NEXT LEVEL COMMUNICATIONS INC
10-Q, 2000-08-11
TELEPHONE COMMUNICATIONS (NO RADIOTELEPHONE)
Previous: AUTEO MEDIA INC, 10QSB, EX-27, 2000-08-11
Next: NEXT LEVEL COMMUNICATIONS INC, 10-Q, EX-27.1, 2000-08-11



<PAGE>   1

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

     (Mark One)

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

                       FOR THE QUARTER ENDED JUNE 30, 2000

                                       OR

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

                         COMMISSION FILE NUMBER: 0-27877

                         NEXT LEVEL COMMUNICATIONS, INC.
             (Exact Name of Registrant as Specified in Its Charter)


            DELAWARE                                      95-3342408
   (State or Other Jurisdiction of                     (I.R.S. Employer
    Incorporation or Organization)                     Identification No.)


                              6085 STATE FARM DRIVE
                         ROHNERT PARK, CALIFORNIA 94928
          (Address of Principal Executive Offices, Including Zip Code)

       Registrant's Telephone Number, Including Area Code: (707) 584-6820


        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 quarter that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [X] Yes [ ] No

        The number of shares of our common stock, par value $0.01 per share,
outstanding as of August 8, 2000 was approximately 83,606,932.


<PAGE>   2

                                TABLE OF CONTENTS


                          PART I. FINANCIAL INFORMATION

<TABLE>
<CAPTION>
                                                                                                            Page No.
                                                                                                            --------
<S>                                                                                                         <C>
Item 1.  Financial Statements.............................................................................      1

Item 2.  Management's Discussion and Analysis of Financial Condition
          and Results of Operations.......................................................................      7

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.......................................     22

                                            PART II. OTHER INFORMATION

Item 1.  Legal Proceedings................................................................................     22

Item 2.  Changes in Securities and Use of Proceeds........................................................     22

Item 4.  Submission of Matters to a Vote of Security Holders..............................................     23

Item 6.  Exhibits and Reports on Form 8-K.................................................................     23
</TABLE>


<PAGE>   3

                          PART I. FINANCIAL INFORMATION


ITEM 1. FINANCIAL STATEMENTS

NEXT LEVEL COMMUNICATIONS, INC.

CONDENSED BALANCE SHEETS
JUNE 30, 2000 AND DECEMBER 31, 1999 (IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
                                                                                                JUNE 30, 2000   DECEMBER 31, 1999
                                                                                                -------------   -----------------
<S>                                                                                                <C>              <C>
ASSETS
CURRENT  ASSETS:
  Cash and cash equivalents                                                                        $  90,298        $ 128,752
  Marketable securities                                                                               14,941           14,971
  Trade receivables, less allowance for doubtful accounts of $1,321 and $1,337, respectively          21,792           13,879
  Other receivables                                                                                    1,047            1,435
  Inventories                                                                                         37,874           22,553
  Receivable from Motorola                                                                             1,001              950
  Prepaid expenses and other current assets                                                            1,566            1,792
                                                                                                   ---------        ---------
           Total current assets                                                                      168,519          184,332

MARKETABLE  SECURITIES                                                                                28,000           30,151
PROPERTY  AND  EQUIPMENT,  Net                                                                        49,396           48,263
INTANGIBLES  (less accumulated amortization of $3,741 and $3,141, respectively)                        4,465            5,065
                                                                                                   ---------        ---------
TOTAL                                                                                              $ 250,380        $ 267,811
                                                                                                   =========        =========

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT  LIABILITIES:
  Accounts payable                                                                                 $  29,836        $  13,261
  Other accrued liabilities                                                                           15,120           11,375
  Deferred revenue                                                                                     1,726           11,148
  Current portion of capital lease obligations                                                           436              600
                                                                                                   ---------        ---------
           Total current liabilities                                                                  47,118           36,384
                                                                                                   ---------        ---------
LONG-TERM  DEBT                                                                                       25,000           24,853
                                                                                                   ---------        ---------

LONG-TERM  CAPITAL  LEASE  OBLIGATIONS                                                                   173              346
                                                                                                   ---------        ---------

STOCKHOLDERS'  EQUITY
  Common stock - $.01 par value, 200,000,000 shares authorized;
    shares issued and outstanding, 82,597,075 and 79,752,000, respectively                               761              754
  Additional paid-in capital                                                                         415,530          412,930
  Accumulated deficit                                                                               (238,134)        (205,072)
  Unrealized loss on marketable securities                                                               (68)              --
  Unearned compensation                                                                                   --           (2,384)
                                                                                                   ---------        ---------
           Total stockholders' equity                                                                178,089          206,228
                                                                                                   ---------        ---------

TOTAL                                                                                              $ 250,380        $ 267,811
                                                                                                   =========        =========
</TABLE>

See notes to financial statements.
<PAGE>   4

NEXT LEVEL COMMUNICATIONS, INC.

CONDENSED STATEMENTS OF OPERATIONS
THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2000 AND JUNE 30, 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                      Three Months Ended              Six Months Ended
                                                JUNE 30, 2000  JUNE 30, 1999   JUNE 30, 2000    JUNE 30, 1999
                                                -------------  -------------   -------------    -------------
<S>                                             <C>            <C>             <C>              <C>
REVENUES:
  Equipment                                       $ 39,340        $  8,482        $ 69,029        $ 16,429
  Software                                             836             931           1,626           1,761
                                                  --------        --------        --------        --------
           Total revenues                           40,176           9,413          70,655          18,190
                                                  --------        --------        --------        --------

COST OF REVENUES:
  Equipment                                         32,076           8,651          56,967          16,982
  Software                                              25              84              82             158
                                                  --------        --------        --------        --------
           Total cost of revenues                   32,101           8,735          57,049          17,140
                                                  --------        --------        --------        --------
GROSS PROFIT                                         8,075             678          13,606           1,050
                                                  --------        --------        --------        --------

OPERATING EXPENSES:
  Research and development                          13,652          11,798          27,496          23,051
  Selling, general and administrative               10,966           7,593          20,530          14,384
  Noncash compensation charge                           --              --           2,384              --
                                                  --------        --------        --------        --------
           Total operating expenses                 24,618          19,391          50,410          37,435
                                                  --------        --------        --------        --------
OPERATING LOSS                                     (16,543)        (18,713)        (36,804)        (36,385)

OTHER INCOME (EXPENSE),  Net                           (46)            464             (51)            572
INTEREST INCOME(EXPENSE)                             1,956          (1,691)          3,793          (3,384)
                                                  --------        --------        --------        --------

NET  LOSS                                         $(14,633)       $(19,940)       $(33,062)       $(39,197)
                                                  ========        ========        ========        ========

BASIC AND DILUTED NET
  LOSS PER COMMON SHARE (PRO FORMA IN 1999)       $   (.18)       $   (.26)       $   (.41)       $   (.51)
                                                  ========        ========        ========        ========

SHARES USED TO COMPUTE
  BASIC AND DILUTED NET LOSS
  PER COMMON SHARE (PRO FORMA IN 1999)              80,322          69,967          80,042          69,967
                                                  ========        ========        ========        ========
</TABLE>

See notes to financial statements.



                                       2
<PAGE>   5

NEXT LEVEL COMMUNICATIONS, INC.

