating leases that expire at various dates through 2010.

Standby Letters Of Credit

        We issue standby letters of credit primarily to support international sales activities outside of China. When we submit a bid for a sale, often the potential customer will require that we issue a bid bond or a standby letter of credit to demonstrate our commitment through the bid process. In addition, we may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to twelve months from date of issuance without being drawn by the beneficiary thereof.

Purchase commitments

        We are obligated to purchase raw materials and work-in-process inventory under various orders from various suppliers, all of which should be fulfilled without adverse consequences material to our operations or financial condition. As of June 30, 2006, total open commitments under these purchase orders extending beyond one year were approximately $5.6 million. Additionally, we have agreed to purchase from Marvell certain chip-sets that will be included in our PAS handsets through 2011.

Investment commitments

        As of June 30, 2006, we had invested a total of $2.6 million in Global Asia Partners L.P. that is recorded as a long-term investment. The fund size is anticipated to be $10.0 million and the fund was formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. We have a commitment to invest up to a maximum of $5.0 million. The remaining amount is due at such times and in such amounts as shall be specified in one or more future capital calls to be issued by the general partner.

Intellectual property

        Certain sales contracts include provisions under which customers would be indemnified by us in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. We have not accrued any amounts in relation to these provisions as no such claims have been made and we believe we have valid enforceable rights to the intellectual property embedded in our products.

RECENT ACCOUNTING PRONOUNCEMENTS

        In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109" (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of

66



FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect, if any, of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial statements.


ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

        We are exposed to the impact of interest rate changes, changes in foreign currency exchange rates and changes in the stock market.

Interest Rate Risk

        Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The fair value of our investment portfolio would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of most of our investment portfolio. However, our interest income can be sensitive to changes in the general level of U.S. interest rates since the majority of our funds are invested in instruments with maturities less than one year. Our policy is to ensure the safety of invested funds by generally attempting to limit market risk. Funds in excess of current operating requirements are mostly invested in government-backed notes, commercial paper, floating rate corporate bonds, fixed income corporate bonds and tax-exempt instruments. In accordance with our investment policy, all short-term investments are invested in "investment grade" rated securities with minimum A or better ratings. Currently, most of our short-term investments have AA or better ratings.

        The table below represents carrying amounts and related weighted-average interest rates of our investment portfolio at June 30, 2006:

 
  (in thousands,
except interest rates)

 
Cash and cash equivalents   $ 647,274  
Average interest rate     1.59 %

Restricted cash

 

$

71,119

 
Average interest rate     4.69 %

Short-term investments

 

$

10,339

 
Average interest rate     1.42 %

Total cash, cash equivalents and investment securities

 

$

728,732

 
Average interest rate     1.91 %

Equity Investment Risk:

        Our investment portfolio includes equity investments in publicly traded companies, the values of which are subject to market price volatility. Economic events could adversely affect the public equities market and general economic conditions may worsen. Should the fair value of our publicly traded equity investments decline below their cost basis in a manner deemed to be other-than-temporary, our earnings may be adversely affected. We have also invested in several privately held companies as well as investment funds which invest primarily in privately held companies, many of which can still be considered in the start-up or development stages. These investments are inherently risky, as the market for the technologies or products they have under development are typically in the early stages and may never materialize.

67



Debt Investment Risk:

        Our debt investment portfolio consists of a $5.3 million note receivable from BB Modem, an affiliate of SOFTBANK CORP., pursuant to a Mezzanine Loan Agreement we entered into with BB Modem on July 17, 2003. Our loan is subordinated to certain senior lenders of BB Modem, and repayments are payable to us over a 42-month period, with a substantial portion of the principal amount of the loan schedule to be repaid during the last 16 months of this period. Our recourse for nonpayment of the loan is limited to the assets of BB Modem, the account into which subscriber payments are made and its rights under the securitization transaction documents. The value of BB Modem's modems that serve as collateral for the loan may decrease over time and may not be sufficient upon sale to pay the outstanding amounts on the loan.

Foreign Exchange Rate Risk:

        We are exposed to foreign currency exchange rate risk because most of our sales in China are denominated in Renminbi and portions of our accounts receivable and payable are denominated in Japanese Yen. Due to the limitations on converting Renminbi, we are limited in our ability to engage in foreign currency hedging activities in China. Although the impact of currency fluctuations of Renminbi to date has been slight, fluctuations in currency exchange rates in the future may have a material adverse effect on our results of operations. The balance of cash and short-term investment balance held in China was $504.0 million at June 30, 2006. In July 2005, China uncoupled the Renminbi from the U.S. dollar and let it float in a narrow band against a basket of foreign currencies. The move revalued the Renminbi by 2.1% against the U.S. dollar. Additionally, during 2005 and the first six months of 2006 we made significant sales in both Japanese Yen and in Euros. We maintain Japanese Yen bank accounts for purchasing portions of our inventories and supplies.

        Our revenues, earnings and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. We may hedge currency exposures associated with certain assets and liabilities denominated in nonfunctional currencies and certain anticipated nonfunctional currency transactions using forward foreign currency exchange rate contracts. We have not hedged any such transactions, and due to the limitations on converting Renminbi, we are limited in our ability to engage in currency hedging activities in China. As a global concern, we face exposure to adverse movements in foreign currency exchange rates.

        We have performed a sensitivity analysis as of June 30, 2006, using a modeling technique that measures the change in the fair values arising from a hypothetical 10% positive or adverse movement in the levels of foreign currency exchange rates relative to the U.S. Dollar, with all other variables held constant. The analysis covers all of our foreign currency contracts offset by the underlying exposures. The foreign currency exchange rates used were based on market rates in effect at June 30, 2006. The sensitivity analysis indicated that a hypothetical 10% movement in foreign currency exchange rates would result in a gain or loss in the fair values of our foreign exchange financial instruments of $12.6 million at June 30, 2006.


ITEM 4—CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

        UTStarcom, Inc. (the "Company") maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), as appropriate, to allow timely decisions regarding required financial disclosure.

68



        In connection with the preparation of this Quarterly Report on Form 10-Q, the Company carried out an evaluation under the supervision and with the participation of the Company's management, including the CEO and CFO, as of June 30, 2006 of the effectiveness of the design and operation of the Company's disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon this evaluation, the CEO and CFO concluded that as of June 30, 2006 the Company's disclosure controls and procedures were not effective because of the material weaknesses described in Item 9A of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2005, as amended (the "2005 Form 10-K"), which we are still the in the process of remediation. Investors are directed to Item 9A of the 2005 Form 10-K for the description of these weaknesses.

        To address the material weaknesses described in "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K, the Company performed additional analyses and other procedures (as further described below under the subheading "Interim Measures" under "Management's Further Remediation Initiatives and Interim Measures") to ensure that the Company's consolidated financial statements were prepared in accordance with generally accepted accounting principles in the United States. Accordingly, the Company's management believes that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present in all material respects the Company's financial condition, results of operations and cash flows for the periods presented and that this Quarterly Report on Form 10-Q does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the periods covered by this report.

Management's Remediation Initiatives and Interim Measures

        In response to the matter discussed in "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K, the Company plans to continue to review and make necessary changes to the overall design of its control environment, including the roles and responsibilities of each functional group within the organization and reporting structure, as well as policies and procedures to improve the overall internal control over financial reporting. In particular, the Company has implemented and/or plans to implement during 2006 the specific measures described below to remediate the material weaknesses described above in "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K. In addition, in the absence of full implementation of these remediation measures during the first two quarters of 2006 and subsequent to June 30, 2006 and in connection with the June 30, 2006 quarter-end reporting process, the Company has undertaken the additional measures described under the subheadings "—Interim Measures" below to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company's consolidated financial statements included in this Quarterly Report on Form 10-Q and to ensure that material information relating to the Company and its consolidated subsidiaries was made known to management in connection with the preparation of this Quarterly Report on Form 10-Q.

Material weaknesses described in item 1 of "Management's Report on Internal Control Over Financial Reporting"

        Remediation Initiatives.    The Company's failure to have a sufficient complement of personnel with a level of accounting knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company's financial reporting requirements contributed to the Company's failure to maintain effective controls over the financial reporting process. To remediate the material weaknesses described in item 1 of "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K, the Company has implemented or plans

69


to implement the measures described below, and will continue to evaluate and may in the future implement additional measures.

    1.
    General plan for hiring and training of personnel—The Company's planned remediation measures are intended to generally address this material weakness by ensuring that the Company will have sufficient personnel with knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company's financial reporting requirements. These measures include the following:

    (a)
    The Company hired an executive vice president and chief financial officer with relevant accounting experience, skills and knowledge in August 2005;

    (b)
    The chief financial officer, with assistance from senior financial staff and outside consultants, other than the Company's independent registered public accounting firm, has reviewed and will continue to review and adapt the overall design of the Company's financial reporting structure, including the roles and responsibilities of each functional group within the Company;

    (c)
    The Company hired a corporate controller and vice president of finance with relevant accounting experience, skills and knowledge in November 2005;

    (d)
    The Company hired a vice president of finance for the Company's China operations with relevant accounting experience, skills and knowledge in April 2006;

    (e)
    The Company hired a vice president of compliance with relevant accounting, audit and compliance experience, skills and knowledge in May 2006;

    (f)
    The Company hired a director of cost accounting with relevant accounting experience, skills and knowledge in March 2006;

    (g)
    The Company retained and intends to continue to retain the services of outside consultants, other than the Company's independent registered public accounting firm, with relevant accounting experience, skills and knowledge, working under the supervision and direction of the Company's management, to supplement the Company's existing accounting personnel; and

    (h)
    The Company plans to continue to hire, and has allocated resources to hire, additional accounting and internal audit personnel in the U.S., China and Japan, in the areas of tax, external financial reporting, revenue recognition and corporate accounting with relevant accounting experience, skills and knowledge.

    2.
    Revenue Recognition—The Company's planned remediation measures are intended to address material weaknesses related to revenue and deferred revenue accounts and associated cost of sales that have the potential of misstating revenue, deferred revenue and associated cost of sales in future financial periods. The Company's planned remediation measures include the following:

    (a)
    In the fourth quarter of 2005, the Company further expanded the number of personnel required to certify to senior management with respect to identification and communication of contract amendments, side agreements or other matters which could have a bearing on revenue recognition. The Company also plans to implement additional steps to ensure appropriate members of management have reviewed and confirmed critical information necessary to assess the proper revenue recognition accounting;

    (b)
    During 2006, the Company plans to evaluate and enhance its contract review process including requiring sales, operations, finance and legal staff to provide input during the

70


        contract negotiation process to ensure timely identification and accurate accounting treatment of non-standard contracts;

      (c)
      The Company plans to evaluate and enhance its process during 2006 related to various specific activities associated with revenue recognition including the evaluation and review of handset rebates, invoice processing and the assessment of customer credit;

      (d)
      During the second quarter of 2006, the Company implemented enhancements to its Oracle system which will improve its controls related to the proper release of costs associated with revenue; and

      (e)
      The Company has and will continue its focus on training related to revenue recognition including the impact of amendments and side agreements. In June 2005, the Company conducted a training seminar regarding revenue recognition for the European sales group. In July 2005, a similar seminar was held in China. In October 2005, the Company's key management participated in a seminar on the critical factors associated with revenue recognition. During the first quarter of 2006, several additional seminars were conducted for various sales teams in North and South America and China. The Company plans to conduct additional training seminars in various international locations regarding revenue recognition throughout 2006.

    3.
    Inventory Management—The Company's planned remediation measures are intended to address material weaknesses related to inventory, deferred costs, inventory reserve accounts and cost of sales that have the potential of misstating inventory and deferred costs and expected recoverability of inventory in future financial periods. The Company's planned remediation measures include the following:

    (a)
    During the second quarter of 2006, the Company implemented enhancements to its Oracle system which will improve its ability to more effectively track inventory and evaluate deferred costs;

    (b)
    The Company hired a director of cost accounting with relevant accounting experience, skills and knowledge in March 2006; and

    (c)
    The Company plans in 2006 to enhance its processes and procedures related to the evaluation and impact of obsolete inventory including the development of detailed inventory reports and additional review by management.

