UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended ~~September~~June 30, ~~2003~~2004

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

For the transition period from ~~____________~~ to ~~____________~~

Commission file number: 0-28734

ADVANCED FIBRE COMMUNICATIONS, INC.


A Delaware		I.R.S. Employer
Corporation		Identification No.
		68-0277743

1465 North McDowell Boulevard
Petaluma, California 94954

Telephone: (707) 794-7700

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ~~[X]~~þ No ~~[ ]~~o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ~~[X]~~þ No ~~[ ]~~o

At ~~October~~July 3130, ~~2003~~2004, there were 8688,~~923~~460,~~724~~020 shares of common stock outstanding.

~~TABLE~~ADVANCED OFFIBRE ~~CONTENTS~~COMMUNICATIONS, INC. REPORT ON FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
Index of Exhibits
Exhibit 31
Exhibit 32

ADVANCED FIBRE COMMUNICATIONS, INC. REPORT ON FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

Table of Contents

			~~Page~~	Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Item 1.		Financial Statements (unaudited)
	Condensed Consolidated Statements of Operations Three and nine months ended September 30, 2003 and 2002			2
		Condensed Consolidated Statements of Operations Three and Six months ended June 30, 2004 and 2003			2
	Condensed Consolidated Balance Sheets September 30, 2003 and December 31, 2002			3
		Condensed Consolidated Balance Sheets June 30, 2004 and December 31, 2003			3
	Condensed Consolidated Statements of Cash Flows Nine months ended September 30, 2003 and 2002			4
		Condensed Consolidated Statements of Cash Flows Six months ended June 30, 2004 and 2003			4
	~~Notes to Condensed Consolidated Financial Statements~~	Notes to Condensed Consolidated Financial Statements		5	5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations				10
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
Item 3. Quantitative and Qualitative Disclosures About Market Risk				24
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			35
Item 4. Controls and Procedures				25
Item 4.		Controls and Procedures			35
PART II. OTHER INFORMATION
Item 1. Legal Proceedings				26
Item 1.		Legal Proceedings			37
Item 2. Changes in Securities and Use of Proceeds				26
Item 2.		Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities			37
Item 3. Defaults Upon Senior Securities				26
Item 3.		Defaults Upon Senior Securities			37
Item 4. Submission of Matters to a Vote of Security Holders				26
Item 4.		Submission of Matters to a Vote of Security Holders			37
Item 5. Other Information				26
Item 5.		Other Information			37
Item 6. Exhibits and Reports on Form 8-K				26
Item 6.		Exhibits and Reports on Form 8-K			38
EXHIBIT 31
EXHIBIT 32

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ADVANCED FIBRE COMMUNICATIONS, INC. ~~CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS~~ ~~(In thousands, except per share data)~~ ~~(Unaudited)~~

			Three Months Ended				Nine months Ended
			September 30,				September 30,
			2003		2002		2003		2002
Revenues			$	85,214	$	91,767	$	248,704	$	258,317
Cost of revenues				44,600		46,603		127,367		136,601
		Gross profit		40,614		45,164		121,337		121,716
Operating expenses:
	Research and development			14,831		17,058		50,167		46,124
	Sales and marketing			9,355		12,264		30,196		36,628
	General and administrative			6,498		6,701		21,313		20,067
	Amortization of acquired intangibles			349		1,280		1,793		2,363
	In-process research and development			—		—		—		12,396
	Securities litigation settlement costs			—		—		—		2,943
		Total operating expenses		31,033		37,303		103,469		120,521
Operating income				9,581		7,861		17,868		1,195
Other income (expense):
	Interest income, net			2,850		1,716		8,712		5,893
	Unrealized gains on Cisco investment			—		4,392		1,386		15,004
	Equity in losses of investee			—		—		—		(1,079	)
	Other			—		147		4		(23	)
		Total other income, net		2,850		6,255		10,102		19,795
Income before income taxes				12,431		14,116		27,970		20,990
Income taxes				3,108		4,517		6,993		6,717
Net income			$	9,323	$	9,599	$	20,977	$	14,273
Basic net income per share			$	0.11	$	0.11	$	0.25	$	0.17
Shares used in basic per share computations				86,246		83,836		85,478		83,104
Diluted net income per share			$	0.11	$	0.11	$	0.24	$	0.17
Shares used in diluted per share computations				87,906		85,754		86,832		85,554

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

~~See~~(In ~~accompanying~~thousands, ~~notes~~except toper ~~condensed~~share ~~consolidated financial statements.~~ data)

2 (Unaudited)


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Revenues	$	118,591		$	83,038		$	211,375		$	163,490
Cost of revenues		70,397			41,914			115,901			82,767

Gross profit		48,194			41,124			95,474			80,723

Operating expenses:
Research and development		22,772			19,392			40,397			35,336
Sales and marketing		13,319			11,065			24,457			20,841
General and administrative		13,202			8,875			21,265			14,815
Amortization of acquired intangibles		4,357			651			6,306			1,444
Integration costs		1,438			—			2,551			—
Securities litigation settlement costs		(5,787	)		—			(5,787	)		—
In-process research and development		—			—			14,000			—

Total operating expenses		49,301			39,983			103,189			72,436

Operating income (loss)		(1,107	)		1,141			(7,715	)		8,287
Other income (expense):
Interest income, net		1,834			3,311			4,750			5,862
Unrealized gains on Cisco investment		—			30			—			1,386
Other		59			(36	)		73			4

Total other income, net		1,893			3,305			4,823			7,252

Income (loss) before income taxes		786			4,446			(2,892	)		15,539
Income taxes (benefit)		(135	)		1,112			(1,128	)		3,885

Net income (loss)	$	921		$	3,334		$	(1,764	)	$	11,654

Basic net income (loss) per share	$	0.01		$	0.04		$	(0.02	)	$	0.14

Shares used in basic per share computations		88,125			85,287			87,876			85,094

Diluted net income (loss) per share	$	0.01		$	0.04		$	(0.02	)	$	0.14

Shares used in diluted per share computations		89,405			86,388			87,876			86,280

~~ADVANCED~~See ~~FIBRE~~accompanying ~~COMMUNICATIONS,~~notes ~~INC. CONDENSED~~to ~~CONSOLIDATED~~condensed ~~BALANCE~~consolidated ~~SHEETS (In~~financial ~~thousands, except share data)~~statements. ~~(Unaudited)~~

				September 30,			December 31,
				2003			2002
Assets
	Current assets:
		Cash and cash equivalents		$	305,577		$	94,754
		Cisco marketable securities and related hedge contracts			210,766			688,840
		Other marketable securities			558,469			213,030
		Accounts receivable, less allowances of $800 in 2003 and $819 in 2002			62,101			41,381
		Inventories, net			21,721			30,553
		Other current assets			31,588			26,667
			Total current assets		1,190,222			1,095,225
	Property and equipment, net				44,495			51,076
	Goodwill				55,883			56,119
	Other acquired intangible assets, net				4,654			5,675
	Other assets				25,486			25,555
			Total assets	$	1,320,740		$	1,233,650
Liabilities and stockholders’ equity
	Current liabilities:
		Accounts payable		$	13,704		$	7,503
		Accrued liabilities			37,267			47,384
		Cisco securities loans payable			210,766			—
		Current taxes payable			80,841			33,875
		Deferred tax liabilities			—			221,673
			Total current liabilities		342,578			310,435
	Long-term liabilities				4,014			4,426
	Commitments and contingencies
	Stockholders’ equity:
		Preferred stock, $0.01 par value; 5,000,000 shares authorized; no shares issued and outstanding			—			—
		Common stock, $0.01 par value; 200,000,000 shares authorized; 86,713,345 shares issued and 86,650,669 shares outstanding in 2003, 84,386,969 shares issued and 84,376,169 shares outstanding in 2002			868			844
		Additional paid-in capital			370,745			336,542
		Deferred compensation			(62	)		(833	)
		Accumulated other comprehensive income			1,965			1,880
		Retained earnings			601,472			580,495
		Treasury stock, 62,676 shares in 2003 and 10,800 shares in 2002			(840	)		(139	)
			Total stockholders’ equity		974,148			918,789
			Total liabilities and stockholders’ equity	$	1,320,740		$	1,233,650

SeeTable accompanyingof notes to condensed consolidated financial statements. Contents

3ADVANCED FIBRE COMMUNICATIONS, INC.

~~Table~~CONDENSED ofCONSOLIDATED ~~Contents~~BALANCE SHEETS

~~ADVANCED~~(In ~~FIBRE COMMUNICATIONS~~thousands, ~~INC. CONDENSED~~except ~~CONSOLIDATED~~share ~~STATEMENTS OF CASH FLOWS (In thousands~~data) ~~(Unaudited)~~

					Nine months Ended September 30,
					2003			2002
Cash flows from operating activities:
	Net income				$	20,977		$	14,273
	Adjustments to reconcile net income to net cash provided by operating activities:
		Cash proceeds from settlement of Cisco hedge contracts				690,226			—
		Deferred income taxes				(243,228	)		2,417
		Current income taxes				46,966			(3,845	)
		Depreciation and amortization				14,238			15,072
		Tax benefit from option exercises				6,730			7,947
		Loss on disposal of fixed assets				2,955			878
		Unrealized gains on Cisco investment				(1,386	)		(15,004	)
		Allowance for doubtful accounts				507			650
		In-process research and development				—			12,396
		Equity in losses of investee, net of tax				—			734
		Changes in operating assets and liabilities:
			Accounts receivable			(20,991	)		10,985
			Inventories			8,832			(332	)
			Other current assets			16,634			14,977
			Other assets			194			1,524
			Accounts payable			6,201			(3,533	)
			Accrued and other liabilities			(10,529	)		(7,946	)
				Net cash provided by operating activities		538,326			51,193
Cash flows from investing activities:
	Purchases of other marketable securities					(4,459,794	)		(430,759	)
	Sales of other marketable securities					3,872,418			325,141
	Maturities of other marketable securities					241,870			138,811
	Purchases of property and equipment, net of disposals					(8,793	)		(7,577	)
	Acquisition, net of cash acquired					—			(42,978	)
	Restricted investment					—			(20,063	)
				Net cash used in investing activities		(354,299	)		(37,425	)
Cash flows from financing activities:
	Proceeds from common stock issuances					27,497			13,342
	Purchase of treasury stock					(701	)		—
				Net cash provided by financing activities		26,796			13,342
Increase in cash and cash equivalents						210,823			27,110
Cash and cash equivalents, beginning of period						94,754			39,528
Cash and cash equivalents, end of period					$	305,577		$	66,638

(Unaudited)

See accompanying notes to condensed consolidated financial statements.


	June 30,			December 31,
	2004			2003
Assets
Current assets:
Cash and cash equivalents	$	134,607		$	246,552
Cisco marketable securities		247,407			250,786
Other marketable securities		478,316			594,230
Accounts receivable, net		68,436			54,464
Income tax receivable		210,100			—
Inventories, net		44,714			18,959
Other current assets		5,538			27,026

Total current assets		1,189,118			1,192,017
Property and equipment, net		58,457			43,762
Goodwill		189,612			55,883
Other acquired intangible assets, net		77,552			1,639
Other assets		29,549			24,415

Total assets	$	1,544,288		$	1,317,716

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	22,410		$	11,112
Accrued liabilities		56,925			39,605
Cisco securities loans payable		247,407			250,786
Current taxes payable		34,621			26,989
Deferred tax liabilities		174,457			—

Total current liabilities		535,820			328,492
Long-term liabilities		5,112			4,068
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value; 5,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.01 par value; 200,000,000 shares authorized; 88,345,117 shares issued and 88,282,441 shares outstanding in 2004, 87,075,296 shares issued and 87,012,620 shares outstanding in 2003		883			871
Additional paid-in capital		398,054			376,394
Deferred compensation		(11	)		(29	)
Accumulated other comprehensive income		(166	)		1,560
Retained earnings		605,436			607,200
Treasury stock, 62,676 shares in 2004 and 2003		(840	)		(840	)

Total stockholders’ equity		1,003,356			985,156

Total liabilities and stockholders’ equity	$	1,544,288		$	1,317,716

4See accompanying notes to condensed consolidated financial statements.

~~Table of Contents~~3

ADVANCEDTable FIBREof COMMUNICATIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Contents

~~Note~~ADVANCED 1FIBRE ~~Basis~~COMMUNICATIONS, ~~of Presentation~~INC.

~~The~~CONDENSED ~~accompanying~~CONSOLIDATED ~~unaudited~~STATEMENTS ~~condensed~~OF ~~consolidated~~CASH financial statements have been prepared in accordance with accounting principles generally accepted for interim financial information in the United States and pursuant to the rules and regulations of the Securities and Exchange Commission. While these financial statements reflect all adjustments of a normal and recurring nature which are, in the opinion of management, necessary to present fairly the results of the interim period, 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 contained in our Annual Report on Form 10-K for the year ended December 31, 2002. FLOWS

~~The unaudited condensed consolidated financial statements include Advanced Fibre Communications, Inc. and its subsidiaries~~ (~~AFC).~~In ~~Significant intercompany transactions and accounts have been eliminated. Certain prior period amounts have been reclassified to conform to the current period presentation.~~ thousands)

We operate on 13-week fiscal quarters ending on the last Saturday of each fiscal period. For presentation purposes only, the fiscal periods are shown as ending on the last day of the month of the respective fiscal period. The results of operations for the three and nine month periods ended September 30, 2003, are not necessarily indicative of the operating results for the full year. (Unaudited)

Note 2 Pro Forma Fair Value Information


	Six months Ended
	June 30,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	(1,764	)	$	11,654
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Current income taxes		(202,468	)		105,905
Deferred income taxes		197,367			(239,119	)
Depreciation and amortization		15,944			10,026
In-process research and development		14,000			—
Increase in reserve for returns, rebates and credits		4,654			324
Tax benefit from option exercises		3,905			3,850
Interest receivable		983			(3,512	)
Reduction in reserve for purchase commitments		(836	)		(2,196	)
Increase in reserve for write down of inventories		635			2,432
Allowance for doubtful accounts		16			350
Other non-cash adjustments to operating income		6			2,881
Cash proceeds from settlement of Cisco hedge contracts		—			690,226
Unrealized gains on Cisco investment		—			(1,386	)
Changes in operating assets and liabilities:
Accounts receivable		(1,570	)		(19,038	)
Inventories		(13,291	)		5,490
Other current assets		221			19,358
Other assets		8			61
Accounts payable		(5,142	)		2,983
Accrued and other liabilities		3,358			(6,161	)

Net cash provided by operating activities		16,026			584,128

Cash flows from investing activities:
Purchases of other marketable securities		(1,971,694	)		(1,875,903	)
Sales of other marketable securities		1,712,121			1,514,662
Maturities of other marketable securities		371,646			31,007
Payment for purchase of business		(245,746	)		—
Purchases of property and equipment		(7,015	)		(5,874	)
Restricted investment		(3,050	)		—
Investment in privately held company		(2,000	)		—

Net cash used in investing activities		(145,738	)		(336,108	)

Cash flows from financing activities:
Proceeds from common stock issuances		17,767			10,827
Purchase of treasury stock		—			(701	)

Net cash provided by financing activities		17,767			10,126

Increase (decrease) in cash and cash equivalents		(111,945	)		258,146
Cash and cash equivalents, beginning of period		246,552			94,754

Cash and cash equivalents, end of period	$	134,607		$	352,900

WeSee ~~account~~accompanying ~~for~~notes ~~equity-based compensation plans with employees and non-employee members of the board of directors using the intrinsic value method under APB Opinion No. 25, Accounting for Stock Issued~~ to ~~Employees.~~condensed Asconsolidated offinancial ~~September 30, 2003, executive officers held 1~~statements.~~6 million of the 13.9 million total outstanding~~ ~~options held by employees and board of directors.~~

~~We follow the disclosure requirements of Statement of Financial Accounting~~4 Standards (SFAS) No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure. We use the Black-Scholes option-pricing model to calculate the disclosure requirements. The Black-Scholes option-pricing model was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. AFC uses projected data for expected volatility and expected life of its stock options based on historical and other economic data trended into future years. AFC’s employee stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the estimate. In management’s opinion, the existing valuation models do not provide a reliable measure of fair value of AFC’s employee stock options.

IfTable compensationof cost for our stock-based compensation plans had been determined in accordance with the fair value approach set forth in SFAS No. 123, our net income and earnings per share would have been reduced to the approximate pro forma amounts as follows (in thousands, except per share data): Contents

		Three Months Ended						Nine months Ended
		September 30,						September 30,
		2003			2002			2003			2002
Net income, as reported		$	9,323		$	9,599		$	20,977		$	14,273
Add: Stock based employee compensation expense included in reported net income, net of related tax effects			58			743			579			1,394
Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects			(8,551	)		(9,948	)		(29,009	)		(30,627	)
Pro forma net income (loss)		$	830		$	394		$	(7,453	)	$	(14,960	)
Earnings (loss) per share:
	Basic – as reported	$	0.11		$	0.11		$	0.25		$	0.17
	Basic – pro forma		0.01			0.00			(0.09	)		(0.18	)
	Diluted – as reported		0.11			0.11			0.24			0.17
	Diluted – pro forma		0.01			0.00			(0.09	)		(0.18	)

ADVANCED FIBRE COMMUNICATIONS, INC.