CONDENSED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2000 AND 1999 (IN THOUSANDS, UNAUDITED)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                 JUNE 30, 2000     JUNE 30, 1999
                                                                                 -------------     -------------
<S>                                                                              <C>               <C>
OPERATING ACTIVITIES:
  Net loss                                                                          $ (33,062)       $ (39,197)
  Adjustments to reconcile net loss to net cash used in operating activities:
    Noncash compensation charge                                                         2,384               --
    Depreciation and amortization                                                       5,360            4,161
    Loss on disposal of assets                                                             --              318
    Changes in assets and liabilities:
      Trade receivables                                                                (7,913)           2,806
      Inventories                                                                     (15,321)          (7,436)
      Other current and non-current assets                                                563            4,919
      Accrued interest payable to General Instrument                                       --            3,290
      Accounts payable                                                                 16,575           (5,874)
      Accrued liabilities and deferred revenue                                         (5,677)          13,622
                                                                                    ---------        ---------
           Net cash used in operating activities                                      (37,091)         (23,391)
                                                                                    ---------        ---------

INVESTING ACTIVITIES:
  Purchases of property and equipment                                                  (5,893)          (4,760)
  Proceeds from notes receivable                                                           --               55
  Proceeds from sale of marketable securities                                           2,113               52
                                                                                    ---------        ---------
           Net cash used in investing activities                                       (3,780)          (4,653)
                                                                                    ---------        ---------

FINANCING ACTIVITIES:
  Payment of IPO expenses                                                                (899)              --
  Proceeds from borrowings, net                                                           147               --
  Repayment of capital lease obligations                                                 (337)            (217)
  Sale of common stock                                                                  3,506               --
  General Instrument capital contribution                                                  --           34,000
                                                                                    ---------        ---------
           Net cash provided by/used in financing activities                            2,417           33,783
                                                                                    ---------        ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                  (38,454)           5,739

CASH AND CASH EQUIVALENTS, Beginning of period                                        128,752           28,983
                                                                                    ---------        ---------
CASH AND CASH EQUIVALENTS, End of period                                            $  90,298        $  34,722
                                                                                    =========        =========
</TABLE>

See notes to financial statements.



                                       3
<PAGE>   6

NEXT LEVEL COMMUNICATIONS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)
--------------------------------------------------------------------------------

1.      BASIS OF PRESENTATION

        The accompanying unaudited condensed financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and pursuant to the rules and regulations of the
Securities and Exchange Commission. While these financial statements reflect all
adjustments (consisting of normal recurring items) which are, in the opinion of
management, necessary to present fairly the results of the interim quarter, they
do not include all information and footnotes required by generally accepted
accounting principles for complete financial statements. These financial
statements and notes should be read in conjunction with the financial statements
and notes thereto, for the year ended December 31, 1999 contained in the
Company's Annual Report on Form 10-K. Certain prior quarter amounts have been
reclassified to conform to the current quarter presentation. The results of
operations for the three-month quarter and six month period ended June 30, 2000
are not necessarily indicative of the operating results for the full year.

2.      ORGANIZATION AND RECAPITALIZATION

        Next Level Communications, Inc. (the "Company") is a leading provider of
broadband communications systems that enable telephone companies and other
emerging communications service providers to cost effectively deliver voice,
data and video services over the existing copper wire telephone infrastructure.

        Next Level Communications ("NLC" or the "Limited Partner") was
incorporated as a California corporation on June 22, 1994 and commenced
operations in July 1994. In September 1995, NLC was acquired by General
Instrument Corporation ("General Instrument").

        In January 1998, NLC transferred its net assets, management and
workforce to a newly formed limited partnership, Next Level Communications L.P.
(the "Partnership"), in exchange for an 89% limited partnership interest. The
Partnership recorded the net assets transferred at their historical cost. At the
same time, Spencer Trask (the "General Partner" or "GI") acquired an 11% general
partner interest in the Partnership in exchange for a $10.0 million cash
contribution.

        On August 24, 1999 the Partnership formed the Company as a wholly owned
subsidiary. On October 14, 1999, management of NLC effected a 1-for-3 reverse
stock split.

        All share amounts in the accompanying financial statements have been
restated to give effect to the reverse stock split.

        On November 9, 1999, the Company issued 9,775,000 shares of common stock
at $20.00 per share for net proceeds of $177,016,000 in an initial public
offering (the "Offering"). Prior to the completion of the Offering, the
following recapitalization transactions (the "Recapitalization") occurred:

        -    The note payable and accrued interest to General Instrument of
             $86.8 million was converted into 4,337,633 shares of the Company's
             common stock.

        -    The Partnership and NLC (a wholly owned subsidiary of General
             Instrument) were merged into the Company. As part of this merger,
             the General Partner received 5,863,329 shares of the



                                       4
<PAGE>   7

             Company's common stock and General Instrument received 55,366,091
             shares of the Company's common stock in exchange for their
             respective partnership interests.

        -    The Company issued a common stock dividend of 4,400,000 shares to
             General Instrument to reflect the additional value, $88 million,
             that will be received by the Company upon exercise of the warrants
             described below. In accordance with the Partnership agreement. NLC
             was entitled to receive $88.0 million exercise price. As a result
             of the Recapitalization, such amount will be received by the
             Company, should these warrants be exercised. Accordingly, General
             Instrument received the $88.0 million of common stock (4,400,000
             shares) because it would have received that amount under the
             Partnership agreement.

        -    The General Partner's option and the Partnership agreement to
             acquire up to 11% of NLC upon an initial public offering was
             converted into warrants to acquire 8,480,102 shares of the
             Company's common stock at $10.38 per share.

        -    Options granted to employees of the Partnership to purchase shares
             of NLC were converted on a one-for-one basis into options to
             purchase a total of 6,964,904 shares of the Company's common stock.

        The Recapitalization was accounted for at historical cost. The
accompanying financial statements represent those of the Company from November
10, 1999 and those of the Partnership for the six months ended June 30, 2000. In
January 2000, General Instrument was acquired by Motorola, Inc.

3.      INVENTORIES

        Inventories at June 30, 2000 and December 31, 1999 consist of (in
thousands):

<TABLE>
<CAPTION>
                      June 30,    December 31,
                       2000          1999
                      -------       -------
<S>                   <C>         <C>
Raw Materials         $13,981       $ 8,175
Work-in-process         4,974         1,542
Finished goods         18,919        12,836
                      -------       -------
Total                 $37,874       $22,553
</TABLE>

4.      LONG-TERM DEBT

        In December 1999, the Company entered into a revolving bank line of
credit ("Line") under which the Company may borrow up to the lesser of $50
million or the value of pledged collateral. At June 30, 2000, the balance
outstanding was $25,000,000. Interest on the Line is at IBOR plus .7%. The
Line's maturity is October 1, 2001. At June 30, 2000, there was $25,000,000
under the line of credit available to the Company. The line was secured by
$25,000,000 of marketable securities held by a custodian. On July 19, 2000 the
Company repaid all outstanding principal and interest related to the Line.



                                       5
<PAGE>   8

5.      NET LOSS AND PRO FORMA NET LOSS PER SHARE

         Basic and diluted net loss per share for the quarter ended June 30,
2000 is computed by dividing net loss by the average shares outstanding for the
quarter. Pro forma basic and diluted net loss per share for the quarter ended
June 30, 1999 is computed by dividing the pro forma net loss by the pro forma
shares outstanding for the quarter giving effect to the Recapitalization as if
it had occurred on January 1, 1999.

        The following is a reconciliation of the components of the basic and
diluted net loss per share (in thousands except per share amounts):

<TABLE>
<CAPTION>
                                                           THREE MONTHS ENDED JUNE 30        SIX MONTHS ENDED JUNE 30
                                                              2000             1999            2000            1999
                                                           ----------        --------        --------        --------
                                                                             PRO FORMA                       PRO FORMA
<S>                                                        <C>               <C>             <C>             <C>
Net loss                                                   $  (14,633)       $(19,940)       $(33,062)       $(39,197)
Less: Interest expense for converted GI note payable               --           1,645              --           3,290
                                                           ----------        --------        --------        --------
Net loss                                                   $  (14,633)       $(18,295)       $(33,062)       $(35,907)
                                                           ==========        ========        ========        ========

Weighted average shares outstanding                            80,322          69,967          80,042          69,967
                                                           ==========        ========        ========        ========

Basic and diluted net loss per share                       $     (.18)       $   (.26)       $   (.41)       $   (.51)
                                                           ==========        ========        ========        ========
</TABLE>

        For the periods ended June 30, 2000 and 1999, the Company had securities
outstanding that could potentially dilute basic earnings per share in the
future, but were excluded from the computation of diluted net loss per share, as
their effect would have been antidilutive. Such outstanding securities consist
of the following (in thousands):