    4.
    Recording of Accrued Expenses—The Company's planned remediation measures are intended to address a material weakness related to the Company's recording of accrued expenses that has the potential of misstating accrued expenses and related income statement accounts in future financial periods. The Company's planned remediation measures include the implementation in 2006 of a process of enhanced review of open purchase orders and review of invoices and disbursements after the end of each quarter to ensure proper recording of accrued expenses and open purchase order commitments.

    5.
    Accurate Preparation and Review of Financial Statements and Segment Reporting—The Company's planned remediation measures are intended to address material weaknesses related to the financial close and reporting process that have the potential of preventing the accurate preparation and review of the Company's consolidated financial statements in future financial periods. The Company's planned remediation measures include the following:

    (a)
    During 2005, the Company implemented and in 2006 plans to continue to enhance its month and quarter-end closing procedures to standardize its processes for financial review to ensure that U.S. reviewers monitor financial information from decentralized locations in a consistent manner.

71


      (b)
      In 2006, The Company's corporate finance department plans to expand and improve the required reporting package from various business units and subsidiaries in order to ensure it has accumulated the necessary accounting, finance and operational information to effectively analyze information required for financial statement preparation and footnote disclosures;

      (c)
      The Company's external reporting department plans in 2006 to expand and improve the documentation and review of required information associated with the preparation of its quarterly and annual filings under the Exchange Act; and

      (d)
      During 2005, the Company implemented, and plans to continue to improve new and enhanced procedures to ensure that non-routine transactions are identified and escalated to senior financial management during the close process to help ensure proper accounting treatment.

    6.
    Income Tax Analysis—The Company's planned remediation measures are intended to address material weaknesses related to the calculation of its provision for income taxes that have the potential of misstating the provision for income taxes and related balance sheet accounts in future financial periods. The Company's planned remediation measures include the following:

    (a)
    The Company plans to hire and train additional experienced tax managers and supporting staff in 2006 to support the preparation of the Company's income tax provision and to assist in managing audits and to monitor tax compliance in China and other foreign locations;

    (b)
    During 2005 and the first half of 2006, the Company utilized outside consultants, other than the Company's independent registered public accounting firm, to assist the Company's management, working under its supervision and direction, in its analysis and calculation of its income tax provision, and the Company plans to continue to utilize outside consultants, other than the Company's independent registered public accounting firm, to assist the Company's management, working under its supervision and direction, in its analysis of such matters in future periods; and

    (c)
    The Company plans to develop a more formalized and comprehensive process to accumulate and organize financial and tax data used in connection with income tax calculation and reporting.

    7.
    Utilization of Automated Controls—The Company's planned remediation measures are intended to address a material weakness related to the segregation of duties and user access to certain J. D. Edwards business process applications associated with the Company's Personal Communications Division that have the potential of misstating various accounts in future financial periods. The Company's planned remediation measures include the following:

    (a)
    During the first quarter of 2006, the Company removed access rights from certain employees associated with inappropriate segregation of duties; and

    (b)
    The Company has expanded its level of management oversight related to areas associated with segregation of duties issues including changes to the general ledger master file, invoice terms and inventory.

        Interim Measures.    Management has not yet implemented all of the measures described in items 1 through 7 above and/or tested them. Nevertheless, management believes those measures identified above as having been implemented, together with the other measures undertaken by the Company described below, all of which were undertaken during the first and second quarters of 2006 or subsequent to June 30, 2006 in connection with the June 30, 2006 quarter-end reporting process, address the material weaknesses described in item 1 of "Management's Report on Internal Control

72



Over Financial Reporting" in Item 9A of the 2005 Form 10-K. These other measures include the following:

    1.
    The Company retained on an interim basis outside consultants, other than the Company's independent registered public accounting firm, with relevant accounting experience, skills and knowledge, working under the supervision and direction of the Company's management, to assist with the June 30, 2006 quarter-end reporting process.

    2.
    The Company conducted an additional review of a substantial majority of its revenue-generating contracts for compliance with revenue recognition criteria. As part of this review, the Company gathered and analyzed evidence of delivery and final acceptance.

    3.
    The Company performed the following reviews of inventory-related matters: it reviewed consolidated revenue schedules from the second quarter of 2006 to determine the proper recording of cost of goods sold; it conducted a reconciliation of inventories at customer sites to outstanding contracts as of the quarter-end and analyzed inventory for recovery and potential impairment; and it conducted an analysis of inventory relating to purchase orders to identify under-recorded inventory.

    4.
    The Company conducted a review of the processes to record inventory reserves and a review of the manual procedures by which the Company tracks the cost of its products.

    5.
    The Company conducted a variety of manual review procedures, such as an extensive review of journal entry postings into the Oracle system and an extensive review of account reconciliations.

    6.
    The Company conducted a detailed and extensive review of the following matters: all non-routine transactions and internal representations; financial statements, as well as certifications from decentralized locations, for accuracy; spreadsheets; and journal entries.

    7.
    The Company reviewed its reserves and related schedules and reported its findings to the Audit Committee.

Material weakness described in item 2 of "Management's Report on Internal Control Over Financial Reporting"

        Remediation Initiatives.    The Company's failure to ensure that key management fully understood the nature and potential significance of related parties and to ensure that a robust process for the identification of related party transactions contributed to the Company's failure to maintain effective controls over the identification of and accounting for related party relationships and related party transactions with the Company. To remediate the material weakness described in item 2 of "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K, the Company has implemented or plans to implement the measures described below, and will continue to evaluate and may in the future implement additional measures.

    1.
    The Company conducted an educational seminar with the Company's key management in March 2005 in which the Company's internal and outside legal counsel and members of the Audit Committee reviewed certain key objectives of the Company's Code of Conduct, including the identification, recognition and disclosure of related party transactions.

    2.
    In the fourth quarter of 2005, the Company further expanded the number of Company personnel required to certify to senior management with respect to identification, recognition and disclosure of related party transactions for SEC reporting purposes, and revised the Company's internal certification process concerning identification, recognition and disclosure of related party transactions.

73


    3.
    The Company plans to continue to evaluate the Company's procedures to ensure the identification, recognition and disclosure of related party transactions.

    4.
    The Company plans to conduct periodic training sessions with key managers and senior executives regarding the Code of Conduct, including the identification, recognition and disclosure of related party transactions.

    5.
    The Company plans to provide key managers and senior executives with access to legal and accounting personnel to enable such managers and executives to more accurately and comprehensively comply with the Company's internal certification process for SEC reporting purposes.

        Interim Measures.    Management has not yet implemented all of the measures described above and/or tested them. Nevertheless, management believes those measures identified above as having been implemented, together with the other measures undertaken by the Company described below, all of which were undertaken during the second quarter of 2006 or subsequent to June 30, 2006 in connection with the June 30, 2006 quarter-end reporting process are sufficient to address the material weakness described in item 2 of "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K. These other measures include the following:

    1.
    Senior executives provided new certifications regarding related party transactions.

Material weakness described in item 3 of "Management's Report on Internal Control Over Financial Reporting"

        Remediation Initiatives.    Lack of clarity in roles and responsibilities in certain areas affecting the Company's financial reporting structure contributed to a material weakness relating to the monitoring of its business unit accounting functions. To remediate this material weakness, described in item 3 of "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K, the Company has implemented or plans to implement the measures described under "—Material weaknesses described in item 1 of 'Management's Report on Internal Control Over Financial Reporting'—Remediation Initiatives—1. General plan for hiring and training of personnel" in Item 9A of the 2005 Form 10-K, as well as those described below. The Company will continue to evaluate and may in the future implement additional measures.

    1.
    During 2005, the Company implemented and in 2006 plans to continue to enhance its month and quarter-end closing procedures to standardize its processes for financial review to ensure that U.S. reviewers monitor financial information from decentralized locations in a consistent manner.

    2.
    In 2006, the Company's corporate finance department plans to expand and improve the required reporting package from various business units and subsidiaries in order to ensure it has accumulated the necessary accounting, finance and operational information to effectively analyze information required for financial statement preparation and footnote disclosures.

    3.
    In 2006, the Company's external reporting department plans to expand and improve the documentation and review of required information associated with the preparation of its quarterly and annual filings under the Exchange Act.

    4.
    The Company plans to expand the size of the internal audit group and the scope of the internal audit group's responsibilities to monitor decentralized operations through reviews and audits of such business units, subsidiaries and locations.

    5.
    The Company's chief financial officer, with assistance from senior financial staff and outside consultants, other than the Company's independent registered public accounting firm, has reviewed and will continue to review and adapt the overall design of the Company's financial

74


      reporting structure, including the roles and responsibilities of each functional group within the Company.

        Interim Measures.    Management has not yet implemented all of the measures described above and/or tested them. Nevertheless, management believes those measures identified above as having been implemented, together with the other measures undertaken by the Company described below, all of which were undertaken during the second quarter of 2006 or subsequent to June 30, 2006 in connection with the June 30, 2006 quarter-end reporting process, address the material weakness described in item 3 of "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K. These other measures include the following:

    1.
    Senior financial staff in the Company's U.S. headquarters did a thorough review of trial balances issued from decentralized locations.

    2.
    The Company utilized outside consultants, other than the Company's independent registered public accounting firm, to assist the Company's management, working under its supervision and direction, with the June 30, 2006 quarter-end review of decentralized operations.

    3.
    All non-routine material transactions for decentralized locations were documented by staff in such decentralized locations and reviewed by senior financial staff in the Company's U.S. headquarters.

Material weakness described in item 4 of "Management's Report on Internal Control Over Financial Reporting"

        Remediation Initiatives.    The Company's failure to have sufficient personnel with knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company's financial reporting requirements as well as failure to prevent or detect instances of non-compliance with established policies and procedures or instances of non-compliance with laws and regulations contributed to a material weakness relating to the Company's control environment. To remediate this material weakness, described in item 4 of "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K, the Company has implemented or plans to implement the measures described under "—Material weaknesses described in item 1 of 'Management's Report on Internal Control Over Financial Reporting'—Remediation Initiatives—1. General plan for hiring and training of personnel" in Item 9A of the 2005 Form 10-K, as well as those described below. The Company will continue to evaluate and may in the future implement additional measures.

    1.
    During the second quarter of 2006, the Company launched a formal investigation at the direction of the Audit Committee, to review alleged violations of the Foreign Corrupt Practices Act. Upon the conclusion of this investigation, the Company will take any appropriate actions including possible changes to its processes and procedures related to the due diligence evaluation of business partnerships.

    2.
    During 2005, the Company implemented and in 2006 plans to continue to enhance its month-end and quarter-end closing procedures to standardize its processes for financial review to ensure that U.S. reviewers monitor financial information from decentralized locations in a consistent manner.

    3.
    In 2006, the Company's corporate finance department plans to expand and improve the required reporting package from various business units and subsidiaries in order ensure it has accumulated the necessary accounting, finance and operational information to effectively analyze information required for financial statement preparation and footnote disclosures.

75


    4.
    In 2006, the Company's external reporting department plans to expand and improve the documentation and review of required information associated with the preparation of its quarterly and annual filings under the Exchange Act.

    5.
    The Company plans to expand the size of the internal audit group and the scope of the internal audit group's responsibilities to monitor decentralized operations through reviews and audits of such business units, subsidiaries and locations.

    6.
    The Company's chief financial officer, with assistance from senior financial staff and outside consultants, other than the Company's independent registered public accounting firm, has reviewed and will continue to review and adapt the overall design of the Company's financial reporting structure, including the roles and responsibilities of each functional group within the Company.

        Interim Measures.    Management has not yet implemented all of the measures described above and/or tested them. Nevertheless, management believes those measures identified above as having been implemented, together with the other measures undertaken by the Company described below, all of which were undertaken during the second quarter of 2006 or subsequent to June 30, 2006 in connection with the June 30, 2006 quarter-end reporting process, address the material weaknesses described in item 4 of "Management's Report on Internal Control Over Financial Reporting." These other measures include the following:

    1.
    Senior financial staff in the Company's U.S. headquarters did a thorough review of trial balances issued from decentralized locations.

    2.
    The Company utilized outside consultants, other than the Company's independent registered public accounting firm, to assist the Company's management, working under its supervision and direction, with the June 30, 2006 quarter-end review of decentralized operations.

