NEXT LEVEL COMMUNICATIONS INC
10-Q, 2000-11-14
TELEPHONE COMMUNICATIONS (NO RADIOTELEPHONE)
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<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 SEPTEMBER 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                                             94-3342408
(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 November 1, 2000 was approximately 83,924,108.

<PAGE>   2

                                TABLE OF CONTENTS

                          PART I. FINANCIAL INFORMATION

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

Item 2.  Management's Discussion and Analysis of Financial Condition
          and Results of Operations................................................8

Item 3.  Quantitative and Qualitative Disclosures About Market Risk................23

                           PART II. OTHER INFORMATION

Item 1.  Legal Proceedings.........................................................23

Item 2.  Changes in Securities and Use of Proceeds.................................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 CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2000 AND DECEMBER 31, 1999 (IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------
                                                          SEPTEMBER 30, 2000      DECEMBER 31, 1999
<S>                                                        <C>                    <C>
ASSETS
CURRENT ASSETS:
  Cash and cash equivalents                                $  54,893              $ 128,752
  Marketable securities                                       14,967                 14,971
  Trade receivables, less allowance for doubtful
     accounts of $1,332 and $1,337, respectively              35,903                 13,879
  Other receivables                                            3,857                  1,435
  Inventories                                                 55,866                 22,553
  Receivable from Motorola                                         -                    950
  Prepaid expenses and other current assets                    3,712                  1,792
                                                           ---------              ---------
           Total current assets                              169,198                184,332


INVESTMENTS                                                   36,316                 30,151
PROPERTY AND EQUIPMENT,  Net                                  51,892                 48,263
INTANGIBLES (less accumulated amortization of $5,800
   and $3,141, respectively)                                  19,372                  5,065
                                                           ---------              ---------
TOTAL                                                      $ 276,778              $ 267,811
                                                           =========              =========

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
  Accounts payable                                         $  44,001              $  13,261
  Other accrued liabilities                                   17,028                 11,375
  Deferred revenue                                             7,447                 11,148
  Current portion of capital lease obligations                   376                    600
                                                           ---------              ---------
           Total current liabilities                          68,852                 36,384
                                                           ---------              ---------
LONG-TERM DEBT                                                25,000                 24,853
                                                           ---------              ---------
LONG-TERM CAPITAL LEASE OBLIGATIONS                               88                    346
                                                           ---------              ---------

STOCKHOLDERS' EQUITY
  Common stock - $.01 par value, 400,000,000 shares authorized;
    shares issued and outstanding, 83,780,903 and 79,752,000,
    respectively                                                 772                   754
  Additional paid-in capital                                 433,982               412,930
  Accumulated deficit                                       (251,527)             (205,072)
  Unrealized loss on marketable securities                       (37)                   -
  Unearned compensation                                         (352)               (2,384)
                                                            ---------             ---------
           Total stockholders' equity                         182,838               206,228
                                                            ---------             ---------

TOTAL                                                       $ 276,778             $ 267,811
                                                            =========           =========
</TABLE>

See notes to condensed consolidated financial statements.

<PAGE>   4

NEXT LEVEL COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2000 AND
SEPTEMBER 30, 1999
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------------------
                                                             Three Months Ended                    Nine Months Ended
                                                 SEPTEMBER 30, 2000   SEPTEMBER 30, 1999  SEPTEMBER 30, 2000  SEPTEMBER 30, 1999
<S>                                                   <C>                 <C>                 <C>                 <C>
REVENUES:
  Equipment                                           $  47,126           $  13,419           $ 116,155           $  29,848
  Software                                                1,144                 821               2,770               2,582
                                                      ---------           ---------           ---------           ---------
           Total revenues                                48,270              14,240             118,925              32,430
                                                      ---------           ---------           ---------           ---------

COST OF REVENUES:
  Equipment                                              36,132              12,759              93,099              29,741
  Software                                                    7                  70                  89                 228
                                                      ---------           ---------           ---------           ---------
           Total cost of revenues                        36,139              12,829              93,188              29,969
                                                      ---------           ---------           ---------           ---------
GROSS PROFIT                                             12,131               1,411              25,737               2,461
                                                      ---------           ---------           ---------           ---------