<TABLE>
<CAPTION>
                                          Periods Ended
                                ---------------------------------
                                June 30, 2000       June 30, 1999
                                -------------       -------------
<S>                             <C>                 <C>
General Partner's warrants          5,987                8,480
Outstanding employee options       19,195                6,962
                                   ------               ------
Total                              25,182               15,442
</TABLE>


6.      COMPREHENSIVE INCOME (LOSS)

        The following table sets forth the calculation of comprehensive
income(loss):

<TABLE>
<CAPTION>
                                                         THREE MONTHS ENDED JUNE 30      SIX MONTHS ENDED JUNE 30
                                                           2000            1999            2000            1999
                                                         --------        --------        --------        --------
<S>                                                      <C>             <C>             <C>             <C>
Net loss                                                 $(14,633)       $(19,940)       $(33,063)       $(39,197)
Unrealized gains (losses) on marketable securities             20              --             (68)             --
                                                         --------        --------        --------        --------
Total Comprehensive Loss                                 $(14,613)       $(19,940)       $(33,131)       $(39,197)
                                                         ========        ========        ========        ========
</TABLE>



                                       6
<PAGE>   9

7.      ACQUISITIONS

        In July 2000, the Company issued 138,615 shares of common stock to
purchase 100% of SoftProse, a company that provides products and development
services for consumer electronics, embedded systems, real-time systems and
communications systems.

        In addition, in July 2000, the Company announced the formation of a
strategic partnership with Outreach Communications, L.L.C. to provide integrated
broadband service to local telephone companies in rural areas. The Company will
contribute $7,000,000 in cash in exchange for an ownership interest of less than
20%.

ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
         OPERATIONS

        Some of the statements in the following discussion and elsewhere in this
report constitute forward-looking statements. These statements relate to future
events or our future financial performance. In some cases, you can identify
forward-looking statements by terminology such as "may," "will," "should,"
"expect," "plan," "anticipate," "believe," "estimate," "predict," "potential" or
"continue" or the negative of such terms or other comparable terminology. These
statements involve known and unknown risks, uncertainties, and other factors
that may cause our or our industry's actual results, levels of activity,
performance, or achievements to be materially different from any future results,
levels of activity, performance or achievements expressed or implied by such
forward-looking statements. These factors include, among other things, those
listed under "Risk Factors" and elsewhere in this report.

        Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we cannot guarantee future results,
levels of activity, performance or achievements.


OVERVIEW


        We design and market broadband communications equipment that enables
telephone companies and other communications service providers to
cost-effectively deliver a full suite of voice, data and video services over the
existing copper wire telephone infrastructure. We commenced operations in July
1994 and recorded our first sale in September 1997. From January 1998 until
November 1999, we operated through Next Level Communications L.P., which was
formed in connection with the transfer of all of the net assets, management and
workforce of a wholly owned subsidiary of General Instrument. In November 1999,
the business and assets of that partnership were merged into Next Level
Communications, Inc. as part of our recapitalization. In January 2000, General
Instrument was acquired by Motorola, Inc., making us an indirect subsidiary of
Motorola.

        From our inception through September 1997, our operating activities
related primarily to establishing a research and development organization,
testing prototype designs, designing circuits, commencing the staffing of
marketing, sales and field service and technical support organizations and
establishing manufacturing relationships. Since then, we have expanded our sales
and marketing and customer support activities. These activities include
commencing trials with our customers, expanding our



                                       7
<PAGE>   10

customer base, developing customer relationships, marketing our brand, hiring
field service and customer support personnel, developing new products and
technologies and enhancing existing products.

        We generate our revenues primarily from sales of our equipment. A small
number of customers have accounted for a large part of our revenues to date, and
we expect this concentration to continue in the future. U S WEST accounted for
67% of total revenues for the quarter ended June 30, 2000 and 61% of our total
revenues for the quarter ended June 30, 1999. Our agreements with our largest
customers are cancelable by these customers on short notice and without penalty,
and do not obligate the customers to purchase any products. In addition, our
significant customer agreements generally contain fixed-price provisions. As a
result, our ability to generate a profit on these contracts depends upon our
ability to produce and market our products at costs lower than these fixed
prices.

        The timing of our revenues is difficult to predict because of the length
and variability of the sales cycle for our products. Customers view the purchase
of our products as a significant and strategic decision. As a result, customers
typically undertake significant evaluation, testing and trial of our products
before deploying them. This evaluation process frequently results in a lengthy
sales cycle, typically ranging from six months to more than a year. While our
customers are evaluating our products and before they place an order, if at all,
we may incur substantial sales and marketing expenses and expend significant
management efforts.

        Revenues. Our revenues consist primarily of sales of equipment and sales
of data communications software. We recognize equipment revenues upon shipment
of our products. Software revenues consist of sales to original equipment
manufacturers that supply communications software and hardware to distributors.
Software license revenues are recognized when a noncancelable license agreement
has been signed, delivery has occurred, the fees are fixed and determinable and
collection is probable. The portion of revenues from new software license
agreements that relates to our obligations to provide customer support is
deferred and recognized ratably over the maintenance period.

        Cost of revenues. Cost of equipment revenues includes direct material
and labor, depreciation and amortization expense on property and equipment,
warranty expenses, license fees and manufacturing and service overhead. Cost of
software revenues primarily includes the cost of the media the software is
shipped on (usually CDs) and documentation costs.

        Research and development. Research and development expenses consist
principally of salaries and related personnel expenses, consultant fees,
prototype component expenses and development contracts related to the design,
development, testing and enhancement of our products. All research and
development costs are expensed as incurred.

        Selling, general and administrative. Selling, general and administrative
expenses consist primarily of salaries and related expenses for personnel
engaged in direct marketing and field service support functions, executive,
accounting and administrative personnel, recruiting expenses, professional fees
and other general corporate expenses.

RESULTS OF OPERATIONS

        Revenues. Total revenues for the quarter ended June 30, 2000 increased
to $40.2 million from $9.4 million in the quarter ended June 30, 1999. Total
revenues in the first six months of 2000 increased to $70.7 million from $18.2
million in the six-month period ended June 30, 1999. The increase was primarily



                                       8
<PAGE>   11

due to an increase in equipment sales. Total revenues for the second quarter of
2000 included $39.3 million of equipment sales, compared to $8.5 million for the
comparable quarter in 1999. Equipment sales for the six-month period ended June
30, 2000 were $69.0 million, compared to $16.4 million for the comparable period
in 1999.

        U S WEST accounted for $26.8 million of equipment revenue in the second
quarter of 2000 as compared to $5.7 million in the second quarter of 1999. Sales
to US WEST for the first half of 2000 were $52.2 million, compared to $11.6
million for the comparable period in 1999. This increase was primarily
attributable to U S WEST's ability to increase its deployment in 2000. Bell
Atlantic accounted for $26,000 of equipment revenue in the second quarter of
2000 as compared to $1.4 million in the comparable quarter in 1999. Sales to
Bell Atlantic for the six-month periods ended June 30, 2000 and 1999 were
$105,000 and $3.4 million, respectively. Sales to Bell Atlantic decreased in
2000 due to the Bell Atlantic merger with NYNEX and the new company's shift in
focus from network rehabilitation to the entry into the long distance market. As
a result, we do not expect significant sales to NYNEX in the near term. We
expect to continue to derive substantially all of our revenues from sales of
equipment to the regional Bell operating companies and local and independent
telephone companies for the foreseeable future. The growth in equipment revenue
in future quarters will depend upon whether and how quickly our existing
customers roll out broadband services in their coverage areas and whether and
how quickly we obtain new customers.

        Software revenue decreased to $836,000 in the second quarter of 2000
from $931,000 in the second quarter of 1999. Software revenue in the six-month
periods ended June 30, 2000 and 1999 was $1.6 million and $1.8 million,
respectively. We expect demand for our software to remain relatively flat in the
near term because the market for these products is mature.