    3.
    Non-routine material transactions for decentralized locations were documented by staff in such decentralized locations and reviewed by senior financial staff in the Company's U.S. headquarters.

Control deficiencies not constituting material weaknesses

        In addition to the material weaknesses described in "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K management has identified other deficiencies in internal control over financial reporting that did not constitute material weaknesses as of December 31, 2005. The Company has implemented and/or plans to implement during 2006 various measures to remediate these control deficiencies and has undertaken other interim measures to address these control deficiencies.

Management's Conclusions

        Management believes the remediation measures described under "Management's Remediation Initiatives and Interim Measures" above will strengthen the Company's internal control over financial reporting and remediate the material weaknesses identified in "Management's Report on Internal Control Over Financial Reporting" in Item 9A of the 2005 Form 10-K. However, management has not yet implemented all of these measures and/or tested them. Management has concluded that the interim measures described under "Management's Further Remediation Initiatives and Interim Measures" above provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company's financial statements included in this Quarterly Report on Form 10-Q and has discussed its conclusions with the Company's Audit Committee.

76



        The Company is committed to continuing to improve its internal control processes and will continue to diligently and vigorously review its disclosure controls and procedures and its internal control over financial reporting in order to ensure compliance with the requirements of Section 404 of the Sarbanes-Oxley Act. However, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. As management continues to evaluate and work to improve the Company's internal control over financial reporting, it may determine to take additional measures to address control deficiencies, and it may determine not to complete certain of the measures described under "Management's Further Remediation Initiatives and Interim Measures" above.

Changes in Internal Control over Financial Reporting

        The discussion above under "Management's Remediation Initiatives and Interim Measures" describes the material planned and actual changes to the Company's internal control over financial reporting during the first two quarters of 2006 and subsequent to June 30, 2006 that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

77



PART II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

Securities Class Action Litigation

        Beginning in October 2004, several shareholder class actions alleging federal securities violations were filed against us and various officers and directors. The actions have been consolidated in United States District Court for the Northern District of California. The lead plaintiffs in the case filed a First Amended Consolidated Complaint on July 26, 2005. The First Amended Complaint alleged violations of the Securities Exchange Act of 1934, and was brought on behalf of a putative class of shareholders who purchased our stock after April 16, 2003 and before September 20, 2004. On April 13, 2006, the lead plaintiffs filed a Second Amended Complaint adding new allegations and extending the end of the class period to October 6, 2005. In addition to the Company defendants, the plaintiffs are also suing Softbank. Plaintiffs' complaint seeks recovery of damages in an unspecified amount.

        This litigation is in its preliminary stage, and we cannot predict its outcome. Our management believes that the claims are not meritorious. Nevertheless, an adverse outcome in the litigation, if it occurred, could have a material adverse effect on our results of operations, financial position and cash flows.

Governmental Investigations

        We have received notice of a formal inquiry by the staff of the Securities & Exchange Commission ("SEC") into certain aspects of our financial disclosures during prior reporting periods and certain other issues. In addition, in December 2005, the U.S. Embassy in Mongolia informed us that it had forwarded to the Department of Justice ("DOJ") allegations that an agent of our Mongolia joint venture had offered payments to a Mongolian government official in possible violation of the Foreign Corrupt Practices Act (the "FCPA"). In April 2006, we became aware that an agent of the Company may have made an offer to pay an Indian government official in possible violation of the FCPA. In June 2006, we became aware that one of our former employees may have made a payment to a Thailand government official in possible violation of the FCPA. We, through our Audit Committee, authorized an independent investigation into these matters, and we have been in contact with the DOJ and SEC regarding the investigation. At this time, we cannot predict when any governmental inquiry will be completed or what the outcome of any governmental inquiry will be.

IPO Allocation

        On October 31, 2001, a complaint was filed in United States District Court for the Southern District of New York against us, some of our directors and officers and various underwriters for our initial public offering. Substantially similar actions were filed concerning the initial public offerings for more than 300 different issuers, and the cases were coordinated as In re Initial Public Offering Securities Litigation, MC 92 for pretrial purposes. In April 2002, a consolidated amended complaint was filed in the matter against the Company, captioned In re UTStarcom, Initial Public Offering Securities Litigation, Civil Action No. 01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 through undisclosed improper underwriting practices concerning the allocation of IPO shares in exchange for excessive brokerage commissions, agreements to purchase shares at higher prices in the aftermarket and misleading analyst reports. Plaintiffs seek unspecified damages on behalf of a purported class of purchasers of our common stock between March 2, 2000 and December 6, 2000. Our directors and officers have been dismissed without prejudice pursuant to a stipulation. On February 19, 2003, the Court granted in part and denied in part a motion to dismiss brought by defendants including us. The order dismisses all claims against us except for a claim brought under Section 11 of the Securities Act of 1933, which alleges that the registration statement filed in accordance with the IPO was misleading. In June 2004, a stipulation of settlement and release of claims

78



against the issuer defendants, including us, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including us). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On February 15, 2005, the Court issued an order granting conditional preliminary approval of the settlement. On August 31, 2005, the Court entered an order confirming its preliminary approval of the settlement. On April 24, 2006, the Court conducted a fairness hearing in connection with the motion for final approval of the settlement. The Court did not issue a ruling on the motion for final approval at the fairness hearing. The settlement remains subject to a number of conditions, including final court approval. The total amount of the loss associated with the above litigation is not determinable at this time. Therefore, we are unable to currently estimate the loss, if any, associated with the litigation.

Starent Patent Infringement Litigation

        We have sued Starent Networks Corporation ("Starent") for patent infringement in the U.S. District Court for the Northern District of California. On March 22, 2004, we filed our Complaint. On June 3, 2004, we served our Complaint on Starent. On July 30, 2004, Starent filed and served its answer and counterclaims. On August 30, 2004, we served and filed our Amended Complaint. In our Amended Complaint, we assert that Starent infringes a UTStarcom patent through the manufacture, use, offer for sale, and sale of Starent's ST-16 Intelligent Mobile Gateway. We seek, inter alia, compensatory damages and injunctive relief. Starent filed its answer to the Amended Complaint and counterclaims on September 17, 2004. In its answer and counterclaims, Starent denies our allegations and seeks a declaration that the patent-in-suit is not infringed, is invalid, and is unenforceable. The Court held an initial case management conference on November 2, 2004. On February 17, 2005, we filed a motion for a preliminary injunction against Starent's use, sale, and offer for sale of products having the infringing feature. The Court held a hearing on our motion on May 11, 2005 and denied our motion on June 17, 2005. On June 30, 2005, the Court held a hearing on the proper meaning or construction of the claims of the patent-in-suit and entered an order construing these claims on August 11, 2005. On September 20, 2005, Starent filed a motion for summary judgment of non-infringement and UTStarcom filed a motion for summary judgment that Starent is estopped from asserting invalidity and unenforceability. On October 4, 2005, Starent filed a motion to strike UTStarcom's final infringement contentions. On November 7, 2005, Starent's motion to strike was denied. Oral argument on UTStarcom's estoppel motion and Starent's non-infringement motion was held on November 8, 2005. On December 6, 2005, the Court granted Starent's motion for summary judgment of non-infringement. On December 12, 2005, the Court dismissed as moot Starent's counterclaims for declaratory relief based on invalidity or unenforceability of the asserted patent. On February 2, 2006, the Court entered judgment in favor of Starent. On March 2, 2006, UTStarcom filed a notice of appeal. The case is currently pending at the Court of Appeals for the Federal Circuit. UTStarcom believes that the appeal will be successful, nonetheless, UTStarcom has indicated that it believes that an adverse judgment will not have a material adverse effect on the business, financial condition, or results of its operations.

        On February 16, 2005, we filed a second suit against Starent for patent infringement in the U.S. District Court for the Northern District of California. On May 6, 2005, we served the Complaint on Starent. In the Complaint, we assert that Starent infringes a UTStarcom patent through Starent's development and testing of a software upgrade for its customer's installed ST-16 Intelligent Mobile Gateways. We seek, inter alia, declaratory and injunctive relief. Starent filed its answer and counterclaims on May 31, 2005, denying our allegations and seeking a declaration that the patent-in-suit is not infringed, is invalid, and is unenforceable. On June 16, 2005, we filed a motion to strike Starent's affirmative defense and dismiss Starent's counterclaim alleging inequitable conduct.

79



Pursuant to the parties' stipulation, we withdrew our motion to strike and, on July 27, 2005, Starent filed an amended answer and counterclaims, which pleaded its inequitable conduct allegations with more specificity. UTStarcom filed its answer to the amended counterclaims on August 10, 2005. The initial case conference was scheduled for March 31, 2006, but was vacated by the Judge, who instead issued a scheduling order and referred the case to the Magistrate on March 29, 2006. On May 17, 2006, the Magistrate issued a new scheduling order to accommodate the parties' request. On June 30, 2006, the Magistrate amended the earlier order and issued second new scheduling order to accommodate the parties' request. The litigation is in the preliminary stage and its outcome cannot be predicted. However, UTStarcom believes that its claims are meritorious. Nonetheless, UTStarcom has indicated that it believes that any adverse judgment on Starent's counterclaims will not have a material adverse effect on the business, financial condition, or results of its operations.

Fenner Investments Patent Infringement Litigation

        On January 6, 2005, Fenner Investments, Ltd. ("Fenner") filed suit against us and co-defendants Juniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., Lucent Technologies, Inc., and Cisco Systems, Inc. in the U.S. District Court for the Eastern District of Texas. On May 17, 2005, Fenner amended its complaint to add as defendants Ericsson Inc., Ericsson AB, Telefonaktiebolaget LM Ericsson, and Alcatel USA Inc. The suit alleged that certain products infringe two Fenner patents, U.S. Patent Nos. 5,561,706 and 6,819,670, for which Fenner sought compensatory and injunctive relief. On March 20, 2006, we agreed to settle Fenner's claims against us for $1.4 million. As part of this settlement, Fenner agreed to dismiss with prejudice its claims against us. On April 27, 2006, the court ordered the dismissal with prejudice of Fenner's claims against us as a result of the settlement. The settlement did not have a significant financial impact on operations.

Telos Technology, Inc. Arbitration

        On November 22, 2005, Telos Technology, Inc. ("Telos") filed a formal Demand for Arbitration against us with JAMS/Endispute in San Jose, California. The Demand for Arbitration seeks the release of $2.4 million from an escrow fund. Pursuant to the terms of an Asset Purchase Agreement dated April 21, 2004 and an Escrow Agreement dated May 19, 2004 between the parties, the escrow fund was created to indemnify us from certain losses associated with our purchase of assets from Telos. Telos asserts that our refusal to release the escrowed funds constitutes a breach of our contractual obligations under the agreements. Telos also seeks attorneys' fees, costs and prejudgment interest in the amount of $500,000. In our response to the Demand for Arbitration, we denied that we had breached our contractual obligations. In January 2006, Telos moved for summary judgment on its claim and we opposed the motion. On March 6, 2006, the Arbitrator issued a ruling denying Telos' motion. In light of the ruling on summary judgment, Telos dismissed its claim for arbitration without prejudice, subject to its contractual right to dispute any future disbursement from escrow.

Telos Technology, Inc. Litigation

        On November 22, 2005, plaintiffs Telos Technology, Inc., Telos Technology (Canada), Inc., Telos Technology (Bermuda) Ltd., and Telos Engineering Limited (collectively, the "Telos Plaintiffs") filed a Complaint against us in the Superior Court of California, County of Santa Clara. The Complaint alleges five causes of action, including breach of contract, breach of the implied covenant of good faith and fair dealing, fraudulent inducement, intentional misrepresentation and negligent misrepresentation, all of which arise from the Asset Purchase Agreement between the parties dated April 21, 2004. The Telos Plaintiffs assert that we breached the express and implied terms of the Asset Purchase Agreement and made representations to the Telos Plaintiffs during negotiations that we never intended to fulfill. The Telos Plaintiffs seek at least $19 million in damages, unspecified punitive damages and attorneys' fees. On December 28, 2005, the Telos Plaintiffs filed a First Amended Complaint, alleging substantially the same facts and seeking the same relief. On January 26, 2006, we filed a demurrer with respect to

80



Telos' three tort causes of action. On March 23, 2006, the Court sustained our demurrer to all three tort causes of action and allowed Telos thirty days to amend its complaint. On April 12, 2006, Telos filed a Second Amended Complaint, alleging substantially the same facts and seeking the same relief as in the First Amended Complaint. On May 12, 2006, we filed an Answer to the Second Amended Complaint, denying all material factual allegations asserted by the Telos Plaintiffs. Discovery is underway, and no trial date has been set.