~~The~~NOTES ~~fair~~TO ~~value~~CONDENSED ofCONSOLIDATED ~~option~~FINANCIAL grants in the three and nine month periods ended September 30, 2003 and 2002 were estimated on the date of grant using the Black-Scholes option-pricing model assuming no dividend yield, with the following weighted average assumptions: STATEMENTS

				Weighted Average			Weighted Average
				Risk-free Interest			Expected Lives
	Volatility			Rate			(Years)
Three months ended September 30, 2003		88	%		2.7	%		4
Nine months ended September 30, 2003		90	%		2.5	%		4
Three months ended September 30, 2002		96	%		4.0	%		3.6
Nine months ended September 30, 2002		96	%		4.0	%		3.6

Note 1 Basis of Presentation

~~Pro~~The ~~forma~~accompanying ~~compensation~~unaudited ~~costs~~condensed ~~related~~consolidated tofinancial statements have been prepared in accordance with accounting principles generally accepted for interim financial information in the ~~Employee~~United ~~Stock~~States ~~Purchase~~and ~~Plan~~pursuant ~~were~~to the rules ~~calculated~~and ~~based~~regulations onof the ~~Black-Scholes~~Securities ~~option-pricing~~and ~~model~~Exchange Commission. ~~The~~While ~~fair~~these financial ~~value~~statements reflect all adjustments of a normal and recurring nature which are, in the ~~employees’~~opinion ~~purchase~~of ~~rights~~management, ~~was~~necessary ~~estimated~~to aspresent fairly the results of the ~~date~~interim ofperiod, ~~grant~~they do not include all information and footnotes required by generally accepted accounting principles for ~~2003~~complete ~~and~~financial ~~2002~~statements. ~~The~~These ~~following~~financial ~~weighted~~statements ~~average~~and ~~assumptions~~notes ~~were~~should ~~used,~~be ~~assuming~~read noin ~~dividend~~conjunction ~~yield:~~with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2003.

				Weighted Average			Weighted Average
				Risk-free Interest			Expected Lives
	Volatility			Rate			(Months)
January 2004		91	%		1.1	%		9
January 2003		96	%		1.0	%		6

The unaudited condensed consolidated financial statements include Advanced Fibre Communications, Inc. and its subsidiaries, or AFC. Significant intercompany transactions and accounts have been eliminated.

5We operate on 13-week fiscal quarters ending on the last Saturday of each fiscal period. For presentation purposes only, the fiscal periods are shown as ending on the last day of the month of the respective fiscal period. The results of operations for the three and six month periods ended June 30, 2004 are not necessarily indicative of the operating results for the full year.

~~Table~~Note of2 ~~Contents~~Pro Forma Fair Value Information

~~Note~~We 3account ~~Settlement~~for equity-based compensation plans with employees and non-employee members of ~~Cisco~~the ~~Hedge~~board ~~Contracts~~of directors using the intrinsic value method under Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees. As of June 30, 2004, executive officers held 1.7 million of the 15.8 million total outstanding options held by employees and board of directors.

InWe ~~February~~follow ~~and~~the ~~May~~disclosure requirements of ~~2003,~~Statement ~~the~~of ~~hedge~~Financial ~~contracts~~Accounting Standards, onor ~~our Cisco Systems~~SFAS, ~~Inc~~No. ~~(Cisco)~~ 123, ~~stock~~Accounting ~~matured.~~for ~~The~~Stock-Based ~~hedge~~Compensation ~~contracts~~and ~~covered 10~~SFAS No.6 ~~million~~148, ofAccounting ~~the~~for ~~Cisco~~Stock-Based ~~shares~~Compensation — Transition weand ~~own~~Disclosure. We Inuse ~~February~~the ~~and~~Black-Scholes ~~May~~option-pricing ~~2003,~~model weto ~~borrowed~~calculate athe ~~total~~disclosure requirements. ofThe ~~10.6 million shares~~Black-Scholes ofoption-pricing ~~Cisco~~model ~~stock~~was todeveloped ~~settle~~for use in estimating the ~~hedge~~value ~~contracts.~~of Wetraded ~~retained~~options ~~the~~that ~~Cisco~~have no vesting restrictions and ~~shares~~are wefully ~~already~~transferable. ~~owned~~In addition, ~~which~~option-pricing ~~were~~models ~~pledged~~require asthe ~~security~~input ~~under~~of subjective assumptions including the ~~Cisco~~expected stock ~~loans.~~ Weprice ~~received $690~~volatility.~~3 million~~ inAFC ~~cash~~uses projected data for ~~settling~~expected ~~the~~volatility ~~hedge contracts~~ and ~~invested~~ itexpected inlife ~~available-for-sale~~of ~~municipal~~its ~~and~~stock ~~corporate~~options based ~~debt~~on historical and ~~equity securities~~other ineconomic ~~accordance~~data ~~with~~trended ~~our~~into ~~investment~~future ~~policy~~years. ~~We reclassified~~AFC’s ~~approximately~~employee ~~$265 million~~stock inoptions ~~deferred~~have ~~taxes~~characteristics ~~related~~significantly todifferent ~~the~~from ~~recognized gain on~~those ~~the~~of ~~10.6 million~~traded ~~Cisco~~options, ~~shares~~ and ~~related~~changes ~~hedge~~in ~~contracts~~the tosubjective ~~current~~input ~~taxes~~assumptions can ~~payable~~materially inaffect the ~~first~~estimate. ~~and~~In ~~second~~management’s ~~quarters~~opinion, ofthe ~~2003.~~existing ~~The~~valuation models ~~fair~~do ~~market~~not ~~values~~provide ~~of the~~a ~~new~~reliable ~~Cisco~~measure ~~stock~~of ~~loans~~fair ~~are~~value ~~reflected~~of asAFC’s ~~current~~employee ~~liabilities~~stock options.

~~By using borrowed shares to settle the hedge contracts, we believe that payment~~5 ~~of the estimated taxes on the gains attributable to the hedge contracts could be deferred until we settle the new Cisco stock loans.~~

NoteTable 4of Cisco Stock Loan Fees Contents

InIf ~~connection~~compensation ~~with~~cost ~~borrowing~~for ~~the~~our ~~Cisco shares under the~~ stock-based ~~loans,~~compensation weplans ~~pay various~~had ~~borrowing~~been ~~fees on a quarterly basis. We pay borrowing fees and a fee~~determined ~~adjustment~~in ~~based~~accordance onwith the ~~average~~fair ~~daily~~value ~~price~~approach ofset ~~Cisco~~forth ~~stock.~~in WeSFAS ~~are~~No. 123, ~~expensing~~our net ~~the~~income ~~borrowing~~(loss) and ~~fees~~earnings on(loss) per ashare ~~straight-line~~would ~~basis~~have ~~over~~been ~~the~~reduced ~~lives~~to of the ~~loans. We~~ ~~expect~~approximate topro ~~incur~~forma ~~costs~~amounts ofas ~~approximately~~follows ~~$1 million~~(in ~~annually~~thousands, ~~net~~except ofper ~~taxes,~~share todata): ~~pursue our tax position. These costs include legal fees and borrowing fees,~~ ~~which are expensed as incurred.~~

Provisions in the February and May 2003 Cisco stock loans contain “make-whole” fee arrangements. The make-whole fees would provide the lender with the discounted net present value of a portion of future borrowing fees. The make-whole fees are triggered if we assign the loans to another lender, or terminate and enter into a similar transaction with another lender, or if we are acquired by Cisco. The make-whole fees are calculated based on the net present value, discounted at 10%, of a portion of future borrowing fees due up to and including the seventh year. Over the next seven years, the maximum gross potential amount payable would be $2.2 million.


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Net income (loss), as reported	$	921		$	3,334		$	(1,764	)	$	11,654
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		40			197			41			521
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		11,526			8,384			12,938			18,919

Pro forma net income (loss)	$	(10,565	)	$	(4,853	)	$	(14,661	)	$	(6,744	)
Earnings (loss) per share:
Basic — as reported	$	0.01		$	0.04		$	(0.02	)	$	0.14
Basic — pro forma	$	(0.12	)	$	(0.06	)	$	(0.17	)	$	(0.08	)
Diluted — as reported	$	0.01		$	0.04		$	(0.02	)	$	0.14
Diluted — pro forma	$	(0.12	)	$	(0.06	)	$	(0.17	)	$	(0.08	)

6The fair value of option grants in the three and six months ended June 30, 2004 and 2003 were estimated on the date of grant using the Black-Scholes option-pricing model assuming no dividend yield and with the following assumptions:


				Weighted Average			Weighted Average
				Risk-Free Interest			Expected Lives
	Volatility			Rate			(Years)
Three months ended June 30, 2004		73	%		3.0	%		4
Six months ended June 30, 2004		79	%		2.9	%		4
Three months ended June 30, 2003		88	%		2.3	%		4
Six months ended June 30, 2003		91	%		2.5	%		4

~~Note~~Pro 5forma ~~Warranty~~compensation ~~Reserve~~costs related to the Employee Stock Purchase Plan were calculated for the fair value of the employees’ purchase rights, as of the date of grant using the Black-Scholes option-pricing model. The following assumptions were used, assuming no dividend yield:

Warranty reserve activity for the nine months ended September 30, 2003, consisted of the following (in thousands):


				Weighted Average			Weighted Average
				Risk-Free Interest			Expected Lives
Next Purchase Date	Volatility			Rate			(Months)
July 2004		51	%		1.3	%		17
July 2003		77	%		1.2	%		12

Balance at December 31, 2002	$	15,097
Accrual for warranty costs		6,204
Settlements made in cash or in kind		(6,335	)
Reduction in reserve due to cost true-up and change in accrual rate		(2,000	)
Balance at September 30, 2003	$	12,966

ATable provision for estimated warranty costs is established at the time of sale and adjusted periodically based on historical trends in warranty claims and expected material and labor costs to provide warranty services. In addition, we evaluate the overall reasonableness and adequacy of the warranty reserve provision at the end of each quarter. In the second quarter of 2003, we performed an analysis of warranty service activities and costs. We adjusted the reserve level and reduced our estimate for the warranty reserve accrual rate for future periods. Additionally, some personnel-related costs previously charged to the warranty reserve are now charged to operating expenses as incurred. Contents

Note 63 ~~Inventories~~Pending Merger

~~Inventories~~On ~~are~~May 20, ~~valued~~2004, atAFC and Tellabs, Inc., or Tellabs, announced a definitive merger agreement under which Tellabs will acquire AFC through a two-step merger. Under the ~~lower~~terms of ~~cost~~the ~~(first~~transaction, which was approved by both companies’ boards of directors, AFC stockholders will receive 1.55 shares of Tellabs common stock and $7.00 cash for each AFC share. The transaction is subject to certain closing conditions, including regulatory approval and approval by Tellabs’ and AFC’s stockholders. We currently anticipate closing the merger before the end of October 2004. We have incurred merger-related cost of $3.5 million related to investment banking, legal, accounting and other fees, which were expensed in the three months ended June 30, 2004. We have a commitment to pay additional investment banking fees upon consummation of the merger, in an amount based on the value of the merger consideration when the merger was first~~-out~~ ~~basis)~~publicly announced, when the merger agreement was signed or when the merger is ~~market~~completed, ~~and~~whichever ~~consist~~is higher. The remaining commitment, calculated as of the ~~following~~signing ~~(in~~of ~~thousands):~~the merger agreement, totals $9.5 million. Also see Note 14 Pending Litigation for a matter related to the merger.

		September 30,		December 31,
		2003		2002
Raw materials		$	11,349	$	9,919
Work-in-progress			1,012		1,152
Finished goods			9,360		19,482
	Inventories	$	21,721	$	30,553

Note 4 Acquisition

~~Note~~On 7February 20, ~~Accumulated~~2004, ~~Other~~we ~~Comprehensive~~completed ~~Income~~the acquisition of North American Access, or NAA, a business unit of Marconi Communications, Inc., a subsidiary of Marconi Corporation plc. We acquired 100% of the business interests of NAA. We accounted for the acquisition as a purchase in accordance with the guidance in SFAS No. 141, Business Combinations. The purchase consideration for NAA consisted of $240.9 million in cash, plus liabilities assumed and acquisition-related expenses. Our results of operations for the three and six months ended June 30, 2004 include those of NAA beginning as of February 20, 2004.

~~The~~This ~~following~~acquisition ~~table~~enables ~~presents~~us to offer a more robust portfolio of fiber-based access network solutions. We view the ~~components~~product line from NAA to be complementary to our own, particularly NAA’s fiber-to-the-curb offering and our Fiber-to-the-Premises, or FTTP, solution. We believe that synergies among our product lines enable us to serve a broader base of ~~accumulated~~customers, ~~other~~from ~~comprehensive~~the smallest ~~income~~independent ~~(in~~operating ~~thousands)~~company to the largest regional Bell operating company. The value of the purchase price was $276 million, which consisted of the following:

			Three Months Ended						Nine months Ended
			September 30,						September 30,
			2003			2002			2003			2002
Net income			$	9,323		$	9,599		$	20,977		$	14,273
Other comprehensive income (loss), net of tax:
	Foreign currency translation adjustments			(1	)		(3	)		(6	)		(2	)
	Unrealized gain (loss) on available-for-sale marketable securities, net of tax			(294	)		219			91			480
		Total comprehensive income	$	9,028		$	9,815		$	21,062		$	14,751

•		$240.9 million in cash paid;

•		$32 million in liabilities assumed;

•		$5.1 million in acquisition-related charges; and

•		$2 million credit for working capital adjustment.

7We engaged third party appraisers to value the acquired tangible and intangible assets. The allocation of the purchase price, the final adjustment to working capital, and final agreement on amounts to be paid on certain assets were finalized during the three months ended June 30, 2004. Following is a condensed balance sheet disclosing the finalized fair values of the assets acquired and liabilities assumed as of the date of acquisition (in thousands):


Assets:
Accounts receivable, net	$	14,155
Inventory, net		13,099
Property and equipment		16,984
Other receivables		921
Other assets		944
Completed technology		20,000
In-process research and development		14,000
Order backlog		300
Customer relationships		61,900
Goodwill		133,729

Total assets		276,032

Liabilities:
Accounts payable		16,440
Accrued liabilities		15,609
Other liabilities		8

Net assets acquired	$	243,975

~~Note 8 Net Income Per Share~~7

TheTable shares and net income amounts used in the computation of basic and diluted net income per share for the three and nine months ended September 30, 2003 and 2002 are as follows (in thousands, except per share data): Contents

	Three Months Ended				Nine months Ended
	September 30,				September 30,
	2003		2002		2003		2002
Net income	$	9,323	$	9,599	$	20,977	$	14,273
Shares used in basic per share computations, actual weighted average common shares outstanding for the period		86,246		83,836		85,478		83,104
Weighted average number of shares upon exercise of dilutive options		1,660		1,918		1,354		2,450
Shares used in diluted per share calculations		87,906		85,754		86,832		85,554
Basic net income per share	$	0.11	$	0.11	$	0.25	$	0.17
Diluted net income per share	$	0.11	$	0.11	$	0.24	$	0.17

The allocation of the purchase price to intangible assets included:

~~Options~~• toIn-process ~~purchase~~research ~~5,237,170~~ and 8development,~~178,177~~ ~~shares~~or in-process R&D, of ~~common~~$14 ~~stock~~million, which was expensed during the three months ended ~~September 30~~March 31, ~~2003~~2004 ~~and~~at ~~2002,~~the ~~respectively,~~time ~~were~~of ~~excluded from~~ the ~~computation~~acquisition; • Completed technology of ~~diluted~~$20 ~~net~~million, ~~income~~projected ~~per~~to ~~share.~~be ~~Options~~amortized over the weighted average useful lives ranging from four to ~~purchase 6,888,633~~seven ~~and~~years 7based on revenues from products containing the technology; • Order backlog of $0.3 million,~~777,353~~ ~~shares~~which was capitalized at the time of ~~common~~acquisition ~~stock~~and expensed during the ~~nine~~three months ended ~~September 30~~ March 31, ~~2003~~2004 ~~and~~as ~~2002,~~inventory ~~respectively~~shipped; • Customer relationships of $61.9 million, ~~were~~projected ~~excluded~~to ~~from~~be amortized over the ~~computation of~~next ~~diluted~~nine ~~net~~years; ~~income~~and ~~per~~• ~~share~~Goodwill of $133.7 ~~The~~million, ~~exercise~~which ~~prices~~will not be amortized but is deductible for tax purposes over 15 years.