        Cost of Revenues. Total cost of revenues increased to $32.1 million in
the quarter ended June 30, 2000 from $8.7 million in the second quarter of 1999.
Total cost of revenues in the first six months of 2000 increased to $57.0
million from $17.1 million in the six-month period ended June 30, 1999. Our
gross margin percentage increased to 20.1% in the quarter ended June 30, 2000
from 7.2% in the same 1999 period. Our gross margin percentage grew to 19.3% in
the six month period ended June 30, 2000 from 5.7% in the comparable 1999
period. The increase in the cost of revenues in absolute dollars was
attributable to an increase in equipment volume and consisted primarily of
materials and costs associated with increasing production at our contract
manufacturers. The increase in our gross margin percentage was primarily the
result of higher unit volumes, leading to greater efficiencies, including lower
fixed costs per unit. We currently expect gross margin improvements as we
increase sales of our higher margin products, increase volume and continue
implementing cost reductions. In the future, cost of sales as a percent of sales
may fluctuate due to a wide variety of factors, including: the customer mix, the
product mix, the timing and size of orders which are received, the availability
of adequate supplies of key components and assemblies, our ability to introduce
new products and technologies on a timely basis, the timing of new product
introductions or announcements by us or our competitors, price competition and
unit volume.

        Our software gross margin percentage increased in the current quarter to
97% from 91% in the same 1999 period. Our software gross margin percentage in
the six-month period ended June 30, 2000 increased to 95% from 91% in the
comparable 1999 period.

        Research and development. Research and development expenses increased to
$13.7 million in the quarter ended June 30, 2000 from $11.8 million in the same
quarter in 1999. R&D expenses in the first six months of 2000 increased to $27.5
million from $23.1 million in the six-month period ended June 30, 1999. The
increase was primarily due to an increase in research and development personnel.
We believe that



                                       9
<PAGE>   12

continued investment in research and development is critical to attaining our
strategic product development and cost reduction objectives and, as a result,
expect these expenses to increase in absolute dollars. We expense all of our
research and development costs as incurred.

        Selling, general and administrative. Selling, general and administrative
expenses were $11.0 million in the quarter ended June 30, 2000 compared to $7.6
million in the same quarter in 1999. Total SG&A expenses in the first six months
of 2000 increased to $20.5 million from $14.4 million in the six-month period
ended June 30, 1999. The increase is primarily attributable to the increase in
the scale of our operations including additional personnel in our sales and
marketing organizations, promotional expenses and other administrative expenses.
We have generated higher sales expenses by hiring new sales representatives in
order to increase the number and size of our customer accounts. We expect
selling, general and administrative expenses to increase as we continue to add
personnel and incur additional costs as we increase the scale of our operations.

        Noncash compensation charge. In the six months ended June 30, 2000, we
incurred $2,384,000 of noncash compensation charges as a result of vesting that
occurred upon the Motorola acquisition of General Instrument in January 2000.

        Other income (expense), net. For the quarter and six month period ended
June 30, 2000, the amount primarily represents a loss on the sale of property
and equipment. For the quarter and six month period ended June 30, 1999, the
amount represents interest income.

        Interest income (expense). For the quarter ended June 30, 2000, the
amount represents interest income earned on proceeds from our initial public
offering. For the quarter ended June 30, 1999, the amount primarily represents
interest on a $75 million note and accrued interest thereon payable to General
Instrument contributed to us in exchange for shares of our common stock
immediately prior to our initial public offering.

RECENTLY ISSUED ACCOUNTING STANDARDS

        In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This statement requires companies to record
derivatives on the balance sheet as assets or liabilities, measured at fair
value. Gains or losses resulting from changes in the values of those derivatives
would be accounted for depending on the use of the derivative and whether it
qualifies for hedge accounting. Statement of Financial Accounting Standards No.
133, as amended by Statement of Financial Accounting Standards No. 137, will be
effective for our fiscal year ending December 31, 2001. We do not believe this
will have a material effect on our operations.

        In December 1999, the Securities and Exchange Commission released Staff
Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements" which
summarizes certain of the staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements. We will
adopt this statement in the fourth quarter of the year ending December 31, 2000.
We do not expect any material impact as a result of adopting the guidelines of
this standard.

        In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation (FIN 44), that clarifies guidance for certain issues related to the
application of APB Opinion No. 25, Accounting for Stock Issued to employees (APB
25). FIN 44 is effective July 1, 2000.



                                       10
<PAGE>   13

LIQUIDITY AND CAPITAL RESOURCES

        We have financed our operations primarily through cash contributions and
borrowings from General Instrument and our initial public offering of our stock
in November 1999. We will not receive additional funds from General Instrument,
which was acquired by Motorola in January 2000.

        Net cash used in operating activities was $37.1 million in the six-month
period ended June 30, 2000 and $23.4 million in the six-month period ended June
30, 1999. In each case, the use of cash in operating activities was primarily
due to our net losses. In the six-month period ended June 30, 1999, this amount
was partially offset by a $12.8 million increase in deferred revenue.

        Net cash used in investing activities of $3.8 million in the six-month
period ended June 30, 2000 and $4.7 million in the six-month period ended June
30, 1999 was primarily attributable to capital expenditures to support our
engineering and testing activities. As we increase the scope of our operations,
we expect that our capital expenditures will increase.

        Net cash provided by financing activities of $2.4 million in the
six-month period ended June 30, 2000 was primarily attributable to the sale of
common stock of $3.5 million, partially offset by the payment of expenses
related to our November 1999 initial public offering. In the six-month period
ended June 30, 1999, net cash provided by financing activities of $33.8 million
was primarily attributable to a $34.0 million capital contribution by General
Instrument.

        In June 2000, Spencer Trask Holdings, Incorporated and related parties
exercised warrants to purchase 2,070,000 shares of the Company's common stock.
The exercise price of $10.38 per share was paid by Spencer Trask by the
surrender of 423,493 additional warrants. The Company did not receive any
proceeds from the sale of such common stock by Spencer Trask in June 2000.

        At June 30, 2000, we had $90.3 million of cash and cash equivalents, and
$121.4 million of working capital. We anticipate that we will increase our
capital expenditures and lease commitments consistent with anticipated growth in
operations, infrastructure and personnel. We may establish sales offices and
lease additional space, which will require us to commit to additional lease
obligations, purchase equipment and install leasehold improvements.

        We have commitments with suppliers to purchase a total of approximately
$35.4 million of components through 2002.

        We expect to experience significant growth in our operating expenses for
the foreseeable future. As a result, we anticipate that operating expenses, as
well as planned capital expenditures, will constitute a material use of our cash
resources. In addition, we may use cash resources to fund acquisitions or
investments in complementary businesses, technologies or product lines. Our long
term operating and capital lease obligations are generally less than $3.0
million per year. Other than capital lease commitments, we have no material
commitments for capital expenditures. As we increase the scope of our
operations, we expect that our capital expenditures will increase. We believe
that our cash on hand will be sufficient to meet our working capital and capital
expenditure requirements for at least the next 12 months. However, it may still
be necessary to obtain additional equity or debt financing either during or
after the next 12 months if we are not able to generate sufficient cash from
operating activities to meet our capital



                                       11
<PAGE>   14

expenditure and working capital needs. In the event additional financing is
required, we may not be able to raise it on acceptable terms, or at all.

RISK FACTORS

        You should carefully consider the risk factors set forth below.

WE HAVE INCURRED NET LOSSES AND NEGATIVE CASH FLOW FOR OUR ENTIRE HISTORY, WE
EXPECT TO INCUR FUTURE LOSSES AND NEGATIVE CASH FLOW FOR THE FORESEEABLE FUTURE,
AND WE MAY NEVER ACHIEVE PROFITABILITY.

        We incurred net losses of $33.1 million in the six months ended June 30,
2000, and $39.2 million in the six months ended June 30, 1999. Our ability to
achieve profitability on a continuing basis will depend on the successful
design, development, testing, introduction, marketing and broad commercial
distribution of our broadband equipment products.