Passave Litigation

        In November 2005, we filed suit in the Superior Court of California, County of Santa Clara, against Passave, Inc. ("Passave") for breaches of contract and warranties in connection with a semiconductor device sold by Passave, Ltd. (Passave's wholly-owned subsidiary) to us. Our Complaint alleges that the Passave device, known as the PAS5001M3 chip, has exhibited certain operational malfunctions within some of our Fiber-to-the-Home product line, and has thereby caused damage to us. On or about January 20, 2006, Passave filed its answer, affirmative defenses and demurrer to the Complaint. The Court sustained Passave's demurrer after the hearing on March 28, 2006. On May 9, 2006, we filed our Amended Complaint naming both Passave, Inc. and its Israeli subsidiary, Passave, Ltd., as defendants. The Amended Complaint states causes of action for breach of contract, breaches of warranty, indemnification, unfair competition and negligent misrepresentation, and seeks compensatory damages and other relief. Discovery is ongoing. On June 7, 2006, both Passave defendants removed the case from the state court to the Northern District Court of California, San Jose Division. Both Passave defendants thereafter filed motions to dismiss the Amended Complaint in the Northern District Court, and noticed the hearing for August 18, 2006. On June 19, 2006, we filed a motion for remand to return the action to the Santa Clara County Superior Court, and noticed the hearing for August 18, 2006. We intend to pursue our rights and remedies against Passave, Inc. and Passave, Ltd. vigorously.

Cell Communication Ltd. Arbitration

        On October 27, 2005, we received notice of a demand for arbitration filed against us by Cell Communication Ltd. of Nigeria. The demand was filed in the London Court of International Arbitration ("LCIA"). In its Amended Claim, Cell Communication claims 'general' damages of $26.6 million and 'special' damages of $15 million (alternatively $41 million general damages) in connection with alleged failures of products purchased from Telos Technology, whose assets have been acquired by us.

        An arbitrator has been selected by the LCIA. The arbitrator ordered the determination of certain preliminary issues as to whether the claims made by Cell Communication are irrecoverable as a matter of English law. There was a hearing on May 26, 2006 in respect of these preliminary issues. On June 13, 2006, the arbitrator issued a partial award in which he addressed several issues. Among them, the arbitrator adopted our position that liability in this matter is limited to the amount of the purchase price paid by Cell Communication. The purchase price is not agreed but we believe it is less than $5 million. Cell Communication is also required to replead its 'general' damages claim. No further directions have been given nor has a date for the substantive hearing been scheduled. We intend to deny all liability, and believe we have meritorious defenses.

Other

        We are a party to other litigation matters and claims that are normal in the course of operations, and while the results of such litigation matters and claims cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse impact on our financial position or results of operations.

81



        In the future we may subject to other lawsuits. Any litigation, even if not successful against us, could result in substantial costs and divert management's attention and other resources away from our business operations.


ITEM 1A—RISK FACTORS

FACTORS AFFECTING FUTURE OPERATING RESULTS
RISKS RELATED TO OUR COMPANY

Our future product sales are unpredictable and, as a result, our operating results are likely to fluctuate from quarter to quarter.

        Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate in the future due to a variety of factors, some of which are outside of our control. Factors that may affect our future operating results include:

    1.
    the timing and size of the orders for our products;

    2.
    consumer acceptance of new products we may introduce to market;

    3.
    changes in the growth rate of customer purchases of communications services;

    4.
    the lengthy and unpredictable sales cycles associated with sales of our products;

    5.
    revenue recognition, which is based primarily on customer acceptance of delivered products, is unpredictable;

    6.
    cancellation, deferment or delay in implementation of large contracts;

    7.
    quality issues resulting from the design or manufacture of the products, or from the software used in the product;

    8.
    cash collection cycles in China and other emerging markets;

    9.
    the decline in business activity we typically experience during the Chinese Lunar New Year, which leads to decreased sales and collections during our first fiscal quarter;

    10.
    issues that might arise from the integration of acquired entities or the inability to achieve expected results from such acquisitions; and

    11.
    shifts in our product mix or market focus.

        As a result of these and other factors, period-to-period comparisons of our operating results are not necessarily meaningful or indicative of future performance. In addition, the factors noted above may make it difficult for us to forecast and provide in a timely manner public guidance (including updates to prior guidance) related to our projected financial performance. Furthermore, it is possible that in some future quarters our operating results will fall below the expectations of securities analysts or investors. If this occurs, the trading price of our common stock could decline.

Competition in our markets may lead to reduced prices, revenues and market share.

        We have experienced intense competition in the past years, and we believe that we will continue to face intense competition from both domestic and international companies in our target markets, many of which may operate under lower cost structures or may be given preferential treatment by applicable governmental regulators and policies and have much larger sales forces than we do. Additionally, other companies not presently offering competing products may also enter our target markets. Many of our competitors have significantly greater financial, technical, product development, sales, marketing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in service provider requirements. Our competitors may also be able to devote greater resources than we can to the development, promotion and sale of new products.

82



These competitors may be able to offer significant financing arrangements to service providers, which may give them a competitive advantage in selling systems to service providers with limited financial resources. In many of the developing markets in which we operate or intend to operate, relationships with local governmental telecommunications agencies are important to establish and maintain. In many such markets, our competitors may have or be able to establish better relationships with local governmental telecommunications agencies than we have, which could result in their ability to influence governmental policy formation and interpretation to their advantage. Additionally, our competitors might have better relationships with their third party suppliers and obtain component parts at a reduced rate, allowing them to offer their end products at reduced prices. Moreover, the telecommunications and data transmission industries have experienced significant consolidation, and we expect this trend to continue. If we have fewer significant customers, we may be more reliant on such large customers and our bargaining position and profit margins may suffer. Increased competition is likely to result in price reductions, reduced gross profit as a percentage of net sales and loss of market share, any one of which could materially harm our business, cash flows and financial condition, including potential impairment in value of our tangible and intangible assets and goodwill if extended losses were incurred.

If we seek to secure additional financing and are not able to do so, our ability to expand strategically may be limited. If we are able to secure additional financing, our stockholders may experience dilution of their ownership interest, or we may be subject to limitations on our operations and increased leverage.

        We currently anticipate that our available cash resources, which include existing cash and cash equivalents, short-term investments, cash from operations and available credit lines will be sufficient to meet our anticipated needs for working capital and capital expenditures for at least the next twelve months. If we are unable to generate sufficient cash flows from operations, we may need to raise additional funds to develop new or enhanced products, respond to competitive pressures, take advantage of acquisition opportunities or raise capital for strategic purposes. If we raise additional funds through the issuance of equity securities, our stockholders will experience dilution of their ownership interest, and the newly issued securities may have rights superior to those of common stock. If we raise additional funds by issuing debt, we may be subject to limitations on our operations and our leverage may increase. For example, in connection with the sale of convertible debt securities in March 2003, we incurred $402.5 million of indebtedness. As a result of this indebtedness, our principal and interest payment obligations have increased substantially. In fiscal year 2005, approximately $127.9 million of this indebtedness was exchanged with the holders for $57.1 million in cash and 4,988,100 shares of our common stock. The degree to which we are leveraged could materially and adversely affect our ability to obtain financing for working capital, acquisitions or other purposes and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control. Finally, we are not certain that we can maintain our existing unsecured credit lines available to our China operations or additional sources of financing may not be available on reasonable terms or at all if and when we require it, either of which could harm our business.

The average selling prices of our products may decrease, which may reduce our revenues and our gross profit. As a result, we must introduce new products and reduce our costs in order to maintain profitability.

        The average selling prices for communications access and switching systems and handsets have historically declined as a result of a number of factors, including:

    1.
    increased competition;

    2.
    aggressive price reductions by competitors;

    3.
    rapid technological change; and

83


    4.
    constant change in customer buying behavior and market trends.

        The average selling prices of our products may continue to decrease in the future in response to product introductions by us or our competitors or other factors, including price pressures from customers. Certain of our products, including wireless handsets, have historically had low gross profit margins, and any further deterioration of our profit margins on such products could result in losses with respect to such products. Therefore, we must continue to develop and introduce new products and enhancements to existing products that incorporate features that can be sold at higher average selling prices. Failure to do so or the failure of consumers or our direct customers to accept such new products could cause our revenues and gross profit to decline.

        Our cost reduction efforts may not allow us to keep pace with competitive pricing pressures or lead to improved gross profit, as a percentage of net sales. In order to be competitive, we must continually reduce the cost of manufacturing our products through design and engineering changes. We may not be successful in these efforts or in delivering our products to market in a timely manner. In addition, any redesign may not result in sufficient cost reductions to allow us to reduce the prices of our products to remain competitive or to improve or maintain our gross profit, as a percentage of net sales, which would cause our financial results to suffer.

Sales in China have historically accounted for a material portion of our total sales, and our business, financial condition and results of operations are to a significant degree subject to economic, political and social events in China.

        Approximately $929.0 million, or 32%, and $2,133.3 million, or 79%, of our net sales in the fiscal years ended 2005 and 2004, respectively, occurred in China. While we have expanded into other markets, a significant portion of our net sales will be derived from China for the foreseeable future. In addition, we have made substantial investments in China and, therefore, our business, financial condition and results of operations are to a significant degree subject to economic, political, legal and social developments and other events in China. Please read the risks detailed below under the heading "Risks Related to Conducting Business in China" for additional information about the risks we face in connection with our China operations.

Our market is subject to rapid technological change, and to compete effectively, we must continually introduce new products and product enhancements that achieve market acceptance.

        The market for communications equipment is characterized by rapid technological developments, frequent new product introductions, changes in consumer preferences and evolving industry and regulatory standards. Our success will depend in large part on our ability to enhance our technologies and develop and introduce new products and product enhancements that anticipate changing service provider requirements, technological developments and evolving consumer preferences. We may need to make substantial capital expenditures and incur significant research and development costs to develop and introduce new products and enhancements. If we fail to develop and introduce new products or enhancements to existing products that effectively respond to technological change on a timely basis, our business, financial condition and results of operations could be materially adversely affected. Certain of our products, including wireless handsets, have a short product life. Moreover, from time to time, our competitors or we may announce new products or product enhancements, technologies or services that have the potential to replace or shorten the life cycles of our products and that may cause customers to defer purchasing our existing products, resulting in charges for inventory obsolescence reserves. Future technological advances in the communications industry may diminish or inhibit market acceptance of our existing or future products or render our products obsolete. Even if

84



we are able to develop and introduce new products, they may not gain market acceptance. Market acceptance of our products will depend on various factors, including:

    1.
    our ability to obtain necessary approvals from regulatory organizations within the countries in which we operate and for any new technologies that we introduce;

    2.
    the length of time it takes service providers to evaluate our products, causing the timing of purchases to be unpredictable;

    3.
    the compatibility of our products with legacy technologies and standards existing in previously deployed network equipment;

    4.
    our ability to attract customers who may have preexisting relationships with our competitors;

    5.
    product pricing relative to performance;

    6.
    the level of customer service available to support new products; and

    7.
    the timing of new product introductions meeting demand patterns.

        If our products fail to obtain market acceptance in a timely manner, our business and results of operations could suffer.

We depend on some sole source and key suppliers, as well as international sources, for handsets, base stations, components and materials used in our products. If we cannot secure adequate supplies of high quality products at competitive prices or in a timely manner from these suppliers or sources, or if the suppliers successfully market their products directly to our customers, our competitive position, reputation and business could be harmed.