8Our methodology for allocating the purchase price to in-process R&D was determined based on valuations performed by an independent third party. We acquired three in-process R&D projects:

~~Table~~• Project A, estimated to be 62% complete as of ~~Contents~~the acquisition date, with $1.4 million in estimated costs to complete; • Project B, estimated to be 71% complete as of the acquisition date, with $1.3 million in estimated costs to complete; and • Project C, estimated to be 68% complete as of the acquisition date, with $4.3 million in estimated costs to complete.

~~these~~A ~~options~~15% ~~were~~risk-adjusted ~~greater~~rate ~~than~~was ~~the~~used ~~respective~~to ~~average~~value ~~market~~these ~~price~~projects, resulting in a valuation of $14 million. We expensed the $14 million upon acquisition because ~~common~~technological ~~shares,~~feasibility for these projects had not been established and ~~inclusion~~no future ~~would~~alternative beuses ~~anti-dilutive~~existed.

~~Note~~We 9consider ~~Workforce~~the ~~Reduction~~acquired business to be part of our access solutions for segment reporting purposes. We operate as one business segment and our chief operating decision maker continues to review and make operating decisions based on consolidated results.

~~In April 2003, we announced a~~8 102-employee workforce reduction to reduce expenses and align our cost structure with our revised business outlook. The major components of the reduction included severance and employee related expenses, and consolidation of excess leased facilities. The following table displays expenditures from April 2003 through September 30, 2003 related to the workforce reduction (in thousands):

	Reserve									Reserve
	Balance									Balance at
	at March 31,									September 30,
	2003		Charges		Reductions			Reversals		2003
Severance and employee related expenses	$	—	$	2,706	$	(2,550	)	$	—	$	156
Consolidation of excess leased facilities		—		2,768		(1,394	)		—		1,374
Total	$	—	$	5,474	$	(3,944	)	$	—	$	1,530

~~Estimated~~The ~~cost~~consolidated ~~savings~~financial ~~from~~statements include the ~~workforce~~ ~~reduction~~operating ~~are~~results ~~approximately~~of $8NAA from the date of acquisition.~~1 million~~ ~~through~~The pro forma condensed consolidated statements of ~~December 31~~operations for the acquisition of NAA are presented below, ~~2003.~~assuming Wethe transaction ~~anticipate~~was consummated at the ~~remaining~~beginning ~~severance~~of AFC’s fiscal year 2004 and 2003 ~~employee~~for ~~related~~comparative ~~expenses~~purposes. ~~will~~These pro forma amounts do not purport to be indicative ~~paid~~of ~~through~~the ~~mid~~results ~~2004.~~that ~~The~~would ~~remaining~~have been actually obtained if the ~~expenditures~~acquisition ~~relating~~occurred toas of the ~~consolidation~~beginning of ~~excess~~the ~~leased facilities~~period ~~will~~presented or that may be obtained ~~paid~~in ~~through~~the ~~2009.~~future:

Note 10 Recent Accounting Pronouncements


	Six Months Ended June 30,
	2004			2003
	(In thousands, except per share data)
	(Unaudited)
	Pro Forma			Pro Forma
	Results			Results
Revenues	$	241,779		$	241,798
Cost of revenues		137,580			142,306

Gross profit		104,199			99,492

Operating expenses:
Research and development		43,315			45,692
Sales and marketing		26,069			26,980
General and administrative		21,771			15,895
In-process research and development		14,000			14,000
Amortization of acquired intangibles		6,306			7,163
Integration costs		2,551			1,113
Securities litigation settlement costs		(5,787	)		—

Total operating expenses		108,225			110,843

Operating loss		(4,026	)		(11,351	)
Other income:
Interest income, net		4,350			4,462
Unrealized gains on Cisco investment		—			1,386
Other		73			(232	)

Total other income, net		4,423			5,616

Income (loss) before income taxes		397			(5,735	)
Income taxes (benefit)		155			(1,434	)

Net income (loss)	$	242		$	(4,301	)

Basic net income (loss) per share	$	0.00		$	(0.05	)

Shares used in basic per share computations		87,876			85,094

Diluted net income (loss) per share	$	0.00		$	(0.05	)

Shares used in diluted per share computations		89,784			85,094

~~In January 2003, the Financial~~9 Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires a company to consolidate a variable interest entity if the company is subject to the majority of the risk of loss from the entity’s activities, is entitled to a majority of the entity’s residual returns, or both. This Interpretation is effective for AFC in the fourth quarter of 2003. We expect adoption of the Interpretation will not have a material impact on our financial position or results of operations.

InTable April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133. This Statement is effective for AFC in the third quarter of 2003. We expect adoption of the Statement will not have a material impact on our financial position or results of operations. Contents

InNote ~~May~~5 ~~2003,~~Accounts ~~the FASB issued SFAS No. 150, Accounting for Certain Financial~~Receivable ~~Instruments with Characteristics of Both Liabilities and Equity. The~~ ~~Statement provides guidance on how a company classifies and measures certain~~ financial instruments with characteristics of both liabilities and equity. Under previous guidance, a company could account for these financial instruments as equity. The Statement requires that a company classify a financial instrument that is within its scope as a liability, or as an asset in some circumstances. This Statement is effective for AFC in the third quarter of 2003. We expect adoption of the Statement will not have a material impact on our financial position or results of operations.

9Accounts receivable are comprised of the following (in thousands):


	June 30,			December 31,
	2004			2003
Accounts receivable, gross	$	74,126		$	60,622
Reserve for product returns		(3,650	)		(2,047	)
Reserve for promotional rebates		(1,175	)		(1,364	)
Reserve for other rebates & credits		(220	)		(2,028	)

Accounts receivable, net of reserves for returns, rebates and credits		69,081			55,183
Allowance for doubtful accounts		(645	)		(719	)

Net accounts receivable	$	68,436		$	54,464

~~Item 2.~~Note ~~Management’s~~6 ~~Discussion~~Income ~~and~~Tax ~~Analysis of Financial Condition and Results of Operations~~Receivable

~~This~~During ~~report~~the ~~contains~~three ~~“forward-looking~~months ~~statements~~ended June 30, 2004, we recorded an income tax receivable of $210.”1 million Inbased ~~some~~on ~~cases,~~the ~~you~~receipt ~~can~~of a Private Letter Ruling ~~identify~~from ~~these~~the ~~statements~~Internal byRevenue ~~terms~~Service. ~~such~~This asruling ~~“may,”~~addressed ~~“intend,”~~the ~~“might,”~~tax ~~“expect,”~~treatment of ~~“believe,”~~settling ~~“seek,”~~with ~~“anticipate,”~~borrowed ~~“estimate,”~~shares ~~“predict,”~~the ~~“potential,”~~two ~~“target,”~~hedge contracts on 10.6 million Cisco ~~“goals~~Systems,” ~~“projects~~Inc.,” ~~“plan,”~~or ~~“should~~Cisco,” ~~“could,”~~shares ~~“would,”~~that ormatured ~~the~~in ~~negative~~2003. ofThe cash proceeds ~~these~~received ~~terms~~from ~~and~~the ~~similar~~settlement ~~expressions~~were ~~intended~~approximately to$690 million. ~~identify~~Because ~~forward-looking~~we used ~~statements.~~borrowed ~~These~~shares ~~statements~~rather ~~reflect~~than our existing Cisco shares to settle the hedge contracts, we believe that current ~~views~~law ~~with~~allows ~~respect~~the todeferral ~~future~~of taxes on the gain ~~events~~attributable ~~and~~to the hedge contracts until the new Cisco stock loans are settled. ~~based~~The ontotal ~~assumptions~~tax ~~and~~liability ~~subject~~related to ~~risks~~the gain on the Cisco stock and hedge ~~uncertainties.~~contracts Weassuming no deferral would be approximately $265 million. ~~discuss~~During ~~many~~2003, estimated federal and state taxes net of ~~these~~applicable ~~risks~~credits ~~and~~were paid ~~uncertainties~~on inthe ~~greater~~full ~~detail~~amount ~~under~~of the ~~heading~~ ~~“Risk~~gain ~~Factors~~because ~~That~~of ~~Might~~concern ~~Affect~~that ~~Future~~the ~~Operating~~tax ~~Results~~authorities could challenge the tax deferral position, and ~~Financial Condition”~~payment of ~~this~~these ~~Quarterly~~taxes ~~Report~~were accounted for on ~~Form 10-Q~~the balance sheet. ~~These~~In ~~risks~~response ~~and~~to our request, the Internal ~~uncertainties~~Revenue ~~may~~Service ~~cause~~issued ~~our~~a ~~actual~~Private ~~results,~~Letter ~~performance~~Ruling orthat ~~achievements~~was favorable to bedeferring ~~materially~~taxes ~~different~~on ~~from~~the ~~any~~settlement ~~future~~of ~~results,~~the ~~performance~~hedge orcontracts ~~achievements~~with borrowed shares. Although a ~~expressed~~Private orLetter ~~implied~~Ruling byfrom the ~~forward-looking~~Internal ~~statements.~~Revenue ~~These~~Service ~~factors~~is ~~are~~ not conclusive of ~~intended~~all toissues, bebased anupon ~~all-encompassing~~the ~~list~~strength of ~~risks~~the ruling, we will file federal and state ~~uncertainties~~income tax returns requesting refunds that ~~may~~total $210.1 million. In ~~affect~~addition to the ~~operations,~~income ~~performance~~tax receivable, ~~development~~a ~~and~~deferred ~~results~~tax liability of ~~our business~~$210.1 ~~You~~million ~~should~~has ~~not~~been ~~place~~recorded. ~~undue~~The ~~reliance~~balance onsheet ~~these~~reports ~~forward-looking~~a ~~statements.~~net ~~Also,~~deferred tax ~~these~~liability ~~forward-looking~~of ~~statements~~$174.5 million, ~~represent~~which ~~our~~is ~~estimates~~net ~~and~~of ~~assumptions~~the asdeferred ~~of the~~tax ~~date~~assets. ofTaxes will ~~this~~be ~~report.~~due Weon ~~are~~the ~~under~~gain nofrom ~~duty~~the tohedge ~~update~~contracts ~~any~~upon termination of the Cisco ~~forward-looking~~stock ~~statements~~loans. ~~after~~We intend to maintain the ~~date~~stock ofloans ~~this~~for ~~report~~an toextended ~~conform~~period ~~such~~of ~~statements~~time, tohowever, ~~actual~~there ~~results~~is orno toassurance ~~changes~~that inwe ~~our~~will ~~expectations~~be able to do so.

~~The~~Note ~~following~~7 ~~discussion should be read in conjunction with the financial~~Inventories ~~statements and notes thereto in this Quarterly Report on Form 10-Q and the~~ ~~financial statements and notes in our Annual Report on Form 10-K for the year~~ ended December 31, 2002. Copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and any amendments to those reports filed or furnished to the SEC are accessible, free of charge, at our Internet website http://www.afc.com. Information on our website is not part of this report. Copies of these reports are also available without charge by contacting the Investor Relations Department, c/o Advanced Fibre Communications, Inc., P.O. Box 751239, Petaluma, California 94975-1239.

~~Overview~~Inventories are valued at the lower of cost or market, with cost computed on a first-in, first-out basis, and consist of the following (in thousands):

Over the last several years, the telecommunications industry has been adversely affected by the general economic downturn, a decrease in capital spending, the uncertainty in the regulatory environment, company closures and job losses. Despite this challenging business environment, we have continued to expand our portfolio of innovative access solutions, grow our market share, and expand our presence within key customer accounts.


	June 30,			December 31,
	2004			2003
Raw materials	$	25,921		$	10,015
Work in progress		2,054			1,314
Finished goods		47,988			17,284
Inventory consigned to others		1,721			5,651

Gross inventories		77,684			34,264
Inventory reserves		(32,970	)		(15,305	)

Inventories, net	$	44,714		$	18,959

~~We are the largest U.S. wireline equipment manufacturer dedicated solely to the~~10 access network. We sell access solutions to telecommunications companies in the U.S. and international marketplaces. Our long-term strategy includes continued development of access solutions that enable our customers to deploy emerging broadband services in a more efficient and cost-effective manner to their customers.

WeTable offer comprehensive carrier-class solutions to our customers that satisfy the demand for such leading technologies and architectures as digital subscriber line (DSL), video, Fiber-to-the-Premises (FTTP), and packetized voice. AccessMAXTM is our flagship next generation digital loop carrier product for delivering integrated voice and broadband services. We see considerable opportunities for AccessMAX to provide network evolution from circuit-based to packet-based technology. TelliantTM is our multi-service broadband access and aggregation solution, capable of delivering significant capacity and density for the evolving broadband network. We believe Telliant helps telecommunications companies reduce their capital and operating expenses when deploying broadband services, as well as video over DSL. Contents

~~With~~Note ~~our~~8 ~~TelcoVideoSM~~Cisco ~~solution,~~Stock ~~telecommunications~~Loan ~~companies worldwide can~~Fees ~~efficiently complete the bundling of voice, video and data services over a~~ ~~single infrastructure. Completing this “Triple Play” makes it possible for~~ carriers to compete more effectively, and increase customer acquisition and retention. Our TelcoVideo solution is a fully integrated, end-to-end offering including head-end equipment, transport, access and routing, and customer premise equipment. TelcoVideo delivers a flexible, fully integrated solution that is available today over existing copper and future fiber networks.

WeDuring ~~believe~~2003, ~~our~~we ~~FiberDirectSM,~~borrowed ~~solution~~10.6 million ~~enables~~shares ~~telecommunications~~of ~~companies~~Cisco stock to settle the hedge ~~quickly~~contracts ~~and~~on ~~economically~~our ~~transition~~Cisco ~~from~~stock. ~~legacy~~In ~~copper~~connection towith ~~high-speed~~borrowing the Cisco shares under the stock loans, we pay quarterly borrowing fees and a fee adjustment ~~high-capacity~~based ~~fiber~~on ~~networks~~the average daily price of Cisco stock. ~~With~~The majority of the ~~addition~~borrowing fees is expensed based on the average share price of Cisco stock during each quarter. A portion of the borrowing fees is expensed on a ~~passive~~straight-line basis over the lives of the loans. We accrued or paid a total of $0.4 million and $0.7 million, respectively, in borrowing fees during the three and six months ended June 30, 2004.

Provisions in the Cisco stock loans contain “make-whole” fee arrangements. The make-whole fees would provide the lender with the discounted net present value of a portion of future borrowing fees. The make-whole fees are triggered if we assign the loans to another lender, or terminate and enter into a similar transaction with another lender, or if we are acquired by Cisco. The make-whole fees are calculated based on the net present value, discounted at 10% per annum, of a portion of future borrowing fees due up to and including the seventh year. Based on the arithmetic average closing price of Cisco’s stock for the three months ended June 30, 2004, the maximum gross potential amount payable would be $2.4 million over the next six years.

~~Table~~Note of9 ~~Contents~~Accrued Liabilities

~~optical~~Accrued ~~network~~liabilities ~~plug-in~~are ~~card~~comprised toof ~~our multi-service access platform, AccessMAX can be upgraded to an AccessMAX FiberDirect system. We have over 100,000 AccessMAX platforms, or FTTP-capable systems, already deployed in~~ the ~~field. We~~following ~~designed FiberDirect around the full service access network standard that is accepted by large carriers~~ (in ~~the U.S. and internationally. FTTP is another~~thousands): ~~key architecture for offering the Triple Play, and more importantly, sets the~~ ~~foundation for the next generation network.~~

We continue to enable the convergence of services in the network with our PacketVoiceSM solution. Softswitch controlled voice interfaces can be deployed directly from our multi-service access platform, enabling true packet network convergence of voice and data services. This solution provides management, transport and control of all services - voice, video and data - over a single packetized network infrastructure. We believe PacketVoice allows telecommunications companies to offer more services while significantly reducing their operational costs.


	June 30,		December 31,
	2004		2003
Warranty	$	22,505	$	11,117
Salaries and benefits		14,387		11,610
Accounts payable		5,970		3,119
Tellabs merger costs		2,147		—
Facility losses		1,905		2,325
Outside services		2,044		2,155
Workers’ compensation		1,411		414
Purchase commitments to contract manufacturers		1,082		812
Business and sales taxes		869		432
Deferred revenue		387		990
Sales return commitments to customers		—		2,076
Other		4,218		4,555

Accrued liabilities	$	56,925	$	39,605

~~From~~Note an10 ~~industry~~Warranty ~~standpoint, we believe the Federal Communications Commission’s~~Reserve ~~(FCC’s) Triennial Review has had some impact on the regional Bell operating~~ ~~companies’ (RBOCs) investment decisions. We believe the final ruling~~ encourages long-term investment in broadband networks and migration to FTTP-based services. During the second quarter of 2003, BellSouth Corporation, SBC Communications, Inc. (SBC) and Verizon Communications, Inc. (Verizon) issued a joint request for proposal (RFP) for FTTP solutions. This RFP is important for the telecommunications industry because of the potential for setting access network architecture and technology standards for the long-term. We are actively pursuing FTTP opportunities in both large and small markets.