        We expect to continue to incur significant product development, sales
and marketing, and administrative expenses. In addition, we depend in part on
cost reductions to improve gross profit margins because the fixed-price nature
of most of our long-term customer agreements prevents us from increasing prices.
As a result, we will need to generate significant revenues and improve gross
profit margins to achieve and maintain profitability. We may not be successful
in reducing our costs or in selling our products in sufficient volumes to
realize cost benefits from our manufacturers. We cannot be certain that we can
achieve sufficient revenues or gross profit margin improvements to generate
profitability.

OUR LIMITED OPERATING HISTORY MAKES IT DIFFICULT FOR YOU TO EVALUATE OUR
BUSINESS AND PROSPECTS.

        We recorded our first sale in September 1997. As a result, we have only
a limited operating history upon which you may evaluate our business and
prospects. You should consider our prospects in light of the heightened risks
and unexpected expenses and difficulties frequently encountered by companies in
an early stage of development. These risks, expenses and difficulties, which are
described further below, apply particularly to us because the market for
equipment for delivering voice, data and video services is new and rapidly
evolving. Due to our limited operating history, it will be difficult for you to
evaluate whether we will successfully address these risks.

WE EXPECT OUR QUARTERLY REVENUES AND OPERATING RESULTS TO FLUCTUATE, AND THESE
FLUCTUATIONS MAY MAKE OUR STOCK PRICE VOLATILE.

        Our quarterly revenues and operating results have fluctuated in the past
and are likely to fluctuate significantly in the future. As a result, we believe
that quarter-to-quarter comparisons of our operating results may not be
meaningful. Fluctuations in our quarterly revenues or operating results may
cause volatility in the price of our stock. It is likely that in some future
quarter our operating results may be below the expectations of public market
analysts and investors, which may cause the price of our stock to fall. Factors
likely to cause variations in our quarterly revenues and operating results
include:

        -    delays or cancellations of any orders by U S WEST, which accounted
             for approximately 67% of our revenues in the second quarter of
             2000, or by any other customer accounting for a significant portion
             of our revenues;



                                       12
<PAGE>   15

        -    variations in the timing, mix and size of orders and shipments of
             our products throughout a quarter or year;

        -    new product introductions by us or by our competitors;

        -    the timing of upgrades of telephone companies' infrastructure;

        -    variations in capital spending budgets of telephone companies; and

        -    increased expenses, whether related to sales and marketing, product
             development or administration.

        The amount and timing of our operating expenses generally will vary from
quarter to quarter depending on the level of actual and anticipated business
activity. Because most of our operating expenses are fixed in the short term, we
may not be able to quickly reduce spending if our revenues are lower than we had
projected and our results of operations could be harmed.

BECAUSE OUR SALES CYCLE IS LENGTHY AND VARIABLE, THE TIMING OF OUR REVENUE IS
DIFFICULT TO PREDICT, AND WE MAY INCUR SALES AND MARKETING EXPENSES WITH NO
GUARANTEE OF A FUTURE SALE.

        Customers view the purchase of our products as a significant and
strategic decision. As a result, customers typically undertake significant
evaluation, testing and trial of our products before deployment. This evaluation
process frequently results in a lengthy sales cycle, typically ranging from six
months to more than a year. Before a customer places an order, we may incur
substantial sales and marketing expenses and expend significant management
efforts. In addition, product purchases are frequently subject to unexpected
administrative, processing and other delays on the part of our customers. This
is particularly true for customers for whom our products represent a very small
percentage of their overall purchasing activities. As a result, sales forecasted
to be made to a specific customer for a particular quarter may not be realized
in that quarter; and this could result in lower than expected revenues.

WE MAY NOT BE ABLE TO OBTAIN SUFFICIENT FINANCING TO FUND OUR BUSINESS AND, AS A
RESULT, WE MAY NOT BE ABLE TO GROW AND COMPETE EFFECTIVELY.

        We may need to raise additional funds if our estimates of revenues or
capital requirements change or prove inaccurate. If we cannot raise these funds,
we may not be able to grow our business. We may need additional capital if we
need to respond to unforeseen technological or marketing hurdles or if we desire
to take advantage of unanticipated opportunities. In addition, we expect to
review potential acquisitions that would complement our existing product
offerings or enhance our technical capabilities that could require potentially
significant amounts of capital. Funds may not be available at the time or times
needed on terms acceptable to us, if at all. If adequate funds are not
available, or are not available on acceptable terms, we may not be able to take
advantage of market opportunities, to make acquisitions, to develop new products
or to otherwise respond to competitive pressures effectively.

OUR CUSTOMER BASE OF TELEPHONE COMPANIES IS EXTREMELY CONCENTRATED AND THE LOSS
OF OR REDUCTION IN BUSINESS FROM EVEN ONE OF OUR CUSTOMERS, PARTICULARLY U S
WEST, COULD CAUSE OUR SALES TO FALL SIGNIFICANTLY.



                                       13
<PAGE>   16

        A small number of customers have accounted for a large part of our
revenues to date. We expect this concentration to continue in the future. If we
lose one of our significant customers, our revenues could be significantly
reduced. U S WEST accounted for 67% of total revenues in the second quarter of
2000 and 61% of total revenues in the second quarter of 1999. Our agreements
with our customers are cancelable by these customers on short notice, without
penalty, do not obligate the customers to purchase any products and are not
exclusive. Accordingly, we may lose revenues from our significant customers at
any time.

CONSOLIDATION AMONG TELEPHONE COMPANIES MAY REDUCE OUR SALES.

        Consolidation in the telecommunications industry may cause delays in the
purchase of our products and cause a reexamination of strategic and purchasing
decisions by our customers. In addition, we may lose relationships with key
personnel within a customer's organization due to budget cuts, layoffs, or other
disruptions following a consolidation. For example, our sales to Bell Atlantic,
previously one of our largest clients, have decreased significantly as a result
of a shift in focus by Bell Atlantic resulting from its merger with NYNEX.
Additionally, U S WEST, our largest customer, has recently merged with Qwest,
and we cannot predict the effect that this merger will have on our sales to U S
WEST.

A SIGNIFICANT MARKET FOR OUR PRODUCTS MAY NOT DEVELOP IF TELEPHONE COMPANIES DO
NOT SUCCESSFULLY DEPLOY BROADBAND SERVICES SUCH AS HIGH-SPEED DATA AND VIDEO.

        Telephone companies have just recently begun offering high-speed data
services, and most telephone companies have not offered video services at all.
Unless telephone companies make the strategic decision to enter the market for
providing broadband services, a significant market for our products may not
develop. Sales of our products largely depend on the increased use and
widespread adoption of broadband services and the ability of our customers to
market and sell broadband services, including video services, to their
customers. Certain critical issues concerning use of broadband services are
unresolved and will likely affect their use. These issues include security,
reliability, speed and volume, cost, government regulation and the ability to
operate with existing and new equipment.

        Even if telephone companies decide to deploy broadband services, this
deployment may not be successful. Our customers have delayed deployments in the
past and may delay deployments in the future. Factors that could cause telephone
companies not to deploy, to delay deployment of, or to fail to deploy
successfully the services for which our products are designed include the
following:

        -    industry consolidation;

        -    regulatory uncertainties and delays affecting telephone companies;

        -    varying quality of telephone companies' network infrastructure and
             cost of infrastructure upgrades and maintenance;

        -    inexperience of telephone companies in obtaining access to video
             programming content from third party providers;

        -    inexperience of telephone companies in providing broadband services
             and the lack of sufficient technical expertise and personnel to
             install products and implement services effectively;

        -    uncertain subscriber demand for broadband services; and



                                       14
<PAGE>   17

        -    inability of telephone companies to predict return on their
             investment in broadband capable infrastructure and equipment.

        Unless our products are successfully deployed and marketed by telephone
companies, we will not be able to achieve our business objectives and increase
our revenues.