        We have contracts with a limited group of suppliers to purchase some components and materials used in our products. If any supplier is unwilling or unable to provide us with high-quality components and materials in the quantities required and at the costs specified by us, we may not be able to find alternative sources on favorable terms, in a timely manner, or at all. Further, a supplier could market its products directly to our customers. The possibility of a supplier marketing its own products would create direct competition and may affect our ability to obtain adequate supplies. Our inability to obtain or to develop alternative sources if and as required could result in delays or reductions in manufacturing or product shipments. From time to time, there could be shortages of certain products or components. Moreover, our suppliers may supply us with inferior quality products. If an inferior product supplied by a third party is embedded in our end product and causes a problem, it might be difficult to identify the source of the problem as being due to the component parts. If any of these events occur, our competitive position, reputation and business could suffer.

        Our ability to source a sufficient quantity of high-quality, cost-effective components used in our products may also be limited by import restrictions and duties in the foreign countries in which we manufacture our products. We require a significant number of imported components to manufacture our products, and imported electronic components and other imported goods used in the operation of our business may be limited by a variety of permit requirements, approval procedures, import duties and licensing requirements. Moreover, import duties on such components increase the cost of our products and may make them less competitive.

Product defects or performance quality issues could cause us to lose customers and revenue or to incur unexpected expenses.

        Many of our products are highly complex and may have quality deficiencies resulting from the design or manufacture of such product, or from the software or components used in the product. For example, during 2005 we recorded warranty charges of $70.6 million, including special warranty charges of $11.7 million for certain asynchronous digital subscriber line ("ADSL") products, $4.0 million for

85



NetRing™ equipment and $14.9 million for GEPON equipment sold to SBBC, an affiliate of SOFTBANK CORP and SOFTBANK America Inc., during 2003 and 2004. Often these issues are identified prior to the shipment of the products and may cause delays in market acceptance of our products, delays in shipping products to customers, or the cancellation of orders. In other cases, we may identify the quality issues after the shipment of products. In such cases, we may incur unexpected expenses and diversion of resources to replace defective products or correct problems. Such pre-shipment and post-shipment quality issues could result in delays in the recognition of revenue, loss of revenue or future orders, and damage to our reputation and customer relationships. In addition, we may be required to pay damages for failed performance under certain customer contracts.

Our global diversification strategy and growth has strained our resources, and if we are unable to manage this growth, our operating results will be negatively affected.

        We have recently experienced a period of rapid growth and anticipate that we must continue to transform our operations to address market demands and potential market opportunities globally. This transformation will place a significant strain on our management, operational, financial and other resources. To manage this transformation effectively, we will need to take various actions, including:

    1.
    enhancing management information systems, including forecasting procedures;

    2.
    further developing our operating, administrative, financial and accounting systems and controls;

    3.
    managing our working capital and sources of financing;

    4.
    maintaining close coordination among our engineering, accounting, finance, marketing, sales and operations organizations;

    5.
    retaining, training and managing our employee base;

    6.
    enhancing human resource operations and improving employee hiring and training programs;

    7.
    reorganizing our business structure to more effectively allocate and utilize our internal resources;

    8.
    improving and sustaining our supply chain capability; and

    9.
    managing both our direct and indirect sales channels in a cost-efficient and competitive manner.

        If we fail to implement or improve systems or controls or to manage any future growth and transformation effectively, our business could suffer.

Any failure by us to execute planned cost reductions successfully could result in total costs and expenses that are greater than expected.

        We have undertaken restructuring plans to bring operational expenses to appropriate levels for each of our businesses, while simultaneously implementing extensive new company-wide expense-control programs. In 2005, we announced workforce restructurings. These programs involved the termination of approximately 1,595 employees worldwide through December 31, 2005. We expect the cost savings to be used to offset market forces or to be reinvested in our businesses to strengthen our competitiveness. We may have further workforce reductions or rebalancing actions in the future. Significant risks associated with these actions and other workforce management issues that may impair our ability to achieve anticipated cost reductions or may otherwise harm our business include delays in implementation of anticipated workforce reductions in highly regulated locations outside of the United States, particularly in Europe and Asia, redundancies among restructuring programs, decreases in employee morale and the failure to meet operational targets due to the loss of employees, particularly sales employees.

86



Our success is dependent on continuing to hire and retain qualified personnel, and if we are not successful in attracting and retaining these personnel and in managing key employee turnover, our business will suffer.

        The success of our business depends in significant part upon the continued contributions of key technical and senior management personnel, many of whom would be difficult to replace. In particular, our success depends in large part on the knowledge, expertise and services of Hong Liang Lu, our Chairman of the Board, President and Chief Executive Officer, Ying Wu, our Chairman and Chief Executive Officer of China Operations, and Philip Christopher, President and Chief Executive Officer of our Personal Communications Division. The loss of any key employee, the failure of any key employee to perform satisfactorily in his or her current position or our failure to attract and retain other key technical and senior management employees could have a significant negative impact on our operations. For example, Mr. Lu has announced that he will resign as our Chairman of the Board, President and Chief Executive Officer, effective as of December 31, 2006. Mr. Wu will assume the CEO position as of January 1, 2007. Moreover, we have experienced turnover in key employee positions within our financial management team—each of our current chief financial officer and controller joined the Company in the latter half of 2005. If we cannot adequately transition management of our Company after Mr. Lu's resignation or if we cannot successfully manage employee turnover in other key positions, our business may suffer.

        Notwithstanding our workforce restructurings, to effectively manage our operations, we will need to recruit, train, assimilate, motivate and retain qualified employees both locally and internationally. Competition for qualified employees is intense, and the process of recruiting personnel in all fields, including technology, research and development, sales and marketing, administration and management with the combination of skills and attributes required to execute our business strategy can be difficult, time-consuming and expensive. As we grow globally, we must implement hiring and training processes that are capable of quickly deploying qualified local residents to knowledgeably support our products and services. Alternatively, if there is an insufficient number of qualified local residents available, we might incur substantial costs importing expatriates to service new global markets. For example, we have historically experienced difficulty finding qualified accounting personnel knowledgeable in both U.S. and Chinese accounting standards who are Chinese residents. If we fail to attract, hire, assimilate or retain qualified personnel, our business would be harmed. Competitors and others have in the past, and may in the future, attempt to recruit our employees. In addition, companies in the telecommunications industry whose employees accept positions with competitors frequently claim that the competitors have engaged in unfair hiring practices. We may be the subject of these types of claims in the future as we seek to hire qualified personnel. Some of these claims may result in material litigation and disruption to our operations. We could incur substantial costs in defending ourselves against these claims, regardless of their merit.

Any acquisitions and divestitures that we undertake could be difficult to integrate, disrupt our business, dilute our stockholders and harm our operating results.

        We have acquired and divested certain businesses, products and technologies. Anticipated benefits of these acquisitions and divestitures may not be realized. We have in the past and will continue to evaluate acquisition prospects that would complement our existing product offerings, augment our market coverage, enhance our technological capabilities, or that may otherwise offer growth opportunities. Acquisitions may result in dilutive issuances of equity securities, use of our cash resources, the incurrence of debt and the amortization of expenses related to intangible assets. In addition, acquisitions involve numerous risks, including difficulties in the assimilation of operations, technologies, products and personnel of the acquired company, diversion of management's attention from other business concerns, risks of entering markets in which we have no direct or limited prior experience, the potential loss of key employees of the acquired company, unanticipated costs and, in the case of the acquisition of financially troubled businesses, challenges as to the validity of such acquisitions from third party creditors of such businesses. For example, in the fourth quarter 2004, we

87



encountered difficulties in integrating Hyundai Syscomm, Inc. ("HSI") legacy operations into our operations and determined to abandon a substantial amount of HSI's legacy operations. As a result, in the fourth quarter 2004, we wrote off the entire goodwill and intangibles associated with HSI.

We may be unable to adequately protect the loss or misappropriation of our intellectual property, which could substantially harm our business.

        We rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual obligations to protect our technology. We have applied for patents in the United States and internationally. Additional patents may not be issued from our pending patent applications, and our issued patents may not be upheld. In addition, we have, from time to time, chosen to abandon previously filed patent and trademark applications. Moreover, we may face difficulties in registering our existing trademarks in new jurisdictions in which we operate, and we may be forced to abandon or change product or service trademarks because of the unavailability of our existing trademarks. We cannot guarantee that the intellectual property protection measures that we have taken will be sufficient to prevent misappropriation of our technology or trademarks or that our competitors will not independently develop technologies that are substantially equivalent or superior to ours. In addition, the legal systems of many foreign countries do not protect or honor intellectual property rights to the same extent as the legal system of the United States. For example, in China, the legal system in general, and the intellectual property regime in particular, are still in the development stage. It may be very difficult, time-consuming and costly for us to attempt to enforce our intellectual property rights in these jurisdictions.

We may be subject to claims that we infringe the intellectual property rights of others, which could substantially harm our business.

        The industry in which we compete is moving towards aggressive assertion, licensing, and litigation of patents and other intellectual property rights. From time to time, we have become aware of the possibility or have been notified that we may be infringing certain patents or other intellectual property rights of others. Regardless of their merit, responding to such claims could be time consuming, divert management's attention and resources and cause us to incur significant expenses. In addition, although some of our supplier contracts provide for indemnification from the supplier with respect to losses or expenses incurred in connection with any infringement claim, certain contracts with our key suppliers do not provide for such protection. Moreover, certain of our sales contracts provide that we must indemnify our customers against claims by third parties for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. Therefore, we may incur substantial costs related to any infringement claim, which may substantially harm our results of operations and financial condition.

        We have been and may in the future become subject to litigation to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Future litigation may also be necessary to enforce and protect our patents, trade secrets and other intellectual property rights. Any intellectual property litigation or threatened intellectual property litigation could be costly, and adverse determinations or settlements could result in the loss of our proprietary rights, subject us to significant liabilities, require us to seek licenses from or pay royalties to third parties which may not be available on commercially reasonable terms, if at all, and/or prevent us from manufacturing or selling our products, which could cause disruptions to our operations.

        In the event that there is a successful claim of infringement against us and we fail to develop non-infringing technology or license the propriety rights on commercially reasonable terms and conditions, our business, results of operations and financial condition could be materially and adversely impacted.

88


Our multinational operations subject us to various economic, political, regulatory and legal risks.

        We market and sell our products globally, with a significant portion of our sales made in China. The expansion of our existing multinational operations and entry into new markets will require significant management attention and financial resources. Multinational operations are subject to a variety of risks, such as:

    1.
    the burden of complying with a variety of foreign laws and regulations;

    2.
    the burden of complying with United States laws and regulations for foreign operations, including the Foreign Corrupt Practices Act;

    3.
    difficulty complying with continually evolving and changing global product and communications standards and regulations for both our end products and their component technology;

    4.
    market acceptance of our new products, including longer product acceptance periods in new markets into which we enter;

    5.
    reliance on local original equipment manufacturers ("OEMs"), third party distributors and agents to effectively market and sell our products;

    6.
    unusual contract terms required by customers in developing markets;

    7.
    changes in local governmental control or influence over our customers;

    8.
    changes to import and export regulations, including quotas, tariffs, licensing restrictions and other trade barriers;

    9.
    evolving and unpredictable nature of the economic, regulatory, competitive and political environments;

    10.
    reduced protection for intellectual property rights in some countries;

    11.
    unproven business operation models developed or operated in specific countries or regions;

    12.
    longer accounts receivable collection periods; and

    13.
    difficulties and costs of staffing, monitoring and managing multinational operations, including but not limited to internal controls and compliance.

We do business in markets that are not fully developed, which subjects us to various economic, political, regulatory and legal risks unique to developing economies.

        Less developed markets present additional risks, such as the following:

    1.
    customers that may be unable to pay for our products in a timely manner or at all;

    2.
    new and unproven markets for our products and the telecommunications services that our products enable;

    3.
    lack of a large, highly trained workforce;

    4.
    difficulty in controlling local operations from our headquarters;

    5.
    variable ethical standards and an increased potential for fraud;

    6.
    unstable political and economic environments; and

    7.
    lack of a secure environment for our personnel, facilities and equipment.

        In particular, these factors create the potential for physical loss of inventory and misappropriation of operating assets. We have in the past experienced cases of vandalism and armed theft of our equipment that had been or was being installed in the field. If disruptions for any of these reasons become too severe in any particular market, it may become necessary for us to terminate contracts and withdraw from that market and suffer the associated costs and lost revenue.

89


Our wireless handset products are subject to a wide range of environmental, health and safety laws, and may expose us to potential health and environmental liability claims.