OPERATING EXPENSES:
  Research and development                               13,053              12,810              40,549              35,861
  Selling, general and administrative                    13,705               7,836              34,235              22,220
  Noncash compensation charge -                               -               2,384                   -                   -
                                                      ---------           ---------           ---------           ---------
           Total operating expenses                      26,758              20,646              77,168              58,081
                                                      ---------           ---------           ---------           ---------
OPERATING LOSS                                          (14,627)            (19,235)            (51,431)            (55,620)

OTHER INCOME (EXPENSE), Net                                 (30)                (17)                (82)               (263)
INTEREST INCOME (EXPENSE)                                 1,264              (1,499)              5,058              (4,065)
                                                      ---------           ---------           ---------           ---------
NET LOSS                                              $ (13,393)          $ (20,751)          $ (46,455)          $ (59,948)
                                                      =========           =========           =========           =========
BASIC AND DILUTED NET
   LOSS PER COMMON SHARE (PRO FORMA IN 1999)          $    (.16)          $    (.27)          $    (.57)          $    (.79)
                                                      =========           =========           =========           =========
SHARES USED TO COMPUTE
   BASIC AND DILUTED NET LOSS
   PER COMMON SHARE (PRO FORMA IN 1999)                  83,483              69,967              81,164              69,967
                                                      =========           =========           =========           =========
</TABLE>

See notes to condensed consolidated financial statements.


                                       2
<PAGE>   5

NEXT LEVEL COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2000 AND SEPTEMBER 30, 1999
(IN THOUSANDS, UNAUDITED)
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------
                                                            SEPTEMBER 30, 2000  SEPTEMBER 30, 1999
<S>                                                              <C>                 <C>
OPERATING  ACTIVITIES:
  Net loss                                                       $ (46,455)          $ (59,948)
  Adjustments to reconcile net loss to net cash used in
    operating activities:
    Noncash compensation charge                                      2,384                   -
    Depreciation and amortization                                    9,474               6,504
    Loss on disposal of assets                                          62                 300
    Changes in assets and liabilities:
      Trade receivables                                            (21,818)             (3,275)
      Inventories                                                  (33,313)             (4,823)
      Other current and non-current assets                          (3,389)              2,567
      Accrued interest payable to General Instrument                     -               5,010
      Accounts payable                                              30,649              (5,053)
      Accrued liabilities and deferred revenue                       1,952              14,340
                                                                 ---------           ---------
           Net cash used in operating activities                   (60,454)            (44,378)
                                                                 ---------           ---------
INVESTING ACTIVITIES:
 Purchases of property and equipment                               (11,093)             (6,186)
  Proceeds from notes receivable                                         -                  80
  Purchases of investments, net                                     (6,186)                  -
                                                                 ---------           ---------
           Net cash used in investing activities                   (17,279)             (6,106)
                                                                 ---------           ---------
FINANCING ACTIVITIES:
  Payment of IPO expenses                                             (899)                  -
  Proceeds from borrowings, net                                        147                   -
  Repayment of capital lease obligations                              (482)                  -
  Issuance of common stock                                           5,108                   -
  General Instrument capital contribution                                -              34,000
                                                                 ---------           ---------
           Net cash provided by financing activities                 3,874              34,000
                                                                 ---------           ---------

NET DECREASE IN CASH AND CASH EQUIVALENTS                          (73,859)            (16,484)

CASH AND CASH EQUIVALENTS, Beginning of period                     128,752              28,983

CASH AND CASH EQUIVALENTS, End of period                         $  54,893           $  12,499
                                                                 =========           =========
</TABLE>

See notes to condensed consolidated financial statements.


                                       3
<PAGE>   6

NEXT LEVEL COMMUNICATIONS, INC.

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

1.    BASIS OF PRESENTATION

      The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial information and pursuant
to the rules and regulations of the Securities and Exchange Commission. 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 annual
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 months and nine months
ended September 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") 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, the Company 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:


                                       4
<PAGE>   7

      o   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.

      o   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 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.

      o   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.

      o   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.

      o   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 nine months ended September 30,
1999. In January 2000, General Instrument was acquired by Motorola, Inc.