GOVERNMENT REGULATION OF OUR CUSTOMERS AND RELATED UNCERTAINTY COULD CAUSE OUR
CUSTOMERS TO DELAY THE PURCHASE OF OUR PRODUCTS.

        The Telecommunications Act requires telephone companies, such as the
regional Bell operating companies, to offer their competitors cost-based access
to some elements of their networks, including facilities and equipment used to
provide high-speed data and video services. These telephone companies may not
wish to make expenditures for infrastructure and equipment required to provide
broadband services if they will be forced to allow competitors access to this
infrastructure and equipment. The Federal Communications Commission, or FCC,
recently announced that, except in limited circumstances, it will not require
incumbent carriers to offer their competitors access to the facilities and
equipment used to provide high-speed data services. Nevertheless, other
regulatory and judicial proceedings relating to telephone companies' obligations
to provide elements of their network to competitors are pending. The
uncertainties caused by these regulatory proceedings may cause these telephone
companies to delay purchasing decisions at least until the proceedings and any
related judicial appeals are completed. The outcomes of these regulatory
proceedings, as well as other FCC regulation, may cause these telephone
companies not to deploy services for which our products are designed or to
further delay deployment. Additionally, telephone companies' deployment of
broadband services may be slowed down or stopped because of the need for
telephone companies to obtain permits from city, state or federal authorities to
implement infrastructure for products such as ours. Any delay in deployment of
products by our customers could harm our sales.

OUR CUSTOMERS AND POTENTIAL CUSTOMERS WILL NOT PURCHASE OUR PRODUCTS IF THEY DO
NOT HAVE THE INFRASTRUCTURE NECESSARY TO USE OUR PRODUCTS.

        The copper wire infrastructures over which telephone companies may
deliver voice, data and video services using our products vary in quality and
reliability. As a result, some of these telephone companies may not be able to
deliver a full set of voice, data and video services to their customers, despite
their intention to do so, and this could harm our sales. Even after installation
of our products, we remain highly dependent on telephone companies to continue
to maintain their infrastructure so that our products will operate at a
consistently high performance level. Infrastructure upgrades and maintenance may
be costly, and telephone companies may not have the necessary financial
resources. This may be particularly true for our smaller customers and potential
customers such as independent telephone companies and domestic local telephone
companies. If our current and potential customers' infrastructure is inadequate,
we may not be able to generate anticipated revenues from them.

IF COMPETING TECHNOLOGIES THAT OFFER ALTERNATIVE SOLUTIONS TO OUR PRODUCTS
ACHIEVE WIDESPREAD ACCEPTANCE, THE DEMAND FOR OUR PRODUCTS MAY NOT DEVELOP.

        Technologies that compete with our products include other
telecommunications-related wireline technologies, cable-based technologies,
fixed wireless technologies and satellite technologies. If these alternative
technologies are chosen by our existing and potential customers, our business,
financial condition and results of operations could be harmed. In particular,
cable operators are currently deploying products that will be capable of
delivering voice, high-speed data and video services over cable, including



                                       15
<PAGE>   18

products from General Instrument, our principal stockholder, and Motorola, its
parent. Our technology may not be able to compete effectively against these
technologies on price, performance or reliability.

        Our customers or potential customers that also offer cable-based
services may choose to purchase cable-based technologies. Cable service
providers that offer not only data and video but also telephony over cable
systems will give subscribers the alternative of purchasing all communications
services from a single communications service provider, allowing the potential
for more favorable pricing and a single point of contact for bill payment and
customer service. If these services are implemented successfully over cable
connections, they will compete directly with the services offered by telephone
companies using our products. In addition, several telephone companies have
commenced the marketing of video services over direct broadcast satellite while
continuing to provide voice and data services over their existing copper wire
infrastructure. If any of these services are accepted by consumers, the demand
for our products may not develop and our ability to generate revenues will be
harmed.

WE FACE INTENSE COMPETITION IN PROVIDING EQUIPMENT FOR TELECOMMUNICATIONS
NETWORKS FROM LARGER AND MORE WELL-ESTABLISHED COMPANIES, AND WE MAY NOT BE ABLE
TO COMPETE EFFECTIVELY WITH THESE COMPANIES.

        Many of our current and potential competitors have longer operating
histories, greater name recognition and significantly greater financial,
technical, marketing and distribution resources than we do. These competitors
may undertake more extensive marketing campaigns, adopt more aggressive pricing
policies and devote substantially more resources to developing new products than
we are able to, which could result in the loss of current customers and impair
our ability to attract potential customers.

        Our significant current customers include Advanced Fibre Communications,
Alcatel, Cisco Systems, Efficient Networks, Ericsson, Lucent Technologies,
Nokia, Nortel Networks, RELTEC (acquired by BAE Systems, CNI Division, formerly
GEC Marconi), Scientific Atlanta, Siemens and our largest stockholder, General
Instrument (which has been acquired by Motorola), as well as emerging companies
that are developing new technologies. Some of these competitors have existing
relationships with our current and prospective customers. In addition, we
anticipate that other large companies, such as Matsushita Electric Industrial
(which markets products under the Panasonic brand name), Microsoft, Network
Computer, Philips, Sony, STMicroelectronics and Toshiba America, will likely
introduce products that compete with our N(3) Residential Gateway product in the
future. Our customer base may be attracted by the name and resources of these
large, well-known companies and may prefer to purchase products from them
instead of us.

CONSOLIDATION OF OUR COMPETITORS MAY CAUSE US TO LOSE CUSTOMERS AND NEGATIVELY
AFFECT OUR SALES.

        Consolidation in the telecommunications equipment industry may
strengthen our competitors' positions in our market, cause us to lose customers
and hurt our sales. For example, Alcatel acquired DSC Communications, Lucent
acquired Ascend Communications and BAE Systems, CNI Division, formerly GEC
Marconi, acquired RELTEC. Acquisitions such as these may strengthen our
competitors' financial, technical and marketing resources and provide them
access to regional Bell operating companies and other potential customers.
Consolidation may also allow some of our competitors to penetrate new markets
that we have targeted, such as domestic local, independent and international
telephone companies. This consolidation may negatively affect our ability to
increase revenues.

IF WE DO NOT RESPOND QUICKLY TO CHANGING CUSTOMER NEEDS AND FREQUENT NEW PRODUCT
INTRODUCTIONS BY OUR COMPETITORS, OUR PRODUCTS MAY BECOME OBSOLETE.



                                       16
<PAGE>   19

        Our position in existing markets or potential markets could be eroded
rapidly by product advances. The life cycles of our products are difficult to
estimate. Our growth and future financial performance will depend in part upon
our ability to enhance existing products and develop and introduce new products
that keep pace with:

        -    the increasing use of the Internet;

        -    the growth in remote access by telecommuters;

        -    the increasingly diverse distribution sources for high quality
             digital video; and

        -    other industry and technological trends.

We expect that our product development efforts will continue to require
substantial investments. We may not have sufficient resources to make the
necessary investments. If we fail to timely and cost-effectively develop new
products that respond to new technologies and customer needs, the demand for our
products may fall and we could lose revenues.

OUR EXECUTIVE OFFICERS AND CERTAIN KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS
AND THE LOSS OF THEIR SERVICES COULD DISRUPT OUR OPERATIONS AND OUR CUSTOMER
RELATIONSHIPS.

        None of our executive officers or key employees is bound by an
employment agreement. Many of these employees have a significant number of
options to purchase our common stock. Many of these options are currently vested
and some of our key employees may leave us once they have exercised their
options. In addition, our engineering and product development teams are critical
in developing our products and have developed important relationships with our
regional Bell operating company customers and their technical staffs. The loss
of any of these key personnel could harm our operations and customer
relationships.

COMPETITION FOR QUALIFIED PERSONNEL IN THE TELECOMMUNICATIONS EQUIPMENT INDUSTRY
IS INTENSE, AND IF WE ARE NOT SUCCESSFUL IN ATTRACTING AND RETAINING THESE
PERSONNEL, OUR ABILITY TO GROW OUR BUSINESS MAY BE HARMED.