        Our handset products are subject to a wide range of environmental, health and safety laws, including laws relating to the use, disposal and clean up of, and human exposure to hazardous substances. In the United States, these laws often require parties to fund remedial action regardless of fault. Factors such as the discovery of additional contaminants, the extent of remediation and compliance expenses, and the imposition of additional clean up obligations could cause us to incur substantial costs relating to remediation activities. Compliance with existing or future environmental, health and safety laws could also cause us to incur substantial costs relating to such compliance, including the expense of modifying product designs and manufacturing processes. In addition, restrictions on the use of certain materials in our facilities or products in the future could have a negative impact on our operations.

        Additionally, there have been claims made alleging a link between the use of wireless handsets and the development or aggravation of certain cancers, including brain cancer. The scientific community is divided on whether there is a risk from wireless handset use, and if so, the magnitude of the risk. Even if there is no link established between wireless handset use and cancer, the negative publicity and possible litigation could have a material adverse effect on our business. In the past, several plaintiffs' groups have brought class actions against wireless handset manufacturers and distributors, alleging that wireless handsets have caused cancer. To date, we have not been named in any of these actions and none of these actions has been successful. In the future we could incur substantial costs in defending ourselves against similar claims, regardless of their merit. Also, claims may be successful in the future and may have a material adverse effect on our business.

We are subject to a wide range of environmental, health and safety laws and efforts to comply with such laws may be costly and may adversely impact our financial performance.

        Our operations and the products we manufacture and/or sell are subject to a wide range of global environmental, health and safety laws. Compliance with existing or future environmental, health and safety laws could subject us to future costs, liabilities, impact our production capabilities, constrict our ability to sell, expand or acquire facilities and generally impact our financial performance. Some of these laws relate to the use, disposal, clean up of, and exposure to hazardous substances. In the United States, laws often require parties to fund remedial studies or action regardless of fault. Over the last several years, the European Union (the "EU") countries have enacted environmental laws regulating electronic products. For example, beginning July 1, 2006, our products are subject to laws that mandate the recycling of waste in electronic products sold in the EU and that limit or prohibit the use of certain substances in electronic products. Other countries outside of Europe are expected to adopt similar laws. We may incur additional expenses to comply with these laws.

Currency rate fluctuations and exchange controls may adversely affect our cash flow and operating results.

        Because a significant percentage of our sales are made in foreign countries and denominated in local currency, we are exposed to market risk for changes in foreign exchange rates on our foreign currency denominated accounts and notes receivable balances. Historically, the majority of our sales have been made in China and denominated in Renminbi. Prior to July 2005, the impact of currency fluctuations of Renminbi were insignificant as it was fixed to the U.S. dollar. However, in July 2005, China uncoupled the Renminbi from the U.S. dollar and let it float in a narrow band against a basket of foreign currencies. The move revalued the Renminbi by 2.1% against the U.S. dollar; however, it is uncertain what further adjustments may be made in the future. The Renminbi-U.S. dollar exchange rate could float, and the Renminbi could appreciate relative to the U.S. dollar. For example, the Renminbi-U.S. dollar exchange rate was 8.28 to the U.S. dollar prior to the float of the Renminbi in July 2005 and 8.07 Renminbi to the U.S. dollar at the end of 2005. Any significant revaluation of the

90



Renminbi may materially and adversely affect our cash flows, revenues, operating results and financial position.

        Outside of China, our primary foreign currency exposures have related to non-dollar denominated sales and purchases in Japan, Europe and Canada. Additionally, we have exposures to emerging market currencies, which can have extreme currency volatility. We have experienced material adverse impacts on our results of operations from fluctuations in currency exchange rates and may continue to do so in the future.

        We may, from time to time, enter into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on certain foreign currency receivables and payables. Our attempts to hedge against these risks may not be successful, resulting in an adverse impact on our results of operations. Moreover, some of the foreign countries in which we do business might impose currency restrictions that may limit the ability of our subsidiaries and joint ventures in such countries to obtain and remit foreign currency necessary for the purchase of imported components and may limit our ability to obtain and remit foreign currency in exchange for foreign earnings. For example, China employs currency controls restricting Renminbi conversion, limiting our ability to engage in currency hedging activities in China. Various foreign exchange controls may also make it difficult for us to repatriate earnings, which could have a material adverse effect on our ability to conduct business globally.

Business interruptions could adversely affect our business.

        Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, external interference with our information technology systems, incidents of terrorism and other events beyond our control. For example, our Hangzhou manufacturing facility's ability to produce sufficient products is dependent upon a continuous power supply. However, the Hangzhou facility has in the past been subject to power shortages, which has affected our ability to produce and ship sufficient products. We do not have a detailed disaster recovery plan, and the occurrence of any events like these that disrupt our business could harm our business and operating results.

We may suffer losses with respect to equipment held at customer sites, which could harm our business.

        We face the risk of loss relating to our equipment held at customer sites. In some cases, our equipment held at customer sites is under contract, pending final acceptance by the customer. We generally do not hold title or risk of loss on such equipment, as title and risk of loss are typically transferred to the customer upon delivery of our equipment. However, we do not recognize revenue and accounts receivable with respect to the sale of such equipment until we obtain acceptance from the customer. If we do not obtain final acceptance, we may not be able to collect the contract price and recover this equipment or its associated costs. In other cases, particularly in China, where governmental approval is required to finalize certain contracts, inventory not under contract may be held at customer sites. We hold title and risk of loss on this inventory until the contracts are finalized and, as such, are subject to any losses incurred resulting from any damage to or loss of this inventory.

        If our contract negotiations fail or if the government of China otherwise delays approving contracts, we may not recover or receive payment for this inventory. Moreover, our insurance may not cover all losses incurred if our inventory at customer sites not under contract is damaged prior to contract finalization. If we incur a loss relating to inventory for any of the above reasons, our financial condition, cash flows, and operating results could be harmed.

Restrictions on the use of handsets while driving could affect our future growth.

        Several foreign governments and U.S. state and local governments have adopted or are considering adopting legislation that would restrict or prohibit the use of wireless handsets while driving.

91



Widespread legislation that restricts or prohibits the use of wireless handsets while driving could negatively affect our future growth.

We have been named as a defendant in securities litigation and other lawsuits, as well as lawsuits in the ordinary course of business.

        We are currently a defendant in several securities litigation class actions and other lawsuits, as well as lawsuits in the ordinary course of our business. In the future, we may be subject to similar litigation. The defense of these lawsuits may divert our management's attention, and we may incur significant expenses in defending these lawsuits (including substantial fees of lawyers and other professional advisors and potential obligations to indemnify officers and directors who may be parties to such actions). In addition, we may be required to pay judgments or settlements that could have a material adverse effect on our results of operations, financial condition and liquidity.

We face risks related to pending governmental inquiries.

        We have received notice of a formal inquiry by the staff of the Securities & Exchange Commission ("SEC") into certain aspects of our financial disclosures during prior reporting periods and certain other issues. In addition, in December 2005, the U.S. Embassy in Mongolia informed us that it had forwarded to the Department of Justice ("DOJ") allegations that an agent of our Mongolia joint venture had offered payments to a Mongolian government official in possible violation of the Foreign Corrupt Practices Act (the "FCPA"). In April 2006, we became aware that an agent of the Company may have made an offer to pay an Indian government official in possible violation of the FCPA. In June 2006, we became aware that one of our former employees may have made a payment to a Thailand government official in possible violation of the FCPA.

        We, through our Audit Committee, authorized an independent investigation into these matters, and we have been in contact with the DOJ and SEC regarding the investigation. At this time, we cannot predict when any governmental inquiry will be completed or what the outcome of any governmental inquiry will be. These inquiries could harm relationships with existing customers and our ability to obtain new customers and partners. If the SEC or the DOJ makes a determination that we have violated federal laws, we may face sanctions including, but not limited to, fines, disgorgement and an injunction. Additionally, such a determination by the SEC or the DOJ could adversely affect our stock price. It is also possible that the findings and outcome of these inquiries may affect other lawsuits that are pending. Finally, the inquiries could divert management attention and resources, which could harm our business.

Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business and stock price.

        Section 404 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") requires that we establish and maintain an adequate internal control structure and procedures for financial reporting and include a report of management on our internal control over financial reporting. Our annual report on Form 10-K must contain an assessment by management of the effectiveness of our internal control over financial reporting and must include disclosure of any material weaknesses in internal control over financial reporting that we have identified. In addition, our independent registered public accounting firm must attest to and report on management's assessment of the effectiveness of our internal control over financial reporting.

        We have identified material weaknesses in our internal control over financial reporting. See "Item 9A—Controls and Procedures—Management's Report on Internal Control Over Financial Reporting." As of the date of this quarterly report on Form 10-K, we are still in the process of implementing remedial measures related to the material weaknesses identified both in 2004 and 2005. If our efforts

92



to remediate the weaknesses we identified are not successful, our business and operating results could be harmed and the reliability of our financial statements could be impaired, which could adversely affect our stock price. The requirements of Section 404 of the Sarbanes-Oxley Act are ongoing and also apply to future years. We expect that our internal control over financial reporting will continue to evolve as we continue in our efforts to transform our business. Although we are committed to continue to improve our internal control processes and we will continue to diligently and vigorously review our internal control over financial reporting in order to ensure compliance with the Section 404 requirements, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. In addition, successful remediation of the noted control deficiencies is dependent on the Company's ability to hire and retain qualified personnel. Therefore, we cannot be certain that in the future additional material weaknesses or significant deficiencies will not exist or otherwise be discovered.

Recently enacted changes in securities laws and regulations may result in additional expenses.

        The Sarbanes-Oxley Act has required and will continue to require changes in some of our corporate governance and securities disclosure or compliance practices. The Sarbanes-Oxley Act also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and NASDAQ has revised its requirements for companies that are quoted on it. These developments (i) have required and may continue to require us to devote additional resources to our operational, financial and management information systems procedures and controls to ensure our continued compliance with current and future laws and regulations, (ii) will make it more difficult and more expensive for us to obtain director and officer liability insurance, and may require us to accept reduced coverage, increase our level of self-insurance, or incur substantially higher costs to obtain coverage, and (iii) could make it more difficult for us to attract and retain qualified members on our board of directors, or qualified executive officers. To implement plans and measures to comply with Section 404 of the Sarbanes-Oxley Act and other related rules, we expect to expend significant resources and incur additional expenses. We continue to evaluate and monitor regulatory developments and cannot estimate the timing or magnitude of additional costs that we may incur as a result of such developments.

Changes in accounting rules will increase our compensation expense and may adversely affect our net income.

        We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. For example, there have been changes to FASB guidelines relating to accounting for stock-based compensation that will increase our compensation expense, could make our net income less predictable in any given reporting period and could change the way we compensate our employees or cause other changes in the way we conduct our business.

Our ability to complete our planned restructuring and cost-reduction actions and the impact of such actions on our business may be affected by a variety of factors. These actions may, in turn, expose us to additional operation risks and have an adverse effect on our sales and profitability.

        During the second and third quarters of 2005, we announced our plans to undertake certain restructuring efforts to reduce costs and simplify our product portfolios in all of our business units. As a result, we consolidated certain operations in research and development and manufacturing and reduced our employee population. The impact of these actions on our sales and profitability may be influenced by a variety of factors, including but not limited to our ability to successfully execute our

93



plans, our ability to achieve the anticipated level of cost savings, and our ability to retain key employees. We may reprioritize our new product development initiatives, which may delay new product introductions to the market and may harm our sales. We may face additional costs associated with future actions in streamlining our operations, including but not limited to, outsourcing of certain operations to other parties.

        An important cost-reduction action has been to reduce the number of employees in our work force. While we have assessed the appropriateness of the size of our work force and made adjustments accordingly, the reduced work force could cause disruption to our operations. If this were to occur, we could have difficulties fulfilling our orders and our sales and profits could suffer. Another cost-reduction alternative we may consider is to develop outsourcing arrangements for operations such as supply-chain and information technology management. If we implement these measures, and the third parties we select to provide such services fail to deliver quality services on time and at reasonable costs, we could have difficulties operating efficiently and our operating results may be harmed.