WeWarranty ~~are~~reserve ~~positioning~~activity ~~our comprehensive portfolio to take advantage of the deployment of broadband services over both DSL and FTTP networks. We believe that investment in the access network will be a key focus~~ for ~~telecommunications~~ ~~companies in~~ the ~~future~~six asmonths ~~DSL~~ended ~~continues~~June 30, to2004, beconsisted ~~deployed and~~of the ~~migration~~following ~~to FTTP begins. We expect to begin lab trials for FiberDirect during the fourth quarter of 2003, resulting~~ (in ~~increased research and~~thousands): ~~development spending for the quarter.~~

Our discussion and analysis of financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. Our critical accounting policies are discussed in our Annual Report on Form 10-K for the year ended December 31, 2002, in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” There have been two changes to our critical accounting policies since December 31, 2002. We updated the warranty reserve accrual rate as described in note 5 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report. We also initiated a DSL card rebate program in the quarter ended September 30, 2003. The cost of the rebate program was reserved and recorded to accrued liabilities in the quarter ended September 30, 2003. The rebate program runs through the quarter ending December 31, 2003.


Balance at December 31, 2003	$	11,117
Acquisition of NAA and associated warranty reserve		12,342
Charged to costs and expenses		8,971
Deductions from reserve		(8,125	)
Reversal of reserve		(1,800	)

Balance at June 30, 2004	$	22,505

WeA ~~believe~~provision ~~the~~for ~~application~~estimated ofwarranty ~~our~~costs ~~accounting~~is ~~policies~~established ~~accurately~~at ~~reflects~~the ~~our financial~~time ~~condition~~of sale and adjusted ~~results~~periodically ofbased ~~operations~~on historical trends in ~~the~~warranty ~~consolidated~~claims ~~financial~~and ~~statements,~~expected material and ~~provides~~labor ~~comparability~~costs ~~between~~to ~~periods~~provide warranty service. We ~~believe~~evaluate ~~our~~the ~~accounting~~overall ~~policies~~reasonableness ~~are~~and ~~reasonable~~adequacy ~~and~~of ~~appropriate~~the ~~for~~warranty ~~our~~reserve ~~business~~provision at the end of each quarter. During the

~~Results of Operations~~11

Revenues.Table Totalof revenues were $85.2 million in the quarter ended September 30, 2003, a 7% reduction from the $91.7 million recorded in the quarter ended September 30, 2002. Contents

~~Sales~~six tomonths ~~U.S.~~ended ~~customers decreased 11% to $74.1~~June ~~million in the quarter ended September~~ 30, ~~2003~~2004, ~~compared~~we ~~with~~reversed ~~$83.2 million~~a intotal ~~the quarter ended September 30, 2002. Decreased sales~~ of ~~AccessMAX and lower service revenues were the primary reasons sales to U~~$1.~~S. customers decreased as compared with the same period in the prior year. During the quarter ended September~~8 ~~30,~~million ~~2003, we initiated a DSL card rebate program. The rebate program was reserved and recorded~~ in ~~accrued liabilities, and as a result, lowered total revenues~~unused ~~recognized~~warranty ~~for~~reserve ~~the~~related ~~quarter. Sales~~ to ~~U.S.~~a ~~customers~~range ~~accounted for 87%~~ of ~~total revenues~~products inresulting ~~the~~from ~~quarter~~changes ~~ended September 30, 2003, and 91%~~ in ~~the quarter ended~~ ~~September 30, 2002~~estimates.

Note 11 Accumulated Other Comprehensive Income

~~Table~~The following table presents the components of ~~Contents~~accumulated other comprehensive income (in thousands):

Sales to international customers increased 30% to $11.1 million in the quarter ended September 30, 2003, from $8.5 million in the quarter ended September 30, 2002. Increased sales of AccessMAX were the primary reason sales to international customers increased as compared with the same period in the prior year. Sales to international customers accounted for 13% of total revenues in the quarter ended September 30, 2003, and 9% in the quarter ended September 30, 2002.


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Net income (loss)	$	921		$	3,334		$	(1,764	)	$	11,654
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustments		—			(3	)		(27	)		(5	)
Unrealized gain (loss) on available-for-sale marketable securities, net of tax		(1,945	)		830			(1,699	)		385

Total comprehensive income (loss)	$	(1,024	)	$	4,161		$	(3,490	)	$	12,034

~~Total~~Note ~~revenues~~12 ~~were~~Net ~~$248.7 million~~Income inPer ~~the first nine months of 2003, a 4%~~Share ~~reduction from the $258.3 million recorded in the first nine months of 2002.~~

~~Sales~~The toshares ~~U.S.~~and ~~customers~~net ~~decreased~~income 4%amounts toused ~~$212.4 million~~ in the ~~first~~computation ~~nine months~~ of ~~2003,~~basic ~~compared~~and ~~with $222.1 million in the first nine months of 2002. The~~diluted ~~primary~~net ~~reason~~income ~~sales~~per toshare ~~U.S.~~for ~~customers~~the ~~decreased~~three inand ~~the~~six ~~nine~~ months ended ~~September~~ June 30, ~~2003~~2004 ~~was due to decreased sales of AccessMAX~~ and ~~network~~2003 ~~management~~are ~~products, partially offset by increased sales of Telliant~~ as ~~compared~~ ~~with~~follows ~~the same period~~ (in ~~the prior year. Sales to U.S. customers accounted for 85% of total revenues in the first nine months of 2003~~thousands, ~~and~~except ~~86% in~~per ~~the~~share ~~first nine months of 2002.~~data):

Sales to international customers increased slightly to $36.3 million in the first nine months of 2003, from $36.2 million in the first nine months of 2002. The primary reason sales to international customers increased in the nine months ended September 30, 2003 was due to increased sales of Telliant and network management products, partially offset by a decrease in royalties, as compared with the same period in the prior year. Sales to international customers accounted for 15% of total revenues in the first nine months of 2003, and 14% in the first nine months of 2002.


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2004		2003		2004			2003
Net income (loss)	$	921	$	3,334	$	(1,764	)	$	11,654

Shares used in basic per share computations, actual weighted average common shares outstanding for the period		88,125		85,287		87,876			85,094
Weighted average number of shares upon exercise of dilutive options		1,280		1,101		—			1,186

Shares used in diluted per share computations		89,405		86,388		87,876			86,280

Basic net income (loss) per share	$	0.01	$	0.04	$	(0.02	)	$	0.14

Diluted net income (loss) per share	$	0.01	$	0.04	$	(0.02	)	$	0.14

~~Sprint~~Options ~~North~~to ~~Supply~~purchase ~~Company~~8,360,976 ~~(Sprint)~~ and ~~Alltel Communications Products~~11,164,565 ~~Inc. (Alltel)~~shares ~~accounted for 37.3% and 12.5%~~ of ~~total~~common ~~revenues~~stock induring the three ~~quarter~~months ended ~~September~~ June 30, 2004 and 2003, respectively~~. Sprint~~, ~~Verizon~~were ~~and~~excluded ~~Alltel~~from ~~accounted for~~the ~~26.5%,~~computation ~~14.1%~~of ~~and~~diluted ~~12.6%~~net ofincome ~~total~~per ~~revenues~~share. inOptions ~~the~~to ~~quarter~~purchase ~~ended September 30~~4, ~~2002~~608,542 ~~respectively. Sprint~~ and 8,893,492 ~~Alltel~~shares ~~accounted for 33.7% and 13%~~ of ~~total revenues~~common instock during the ~~first~~six ~~nine~~ months ofended ~~2003~~June 30, ~~respectively.~~2004 ~~Sprint, Alltel~~ and ~~Verizon~~2003, ~~accounted~~respectively, ~~for~~were ~~19.5%,~~excluded ~~12.2%~~from ~~and~~the ~~11.6%~~computation of ~~total~~diluted ~~revenues~~net ~~in the first~~income ~~nine~~per ~~months of 2002, respectively~~share. NoThe ~~other~~exercise ~~customer~~prices ~~accounted~~ for ~~10% or more of total revenues in any of~~ these ~~periods.~~options ~~Although~~were ~~our~~greater ~~largest~~than ~~customers have~~the ~~varied~~respective ~~over~~average ~~time,~~market weprice ~~anticipate~~of ~~that~~the ~~results~~common ofshares, ~~operations~~and ininclusion ~~any~~would ~~given period~~be ~~will~~anti-dilutive. ~~continue~~An toadditional ~~depend~~1,907,959 toshares aupon ~~great~~exercise ~~extent on sales to a small number~~ of ~~large~~dilutive options ~~accounts.~~were ~~Sales~~excluded tofrom ~~our~~the ~~top~~computation ~~five customers accounted~~ for ~~65% of total revenues in~~ the ~~first~~six ~~nine~~ months ofended ~~2003~~June 30, an2004 because ~~increase~~of ~~from~~the ~~56%~~net inloss for the ~~same~~ period ~~a year ago~~.

~~Sprint and Alltel are distribution subsidiaries of Sprint Corporation and~~12 Alltel Corporation, respectively. Our product sales to Sprint and Alltel are distributed to affiliates for deployment in their own networks and sold through to third party independent operating companies (IOC) customers. Historically, approximately 25% to 40% of our sales to Sprint and Alltel are sold to IOC customers.

GrossTable Profit. Gross profit as a percentage of revenues decreased to 47.7% in the quarter ended September 30, 2003, from 49.2% in the quarter ended September 30, 2002. The lower margin in the quarter ended September 30, 2003 was primarily a result of shifts in customer and product mix. The lower margin was also the result of a DSL card upgrade promotion. We increased sales to certain large customers, which carried lower margins in 2003 as compared to 2002. Sales of lower margin cabinets and large-line systems increased during the quarter ended September 30, 2003 as compared to the prior year comparable quarter. In addition, we began offering a DSL card upgrade promotion in 2003, which lowered revenue in the quarter ended September 30, 2003 and had the effect of lowering margin in the third quarter of 2003. There was no comparable upgrade program in 2002. Partially offsetting these decreases in margin were material cost reductions due to a change in contract manufacturer in the fourth quarter of 2002. In addition, the margin for the quarter ended September 30, 2002 included software development cost amortization, which had the effect of lowering 2002 margin. There was no software development cost amortization in the quarter ended September 30, 2003. Contents

12Note 13 Securities Litigation Settlement Costs

~~Table~~In April 2004, we were notified that we had won an arbitration proceeding with a former insurer. On June 30, 2004, we were notified of ~~Contents~~the final award. The insurance company provided us with coverage in 1998 when several lawsuits were brought against AFC and certain former directors and officers relating to securities litigation. The insurance company later refused to pay approximately $5 million in 2002 under an excess liability policy related to the covered defense costs and settlement of the class action securities lawsuit and two individual, non-class actions which were related to the consolidated securities class actions. As a result, we commenced arbitration proceedings in 2003. We have been awarded approximately $5.8 million in compensatory damages and interest. In the decision, the arbitrators found the conduct of the insurer to be in bad faith, such that we were entitled to apply for attorneys’ fees and arbitration fees incurred. We recorded the $5.8 million award for the compensatory damages and interest as a reduction to operating expenses during the three months ended June 30, 2004 because the original defense costs and settlements we incurred were charged to operating expense during 2002. However, the former insurer is appealing the final award in its entirety. We believe there is a high probability that the court will affirm the final judgment relating to the compensatory damages and interest. No accrual has been made for the expected receipt of proceeds for the attorneys’ fees and arbitration fees. When received, the amount will be recorded as a reduction to operating expenses because the original attorneys’ fees and arbitration fees we incurred were charged to operating expense.

~~Gross~~Note ~~profit~~14 ~~increased~~Pending ~~to 48.8% in the first nine months of 2003 from 47.1% in~~Litigation ~~the first nine months of 2002. The increase in the first nine months of 2003~~ ~~was primarily caused by reductions in the warranty reserve and accrual rate~~ during the second quarter of 2003, material cost savings arising from the 2002 change in contract manufacturer, shifts in customer mix and product mix, the DSL card upgrade promotion, and the lack of software development amortization in 2003.

~~Research~~On ~~and~~June 1, ~~Development.~~2004, ~~Research~~a ~~and~~complaint ~~development~~was ~~expenses~~filed ~~decreased~~on ~~13%~~behalf ~~to $14.8 million~~of ina ~~the~~putative ~~quarter~~class ~~ended~~of ~~September 30,~~AFC stockholders ~~2003~~against AFC, ~~and~~certain ~~represented~~of ~~17%~~its ofcurrent officers and directors, and ~~revenues~~Tellabs, ~~compared~~in ~~with~~the ~~19%~~Court of ~~revenues~~Chancery in the ~~quarter~~State ~~ended~~of ~~September 30, 2002.~~Delaware ~~Research~~in and ~~development~~for ~~expenses~~New Castle inCounty. The complaint alleges that the ~~quarter~~individual ~~ended~~defendants ~~September 30,~~breached ~~2003~~their ~~were~~fiduciary ~~lower~~duties ~~than~~to AFC’s public stockholders by acting to cause or facilitate the ~~prior~~merger ~~year~~of ~~comparable~~Tellabs ~~quarter~~and ~~primarily~~AFC ~~due~~for toinadequate ~~lower compensation~~consideration, ~~employee~~and ~~benefits,~~that each anof ~~operating~~the ~~lease~~defendants, ~~loss~~including inAFC ~~2002~~and Tellabs, acted to aid and ~~lower~~abet the ~~engineering~~alleged ~~development~~breaches ~~costs~~of infiduciary ~~2003~~duty. ~~Compensation~~In ~~costs~~particular, ~~were~~plaintiff ~~lower~~alleges ~~due~~that to the merger ~~decreased~~consideration ~~number~~for ofAFC’s ~~research~~public stockholders is unfair and ~~development~~inadequate because, ~~employees~~according ~~resulting~~to ~~from~~the plaintiff, “(a) the intrinsic value of the stock of ~~April~~AFC ~~2003~~is ~~workforce~~materially ~~reduction~~in excess of the $21.24 ~~Employee~~per ~~benefits~~share ~~were~~being ~~lower~~proposed, ~~primarily~~giving due consideration to the possibilities of growth and profitability of AFC in light ~~cost~~of ~~containment~~its ~~efforts.~~business, ~~The~~earnings ~~quarter~~and ~~ended~~earnings ~~September 30~~power, ~~2002~~present ~~included~~and future; (b) the ~~costs~~$21.24 ~~related~~per toshare ~~writing~~price ~~off~~is ainadequate ~~portion~~and ofoffers an inadequate premium to the public ~~operating~~shareholders ~~lease~~of ~~for~~AFC; and (c) the ~~Miramar,~~$21.24 per share price is not the ~~Florida~~result ~~engineering~~of ~~office.~~any ~~Engineering~~structure[d] ~~development~~auction ~~costs~~process ~~were~~by ~~lower~~which inAFC sought to obtain the ~~quarter~~best ~~ended~~deal ~~September 30,~~possible ~~2003~~for ~~due~~its shareholders.” The plaintiff seeks to enjoin the merger, ~~timing~~and ofif ~~product~~the ~~development~~merger ~~as compared~~is consummated, to rescind the ~~prior~~transaction. The ~~year~~plaintiff ~~comparable~~also asserts ~~quarter.~~claims ~~Partially~~for ~~offsetting~~unspecified ~~these decreases~~compensatory ~~between~~and/or ~~quarters~~rescissory ~~was~~damages, and an award ~~increase~~of incosts, ~~engineering~~including ~~materials~~attorneys’ ~~used~~fees. ~~for~~AFC believes that these claims are ~~FiberDirect~~without merit and ~~other~~intends ~~product~~to ~~development~~vigorously ~~during~~defend ~~the~~itself ~~quarter~~in ~~ended~~this ~~September 30, 2003~~action.

~~Research and development expenses increased 9% to $50.2 million in the first~~13 nine months of 2003, and represented 20% of revenues, compared with 18% of revenues in the first nine months of 2002. Research and development expenses in the first nine months of 2003 were higher than the prior year comparable period primarily due to severance and related costs associated with the April 2003 workforce reduction, fixed asset write-offs, engineering materials, the use of outside consultants for product development, and performance-based compensation. Partially offsetting these increases between periods was a reduction in employee benefits as a result of cost containment efforts.