        Competition for qualified personnel in the telecommunications equipment
industry, specifically in the Rohnert Park, California area, is intense, and we
may not be successful in attracting and retaining such personnel. Failure to
attract qualified personnel could harm the growth of our business.

        We are actively searching for research and development engineers and
sales and marketing personnel who are in short supply. 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 receive such notices in the future as we seek to
hire qualified personnel and such notices may result in material litigation and
related disruption to our operations.

OUR OPERATIONS AND CUSTOMER RELATIONSHIPS MAY BECOME STRAINED DUE TO RAPID
EXPANSION.

        We have expanded our operations rapidly since inception. We intend to
continue to expand in the foreseeable future to pursue existing and potential
market opportunities both inside and outside the United



                                       17
<PAGE>   20

States. This rapid growth places a significant demand on management and
operational resources. Our management, personnel, systems, procedures, controls
and customer service may be inadequate to support our future operations. To
manage expansion effectively, we must implement and improve our operational
systems, procedures, controls and customer service on a timely basis. We expect
significant strain on our order and fulfillment process and our quality control
systems if significant expansion of business activity occurs. If we are unable
to properly manage this growth, our operating results, reputation and customer
relationships could be harmed.

OUR LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY MAY AFFECT OUR ABILITY
TO COMPETE, AND WE COULD LOSE CUSTOMERS.

        We rely on a combination of patent, copyright and trademark laws, and on
trade secrets and confidentiality provisions and other contractual provisions to
protect our intellectual property. There is no guarantee that these safeguards
will protect our intellectual property and other valuable confidential
information. If our methods of protecting our intellectual property in the
United States or abroad are not adequate, our competitors may copy our
technology or independently develop similar technologies and we could lose
customers. In addition, the laws of some foreign countries do not protect our
proprietary rights as fully as do the laws of the United States. If we fail to
adequately protect our intellectual property, it would be easier for our
competitors to sell competing products, which could harm our business.

THIRD-PARTY CLAIMS REGARDING INTELLECTUAL PROPERTY MATTERS COULD CAUSE US TO
STOP SELLING OUR PRODUCTS, LICENSE ADDITIONAL TECHNOLOGY OR PAY MONETARY
DAMAGES.

        From time to time, third parties, including our competitors and
customers, have asserted patent, copyright and other intellectual property
rights to technologies that are important to us. We expect that we will
increasingly be subject to infringement claims as the number of products and
competitors in our market grows and the functionality of products overlaps, and
our products may currently infringe on one or more United States or
international patents. The results of any litigation are inherently uncertain.
In the event of an adverse result in any litigation with third parties that
could arise in the future, we could be required:

        -    to pay substantial damages, including paying treble damages if we
             are held to have willfully infringed;

        -    to halt the manufacture, use and sale of infringing products;

        -    to expend significant resources to develop non-infringing
             technology; and/or

        -    to obtain licenses to the infringing technology.

        Licenses may not be available from any third party that asserts
intellectual property claims against us, on commercially reasonable terms, or at
all. In addition, litigation frequently involves substantial expenditures and
can require significant management attention, even if we ultimately prevail. In
addition, we indemnify our customers for patent infringement claims, and we may
be required to obtain licenses on their behalf, which could subject us to
significant additional costs.

WE DEPEND ON THIRD-PARTY MANUFACTURERS AND ANY DISRUPTION IN THEIR MANUFACTURE
OF OUR PRODUCTS WOULD HARM OUR OPERATING RESULTS.



                                       18
<PAGE>   21

        We contract for the manufacture of all of our products and have limited
in-house manufacturing capabilities. We rely primarily on two large contract
manufacturers: SCI Systems and ACT Manufacturing (formerly CMC Industries). The
efficient operation of our business will depend, in large part, on our ability
to have these and other companies manufacture our products in a timely manner,
cost-effectively and in sufficient volumes while maintaining consistent quality.
As our business grows, these manufacturers may not have the capacity to keep up
with the increased demand. Any manufacturing disruption could impair our ability
to fulfill orders and could cause us to lose customers.

WE HAVE NO LONG-TERM CONTRACTS WITH OUR MANUFACTURERS, AND WE MAY NOT BE ABLE TO
DELIVER OUR PRODUCTS ON TIME IF ANY OF THESE MANUFACTURERS STOP MAKING OUR
PRODUCTS.

        We have no long-term contracts or arrangements with any of our contract
manufacturers that guarantee product availability, the continuation of
particular payment terms or the extension of credit limits. If our manufacturers
are unable or unwilling to continue manufacturing our products in required
volumes, we will have to identify acceptable alternative manufacturers, which
could take in excess of three months. For example, Flextronics International,
previously designated to be the sole manufacturer of our ETHERset product,
discontinued its relationship with us due to lack of order volume. It is
possible that a source may not be available to us when needed or be in a
position to satisfy our production requirements at acceptable prices and on a
timely basis. If we cannot find alternative sources for the manufacture of our
products, we will not be able to meet existing demand. As a result, we may lose
existing customers, and our ability to gain new customers may be significantly
constrained.

OUR INABILITY TO PRODUCE SUFFICIENT QUANTITIES OF OUR PRODUCTS BECAUSE OF OUR
DEPENDENCE ON COMPONENTS FROM KEY SOLE SUPPLIERS COULD RESULT IN DELAYS IN THE
DELIVERY OF OUR PRODUCTS AND COULD HARM OUR REVENUES.

        Some parts, components and equipment used in our products are obtained
from sole sources of supply. If our sole source suppliers or we fail to obtain
components in sufficient quantities when required, delivery of our products
could be delayed resulting in decreased revenues. Additional sole-sourced
components may be incorporated into our equipment in the future. We do not have
any long term supply contracts to ensure sources of supply. In addition, our
suppliers may enter into exclusive arrangements with our competitors, stop
selling their products or components to us at commercially reasonable prices or
refuse to sell their products or components to us at any price, which could harm
our operating results.

THE OCCURRENCE OF ANY DEFECTS, ERRORS OR FAILURES IN OUR PRODUCTS COULD RESULT
IN DELAYS IN INSTALLATION, PRODUCT RETURNS AND OTHER LOSSES TO US OR TO OUR
CUSTOMERS OR END-USERS.

        Our products are complex and may contain undetected defects, errors or
failures. These problems have occurred in our products in the past and
additional problems may occur in our products in the future and could result in
the loss of or delay in market acceptance of our products. In addition, we have
limited experience with commercial deployment and we expect additional defects,
errors and failures as our business expands from trials to commercial deployment
at certain customers. We will have limited experience with the problems that
could arise with any new products that we introduce. Further, our customer
agreements generally include a longer warranty for defects than our
manufacturing agreements. These defects could result in a loss of sales and
additional costs and liabilities to us as well as damage to our reputation and
the loss of our customers.

WE DO NOT HAVE SIGNIFICANT EXPERIENCE IN INTERNATIONAL MARKETS AND MAY HAVE
UNEXPECTED COSTS AND



                                       19
<PAGE>   22

DIFFICULTIES IN DEVELOPING INTERNATIONAL REVENUES.

        We plan to extend the marketing and sales of our products
internationally. International operations are generally subject to inherent
risks and challenges that could harm our operating results, including:

        -    unexpected changes in telecommunications regulatory requirements;

        -    limited number of telephone companies operating internationally;

        -    expenses associated with developing and customizing our products
             for foreign countries;

        -    tariffs, quotas and other import restrictions on telecommunications
             equipment;

        -    longer sales cycles for our products; and

        -    compliance with international standards that differ from domestic
             standards.

        To the extent that we generate international sales in the future, any
negative effects on our international business could harm our business,
operating results and financial condition. In particular, fluctuating exchange
rates may contribute to fluctuations in our results of operations.

MOTOROLA MAY EXERCISE SIGNIFICANT INFLUENCE OVER OUR BUSINESS AND AFFAIRS AND
OUR STOCKHOLDER VOTES AND, FOR ITS OWN REASONS, COULD PREVENT TRANSACTIONS WHICH
OUR OTHER STOCKHOLDERS MAY VIEW AS FAVORABLE.