RISKS RELATED TO CONDUCTING BUSINESS IN CHINA

China's governmental and regulatory reforms may impact our ability to do business in China.

        Since 1978, the Chinese government has been in a state of evolution and reform. The reforms have resulted in and are expected to continue to result in significant economic and social development in China. Many of the reforms are unprecedented or experimental and may be subject to change or readjustment due to a variety of political, economic and social factors. Multiple government bodies are involved in regulating and administering affairs in the telecommunications and information technology industries, among which the Ministry of Information Industry ("MII"), the National Development and Reform Commission ("NDRC"), the State-owned Assets Supervision and Administration Commission ("SASAC") and the State Administration of Radio, Film and Television ("SARFT") play the leading roles. These government agencies have broad discretion and authority over all aspects of the telecommunications and information technology industry in China, including but not limited to, setting the telecommunications tariff structure, granting carrier licenses and frequencies, approving equipment and products, granting product licenses, approving of the form and content of transmitted data, specifying technological standards as well as appointing carrier executives, all of which may impact our ability to do business in China.

        While we anticipate that the basic principles underlying the reforms will remain unchanged, any of the following changes in China's political and economic conditions and governmental policies could have a substantial impact on our business:

    1.
    the promulgation of new laws and regulations and the interpretation of those laws and regulations;

    2.
    inconsistent enforcement and application of the telecommunications industry's rules and regulations by the Chinese government between foreign and domestic companies;

    3.
    the restructuring of telecommunications carriers in China, including policy making governing 3G network infrastructure and licensing;

    4.
    restrictions on IPTV license grants, which could limit the potential market for our products;

    5.
    the introduction of measures to control inflation or stimulate growth;

    6.
    the introduction of new guidelines for tariffs and service rates, which affect our ability to competitively price our products and services;

    7.
    changes in the rate or method of taxation;

    8.
    the imposition of additional restrictions on currency conversion and remittances abroad; or

94


    9.
    any actions that limit our ability to develop, manufacture, import or sell our products in China, or to finance and operate our business in China.

        In addition to modifying the existing telecommunications regulatory framework, the Chinese government is currently preparing a draft of a standard, national telecommunications law (the "Telecommunications Law") to provide a uniform regulatory framework for the telecommunications industry. Currently a draft of the law has been finished and delivered to the National People's Congress for discussion. We do not yet know the final nature or scope of the regulations that would be created if the Telecommunications Law is passed. Accordingly, we cannot predict whether it will have a positive or negative effect on us or on some or all aspects of our business.

        Under China's current regulatory structure, the communications products that we offer in China must meet government and industry standards. In addition, a network access license for the equipment must be obtained. Without a license, telecommunications equipment is not allowed to be connected to public telecommunications networks or sold in China. Moreover, we must ensure that the quality of the telecommunications equipment for which we have obtained a network access license is stable and reliable, and will not negatively affect the quality or performance of other installed licensed products.

China's changing economic environment may impact our ability to do business in China.

        Since 1978, the Chinese government has been reforming the economic system in China to increase the emphasis placed on decentralization and the utilization of market forces in the development of China's economy. These reforms have resulted in significant economic growth. However, any economic reform policies or measures in China may from time to time be modified or revised by the Chinese government. While we may be able to benefit from the effects of some of these policies, these policies and other measures taken by the Chinese government to regulate the economy could also have a significant negative impact on economic conditions in China, which would result in a negative impact on our business.

China's entry into the World Trade Organization and relaxation of trade restrictions have led to increased foreign investment in China's telecommunications industry and may lead to increased competition in our markets which may have an adverse impact on our business.

        China's economic environment has been changing as a result of China's entry, in December of 2001, into the World Trade Organization (the "WTO"). As of 2005, China had fulfilled its WTO commitments in allowing up to 49% percent foreign investment in wireless service joint-ventures in major cities. Also, a regulation has been issued to allow 25% foreign investment in basic telecommunication service joint-ventures in Beijing, Shanghai and Guangzhou. Furthermore, China is gradually introducing a market oriented pricing mechanism for the telecommunication services. On July 13, 2005, China MII and National Development and Reform Commission (NDRC) approved the launch of plan-based pricing for fixed-line telephone service by China's 2 fixed-line operators, China Telecom and China Netcom. On August 19, 2005, MII and NDRC endorsed a "Circular on the Changes in Administration of Telecom Service Pricing," which become effective on October 1, 2005 and further loosened the pricing administration on certain telecom services. Operators are allowed to freely set price for VOIP service. This is a further step for China toward a full market oriented pricing administration mechanism. Fueled by perceived market potential, already many overseas companies are carving out niches in China's telecommunications market, including Vodafone, AT&T, British Telecom, Japan Telecom and Hong Kong's PCCW and Hutchison Whampoa. France Telecom, for example, has set up a wholly-owned research and development (R&D) facility in China, as a step towards paving the way for future expansion in the world's biggest telecom market. As China gradually relaxes the foreign-invested enterprises, some international vendors may seize this opportunity to adjust their China strategy, increasing their investment in China and converting some of their joint-ventures into fully-owned enterprises.

95



        As the existing international vendors increase their investment in China, and more vendors enter the China market, the competition in the telecommunication equipment market may increase, and as a result, our business may suffer. If China's entry into the WTO results in increased competition or has a negative impact on China's economy, our business could suffer. In addition, although China is increasingly according foreign companies and foreign investment enterprises established in China the same rights and privileges as Chinese domestic companies as a result of its admission into the WTO, special laws, administrative rules and regulations governing foreign companies and foreign investment enterprises in China may still place foreign companies at a disadvantage in relation to Chinese domestic companies and may adversely affect our competitive position.

Uncertainties with respect to the Chinese legal system may adversely affect us.

        We conduct our business in China primarily through our wholly owned subsidiaries incorporated in China. Our subsidiaries are generally subject to laws and regulations applicable to foreign investment in China. Accordingly, our business might be affected by China's developing legal system. Since 1978, many new laws and regulations covering general economic matters have been promulgated in China, and government policies and internal rules promulgated by governmental agencies may not be published in time, or at all. As a result, we may operate our business in violation of new rules and policies without having any knowledge of their existence. In addition, there are uncertainties regarding the interpretation and enforcement of laws, rules and policies in China. The Chinese legal system is based on written statutes, and prior court decisions have limited precedential value. Because many laws and regulations are relatively new and the Chinese legal system is still evolving, the interpretations of many laws, regulations and rules are not always uniform. Moreover, the relative inexperience of China's judiciary in many cases creates additional uncertainty as to the outcome of any litigation, and the interpretation of statutes and regulations may be subject to government policies reflecting domestic political changes. Finally, enforcement of existing laws or contracts based on existing law may be uncertain and sporadic, and it may be difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a court of another jurisdiction. Any litigation in China may be protracted and result in substantial costs and diversion of resources and management's attention.

If tax benefits available to our subsidiaries located in China are reduced or repealed, our business could suffer.

        The Chinese government is considering the imposition of a "unified" corporate income tax that would phase out, over time, the preferential tax treatment to which foreign investment enterprises, such as ourselves and our joint ventures, are currently entitled. While it is not certain whether the government will implement such a unified tax structure or whether we will be grandfathered into any new tax structure, if a new tax structure is implemented, such new tax structure may adversely affect our financial condition. Moreover, the Chinese central government may review and audit tax benefits granted by local or provincial authorities and could determine to disallow such benefits. Certain of our subsidiaries and joint ventures located in China enjoy tax benefits in China that are generally available to foreign investment enterprises. If these tax benefits are reduced, disallowed or repealed due to changes in tax laws or determination by the Chinese government, our business could suffer.

Our ability to continue successful deployment of PAS system and sales of PAS handsets are limited by certain factors, including the following:

Maturing PAS market and increased competition in handsets and tariffs.

        The market for PAS exceeded 87 million users as of the end of fiscal year 2005 and is available in most of the provinces throughout China. We believe the PAS market has matured. For example, during fiscal year 2005, net sales of the PAS/IPAS system and the wireless infrastructure market declined significantly as compared to fiscal year 2004. In addition, the increase in handset competitors entering

96



the market has resulted in decreased average selling prices and margins. If additional handset competitors enter the market, or if competitors decide to further reduce pricing, our sales of PAS handsets may be adversely impacted.

        Furthermore, competition from mobile operators, such as China Mobile and China Unicom, has increased in cities where PAS is deployed. Mobile operators offering special promotional pricing or incentives to customers, such as free incoming calls or free mobile-to-mobile calls, have harmed the ability of our customers, China Telecom and China Netcom, to compete effectively. The continued use of such incentive programs by mobile operators may adversely impact China Telecom and China Netcom's ability to increase PAS subscriptions. Due to our relationships with China Telecom and China Netcom, reduced subscription growth at these carriers may have a material adverse effect on our pricing and harm our business or results of operations.

Our PAS system and handsets sales may experience a sharp decline if China Telecom or China Netcom obtain licenses allowing them to deliver mobile services.

        China's media sources have widely reported that the MII may grant 3G mobile licenses to China Telecom or China Netcom, or to both in 2006 or 2007. If China Telecom or China Netcom obtain 3G mobile licenses, they may re-allocate capital expenditures to construct 3G networks, and as a consequence, may significantly reduce capital expenditures relating to PAS networks that utilize our existing products. In addition, it is possible that current PAS frequency bands utilized by PAS networks may be reallocated for use by 3G networks, resulting in the restriction of or shutting down of PAS networks. If this were to occur, we could lose current and potential future customers of our products, and our financial condition and results of operations could be significantly harmed.

We only have trial licenses for the PAS system and handsets in China.

        We only have trial licenses for our PAS systems and handsets. We have applied for, but have not yet received, a final official network access license for our PAS systems and handsets. Based upon communication with the MII, we understand that our PAS systems and handsets are considered to still be in the trial period and sales of our PAS systems and handsets may continue to be made by us during this trial period, but that licenses will ultimately be required. If we fail to obtain the required licenses, we could be prohibited from making further sales of the unlicensed products, including our PAS systems and handsets, in China, which would substantially harm our business, financial condition and results of operations. The regulations implementing these requirements are not very detailed, have not been applied by a court and may be interpreted and enforced by regulatory authorities in a number of different ways. Our legal counsel in China has advised us that China's governmental authorities may interpret or apply the regulations with respect to which licenses are required and the ability to sell a product while a product is in the trial period in a manner that is inconsistent with the information received by our legal counsel in China, and either of these conditions could have a material adverse effect on our business, financial condition and results of operations.

Increasing centralization of purchasing decision-making by carriers may lead to customer concentration and affect the results of our business.

        Most Chinese carriers have three levels of operations: the central headquarters level, the provincial level and the local city/county level. Both central and provincial levels are independent legal persons and have their own corporate mandate. The purchasing decision-making process may take various forms for different projects and may also differ significantly from carrier to carrier. In the case of PAS systems, we negotiate and enter into all China Netcom contracts with the provincial operators. However, the central headquarters of China Telecom has chosen to exert its influence in the purchasing decision-making process by negotiating contractual terms, such as purchase price, payment terms, and acceptance clauses at the central level. The provincial operator then further negotiates the contract

97



based on the guidelines provided by the headquarters. We enter into final contracts with the provincial operator. However, if this trend of centralized decision-making expands to unified purchasing, resulting in the negotiation and execution of contracts at the central headquarter level, there may be a concentration of customers which could have a significant impact on our business. If China Netcom follows China Telecom and exerts the headquarters' influence in price negotiation, it may give downward pressure to the margin of our PAS system products to China Netcom.

Television over the internet is a new business in China and laws regulating the business have not been fully-developed and are unpredictable. Unfavorable regulation of the industry may adversely affect our IPTV operations in China and negatively impact our business.