3.    INVENTORIES

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

<TABLE>
<CAPTION>
                                                September 30,          December 31,
                                                     2000                  1999
                                                -------------          ------------
<S>                                             <C>                    <C>
Raw Materials                                      $18,472               $ 8,175
Work-in-process                                      3,050                 1,542
Finished goods                                      34,344                12,836
                                                   -------               -------
Total                                              $55,866               $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 September 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 September 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


                                       5
<PAGE>   8

custodian. On October 20, 2000, the Company repaid all outstanding principal and
interest related to the Line.

5.    NET LOSS AND PRO FORMA NET LOSS PER SHARE

      Basic and diluted net loss per share for the three months and nine months
ended September 30, 2000 is computed by dividing net loss by the average shares
outstanding for the periods. Pro forma basic and diluted net loss per share for
the three months and nine months ended September 30, 1999 is computed by
dividing the pro forma net loss by the pro forma shares outstanding for the
periods 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                NINE MONTHS ENDED
                                                          SEPTEMBER 30     SEPTEMBER 30      SEPTEMBER 30    SEPTEMBER 30
                                                              2000             1999              2000            1999
                                                                             PRO FORMA                         PRO FORMA
<S>                                                         <C>              <C>              <C>              <C>
Net loss                                                    $(13,393)        $(20,751)        $ (46,455)       $(59,948)
Less: Interest expense for converted GI note payable               -            1,720                 -           5,010
                                                            --------         --------         ---------        --------
Net loss                                                    $(13,393)        $(19,031)        $ (46,455)       $(54,938)
                                                            ========         ========         =========        ========

Weighted average shares outstanding                           83,483           69,967            81,164          69,967
                                                            ========         ========         =========        ========
Basic and diluted net loss per share                        $   (.16)        $   (.27)        $    (.57)       $   (.79)
                                                            ========         ========         =========        ========
</TABLE>

      For the periods ended September 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
                                                    September 30,      September 30,
                                                        2000               1999
                                                    -------------      -------------
<S>                                                     <C>                <C>
General Partner's warrants                              5,987              8,480
Outstanding employee options                           20,701              6,946
                                                       ------             ------
Total                                                  26,688             15,426
</TABLE>


6.    COMPREHENSIVE INCOME (LOSS)

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

<TABLE>
<CAPTION>
                                                          THREE MONTHS ENDED            NINE MONTHS ENDED
                                                             SEPTEMBER 30                  SEPTEMBER 30
                                                          2000           1999           2000           1999
<S>                                                     <C>            <C>            <C>            <C>
Net loss                                                $(13,393)      $(20,751)      $(46,455)      $(59,948)
Unrealized gains (losses) on marketable securities            31             --            (37)            --
                                                        --------       --------       --------       --------
Total comprehensive loss                                $(13,362)      $(20,751)      $(46,492)      $(59,948)
                                                        ========       ========       ========       ========
</TABLE>


                                       6
<PAGE>   9

7.    ACQUISITIONS

      In July 2000, the Company acquired SoftProse, a company that provides
products and development services for consumer electronics, embedded systems,
real-time systems and communications systems. The total purchase price was $16.9
million, in the form of the issuance of 138,615 shares of the Company's common
stock. Goodwill of $16.3 million arising from the acquisition will be amortized
over three years.

      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 contributed
$7.0 million in cash in exchange for an ownership interest of less than 20%.

      In September 2000, the Company made a $3.0 million investment in Expanse
Networks Inc., a developer of addressable television ad delivery systems and
software for broadband networks.

      On November 7, 2000, the Company made a $5.0 million investment in Virtual
Access, a network access company.


8.    RECENTLY ISSUED ACCOUNTING STANDARDS

         The Financial Accounting Standards Board has 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, will
be effective for our fiscal year ending December 31, 2001. We are currently
evaluating what impact, if any, this standard will have on our consolidated
financial statements.

         In December 1999, the Securities and Exchange Commission released Staff
Accounting Bulletin (SAB) 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 are currently evaluating what impact, if any, SAB No. 101 will have on our
consolidated financial statements.


                                       7
<PAGE>   10

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 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. Qwest (formerly U S
WEST) accounted for 47% of total revenues for the quarter ended September 30,
2000 and 59% of our total revenues for the quarter ended September 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.