WeTable believe rapidly evolving technology and competition in our industry necessitates the continued commitment of our resources to research and development to remain competitive. We plan to continue to support the development of new products and features, while seeking to carefully manage associated costs through expense controls. Contents

~~Sales~~Item ~~and Marketing~~2. ~~Sales~~Management’s ~~and~~Discussion ~~marketing expenses decreased 24% to $9.4 million in the quarter ended September 30, 2003,~~ and ~~represented~~Analysis ~~11%~~ of ~~revenues,~~ ~~compared~~Financial ~~with~~Condition ~~13% of revenues in the quarter ended September 30, 2002. Sales~~ and ~~marketing~~Results ~~expenses~~of in the quarter ended September 30, 2003, were lower than the prior year comparable quarter primarily due to the decrease in compensation resulting from the April 2003 workforce reduction. Cost containment efforts in 2003 lowered trade show-related costs and employee benefit costs. A change in the 2003 commission structure contributed to lower sales commissions as compared to the prior year comparable quarter. Partially offsetting these decreases between quarters was an increase in advertising costs during the quarter ended September 30, 2003. Operations

~~Sales~~This ~~and~~report ~~marketing~~contains ~~expenses~~“forward-looking ~~decreased~~statements.” ~~18%~~In tosome ~~$30.2 million~~cases, inyou ~~the~~can identify ~~first~~these ~~nine~~statements by terms such as “may”, “intend”, “might”, “expect”, ~~months~~“believe”, of“seek”, ~~2003~~“anticipate”, ~~and~~“estimate”, ~~represented~~“predict”, ~~12%~~“potential”, of“target”, “goals”, ~~revenues~~“projects”, ~~compared~~“plan”, ~~with~~“should”, ~~14%~~“could”, of“would”, ~~revenues in~~or ~~the~~similar ~~first~~expressions intended ~~nine~~to ~~months~~identify offorward-looking ~~2002~~statements. ~~Sales~~These statements reflect our current views with respect to future events and ~~marketing~~are ~~expenses~~based inon ~~the~~assumptions ~~first~~and ~~nine~~subject ~~months~~to ofrisks ~~2003~~and ~~declined~~uncertainties. ~~from~~We ~~the~~discuss ~~prior~~many ~~year~~of ~~comparable~~these ~~period~~risks ~~primarily~~and ~~due~~uncertainties toin greater detail under the ~~decrease~~heading in“Risk ~~compensation~~Factors ~~and~~That ~~employee~~Might Affect ~~benefits~~Future asOperating aResults ~~result~~and Financial Condition” of ~~the~~this Quarterly ~~April~~Report ~~2003~~on ~~workforce~~Form ~~reduction~~10-Q. These risks and ~~cost~~uncertainties ~~containment~~may ~~efforts~~cause our actual results, ~~and~~performance aor ~~change~~achievements into be materially different from any future ~~commission~~results, ~~structure~~performance or achievements expressed or implied by the forward-looking statements. InThese ~~addition,~~factors ~~employee~~are ~~travel~~not ~~and~~intended ~~entertainment~~to ~~costs~~be ~~and~~an ~~trade~~all-encompassing ~~show~~list ~~costs~~of ~~were~~risks ~~lower~~and asuncertainties ~~compared~~that ~~with~~may affect the operations, ~~prior~~performance, ~~year~~development and results of our business. ~~Partially~~You should ~~offsetting~~not ~~these~~place ~~decreases~~undue ~~between~~reliance ~~periods~~on ~~were~~these ~~increased~~forward-looking ~~advertising~~statements. ~~costs~~Also, these ~~and~~forward-looking ~~severance~~statements represent our estimates and ~~related~~assumptions ~~costs~~as ~~associated~~of ~~with~~the date of this report. We are under no duty to update any of the ~~April~~forward-looking statements ~~2003~~after ~~workforce~~the date of this report to conform such statements to actual ~~reduction~~results or to changes in our expectations.

WeThe ~~believe~~following wediscussion ~~have~~should ~~aligned~~be ~~sales~~read in conjunction with the financial statements and ~~marketing~~notes ~~expenses~~included ~~with~~in ~~current~~this ~~results~~report ofand the financial statements and ~~operations~~notes in our Annual Report on Form 10-K for the year ended December 31, 2003. Copies Weof ~~plan~~our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and any amendments to ~~continue~~those reports filed or furnished to ~~monitor~~the ~~sales~~SEC ~~and~~are ~~marketing~~accessible, ~~expenses~~free inof charge, at our Internet Website ~~view~~http://www.afc.com. Information on our Website is not part of ~~future~~this ~~operating~~report. Copies ~~results~~of these reports are also available without charge by contacting the Investor Relations Department, c/o Advanced Fibre Communications, Inc., P.O. Box 751239, Petaluma, California 94975-1239.

~~General and Administrative. General and administrative expenses decreased 3%~~Overview ~~to $6.5 million in the quarter ended September 30, 2003, and represented 8% of~~ ~~revenues, compared to 7% of revenues in the quarter ended September 30, 2002.~~ ~~General and administrative expenses in the quarter ended September 30, 2003 were lower than the prior year comparable quarter primarily due to lower amounts of fixed assets written off, decreases in~~

13AFC sells access solutions to telecommunications companies in the U.S. and international marketplaces. AFC is the largest U.S. wireline equipment manufacturer dedicated solely to the access network. We market our product family through our direct sales force and indirectly through distributors and sales representatives. We sell our products primarily to service providers who install our equipment as part of their access networks. Our customers in the U.S. are generally incumbent local exchange carriers, or ILECs, which include independent operating companies, or IOCs, and regional Bell operating companies, or RBOCs. In international markets, our customers are primarily incumbent local service providers. We have continued to expand our portfolio of innovative access solutions and expand our presence within key customer accounts despite a challenging business environment. We offer a comprehensive portfolio of carrier-class, standards-based solutions to carriers that satisfy the demand for such leading technologies and architectures as packetized voice, Fiber-to-the-Premises, or FTTP, Fiber-to-the-Curb, or FTTC, video, and digital subscriber line, or DSL. Addressing these technologies, we offer the following solutions:

~~Table~~• ofAdvancedVoiceSM, ~~Contents~~which provides both legacy and packet-based voice solutions; • AFC FiberDirectSM, innovative FTTP and FTTC offerings that enable carriers to deploy a high-capacity all-fiber network; • TelcoVideoSM, a solution that delivers advanced voice, high-speed Internet, video and other entertainment services; and • UniversalDSLSM, which delivers DSL technology in multiple deployment options and configurations.

~~compensation~~Our ~~resulting~~suite ~~from~~of ~~the~~access ~~April~~solutions ~~2003~~incorporates ~~reduction~~elements inof ~~force~~our core product portfolio, which includes AccessMAXTM , DISC*STM, Telliant TM , TransMAX TM , PremMAX TM , AFC’s network management system, Panorama TM , professional services and aplant ~~decrease~~cabinets and technologies. On February 20, 2004, we acquired inNorth ~~employee~~American ~~benefits~~Access, ~~resulting~~or ~~from~~NAA, ~~cost~~a ~~containment~~business ~~efforts~~unit of Marconi Communications, Inc., a subsidiary of Marconi Corporation plc. NAA’s product line was added to AFC’s product family and includes:

~~General~~• ~~and~~DISC*S ~~administrative~~Digital ~~expenses~~Loop ~~increased~~Carrier, 6%a toscaleable ~~$21.3 million~~next ingeneration ~~the~~digital ~~first nine~~loop ~~months~~carrier, ofor ~~2003~~NGDLC, ~~and~~providing ~~represented~~plain 9%old oftelephone ~~revenues~~service, ~~compared~~or toPOTS, ~~8% of revenues in the first nine months of 2002. General~~ and ~~administrative~~broadband expenses in the first nine months of 2003 increased from the prior year comparable period primarily due to the April 2003 workforce reduction which included restructuring reserves for leased facility losses and severance and related costs. Partially offsetting these increases between periods was a decrease in employee benefits resulting from cost containment efforts. services;

~~We believe we have aligned general and administrative expenses with current~~14 ~~results of operations. We plan to continue to monitor general and administrative expenses in view of future operating results.~~

Amortization.Table In the quarter ended September 30, 2003, we amortized $0.3 million of deferred compensation, non-compete agreements and completed technology arising from the acquisition of AccessLan Communications, Inc. (AccessLan) in May 2002. For the nine months ended September 30, 2003, we have expensed $1.8 million. We expect to continue expensing these intangibles through approximately 2005. Contents

~~Other~~• ~~Income.~~DISC*S ~~Other income decreased to $2.9 million in the quarter ended September 30~~HD, ~~2003,~~a ~~from~~high ~~$6.3 million~~density inversion ~~the quarter ended September 30, 2002. Other income decreased to $10.1 million in the first nine months~~ of ~~2003 from $19.8 million in~~ the ~~first~~DISC*S ~~nine~~NGDLC ~~months~~platform; of• ~~2002.~~DISC*S ~~The~~MX, ~~decreases~~a inFTTC ~~both comparative~~platform ~~periods~~that ~~were~~supports ~~primarily~~a ~~the~~“triple ~~result~~play” of ~~settling~~consumer ~~the~~voice, ~~Cisco~~Internet ~~hedge contracts~~ and ~~the~~video; ~~decreased~~and ~~gains~~• onThe ~~our~~Deep ~~Cisco~~Fiber ~~investment. Historically~~HFC, ~~the gains~~a ~~generated~~broadband byFTTC ~~the~~architecture ~~hedge~~that ~~contracts~~incorporates ~~more~~radio ~~than~~frequency ~~offset~~return ~~the~~capability ~~Cisco~~into ~~share losses, resulting in unrealized gains. As~~ the ~~hedge~~DISC*S ~~contracts~~fiber ~~approached~~in ~~maturity, there were fewer fluctuations between~~ the ~~contracts~~loop ~~and the Cisco shares~~platform. ~~The last hedge contract was settled in May of 2003.~~

~~Income Taxes.~~ The ~~effective~~NAA ~~tax~~acquisition ~~rate~~completed ~~was~~during ~~25%~~the ~~for~~first ~~the~~quarter ~~three~~of ~~and~~2004 ~~nine~~supports ~~month~~our ~~periods~~business ~~ended~~strategy ~~September 30,~~to ~~2003~~expand our optical access portfolio, asand ~~compared~~enhance our ability to ~~32%~~serve ~~for~~ the ~~three~~demands and ~~nine~~requirements of large telecommunications ~~month~~carriers. ~~periods~~The ~~ended~~acquisition ~~September 30,~~enables ~~2002~~us to offer a more robust portfolio of fiber-based access network solutions. ~~The~~We ~~proceeds~~view the product line from ~~the~~NAA ~~Cisco~~to ~~hedge~~be ~~contract~~complementary ~~settlements~~to inour ~~February~~own, ~~and~~particularly ~~May~~NAA’s ~~2003~~DISC*S ~~were~~FTTC ~~invested~~offering ~~primarily~~with inour FTTP ~~tax-exempt~~solution. ~~marketable~~We ~~securities,~~believe ~~which~~that ~~allowed~~synergies among our product lines enable us to ~~lower~~serve a broader base of customers, from the ~~tax~~smallest ~~rate~~IOCs into the largest RBOCs. Our ~~2003~~results of operations for the six months ended June 30, 2004 include those of NAA beginning as of February 20, 2004. With the acquisition, we added 255 employees.

~~Summary~~On May 20, 2004, AFC and Tellabs, Inc., or Tellabs, announced a definitive merger agreement under which Tellabs will acquire AFC through a two-step merger. Under the terms of ~~Certain~~the ~~Significant~~transaction, ~~Items~~which was approved by both companies’ boards of directors, AFC stockholders will receive 1.55 shares of Tellabs common stock and $7.00 cash for each AFC share. The transaction is subject to certain closing conditions, including regulatory approval and approval by Tellabs’ and AFC’s stockholders. We currently anticipate closing the merger before the end of October 2004.

~~AFC~~Factors ~~management~~Influencing ~~takes~~Our ~~certain~~Results ~~significant~~of ~~items~~Operations. ~~into~~Our ~~consideration when evaluating internal performance and~~ results of operations. ~~We excluded the~~have ~~following~~been ~~significant~~and ~~items~~will ~~from~~continue ~~our~~to ~~GAAP~~be ~~results~~influenced ofby ~~operations~~a ~~for~~variety ~~budgeting purposes~~of factors, ~~reviewing business performance and making investment decisions (in thousands)~~including:

		Three Months Ended				Nine months Ended
		September 30,				September 30,
		2003		2002		2003		2002
Operating:
Amortization of acquired intangibles		$	349	$	1,280	$	1,793	$	2,363
Workforce reduction and restructuring			—		—		5,474		—
In-process research and development			—		—		—		12,396
Securities litigation settlement costs			—		—		—		2,943
Leased facility write-off					439		—		439
Non-operating:
Unrealized gains on Cisco investment			—		4,392		1,386		15,004
	Total	$	349	$	2,673	$	5,881	$	3,137

Pending Merger with Tellabs. In reaching its determination to recommend the adoption of the merger with Tellabs, the AFC board of directors consulted with various advisors and considered various material factors. Among those factors considered were:

~~Three~~• ~~Months~~Enhanced ~~Ended~~strategic ~~September 30~~position of AFC by combining with Tellabs’ substantial resources and experience in servicing RBOCs, ~~2003~~ Tellabs’ complementary product lines, and Tellabs’ international distribution platform, which are expected to provide AFC with a stronger competitive position and greater opportunity for growth; • AFC’s business, financial condition and prospects on a stand-alone basis as compared to a combined company with a more diversified product line, greater resources and experience required to serve RBOCs and other large customers effectively, expanded distribution channels and increased size and scope as a supplier in an increasingly consolidated telecommunications market; and • Tellabs’ business, financial condition and prospects.

~~• $0~~Customer Demands.~~3 million~~ Our operating results reflect our ability to offer products that meet the needs of our customers. In view of reduced overall industry spending, our ability to grow revenue is significantly affected by the degree to which carriers will devote their resources to the introduction of new products and technologies in ~~amortization~~the access network. While we see growth in our broadband business, we are seeing a decline in POTS demand. We have experienced an increased level of ~~acquired~~interest ~~intangibles~~from ~~related~~our customers and potential customers worldwide in both DSL and FTTP solutions. FTTP continues to become a more significant part of our product offering and orders for FTTP are exceeding our forecasts. Our goal is to be the leading supplier of advanced voice and ~~acquisition~~broadband solutions in the access market. From a regulatory standpoint, we believe the Federal Communications Commission’s, or FCC’s, Triennial Review Order encourages long-term investment in broadband networks and migration to FTTP-based services by reducing the incumbent carriers’ unbundling obligations for broadband facilities, and the Court of ~~AccessLan~~Appeals upheld those portions of the FCC’s Order. The FCC, moreover, currently has before it requests for reconsideration that we believe would further enhance incentives to invest in FTTC ~~May~~and ~~2002~~Fiber-to-Multi-Dwelling-Units.

14Investment in New Technology. We expect to continue making investments in new technologies to support existing and new product needs of our customers. For example, in January 2004, we signed a multiyear agreement with Verizon Communications, Inc., or Verizon, to be the primary FTTP project vendor in providing the central office and premises electronics, also known as the active elements of FTTP technology. We are incurring costs and

~~Table of Contents~~15

ThreeTable Monthsof Ended September 30, 2002 Contents

•expenses ~~$1.3~~associated ~~million~~with inpreparation ~~amortization~~for ~~of acquired intangibles related to~~ the ~~acquisition~~deployment of ~~AccessLan;~~our •FTTP ~~$0.4~~systems ~~million related to the Miramar leased facility write-off;~~ and we •are ~~$4.4~~generating ~~million~~revenues infrom ~~unrealized~~the ~~gains~~FTTP ~~on our Cisco securities holdings and related hedge contracts~~systems.

~~Nine~~The ~~months~~FTTP ~~Ended~~systems ~~September 30~~are comprised of various components. Our revenue and profitability are affected by the timing and mix of components in the deployment of FTTP systems under the Verizon contract. As part of our agreement with Verizon, ~~2003~~we recognized that one component of the FTTP systems, the Single Family Optical Network Terminal, or ONT, would be sold at a negative gross profit margin to Verizon until volume increases and unit cost declines. A Single Family ONT is deployed at a residence as a network interface device for connecting fiber to services in the home. We have an active remediation program in place to address the profitability of the ONT component. The other components of the FTTP systems are also expected to sell at a profit to customers, including Verizon.

•In ~~$1.8~~our ~~million~~work inwith ~~amortization~~large ofcustomers ~~acquired~~such ~~intangibles~~as RBOCs, our agreements may contain provisions for performance compensation payments, or PCPs, which are tied to key milestones related to the ~~acquisition~~availability of ~~AccessLan;~~product •releases $5containing certain product features.5 ~~million~~Completion inof ~~expenses~~such ~~from~~milestones ~~severance~~requires timely and successful ~~facility~~R&D ~~closures~~efforts, ~~arising~~and ~~from~~on converting the ~~April~~results ~~2003~~of ~~workforce~~those ~~reduction;~~R&D ~~and~~efforts •into usable, $1cost effective products.4 ~~million~~R&D efforts involve large and complicated projects, which rely in ~~unrealized~~part ~~gains~~on the work of third parties over which we have limited control, and on which there can be no assurance of success. For example, our ~~Cisco~~agreement ~~securities~~with ~~holdings~~Verizon ~~and~~to ~~related~~provide ~~hedge~~FTTP ~~contracts~~systems has several provisions requiring PCPs for failure to meet key milestones or provide product features by specified dates. While we have met a number of these milestones on time, we have also failed to meet some milestones in a timely manner. We failed to achieve a February 23, 2004 milestone for delivery of a product release which triggered a PCP of $2 million. We subsequently provided the required product release on March 8, 2004. We also did not meet a June 30, 2004 milestone for delivery of a product release which triggered a PCP of $1 million. We subsequently provided the required product release for this milestone on July 21, 2004.