        Motorola, through its ownership of General Instrument, beneficially owns
approximately 80% of the outstanding shares of our common stock. Motorola will
be able to exercise significant influence over all matters relating to our
business and affairs, including approval of significant corporate transactions,
which could delay or prevent someone from acquiring or merging with us and could
prevent you from receiving a premium for your shares.

        We do not know whether Motorola's plans for our business and affairs
will be different than our existing plans and whether any changes that may be
implemented under Motorola's control will be beneficial or detrimental to our
other stockholders.

OUR PRINCIPAL STOCKHOLDER AND ITS PARENT MAY HAVE INTERESTS THAT CONFLICT WITH
THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS AND US AND MAY CAUSE US TO FORGO
OPPORTUNITIES OR TAKE ACTIONS THAT DISPROPORTIONATELY BENEFIT OUR PRINCIPAL
STOCKHOLDER.

        It is possible that General Instrument or Motorola could be in a
position involving a conflict of interest with us. In addition, individuals who
are officers or directors both of Motorola or General Instrument and of us may
have fiduciary duties to both companies. For example, a conflict may arise if
our principal stockholder were to engage in activities or pursue corporate
opportunities that may overlap with our business. These conflicts could harm our
business and operating results. Our certificate of incorporation contains
provisions intended to protect our principal stockholder and these individuals
in these situations. These provisions limit your legal remedies.

THE PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE HIGHLY VOLATILE.



                                       20
<PAGE>   23

        The stock markets have in general, and with respect to high technology
companies, including us, in particular, recently experienced extreme stock price
and volume volatility, often unrelated to the financial performance of
particular companies. The price at which our common stock will trade in the
future is likely to also be highly volatile and may fluctuate substantially due
to factors such as:

        -    actual or anticipated fluctuations in our operating results;

        -    changes in or our failure to meet securities analysts'
             expectations;

        -    announcements of technological innovations by us or our
             competitors;

        -    introduction of new products and services by us or our competitors;

        -    limited public float of our common stock;

        -    conditions and trends in the telecommunications and other
             technology industries; and

        -    general economic and market conditions.

SALES OF SHARES OF OUR COMMON STOCK BY EXISTING STOCKHOLDERS COULD CAUSE THE
MARKET PRICE OF OUR COMMON STOCK TO DROP SIGNIFICANTLY

        As of August 8, 2000, we had 83,606,932 shares of common stock
outstanding. As of August 8, 2000, Motorola owned 64,103,724 shares of our
common stock and Spencer Trask owned 3,501,156 shares of our common stock and
its affiliates held warrants to purchase an additional 5,986,609 shares of our
common stock. If Motorola, Spencer Trask or any of our other stockholders sell
substantial amounts of common stock, including shares issued upon exercise of
outstanding options and warrants, in the public market, the market price of the
common stock could fall. In addition, any distribution of shares of our common
stock by Motorola to its stockholders could also have an adverse effect on the
market price.

        Under federal securities laws, the shares beneficially owned by Motorola
and the persons related to Spencer Trask, unless registered under the Securities
Act, generally may be resold in the public market only following a one-year
holding period that began to run on November 12, 1999. Motorola and Spencer
Trask and its related persons and their transferees will be entitled to
registration rights pursuant to which they may require that we register their
shares under the Securities Act.

        In addition, as of June 30, 2000, there were outstanding options to
purchase 19,195,195 shares of our common stock. Subject to vesting provisions
and, in the case of our affiliates, volume and manner of sale restrictions, the
shares of common stock issuable upon the exercise of our outstanding employee
options will be eligible for sale into the public market at various times.

ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT
OR DELAY A CHANGE IN CONTROL OF OUR COMPANY THAT A STOCKHOLDER MAY CONSIDER
FAVORABLE.

        Several provisions of our certificate of incorporation and by-laws and
Delaware law may discourage, delay or prevent a merger or acquisition that a
stockholder may consider favorable. These provisions include:



                                       21
<PAGE>   24

        -    authorizing the issuance of preferred stock without stockholder
             approval;

        -    providing for a classified board of directors with staggered,
             three-year terms;

        -    prohibiting cumulative voting in the election of directors;

        -    restricting business combinations with interested stockholders;

        -    limiting the persons who may call special meetings of stockholders;

        -    prohibiting stockholder action by written consent;

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

        -    requiring super-majority voting to effect amendments to our
             certificate of incorporation and by-laws.

        Some of these provisions do not currently apply to Motorola and its
affiliates.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        Our exposure to market risk is limited to interest rate fluctuation. We
do not engage in any hedging activities and we do not use derivatives or equity
investments for cash investment purposes. The marketable securities in our
portfolio are classified as available for sale and recorded at fair value on our
balance sheet. Our portfolio consists solely of corporate bonds, commercial
paper and government securities, and therefore, our market risk is deemed
relatively low.

                           PART II. OTHER INFORMATION


ITEM 1. LEGAL PROCEEDINGS

        We are not currently involved in any pending legal proceedings that
individually, or in the aggregate, are material to us.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

        (d) In November 1999, we completed our initial public offering through
an underwritten public offering pursuant to a Registration Statement on Form S-1
(File No. 333-85999). These funds have been the principal source of liquidity
for us during the quarter ended June 30, 2000 and were used to fund operating
losses and make capital expenditures as described in the financial statements
included with this report and in our Annual Report on Form 10-K for the year
ended December 31, 1999.

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

        Our 2000 Annual Meeting of Stockholders was held on May 25, 2000. The
following matters were voted upon by the stockholders:

        Election of three Class I Directors. Ferdinand C. Kuznik, John McCartney
and Richard Severns were elected to serve terms extending from the date of
election and qualification, continuing through the third Annual Meeting of
Stockholders following election. Furthermore, each of their terms will also



                                       22
<PAGE>   25

continue until their resignation, removal from office, or until the time when a
successor director is elected and qualified. The result of the voting was as
follows: 76,095,356 shares in favor of Ferdinand C. Kuznik, with 37,469 shares
withheld, 76,094,681 shares in favor of John McCartney, with 38,144 shares
withheld, and 74,573,546 shares in favor of Richard Severns, with 1,559,279
shares withheld. The terms of office of our other Directors, Lynn Forester, Paul
S. Latchford and Dennis Rheault continue until the 2001 Annual Meeting of
Stockholders, and Peter W. Keeler, Scott Poteracki and Richard C. Smith continue
until the 2002 Annual Meeting of Stockholders.

        Approval of the Amendment to the 1999 Equity Incentive Plan which
increased the number of shares available for issuance under the plan. The result
of the vote was 73,081,398 shares in favor, 3,044,866 shares against, and 6,561
shares abstaining.

        Ratification of the selection of Deloitte & Touche LLP as our
independent auditors for our current fiscal year ending December 31, 2000. The
result of the vote was 76,126,903 shares in favor, 2,373 shares against, and
3,549 shares abstaining.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

        (a) Exhibits:

        The following exhibits are included as part of this report:

        Exhibit

          No.                    Description of Exhibit
          ---                    ----------------------
         27. 1                   Financial Data Schedule

        (b) Reports on Form 8-K:

        None.



                                       23
<PAGE>   26

                                   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.

                                       NEXT LEVEL COMMUNICATIONS, INC.



Date:  August 11, 2000                 By:     /s/  PETER W. KEELER
                                          --------------------------------------
                                           Peter W. Keeler
                                           Chief Executive Officer and President


Date:  August 11, 2000                 By:     /s/ JAMES T. WANDREY
                                          --------------------------------------
                                           James T. Wandrey
                                           Chief Financial Officer and Treasurer



                                       24
<PAGE>   27

                                  EXHIBIT INDEX

Exhibit No.                Description of Exhibit
-----------                ----------------------
  27.1.1                   Financial Data Schedule.



© 2022 IncJournal is not affiliated with or endorsed by the U.S. Securities and Exchange Commission