        Broadcasting television over the internet has only recently begun in China. The State Administration of Radio, Film and Television (SARFT) issued a measure in July 2004 to regulate the broadcasting of audio-visual programs through the information network, which includes our Internet Protocol television (IPTV) business. SARFT categorized the information network into the mobile telecommunication network, fixed communications network, microwave communication network, cable television network, satellite or other metropolitan area network, wide area network, local area network and other information networks categories. The receiving terminal equipment includes computers, television sets, mobile phones and other electronic products. While regulating the IPTV business, SARFT is encouraging development in China of the digital television business, a business that may be competitive with IPTV in the target market. The digital television and IPTV target complementary markets and it is not clear the extent of support SARFT will provide for IPTV in setting regulations. For example the Quanzhou Administration of Radio, Film, and Television issued a notice to stop all IPTV business in Quanzhou on December 25, 2005. The Zhejiang Administration of Radio, Film, and Television issued a similar notice on January 10, 2006. In both instances, SARFT had not endorsed the launch of commercial IPTV services in those localities yet through its licensing regime. However, in some other cities, such as Shanghai and Harbin where IPTV licenses were specifically issued by SARFT, IPTV is progressing well. Because the IPTV industry relates to both television and Internet sectors, it may be subject to regulation by different governmental authorities, including the Ministry of Information Industry (MII), which may become involved as a proponent to the IPTV industry. As the growth rate for traditional telecom business slows down, China Telecom, China Netcom and other operators have made great efforts to develop IPTV. At the end of 2005, an official of MII declared that MII and SARFT would jointly administer the IPTV industry in the coming years. However, due to a lack of uniform regulation on the development of the IPTV industry, we cannot predict that our IPTV business will operate smoothly in China. Our business may suffer if the law or policy in China does not encourage the IPTV industry.

We currently do not have a license to engage in the IPTV operator service business in China and development of our IPTV business depends upon the cooperation of IPTV license holder(s) and network operators. If we are unable to work cooperatively with license holder(s) and network operators, our business may suffer.

        Under the measures issued by SARFT in July 2004, entities intending to engage in the IPTV operator service business should obtain a license from SARFT and foreign investment enterprises are prohibited from engaging in the IPTV operator service business. In practice, SARFT only grants such licenses to state-owned companies. Since we are the technical service and equipment provider in this field, our business development will depend on the cooperation of license holders and network operators. Our business may suffer if we fail to cooperate with license holders or network operators, or if the license holder(s) we're cooperating with lose their licenses.

98


RISKS RELATED TO OUR STOCK PERFORMANCE AND CONVERTIBLE DEBT SECURITIES

Our stock price is highly volatile.

        The trading price of our common stock has fluctuated significantly since our initial public offering in March of 2000. Our stock price could be subject to wide fluctuations in the future in response to many events or factors, including those discussed in the preceding risk factors relating to our operations, as well as:

    1.
    actual or anticipated fluctuations in operating results, actual or anticipated gross profit as a percentage of net sales, levels of inventory, our actual or anticipated rate of growth and our actual or anticipated earnings per share;

    2.
    changes in expectations as to future financial performance or changes in financial estimates or buy/sell recommendations of securities analysts;

    3.
    changes in governmental regulations or policies in China;

    4.
    our, or a competitor's, announcement of new products, services or technological innovations;

    5.
    the operating and stock price performance of other comparable companies; and

    6.
    news and commentary emanating from the media, securities analysts or government bodies in China relating to us and to the industry in general.

        General market conditions and domestic or international macroeconomic factors unrelated to our performance may also affect our stock price. For these reasons, investors should not rely on recent trends to predict future stock prices or financial results. In addition, following periods of volatility in a company's securities, securities class action litigation against a company is sometimes instituted. We have experienced substantial costs and the diversion of management's time and resources on this type of litigation and may do so in the future.

        In addition, public announcements by China Telecom, China Netcom, China Mobile, and China Unicom each of which exert significant influence over many of our major customers in China, may contribute to volatility in the price of our stock. The price of our stock may react to such announcements.

SOFTBANK CORP. with its related entities, including SOFTBANK America Inc., has significant influence over our management and affairs, which it could exercise against the best interests of our stockholders.

        SOFTBANK CORP. and its related entities, including SOFTBANK America Inc. (collectively, "SOFTBANK"), beneficially owned approximately 12.1% of our outstanding stock as of June 30, 2006. As a result, SOFTBANK has the ability to influence all matters submitted to our stockholders for approval, as well as our management and affairs. Matters that could require stockholder approval include:

    1.
    election and removal of directors;

    2.
    our merger or consolidation with or into another entity; and

    3.
    sale of all or substantially all of our assets.

        This concentration of ownership may delay or prevent a change of control or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us, which could decrease the market price of our common stock.

99


Delaware law and our charter documents contain provisions that could discourage or prevent a potential takeover, even if the transaction would benefit our stockholders.

        Other companies may seek to acquire or merge with us. Our acquisition or merger could result in benefits to our stockholders, including an increase in the value of our common stock. Some provisions of our Certificate of Incorporation and Bylaws, as well as provisions of Delaware law, may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

    1.
    authorizing the board of directors to issue additional preferred stock;

    2.
    prohibiting cumulative voting in the election of directors;

    3.
    limiting the persons who may call special meetings of stockholders;

    4.
    prohibiting stockholder action by written consent;

    5.
    creating a classified board of directors pursuant to which our directors are elected for staggered three year terms; and

    6.
    establishing advance notice requirements for nominations for election to the board of directors and for proposing matters that can be acted on by stockholders at stockholder meetings.

Together with the holders of our convertible subordinated notes due in 2008, we face a variety of risks related to the notes.

        Holders of our convertible subordinated notes due in 2008 (the "Notes") and we face a variety of risks with respect to the Notes, including the following:

    1.
    we may be limited in our ability to purchase the Notes in the event of a change in control, either for cash or stock, which could result in our defaulting on the Notes at the time of the change in control, and purchases for stock would be subject to market risk;

    2.
    an event of default under our senior debt, including one of our subsidiaries, could restrict our ability to purchase or pay any or all amounts due on Notes, and after paying our senior debt in full, we may not have sufficient assets remaining to pay any or all amounts due on the Notes;

    3.
    there is no listed trading market for the Notes, which could have a negative impact on the market price of the Notes;

    4.
    we have significantly increased our leverage as a result of the sale of the Notes which could have an adverse impact on our

    5.
    ability to obtain additional financing for working capital;

    6.
    hedging transactions related to the Notes and our common stock and other transactions, as well as changes in interest rates and our creditworthiness, may affect the value of the Notes and of our common stock; and

    7.
    the Notes are not rated, nor do we anticipate that they will be rated, ultimately having a negative effect on the price of the Notes and of our common stock.

        In addition, we are subject to various covenants and obligations pursuant to the terms of the indenture governing the Notes (the "Indenture"). Should we default on certain of these obligations, then all unpaid principal and accrued interest on the Notes then outstanding could become immediately due and payable. For example, as of March 16, 2006 and continuing through June 1, 2006, we were in technical noncompliance under the Indenture due to the untimely filing of our annual report on Form 10-K for the year ended December 31, 2005. The Company had received notice from

100



the Trustee asserting that if the Company had failed to file its Annual Report on Form 10-K for the year ended December 31, 2005 on or before June 2, 2006, such failure would constitute an event of default pursuant to the Indenture. If such an event were to occur, the trustee under the Indenture or the holders of at least 25% in aggregate principal amount of the Notes then outstanding would have the right to declare all unpaid principal and accrued interest on the Notes then outstanding to be immediately due and payable. If an event of default under the Indenture occurs and if payment of principal and accrued interest on the Notes is accelerated, our business could be seriously harmed.

Our failure to timely file periodic reports with the Securities and Exchange Commission could result in the delisting of our common stock from the NASDAQ National Market and cause us to default on covenants contained in contractual arrangements.

        If we are unable to maintain compliance with the conditions for continued listing required by NASDAQ, then our shares of common stock may be subject to delisting from the NASDAQ National Market. If our shares of common stock are delisted from the NASDAQ National Market, they may not be eligible to trade on any national securities exchange or the over-the counter market. If our common stock is no longer traded through a market system, the liquidity of our common stock may be greatly reduced, which could negatively affect its price. In addition, we may be unable to obtain future equity financing, or use our common stock as consideration for mergers or other business combinations. A delisting from the NASDAQ National Market may also have other negative implications, including the potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest, and fewer business development opportunities.


ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

        None


ITEM 3—DEFAULTS UPON SENIOR SECURITIES

        The Company delayed the filing of its Annual Report on Form 10-K for the year ended December 31, 2005 ("the 2005 Form 10-K") in order to: (i) enable the Audit Committee of the Board to complete an investigation with regard to the circumstances surrounding the premature recognition of revenue on certain transactions, and (ii) management to complete the preparation of its 2005 consolidated financial statements and its assessment as of December 31, 2005 of the Company's internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002.

        Pursuant to the Indenture (the "Indenture") with respect to the Company's 7/8% Convertible Subordinated Notes due 2008 (the "Notes"), the Company is required to file all reports and other information and documents which it is required to file with the Securities and Exchange Commission pursuant to Section 13 or 15(d) of the Exchange Act of 1934 and provide a copy of such filings to the trustee for the holders of the Notes (the "Trustee"). Pursuant to the Indenture, a default by the Company on this requirement becomes an event of default (as described in the Indenture) (i) if the Trustee notifies the Company of the default or (ii) the holders of at least 25% in aggregate principal amount of the Notes outstanding notify the Company and the Trustee of the default, and (iii) the Company does not cure the default within 60 days after receipt of such notice.

        The Company received notice from the Trustee asserting that if the Company failed to file the 2005 Form 10-K on or before June 2, 2006, such failure would constitute an event of default pursuant to the Indenture. If such an event of default were to occur, the Trustee or the holders of at least 25% in aggregate principal amount of the Notes then outstanding would have had the right to declare all unpaid principal and accrued interest on the Notes then outstanding to be immediately due and payable. This technical default was cured prior to June 2, 2006 with the filing of the 2005 Form 10-K.

101




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

        None


ITEM 5—OTHER INFORMATION

        None


ITEM 6—EXHIBITS

Exhibit
Number

  EXHIBIT DESCRIPTION
10.110 (1) UTStarcom, Inc. 2006 Equity Incentive Plan

10.111

(1)

Form of Stock Option Award Agreement

10.112

(1)

Form of Stock Option Award Agreement for Directors and Officers

10.113

(1)

Form of Restricted Stock Agreement

10.114

(1)

Form of Restricted Stock Unit Agreement

10.115

 

Form of Amended and Restated Change of Control Severance Agreement to be entered into by and between Ying Wu and UTStarcom, Inc.

10.116

 

Form of Amended and Restated Change of Control Severance Agreement to be entered into by and between William X. Huang and UTStarcom, Inc.

10.117

 

Form of Amended and Restated Change of Control/Involuntary Termination Severance Agreement to be entered into by and between Francis P. Barton and UTStarcom, Inc.

31.1

 

Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.

31.2

 

Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.

32.1

 

Certifications of the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1)
Incorporated by reference to the registrant's Current Report on Form 8-K, which was filed on July 27, 2006.

102



SIGNATURES

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

    UTSTARCOM, INC.

Date: August 9, 2006

 

By:

 

/s/  
HONG LIANG LU      
Hong Liang Lu
President, Chief Executive Officer and Director
(Principal Executive Officer)

Date: August 9, 2006

 

By:

 

/s/  
FRANCIS P. BARTON      
Francis P. Barton
Executive Vice President of Finance, Chief Financial Officer
(Principal Financial Officer)

103




QuickLinks

PART I—FINANCIAL INFORMATION
PART II—OTHER INFORMATION
SIGNATURES
Wikinvest © 2006, 2007, 2008, 2009, 2010, 2011, 2012. Use of this site is subject to express Terms of Service, Privacy Policy, and Disclaimer. By continuing past this page, you agree to abide by these terms. Any information provided by Wikinvest, including but not limited to company data, competitors, business analysis, market share, sales revenues and other operating metrics, earnings call analysis, conference call transcripts, industry information, or price targets should not be construed as research, trading tips or recommendations, or investment advice and is provided with no warrants as to its accuracy. Stock market data, including US and International equity symbols, stock quotes, share prices, earnings ratios, and other fundamental data is provided by data partners. Stock market quotes delayed at least 15 minutes for NASDAQ, 20 mins for NYSE and AMEX. Market data by Xignite. See data providers for more details. Company names, products, services and branding cited herein may be trademarks or registered trademarks of their respective owners. The use of trademarks or service marks of another is not a representation that the other is affiliated with, sponsors, is sponsored by, endorses, or is endorsed by Wikinvest.
Powered by MediaWiki