~~Nine~~In mid June 2004 Verizon informed us that it believes our failure to deliver product features by specified milestone dates, for which we paid PCPs of $2 million to Verizon in the three months ~~Ended~~ended ~~September~~March 31, 2004, and our failure to subsequently deliver some of these product features in accordance with our corrective plans, constitute a default and a breach of our obligations under our agreement with Verizon. Verizon has reserved all of its legal rights and remedies under the agreement, which includes termination of the agreement without the required advance notice. We believe that the FTTP project with Verizon is still intact and note that Verizon has continued to order a range of products, including FTTP systems, following its notice of default. In addition, despite these issues, Verizon accounted for 12.3% of revenues during the three months ended June 30, ~~2002~~2004. As indicated above, we did not meet the product release milestone on June 30, 2004 (which Verizon anticipated in its mid June letter to us) for which we have accrued a $1 million PCP payment to Verizon. We based the accrual on past experience; Verizon has not notified us of its intention to enforce the PCP. The accrual was treated as a reduction to revenue during the three months ended June 30, 2004. We could experience an offset to revenues and reduced net income in future quarters due to penalties imposed under such agreements as a result of failures to comply with strict contractual terms.

•Telecommunications $2Industry Conditions.4 ~~million~~Our inresults ~~amortization~~ of ~~acquired~~operations ~~intangibles~~have ~~related~~been adversely toaffected by the ~~acquisition~~downturn ofin ~~AccessLan;~~the •telecommunications ~~$12~~industry and worldwide economies over the last several years.4 ~~million~~Spending inon ~~expenses~~communications equipment ~~for~~and inservices remains at significantly lower levels as compared to pre-~~process~~2001 ~~research~~sales ~~and~~levels. ~~development~~On ~~written~~an ~~off~~ongoing ~~related~~basis, we attempt to balance our operating expenses with lower overall revenue levels associated with the ~~acquisition~~industry downturn ofand ~~AccessLan;~~reduced •capital $2spending.9 ~~million~~We offocus ~~costs~~on ~~related~~cost controls while we continue to ~~the~~invest ~~securities~~in ~~litigation~~research ~~settlement;~~and •development ~~$0.4~~activities ~~million~~that ~~related~~will keep us in a strong position to ~~the~~take ~~Miramar~~advantage ~~leased~~of ~~facility~~sales ~~write-off;~~opportunities when industry conditions improve and •demand ~~$15~~recovers.0 ~~million~~Although inthe ~~unrealized~~current ~~gains~~economic environment onfor our ~~Cisco~~industry ~~securities~~remains ~~holdings~~challenging, ~~and~~we ~~related~~believe ~~hedge~~we ~~contracts~~have positioned our business for success over the long-term.

~~Liquidity~~Acquisition of NAA. The acquisition of NAA impacts our future results of operations. Revenues will increase as a result of the new DISC*S products, although we expect gross profit for these products will be lower than historical gross profit margins. The acquisition will also result in higher operating expenses. In connection with closing the acquisition, we wrote off $14 million for in-process research and ~~Capital~~development ~~Resources~~during the three months ended March 31, 2004. Further, we will incur approximately $1 million in costs through late 2004 to integrate NAA’s business into our operations. Over the next nine years, we will amortize costs stemming from acquired intangible assets. We also expect that interest income will be lower in the future as a result of liquidating a portion of our marketable securities to pay for the acquisition. We anticipate that we will obtain benefits from consolidating our

~~Cash and cash equivalents were $305.6 million at September 30, 2003, compared~~16 ~~with $94.8 million at December 31, 2002. The Cisco hedge contracts matured in February and May of 2003 and a portion of the proceeds were booked to cash and cash equivalents.~~

CiscoTable marketable securities were $210.8 million at September 30, 2003, compared with $688.8 million in Cisco shares and related hedge contracts at December 31, 2002. The $478 million decrease was primarily the result of settling the two hedge contracts in February and May of 2003. Contents

Atsupply ~~September 30,~~chain ~~2003,~~over ~~we owned 10~~time.~~6 million~~ ~~shares~~Our ofability ~~Cisco~~to ~~common~~successfully ~~stock.~~operate ~~In February 2003,~~ the ~~primary~~NAA ~~hedge contract on our Cisco stock matured. This~~business hedge contract covered 10.1 million of the Cisco shares we own. In February 2003, we entered into a Cisco stock loan agreement with a lender. We borrowed 10.1 million shares of Cisco stock to settle the hedge contract and ~~received $656.2 million~~integrate inNAA’s ~~cash.~~products ~~We retained the Cisco shares we already owned, which were pledged as security under the new Cisco stock loan. The $656.2 million was invested in available-for-sale municipal~~ and ~~corporate~~employees ~~debt and equity securities in accordance~~ with our ~~investment~~existing ~~policy.~~business ~~The 10.6 million Cisco~~may ~~shares~~materially weaffect ~~own~~our ~~are~~future ~~reflected~~results in current assets at fair market value. We reclassified approximately $252 million in deferred taxes related to the recognized gain on the 10.1 million Cisco shares and related hedge contract to current taxes payable in the first quarter of ~~2003~~operations. ~~The fair market value of~~ ~~the Cisco stock loan obligation is reflected as a current liability.~~

In ~~May~~connection ~~2003,~~with the ~~hedge~~acquisition, ~~contract~~BellSouth ~~covering~~Communications, 0Inc.~~5 million~~, ofor BellSouth, ~~the~~became ~~Cisco~~a ~~shares~~customer weand ~~own matured.~~accounted Wefor ~~borrowed 0~~24.~~5 million~~6% ~~shares~~ of ~~Cisco~~our ~~stock~~revenues in ~~May~~the ~~2003 to settle~~six ~~the~~months ~~hedge~~ended ~~contract and received $34.1~~June ~~million~~30, ~~in cash~~2004. We ~~retained~~will ~~the~~continue ~~Cisco shares~~to weincur ~~already~~costs ~~owned,~~associated ~~which were pledged as security under the second Cisco~~with ~~stock~~supporting ~~loan. The $34.1 million was invested in available-for-sale municipal~~ and ~~corporate~~ ~~debt~~growing ~~and~~our ~~equity~~relationship ~~securities in accordance~~ with ~~our investment policy~~BellSouth. ~~The 0.5 million Cisco shares we own are reflected in current assets at fair~~ ~~market value. We reclassified approximately $13 million in deferred taxes~~ related to the recognized gain on the 0.5 million Cisco shares and related hedge contract to current taxes payable during the second quarter of 2003. The fair market value of the Cisco stock loan obligation is reflected as a current liability.

WeCritical ~~estimate~~Accounting ~~the~~Policies ~~total amount of taxes on the gain related to the Cisco shares~~ and ~~hedge contracts to be $265 million in 2003. The total amount of taxes due~~Estimates ~~in 2003 is comprised of an estimated $55 million due on the stock~~

15Our discussion and analysis of financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. Applying GAAP requires our judgment in determining the appropriateness of acceptable accounting principles and methods of application in diverse and complex economic activities. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of revenues, expenses, assets and liabilities, and related disclosure of contingent assets and liabilities. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the year ended December 31, 2003 in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We base our estimates on historical experience and other assumptions we believe are reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities, which may not be readily apparent from other sources.

~~Table~~In ofaddition ~~Contents~~to the critical accounting policies and estimates referred to above, we have identified the following additional critical accounting policy and estimate:

~~gain~~Workers’ ~~and~~Compensation. anWe ~~estimated~~are ~~$210 million~~partially ~~due~~self-insured onfor ~~the~~worker’s ~~hedge contracts gain~~compensation. ~~By using~~ ~~borrowed~~Accruals ~~shares~~for tolosses ~~settle~~are ~~the~~made ~~hedge~~based ~~contracts,~~on weour ~~believe~~claims ~~that~~experience ~~payment~~and ~~of the~~actuarial ~~estimated~~assumptions ~~taxes~~followed onin the ~~gain~~insurance ~~attributable~~industry, toincluding ~~the~~provisions ~~hedge contracts could be~~for ~~deferred~~incurred ~~until~~but wenot ~~settle~~reported ~~the~~losses. ~~new~~We ~~Cisco~~rely ~~stock~~on ~~loans.~~data ~~While~~provided weby ~~believe~~third ~~that~~party ~~current~~consultants ~~tax~~as ~~law~~support ~~permits~~for ~~the~~our ~~deferral~~accrual, ofand ~~payment~~we ofreview ~~taxes on~~ the ~~gain~~accrual ~~from~~on a ~~settlement~~quarterly ofbasis ~~the~~for ~~hedge~~adequacy. ~~contracts,~~Actual ~~tax~~losses ~~authorities~~could ~~may~~differ ~~challenge~~from ~~this~~accrued ~~position~~amounts. WeSee ~~are~~Note ~~paying an estimated $265 million in federal and state taxes~~9, ~~less applicable~~Accrued ~~credits~~Liabilities, onfor the ~~full~~amounts ~~amount~~accrued as of ~~the~~June 30, ~~gain in order to avoid~~2004 ~~potentially significant interest~~ and ~~penalties~~December 31, ~~should we be unable to sustain our tax position~~2003. OfDuring ~~the estimated total~~2004, we ~~have~~reviewed ~~paid~~the ~~$191 million~~reserve inand ~~taxes during~~determined the need ~~nine~~to ~~months~~increase ~~ended~~the ~~September 30,~~accrual ~~2003.~~rate Webased ~~will~~on ~~file~~current ~~our~~rates ~~2003 tax return in 2004 and then seek a refund~~ of ~~approximately $210 million~~claims. ~~This~~Determining the ~~refund~~amount ~~represents~~of the ~~amount~~reserve ofincludes ~~taxes~~some ~~paid~~uncertainty ondue to the ~~portion~~difficulty in ofdetermining the ~~gain~~likelihood, ~~that~~volume weand ~~believe~~extent isof ~~subject~~claims toin ~~deferral~~the future.

InWe ~~connection~~believe ~~with borrowing~~ the ~~Cisco~~application ~~shares~~of ~~under~~our ~~the~~accounting ~~stock~~policies ~~loans,~~and weestimates ~~pay~~accurately ~~various~~reflects ~~borrowing~~our ~~fees~~financial oncondition ~~a quarterly basis. We pay borrowing fees~~ and aresults ~~fee adjustment~~of ~~based~~operations onin the ~~average daily price of Cisco stock. We are expensing~~consolidated ~~the~~financial ~~borrowing~~statements, ~~fees~~and onprovides acomparability ~~straight-line~~between ~~basis over the lives of the loans~~periods. We ~~expect~~ ~~to incur costs of approximately $1 million annually, net of taxes, to~~believe ~~pursue~~ our ~~tax~~accounting ~~position.~~policies ~~These~~and ~~costs~~estimates ~~include~~are ~~legal~~reasonable ~~fees~~ and ~~borrowing~~appropriate ~~fees, which~~for ~~are expensed as incurred~~our business.

~~Provisions~~Results ~~in the February and May 2003 Cisco stock loans contain “make-whole” fee arrangements. The make-whole fees would provide the lender with the discounted net present value~~ of ~~a portion of future borrowing fees. The~~Operations ~~make-whole fees are triggered if we assign the loans to another lender, or~~ ~~terminate and enter into a similar transaction with another lender, or we are~~ acquired by Cisco. The make-whole fees are calculated based on the net present value, discounted at 10% per annum, of a portion of future borrowing fees due up to and including the seventh year. Over the next seven years, the maximum gross potential amount payable would be $2.2 million.

~~Other~~Comparison ~~marketable~~of ~~securities~~the ~~were~~three ~~$558.5 million~~and atsix ~~September~~months ended June 30, ~~2003,~~2004 ~~compared~~and 2003 ~~with~~Revenues ~~$213.0 million~~increased atin ~~December 31,~~2004 ~~2002.~~as ~~The~~a ~~$345.5 million~~result ~~increase~~of ~~arose primarily~~our asacquisition of NAA and sales to the ~~result~~acquired ofcustomer ~~investing~~base. aWe ~~portion~~incurred costs associated with the NAA acquisition, amortization of intangible assets, the ~~February~~pending Tellabs merger and leased ~~May~~facility ~~2003~~write-offs. These costs were only partially offset by an ~~Cisco~~arbitration ~~hedge~~award ~~contract~~for securities litigation settlement ~~proceeds~~costs and resulted in an operating loss and a net loss in the first six months of 2004.

AtRevenues. ~~September 30,~~Revenues ~~2003,~~were $20118.06 million in ~~restricted~~the ~~cash~~three ~~equivalents~~months ~~and~~ended June 30, 2004; ~~marketable~~a ~~securities~~43% ~~was~~increase ~~held~~from asthe ~~collateral~~$83 million torecorded ~~back~~in athe three~~-year~~ ~~bond~~months ~~posted~~ended June 30, ~~for~~2003. aRevenues Uwere $211.S.4 million ~~customer~~in ~~contract.~~the ~~The~~six ~~bond~~months ~~guarantees~~ended ~~our~~June 30, ~~performance~~2004; ~~under~~a ~~the~~29% ~~contract~~increase from the $163.5 million Werecorded ~~will~~in ~~continue~~the tosix ~~earn~~months ~~interest~~ended onJune 30, 2003. ~~the~~NAA’s ~~restricted~~stand-alone ~~cash~~revenues ~~equivalents~~ were approximately $47 million and ~~marketable~~$66 million, ~~securities~~respectively, ~~during~~for the ~~bond~~three ~~period.~~months ~~The~~ended ~~$20.0~~June ~~million~~30, ~~restricted cash~~2004, isand ~~recorded~~the inperiod from ~~other~~the ~~assets~~February 20 onacquisition ~~the~~date ~~September~~through June 30, ~~2003~~2004. ~~balance~~NAA’s ~~sheet~~revenues were earned entirely from U.S. customers.

~~Operating~~Sales ~~activities~~to inU.S. ~~the~~customers ~~first~~increased ~~nine~~54% ~~months~~to ~~of 2003 generated net cash of~~ $~~538~~108.31 million. ~~This~~in ~~was primarily~~ the ~~result~~three ~~of cash proceeds from the~~months ~~settlement~~ended ofJune 30, ~~the Cisco stock hedge contracts~~2004, ~~and~~compared ~~also~~with ~~from~~$70.3 million ~~net~~in ~~income and~~ the ~~collection~~ ofthree amonths ~~2002~~ended ~~distribution~~June 30, ~~receivable~~2003. ~~from~~Sales ~~Marconi~~to ~~Communications Inc~~U. ~~(Marconi)~~S. ~~Partially~~customers ~~offsetting~~accounted ~~these~~for ~~inflows~~91% ~~was~~of anrevenues ~~increase~~ in ~~accounts receivable. Investing activities during~~ the ~~first nine~~ three months ofended ~~2003 used net cash of $354.3~~June ~~million~~30, ~~primarily~~2004, asand a85% ~~result~~in ~~of purchasing marketable securities with~~ the ~~proceeds~~three ~~from~~months ~~the~~ended ~~settlement~~June 30, ~~of the Cisco stock hedge contracts~~2003.

~~Days sales outstanding increased to 66 days at September 30, 2003, compared~~17 ~~with 43 days at December 31, 2002. The increase was the result of decreased shipping linearity.~~

Inventories,Table net of inventory reserves, decreased 29% to $21.7 million at September 30, 2003, from $30.6 million at December 31, 2002. Average inventory turnover at September 30, 2003, was 8.2 times per year compared with 5.7 times at December 31, 2002. Contents

~~Working~~Sales ~~capital~~to U.S. customers increased ~~from~~36% to $~~784~~188.84 million atin ~~December 31,~~the ~~2002~~six tomonths ~~$847.6~~ended ~~million at September~~June 30, ~~2003.~~2004, ~~The~~compared ~~increase~~with ~~was~~$138.3 million ~~primarily~~in athe ~~result~~six ofmonths ~~settling~~ended June 30, ~~the~~2003. ~~Cisco~~Sales ~~hedge~~to ~~contracts~~U.S. ~~Cash~~customers ~~and~~accounted ~~marketable~~for ~~securities~~89% ~~increased and taxes payable decreased as a result~~ of ~~the~~revenues ~~proceeds~~in ~~from~~ the ~~hedge~~six ~~settlements. To a~~months ~~lesser~~ended ~~extent~~June 30, ~~the~~2004, ~~additional~~and ~~liability~~85% ~~for~~in the ~~Cisco~~six ~~stock~~months ~~loan~~ended ~~agreements increased~~June 30, ~~current liabilities~~2003.