                                       8
<PAGE>   11

      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 nine 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 September 30, 2000
increased to $48.3 million from $14.2 million in the quarter ended September 30,
1999. Total revenues in the first nine months of 2000 increased to $118.9
million from $32.4 million in the nine-month period ended September 30, 1999.
The increase was primarily due to an increase in equipment sales. Total revenues
for the third quarter of 2000 included $47.1 million of equipment sales,
compared to $13.4 million for the comparable quarter in 1999. Equipment sales
for the nine-month period ended September 30, 2000 were $116.2 million, compared
to $29.8 million for the comparable period in 1999.

      Qwest accounted for $22.5 million of equipment revenue in the third
quarter of 2000 as compared to $8.3 million in the third quarter of 1999. Sales
to Qwest for the nine-month period ended September 30, 2000 were $74.7 million,
compared to $19.9 million for the comparable period in 1999. This increase was
primarily attributable to Qwest's increased deployment in 2000. We expect to
continue to derive substantially all of our revenues from sales of equipment to
Qwest and local, foreign and independent telephone companies for the foreseeable
future. The growth in equipment revenue in future quarters will


                                       9
<PAGE>   12

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 increased to $1.1 million in the third quarter of 2000
from $821,000 in the third quarter of 1999. Software revenue in the nine-month
periods ended September 30, 2000 and 1999 was $2.8 million and $2.6 million. 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 $36.1 million in the
quarter ended September 30, 2000 from $12.8 million in the third quarter of
1999. Total cost of revenues in the first nine months of 2000 increased to $93.2
million from $30.0 million in the nine-month period ended September 30, 1999.
Our gross margin percentage increased to 25.1% in the quarter ended September
30, 2000 from 9.9% in the same 1999 period. Our gross margin percentage grew to
21.6% in the nine month period ended September 30, 2000 from 7.6% in the
comparable 1999 period. 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.

      Research and development. Research and development expenses increased to
$13.1 million in the quarter ended September 30, 2000 from $12.8 million in the
same quarter in 1999. R&D expenses in the first nine months of 2000 increased to
$40.5 million from $35.9 million in the nine-month period ended September 30,
1999. The increase was primarily due to an increase in research and development
personnel. We believe that 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 $13.7 million in the quarter ended September 30, 2000 compared to
$7.8 million in the same quarter in 1999. Total SG&A expenses in the first nine
months of 2000 increased to $34.2 million from $22.2 million in the nine-month
period ended September 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 nine months ended September 30, 2000,
we incurred $2,384,000 of noncash compensation charges as a result of vesting of
employee stock options that occurred upon the Motorola acquisition of General
Instrument in January 2000.

      Interest income (expense). For the quarter and nine month period ended
September 30, 2000, the amount represents interest income earned on proceeds
from our initial public offering. For the quarter and


                                       10
<PAGE>   13

nine month period ended September 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.

     Pro forma net loss per share. The following is a reconciliation of the
components of basic and diluted net loss per share excluding amortization of
Goodwill, stock option expense, interest expense and non-cash compensation
charges for the quarter and nine month periods ended September 30, 2000 and 1999
(in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                       THREE MONTHS ENDED             NINE MONTHS ENDED
                                                   SEPTEMBER 30   SEPTEMBER 30   SEPTEMBER 30   SEPTEMBER 30
                                                       2000          1999            2000          1999
<S>                                                 <C>            <C>            <C>            <C>
Net loss                                            $ (13,393)     $ (20,751)     $ (46,455)     $ (59,948)
Less: Stock Compensation Charge                                                       2,384
Less: Amortization of Goodwill                          1,408                         1,906            747
Less: Stock Option Expense                              1,573                         1,573
Less: Interest expense for converted
  GI note payable                                          --          1,720             --          5,010
                                                    ---------      ---------      ---------      ---------
Pro forma net loss                                  $ (10,412)     $ (19,031)     $ (40,592)     $ (54,191)
                                                    =========      =========      =========      =========
Weighted average shares outstanding                    83,483         69,967         81,164         69,967
                                                    =========      =========      =========      =========
Pro forma basic and diluted net loss per share      $    (.12)     $    (.27)     $    (.50)     $    (.77)
                                                    =========      =========      =========      =========
</TABLE>

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 Motorola, which
acquired General Instrument in January 2000.