WeSales ~~maintain~~to aninternational ~~uncommitted~~customers ~~bank~~decreased ~~facility~~18% ~~for~~to ~~the~~$10.5 million ~~issuance~~in ofthe ~~commercial and~~three ~~standby~~months ~~letters~~ended ~~of credit. At September~~June 30, ~~2003~~2004, wecompared ~~had~~with $112.97 million in the three months ~~letters~~ended ofJune 30, ~~credit~~2003. ~~outstanding~~Sales ~~under~~to ~~this~~international ~~facility,~~customers ~~including~~accounted ~~$0.5 million~~for 9% of ~~issued~~revenues asin athe ~~five-year~~three ~~deposit~~months onended ~~one~~June 30, of2004, ~~our~~and ~~leased~~15% ~~facilities~~in the three months ended June 30, 2003.

16Sales to international customers decreased 9% to $23 million in the six months ended June 30, 2004, compared with $25.2 million in the six months ended June 30, 2003. Sales to international customers accounted for 11% of revenues in the six months ended June 30, 2004, and 15% in the six months ended June 30, 2003.

~~Table~~BellSouth, Sprint North Supply Company, or Sprint, and Verizon accounted for 31.6%, 23.4% and 12.3%, respectively, of ~~Contents~~revenues in the three months ended June 30, 2004. Sprint and Alltel Communications Products, Inc., or Alltel, accounted for 32.9% and 14.1%, respectively, of revenues in the three months ended June 30, 2003. Sprint and BellSouth accounted for 25% and 24.6%, respectively, of revenues in the six months ended June 30, 2004. Sprint and Alltel accounted for 31.8% and 13.3%, respectively, of revenues in the six months ended June 30, 2003. No other customer accounted for 10% or more of revenues in any of these periods. We continue to depend on a small number of large customers for the majority of our sales. Sales to our top five customers accounted for 71% of revenues in the six months ended June 30, 2004, an increase from 62% in the same period a year ago.

WeSprint ~~maintain~~and ~~bank~~Alltel ~~agreements~~are ~~with~~distribution ~~two~~subsidiaries ~~banks~~of ~~under~~Sprint ~~which~~Corporation weand Alltel ~~may~~Corporation, ~~enter~~respectively. ~~into foreign~~These ~~exchange~~subsidiaries ~~contracts~~distribute upour products to their ~~$40.0 million.~~respective ~~There~~affiliates ~~are~~for nodeployment ~~borrowing~~in their own networks and also ~~provisions~~resell orour ~~financial~~products ~~covenants~~to ~~associated~~third ~~with~~party ~~these~~IOC ~~facilities~~customers. ~~At September 30~~Historically, ~~2003,~~we ~~there~~believe ~~were~~that products norepresenting ~~foreign~~approximately ~~exchange~~20% ~~contracts~~to ~~outstanding~~40% of our sales to Sprint and Alltel have been sold to IOC customers.

We ~~seek~~have failed to ~~minimize~~meet ~~foreign~~various ~~currency~~key ~~risk~~development bymilestones ~~using~~in ~~forward~~a ~~contracts~~timely ~~to hedge~~manner ~~material~~under ~~accounts~~our ~~receivable~~agreement with Verizon for which we have paid $2 million and ~~accounts~~accrued $1 million ~~payable~~in penalties in the six months ended June 30, 2004. These ~~contracts~~penalty payments are ~~marked~~accounted for as a corresponding reduction in revenue in the toquarter ~~market~~they are incurred. Our future revenues, gross profit and net income will be affected by the ~~gains~~degree ~~and~~to ~~losses~~which ~~are~~Verizon ~~reflected~~invests in ~~our~~FTTP ~~results~~systems, the mix of ~~operations~~products ordered, the timing of any such investment and our ability to meet key development milestones and avoid penalty payments under our agreement.

InGross ~~April~~Profit. ~~2003,~~Gross weprofit ~~announced~~as a ~~102-employee~~ ~~workforce~~percentage ~~reduction~~of torevenues ~~reduce~~decreased ~~expenses~~to ~~and~~40.6% ~~align~~in ~~our~~the ~~cost~~three ~~structure~~months ~~with~~ended ~~our~~June 30, ~~revised~~2004, ~~business~~from ~~outlook~~49.5% ~~The~~in ~~major~~the ~~components~~three ofmonths ended June ~~the~~30, ~~reduction~~2003. ~~included~~Gross ~~severance~~profit ~~and~~for ~~employee~~the ~~related~~three ~~expenses~~months ended June 30, ~~and~~2004 was $48.2 ~~consolidation~~million. The acquired NAA business accounted for approximately $15 million of our ~~excess~~gross ~~leased~~profit ~~facilities~~during that period. ~~The~~Gross ~~following~~profit ~~table~~as ~~displays~~a percentage of revenues ~~expenditures~~decreased to 45.2% in the six months ended June 30, 2004, from ~~April~~49.4% ~~2003~~in ~~through~~the ~~September~~six months ended June 30, 2003. ~~related~~Gross toprofit for the six months ended June 30, 2004 ~~workforce~~was ~~reduction~~$95.5 million. ~~(in~~The ~~thousands):~~acquired NAA business accounted for approximately $20 million of our gross profit during that period. Margin decreased primarily due to product and customer mix.

	Reserve									Reserve
	Balance									Balance at
	at March 31,									September 30,
	2003		Charges		Reductions			Reversals		2003
Severance and employee related expenses	$	—	$	2,706	$	(2,550	)	$	—	$	156
Consolidation of excess leased facilities		—		2,768		(1,394	)		—		1,374
Total	$	—	$	5,474	$	(3,944	)	$	—	$	1,530

Sales to lower margin RBOC customers increased relative to higher margin customers for both the three and six months ended June 30, 2004. Margin was also affected by the lower margin DISC*S products, which began impacting gross profit starting in February 2004. We also sold a lower volume of higher margin cards during the three months ended June 30, 2004. We have continued our supply chain management and cost reduction efforts. The resulting standard costs savings partially offset the factors noted above that led to decreases in 2004 gross profits. We expect our margins will continue to be negatively impacted in the near term as sales of lower margin DISC*S products and initial sales of Single Family FTTP ONTs to one early adopter FTTP customer at negative margins become a larger part of our sales.

~~Estimated~~During ~~cost~~the ~~savings~~three ~~from~~and ~~the~~six months ended June 30, 2004, our gross profit was ~~workforce~~affected ~~reduction~~by ~~are~~increases ~~approximately~~in reserves of $86.13 million ~~through December~~and $7 31million, ~~2003~~respectively. WeThese ~~anticipate~~reserves ~~the~~were ~~remaining~~for excess ~~severance~~ and ~~employee~~obsolete ~~related~~inventory, ~~expenses~~returned ~~will~~materials, bedemonstration inventory, ~~paid~~purchase ~~through~~commitments ~~mid~~and ~~2004~~warranty. ~~The~~During ~~remaining~~the ~~expenditures~~six ~~relating~~months ended June 30, 2004, the reserve increases reflected offsets due to the ~~consolidation~~ reversal of ~~excess~~$1.8 million ~~leased~~in ~~facilities~~unused warranty ~~will~~reserve befrom ~~paid~~changes ~~through~~in ~~2009~~estimates and $1 million in purchase commitments reserve due to a true-up and revised estimates.

~~In October 2001, our board of directors authorized a stock repurchase plan that~~18 provides for the repurchase of up to 10% of our currently issued and outstanding shares of common stock. Repurchases may be made from time to time at various prices in the open market, through block trades or otherwise. The plan became effective in October 2001 and may be suspended at any time without prior notice. As of September 30, 2003, 62,676 shares had been repurchased or reacquired under this plan.

InTable connection with the stock repurchase plan announced in October 2001, we established a written trading plan in accordance with Securities and Exchange Commission Rule 10b5-1 under which we will repurchase shares of common stock, subject to conditions set forth in the trading plan. The trading plan will run from December 1, 2002 through December 2, 2003. Contents

WeResearch doand ~~not~~Development. ~~have~~Research ~~any~~and ~~off-balance~~development ~~sheet~~expenses ~~arrangements~~increased ~~(as~~17% ~~such~~to $22.8 million ~~term~~in isthe ~~defined~~three ~~in recently~~months ~~enacted~~ended ~~Securities~~June 30, ~~Exchange~~2004, ~~Commission~~and ~~rules)~~represented ~~that~~19% ~~have~~of revenues, orcompared ~~are~~with 23% of revenues in the three months ended June 30, ~~reasonably~~2003. ~~likely~~For tothe ~~have~~three months ended June 30, a2004, ~~current~~the oracquired ~~future~~NAA ~~effect~~business accounted onfor approximately $4.8 million of our ~~financial~~total research and development ~~condition,~~expense. ~~changes~~Research and development expenses increased 14% to $40.4 million in the ~~financial~~six ~~condition,~~months ~~revenues~~ended orJune 30, ~~expenses~~2004, ~~results~~and represented 19% of revenues, compared ~~operations~~with 22% of revenues in the six months ended June 30, ~~liquidity~~2003. For the period February 20, ~~capital~~2004 ~~expenditures~~through June 30, or2004, ~~capital~~NAA ~~resources~~accounted ~~that~~for ~~are~~approximately $6.6 ~~material~~million toof ~~investors~~our total research and development expense.

WeThe ~~believe~~increases ~~our~~in ~~existing~~research ~~cash~~ and ~~marketable~~development ~~securities~~expense ~~and~~for ~~cash~~both ~~flows~~the ~~from operating~~three and ~~financing~~six months ~~activities~~ended ~~are~~June 30, ~~adequate~~2004 toas ~~support~~compared ~~our~~to ~~financial resource~~the ~~needs,~~three ~~working capital~~ and ~~capital~~six ~~expenditure~~months ~~requirements,~~ended ~~and~~June ~~operating lease obligations~~30, ~~for~~2003 atwere ~~least~~primarily ~~the~~attributable ~~next 12 months.~~to:

~~Risk~~• ~~Factors~~Compensation, ~~That~~primarily ~~Might~~due ~~Affect~~to ~~Future~~acquiring ~~Operating~~NAA’s ~~Results~~engineering employees in February 2004; • Employee benefits, primarily due to an adjustment to the workers’ compensation accrual and ~~Financial~~a ~~Condition~~ higher number of engineering employees during the three months ended June 30, 2004; and • Engineering materials and expenses related to new product development and testing.

~~You~~The ~~should~~three ~~carefully~~and ~~consider~~six ~~the~~months ~~following~~ended ~~risk~~June 30, ~~factors~~2003 ~~and~~also ~~the other information~~ included inleased ~~this Quarterly Report on Form 10~~facilities write-Qoffs, ~~before~~severance ~~investing in our common stock. Our business~~ and ~~results~~relocation ofcosts ~~operations~~arising ~~could~~from ~~be seriously impaired by any of~~ the ~~following~~workforce ~~risks. The trading price of our common stock~~reduction ~~could~~initiated ~~decline~~in ~~due~~April 2003 ~~to any of these risks~~ and ~~investors~~fixed ~~could~~asset ~~lose part or all of their investment~~write-offs.

17We believe rapidly evolving technology and competition in our industry necessitates the continued commitment of our resources to research and development to remain competitive. We plan to continue to support the development of new products and features, while seeking to carefully manage associated costs through expense controls.

~~Table~~Sales and Marketing. Sales and marketing expenses increased 20% to $13.3 million in the three months ended June 30, 2004, and represented 11% of revenues, ~~Contents~~compared with 13% of revenues in the three months ended June 30, 2003. For the three months ended June 30, 2004, the acquired NAA business accounted for approximately $2 million of our total sales and marketing expense. Sales and marketing expenses increased 17% to $24.5 million in the six months ended June 30, 2004, and represented 12% of revenues, compared with 13% of revenues in the six months ended June 30, 2003. For the period February 20, 2004 through June 30, 2004, NAA accounted for approximately $3 million of our total sales and marketing expense.

AThe ~~number~~increase ofin ~~factors~~sales ~~could~~and ~~cause~~marketing ~~our~~expense ~~operating~~for ~~results~~the tothree ~~fluctuate~~months ended June 30, ~~significantly~~2004 ~~and~~as ~~cause~~compared ~~volatility~~to inthe ~~our~~three ~~stock~~months ~~price.~~ended June 30, 2003 was primarily attributable to:

~~Our~~• ~~quarterly~~Compensation and ~~annual~~commissions, ~~operating~~largely ~~results have fluctuated in the past and are likely to fluctuate in the future~~ due to aacquiring ~~variety~~NAA’s ofsales ~~factors, many of which are outside our control. These factors include, but are not limited to, telecommunications market conditions~~ and ~~general~~marketing ~~economic~~employees ~~conditions, the uncertain regulatory environment, the level of capital spending and financial strength of our customers, changes~~ in ~~our~~February ~~U.S.~~2004 and ~~international~~severance ~~sales~~payments; ~~and distribution~~• ~~mix,~~Higher ~~our~~costs ~~product~~associated ~~feature~~with ~~component mix, our ability to successfully introduce new technologies and features ahead of our competitors, introductions or announcements of new products by our competitors,~~ the ~~timing,~~Supercom ~~size and~~trade ~~mix~~show; ~~of the orders we receive, adequacy of supplies for key components~~ and ~~assemblies, financial~~• ~~strength~~Advertising ofcosts ~~our~~resulting ~~vendors,~~from our ~~ability~~new tobranding ~~efficiently produce and ship orders promptly on a price-competitive basis, our ability to integrate and operate acquired businesses and technologies, and changes in accounting rules~~campaign. ~~These factors are described below in the following paragraphs.~~

WeThe ~~sell~~increase ~~our~~in ~~product~~sales ~~solutions primarily to telecommunications companies installing our equipment as part of their access networks. Additions to those networks may represent complex~~ and ~~lengthy~~marketing ~~engineering~~expense ~~projects,~~for ~~with our equipment typically representing only a portion of a given project. In an effort to closely manage their resources, our customers often place orders with short lead times. As a result,~~ the ~~timing~~six ofmonths ~~product~~ended ~~shipment is often difficult to forecast. Most of our equipment is installed in outdoor locations~~June 30, ~~so shipments of the~~ ~~system~~2004 ~~can~~as becompared ~~subject~~ to the ~~effects~~six ~~of seasonality, with fewer installation projects normally scheduled during the winter~~ months. ~~These factors may cause revenues in the quarter~~ ended ~~March~~June ~~31 to be lower than revenues in the preceding quarter ended December 31. Sales in developing countries can be affected by currency fluctuations~~30, ~~delays~~2003 ~~and~~was ~~reductions in planned project~~primarily ~~deployment,~~attributable ~~reductions in capital availability, priority changes in government~~to: ~~budgets, delays in receiving government approvals and the political~~ ~~environment.~~

~~Expenditures~~• ~~for~~Compensation ~~research~~ and ~~development~~commissions, ~~sales~~largely ~~and~~due ~~marketing,~~to ~~and~~acquiring ~~general~~NAA’s sales and ~~administrative~~ ~~functions~~marketing ~~are~~employees ~~based~~ in ~~part~~February on2004 ~~future business projections~~ and ~~are~~ ~~relatively~~severance ~~fixed~~payments; ~~for~~• ~~the~~Employee ~~short-term.~~benefits, Weprimarily ~~may~~due ~~be unable~~ to ~~adjust~~an ~~spending~~adjustment ~~in a~~to ~~timely~~the ~~manner~~workers’ incompensation ~~response~~accrual toand ~~any~~a ~~unanticipated~~higher ~~failure~~number toof ~~meet~~sales ~~our~~and ~~business projections.~~marketing ~~There~~employees ~~can~~during bethe nosix ~~assurance~~months ~~that~~ended weJune ~~will~~30, ~~not~~2004; ~~have~~• ~~excess manufacturing~~Advertising ~~capacity~~costs orresulting ~~that~~from ~~further~~our ~~utilization~~new ofbranding ~~our~~campaign; ~~manufacturing~~ and ~~distribution~~ ~~facility~~• ~~will~~Higher ~~continue~~costs ~~without~~associated ~~interruption.~~with ~~This~~the ~~could~~Supercom ~~result~~trade ~~in higher operating expenses and lower net income~~show.