      Net cash used in operating activities was $60.5 million in the nine-month
period ended September 30, 2000 and $44.4 million in the nine-month period ended
September 30, 1999. In each case, the use of cash in operating activities was
primarily due to our net losses. In the current nine-month period, net cash used
increased due to a $22.0 million increase in trade receivables and a $33.3
million increase in inventory, partially off-set by a $30.7 million increase in
accounts payable.

      Net cash used in investing activities of $17.3 million in the nine-month
period ended September 30, 2000 and $6.1 million in the nine-month period ended
September 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. In the
current period, investments, net increased by $6.2 million. The increase was due
to a $10.0 million investment in Expanse Networks, Inc. and OutReach
Communications L.L.C., partially offset by the sale of marketable securities.

      Net cash provided by financing activities of $3.9 million in the
nine-month period ended September 30, 2000 was primarily attributable to the
issuance of common stock of $5.1 million, partially offset by the payment of
expenses related to our November 1999 initial public offering. In the nine-month
period ended September 30, 1999, net cash provided by financing activities of
$34.0 million was attributable to a capital contribution by General Instrument.

      At September 30, 2000, we had $54.9 million of cash and cash equivalents,
and $100.3 million of working capital. We anticipate that we will increase our
capital expenditures 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, together with available credit, will be sufficient to
meet our working capital and capital expenditure


                                       11
<PAGE>   14

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 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 $46.5 million in the nine months ended
September 30, 2000, and $59.9 million in the nine months ended September 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


                                       12
<PAGE>   15

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 Qwest, which accounted for
          approximately 47% of our revenues in the third quarter of 2000, or by
          any other customer accounting for a significant portion of our
          revenues;

      -   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.

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

      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. Qwest accounted for 47% of total revenues in the third quarter of 2000
and 59% of total revenues in the third 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,
which could have a material adverse effect on us.


                                       13
<PAGE>   16

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 (now Qwest).

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 nine 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.

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.


                                       14
<PAGE>   17

      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

      -   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.


                                       15
<PAGE>   18

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
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


                                       16
<PAGE>   19

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.

      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


                                       17
<PAGE>   20

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 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


                                       18
<PAGE>   21

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.

      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.


                                       19
<PAGE>   22

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 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.


                                       20
<PAGE>   23

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 beneficially owns approximately 77% 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 Motorola could be in a position involving a conflict
of interest with us. In addition, individuals who are officers or directors of
Motorola 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.

      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.



                                       21
<PAGE>   24

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

      As of November 1, 2000, we had 83,924,108 shares of common stock
outstanding. As of November 1, 2000, Motorola owned 64,103,724 shares of our
common stock and Spencer Trask owned 3,863,329 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 September 30, 2000, there were outstanding options to
purchase 20,701,197 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:

      -   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.


                                       22
<PAGE>   25

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

      (c) On July 14, 2000, we issued an aggregate of 138,615 shares of our
common stock to the stockholders of SoftProse, Inc. in connection with our
acquisition of all of the outstanding stock of SoftProse. We relied on section
4(2) of the Securities Act in connection with the issuance of those shares.

      (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 September 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 6. EXHIBITS AND REPORTS ON FORM 8-K

      (a) Exhibits:

      The following exhibits are included as part of this report:

<TABLE>
<CAPTION>
      Exhibit
         No.         Description of Exhibit
      -------        ----------------------
<S>                  <C>
        10.1         Form of indemnification agreement entered into by Mssrs.
                     Keeler, Eames, Wandrey, Weeks, Van Welzen, Uraz, Pachynski,
                     Tuhy and Zar on April 14, 2000.

        27.1         Financial Data Schedule
</TABLE>

      (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:  November 14, 2000          By:     /s/  PETER W. KEELER
                                      ------------------------
                                        Peter W. Keeler
                                        Chief Executive Officer and President

Date:  November 14, 2000          By:     /s/ JAMES T. WANDREY
                                      ------------------------
                                        James T. Wandrey
                                        Chief Financial Officer and Treasurer


                                       24
<PAGE>   27

                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit No.          Description of Exhibit
-----------          ----------------------
<S>                  <C>
  10.1               Form of indemnification agreement entered into by Mssrs.
                     Keeler, Eames, Wandrey, Weeks, Van Welzen, Uraz, Pachynski,
                     Tuhy and Zar on April 14, 2000.

  27.1               Financial Data Schedule
</TABLE>





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