~~Changes~~The inthree ~~accounting~~and ~~rules,~~six ~~such~~months asended ~~the FASB requiring adoption of an amendment to SFAS No.~~June ~~123~~30, ~~Accounting~~2003 ~~for~~also ~~Stock~~included ~~Based~~severance ~~Compensation, may cause~~costs ~~significant~~arising ~~fluctuations~~from ~~in our operating results. We currently account for employee stock option grants under~~ the ~~guidance~~workforce ofreduction ~~APB~~initiated ~~No. 25,~~in ~~Accounting for Stock Issued to Employees. SFAS No.~~April ~~123~~2003 ~~requires expensing employee stock option grants,~~ and iffixed ~~we adopt this statement, it may cause significant~~asset ~~fluctuations between periods in our operating income and net income per share~~write-offs.

~~Volatility~~We inbelieve ~~the~~we ~~price~~have ofaligned ~~our~~sales ~~common~~and ~~stock~~marketing ~~may~~expenses ~~occur~~with ascurrent ~~the~~results ~~result~~ of ~~fluctuations~~operations. inWe ~~our~~plan ~~operating~~to ~~results,~~continue ~~such~~to asmonitor ~~revenues~~sales orand ~~operating~~marketing ~~results not~~expenses ~~meeting the expectations of the investment community. In such event, the~~in ~~market~~view ~~price~~ of our ~~common~~expected ~~stock~~future ~~could~~operating ~~significantly decline~~results. ~~A significant~~ ~~market price decline could result in litigation. Litigation can be costly,~~ ~~lengthy and divert management’s attention and resources from our core business~~ ~~operations.~~

1819

WeGeneral ~~operate~~and inAdministrative. aGeneral ~~rapidly~~and ~~changing~~administrative ~~competitive~~expenses ~~and~~increased ~~economic~~49% to ~~environment~~$13.2 million Ifin wethe three months ended June 30, 2004, and represented 11% ~~are~~of ~~unable~~revenues, compared to ~~adapt~~11% ~~quickly~~of torevenues ~~these~~in ~~changes~~the three months ended June 30, 2003. ~~our~~For the three months ended June 30, 2004, the acquired NAA business accounted for approximately $1 million of our total general and ~~results~~administrative expense. General and administrative expenses increased 44% to $21.3 million in the six months ended June 30, 2004, and represented 10% of revenues, compared ~~operations~~to ~~could~~9% beof ~~seriously~~revenues ~~harmed~~in the six months ended June 30, 2003. For the period February 20, 2004 through June 30, 2004, NAA accounted for approximately $1.8 million of our total general and administrative expense.

The ~~telecommunications~~increase ~~equipment~~in ~~market~~general ~~is undergoing competitive~~ and ~~economic changes,~~administrative ~~the~~expense ~~full~~for ~~scope and nature of which are difficult to predict. We believe that technological and regulatory change will continue to attract new entrants to~~ the ~~access~~three ~~market.~~months ~~Industry consolidation among our competitors may~~ended ~~increase their financial resources~~June 30, ~~enabling~~2004 ~~them~~as tocompared ~~reduce their prices. This could require us~~ to ~~either~~the ~~reduce~~three ~~our~~months ~~product prices or risk losing market~~ended ~~share. Moreover~~June 30, a2003 ~~competitor’s~~was ~~customer may acquire one of our customers and~~primarily ~~shift~~attributable ~~all capital spending~~ to ~~our competitor, resulting in possible material~~: ~~reductions to our revenues and net income.~~

~~Some~~• ofTellabs ~~our~~merger ~~competitors~~related ~~are~~costs; in• aCompensation ~~better~~as ~~position~~a toresult ~~withstand reductions in customers’ capital spending. Some~~ of ~~these~~pay ~~competitors~~raises; ~~have broader product portfolios~~ and ~~market~~• ~~share~~Employee benefits, ~~and~~primarily ~~may~~due ~~not be as susceptible~~ to ~~downturns~~an inadjustment ~~the telecommunications industry. These competitors’ offerings compete directly with our product solutions and also provide comprehensive ranges of other products. A customer may elect~~ to ~~consolidate its supplier base for~~ the ~~advantages of one-stop shopping solutions. Reductions in our customers~~workers’ ~~capital~~compensation ~~spending could materially reduce our revenues and net income~~accrual.

~~Our~~These ~~principal~~costs ~~established~~were ~~competitors~~partially ~~include:~~offset ~~Compagnie~~by ~~Financiere~~reductions ~~Alcatel, Lucent~~for ~~Technologies~~leased ~~Inc.~~facility write-offs and ~~Marconi.~~severance ~~Some~~stemming offrom ~~our~~the ~~competitors~~workforce ~~enjoy~~reduction ~~superior name~~initiated ~~recognition~~ in ~~the~~April 2003 ~~market or have more extensive financial, marketing~~ and ~~technical~~lower ~~resources~~performance-based ~~than~~compensation weas ~~do.~~a Weresult ~~expect~~of tonot ~~face~~meeting ~~increased~~internal ~~competition with our established and newly launched product solutions, from both established and emerging competitors~~goals.

~~Continued~~The ~~growth~~increase in ~~the~~general ~~access market is highly dependent on a vibrant economy, a strong level of capital expenditures for broadband access solutions~~ and aadministrative ~~positive~~expense ~~regulatory environment~~ for ~~larger~~the ~~incumbent~~six ~~local~~months ~~exchange~~ended ~~carrier (ILEC)~~June ~~customers.~~30, ~~Further~~2004 ~~reductions~~as incompared ~~capital~~to ~~expenditures by companies in~~ the ~~telecommunications~~six ~~industry,~~months ~~including~~ended ~~some of our customers~~June 30, ~~could~~2003 ~~seriously~~was ~~harm~~primarily attributable ~~our revenues, net income or cash flows.~~to:

We• ~~rely~~Tellabs onmerger arelated ~~limited~~costs; ~~number~~• ofEmployee ~~customers~~benefits, ~~for~~primarily adue ~~substantial~~to ~~portion~~an ofadjustment ~~our revenues.~~to Ifthe weworkers’ ~~lose~~compensation ~~one~~accrual; or• ~~more~~Outside ofservices ~~our~~for ~~significant~~various ~~customers~~projects; or• ~~experience~~Compensation as a ~~decrease~~ inresult ~~the~~of ~~level~~pay ofraises; ~~sales~~and to• ~~any~~Litigation ofcosts ~~these~~related ~~customers,~~to ~~our~~a ~~revenues~~successful ~~and~~arbitration ~~net income~~proceeding ~~could~~with ~~decline~~a former insurer.

~~Sprint~~These ~~North~~costs ~~Supply~~were ~~Company~~partially ~~(Sprint)~~offset ~~and Alltel~~by ~~Communications~~reductions ~~Products, Inc. (Alltel) accounted~~ for ~~37.3%~~leased ~~and~~facility ~~12.5% of total revenues in the~~write-offs ~~quarter ended September 30, 2003, respectively. Sprint, Verizon~~ and ~~Alltel accounted~~severance ~~for~~stemming ~~26.5%,~~from ~~14.1% and 12.6% of total revenues in~~ the ~~quarter~~workforce ~~ended September 30,~~reduction ~~2002,~~initiated ~~respectively. Sprint and Alltel accounted for 33.7% and 13% of total revenues~~ in ~~the first nine months of~~ April 2003, ~~respectively. Sprint,~~ ~~Alltel~~lower ~~and~~performance-based ~~Verizon~~compensation ~~accounted~~as for 19.5%, 12.2% and 11.6% of total revenues in the first nine months of 2002, respectively. No other single customer accounted for 10% or more of total revenues in any of these periods. Our five largest customers accounted for 65% and 56% of total revenues in the first nine months of 2003 and 2002, respectively. Although our largest customers have varied from period to period, we anticipate that results of operations in any given period will continue to depend to a ~~great~~result ~~extent on sales to a small number~~ of ~~large~~not ~~accounts.~~meeting ~~This~~internal ~~dependence may increase due to our strategy of~~goals growing several large accounts. There can be no assurance that significant existing customers will continue to purchase products from us at current levels, if at all. In the event that a significant existing customer merges with another company, there can be no assurance that such customer will continue to purchase our products. The loss of one or more significant existing customers or a decrease in the level of purchases from these customers could result in a decrease in revenues and ~~net~~lower ~~income,~~bad andebt ~~increase~~expense in ~~excess and obsolete inventory, and increase our dependency on our remaining significant customers~~2004.

~~Sprint~~The three and ~~Alltel~~six ~~are~~months ~~distribution~~ended ~~subsidiaries of Sprint Corporation and Alltel Corporation~~June 30, ~~respectively.~~2003 ~~Our~~also ~~product~~included ~~sales~~a toleased ~~Sprint~~facility ~~and~~write-off ~~Alltel are distributed to affiliates for deployment in their own networks~~ and ~~sold~~severance ~~through~~costs toarising ~~third party~~from ~~IOC~~the ~~customers.~~workforce ~~Historically,~~reduction ~~approximately~~initiated ~~25% to 40% of our sales to Sprint and Alltel are~~in ~~sold to IOC customers~~April 2003.

19We believe we have aligned general and administrative expenses with current results of operations. We plan to continue to monitor general and administrative expenses in view of our expected future operating results.

~~Table~~Securities Litigation Settlement Costs. In April 2004, we were notified that we had won an arbitration proceeding with a former insurer. On June 30, 2004, we were notified of ~~Contents~~the final award. The insurance company provided us with coverage in 1998 when several lawsuits were brought against AFC and certain former directors and officers relating to securities litigation. The insurance company later refused to pay approximately $5 million in 2002 under an excess liability policy related to the covered defense costs and settlement of the class action securities lawsuit and two individual, non-class actions which were related to the consolidated securities class actions. As a result, we commenced arbitration proceedings in 2003. We have been awarded approximately $5.8 million in compensatory damages and interest. In the decision, the arbitrators found the conduct of the insurer to be in bad faith, such that we were entitled to apply for attorneys’ fees and arbitration fees incurred. We recorded the $5.8 million award for the compensatory damages and interest as a reduction to operating expenses during the three months ended June 30, 2004 because the original defense costs and settlements we incurred were charged to operating expense during 2002. However, the former insurer is appealing the final award in its entirety. We believe there is a high probability that the court will affirm the final judgment relating to the compensatory damages and interest. No accrual has been made for the expected receipt of proceeds for the attorneys’ fees and arbitration fees. When received, the amount will be recorded as a reduction to operating expenses because the original attorneys’ fees and arbitration fees we incurred were charged to operating expense.

~~Our~~Amortization ~~revenues~~of ~~depend~~Intangibles. onIn connection with the ~~capital~~acquisition ~~spending~~of ~~programs~~intangible assets ~~and~~from ~~financial~~NAA, ~~capabilities~~ we amortized $4.1 million of ~~our~~completed ~~service~~technology ~~provider~~during ~~customers~~the three ~~and~~months ~~ultimately~~ended onJune 30, ~~the~~2004. ~~demand~~In ~~for~~connection ~~new~~with the acquisition of ~~telecommunications~~intangible ~~services~~assets from ~~end~~AccessLan ~~users~~Communications, Inc., or AccessLan, we amortized $0.3 million of deferred compensation, non-compete agreements and completed technology during the three months ended June 30, 2004. During the three months

~~Our customers are public telecommunications companies and, in the U.S., include~~20 ILECs and competitive local exchange carriers (CLECs). Within the ILECs, we sell to the IOCs and RBOCs. Our historical markets have been the U.S. and international small to large-line size markets. Our ability to generate future revenues depends upon the capital spending patterns and financial capabilities of our customers, continued demand by our customers for our product solutions and services, and end user demand for advanced telecommunications services. Severe financial problems affecting the telecommunications industry in general could continue to cause a slowdown in our sales and result in slower payments or defaults on account by our customers. There can be no assurance that telecommunications companies, foreign governments or other customers will pursue infrastructure upgrades that will necessitate the implementation of advanced product solutions such as ours. Infrastructure improvements may be delayed or prevented by a variety of factors including cost, regulatory obstacles, the lack of consumer demand for advanced telecommunications services and alternative approaches to service delivery.

WeTable are targeting Telliant to the broadband marketplace and TransMAX™ 1500 to the optical marketplace. Our ability to generate revenues from these products depends in part on customer capital spending patterns and the financial capabilities of our customers. Revenue levels are also driven by customer acceptance of our new products, our ability to develop new features, and end user demand for new services provided by the Telliant and TransMAX products. The economic slowdown impacting the telecommunications industry has affected customers’ capital spending patterns for deploying new services and we cannot provide assurance as to when, or if, capital spending will improve. Contents

Weended ~~may~~June 30, be2003, ~~unable~~we toamortized ~~sell~~$0.7 million ~~customer-specific~~of ~~inventory~~deferred compensation, non-compete ~~resulting~~agreements inand ~~lower~~completed ~~gross profit~~technology ~~margins~~arising ~~and~~from ~~net~~the ~~income~~AccessLan acquisition.

~~Some~~In ofconnection ~~our~~with ~~customers~~the ~~have~~acquisition ~~order~~of ~~specifications~~intangible ~~requiring~~assets usfrom toNAA, ~~design~~we ~~and~~amortized ~~build~~$5.7 million ~~systems~~of ~~and~~completed ~~purchase~~technology ~~parts~~during ~~that~~the ~~are~~six ~~unique~~months toended aJune 30, ~~customer~~2004. In ~~many~~connection ~~cases, we~~with ~~forecast~~the ~~and~~acquisition ~~purchase~~of ~~components~~intangible inassets ~~advance~~from ~~and~~AccessLan, ~~allocate~~we amortized ~~resources~~$0.6 million toof ~~design and~~deferred ~~manufacture~~compensation, ~~the~~non-compete ~~systems.~~agreements Ifand completed ~~our~~technology ~~customers’~~during ~~requirements~~the ~~change~~six ormonths ifended ~~we experience~~June 30, ~~delays~~2004. orDuring ~~cancellation~~the ofsix months ~~orders~~ended June 30, 2003, we ~~may~~amortized be$1.4 million ~~unable~~of todeferred compensation, ~~cost~~non-~~effectively~~compete ~~rework~~agreements ~~system~~and ~~configurations~~completed ortechnology ~~return~~arising ~~parts~~from tothe ~~inventory as~~AccessLan ~~available-for-sale~~acquisition. ~~Write-downs~~We ~~and~~expect ~~accruals~~to ~~for~~continue ~~unrealizable~~expensing ~~inventory negatively~~the ~~impact~~NAA ~~our~~intangibles ~~gross~~through ~~profit~~2013 and ~~margins~~the ~~and~~AccessLan ~~net~~intangibles ~~income~~through 2005.

WeIntegration ~~must~~Costs. ~~attract~~In connection with integrating NAA into AFC, ~~retain~~we incurred $1.4 million and ~~motivate~~$2.6 million, ~~key~~respectively, ~~technical~~in the three and ~~management~~six ~~personnel~~months ended June 30, 2004, in ~~order~~ tointegration ~~sustain~~costs orfor ~~grow~~consultants, ~~our~~accounting ~~business~~services, travel and other related costs.

~~Our~~In-Process ~~success~~Research ~~depends in large part on our ability to attract~~ and ~~retain key technical and management personnel~~Development. ~~Despite~~For the ~~economic~~six ~~slowdown,~~months ~~competition for~~ended ~~some specific skill sets remains intense. The process of identifying and~~June 30, ~~attracting~~2004, ~~key~~we ~~employees~~recognized ~~is often~~ a ~~lengthy~~$14 million ~~and~~write-off ~~costly~~for ~~process.~~technology ~~Our~~that ~~key employees~~had ~~generally do~~ not ~~have employment agreements nor do we carry~~yet ~~key-person~~reached ~~life~~technological ~~insurance~~feasibility, onhad ~~them.~~no ~~There~~alternative ~~can~~future beuse noand ~~assurance~~for ~~that we will~~which ~~succeed~~successful indevelopment ~~retaining~~was ~~key employees~~uncertain. WeThe ~~expect~~write-off ~~continued~~was ~~challenges~~ in ~~recruiting,~~ ~~assimilating,~~connection ~~motivating~~with ~~and retaining~~ the ~~key technical and~~ ~~management~~acquisition ~~personnel~~of ~~necessary~~NAA toon ~~effectively~~February 20, ~~manage our operations~~2004.

~~Recent~~Other ~~and~~Income. ~~future~~Other ~~acquisitions~~income ~~may~~decreased ~~compromise~~to ~~our~~$1.9 million ~~operations~~in the three months ended June 30, 2004, from $3.3 million in the three months ended June 30, 2003. The decrease was primarily due to liquidating a portion of the marketable securities portfolio and ~~financial~~cash equivalents to pay for the NAA acquisition and ~~results~~the related decrease in interest income earned on the remaining securities.

WeOther ~~may~~income ~~pursue~~decreased ~~acquisitions~~to of$4.8 million ~~companies,~~in ~~products~~the ~~and~~six ~~technologies~~months asended ~~part~~June 30, of2004, ~~our~~from ~~efforts~~$7.3 million toin ~~enhance~~the ~~our~~six ~~existing~~months ~~product~~ended ~~solutions~~June 30, ~~introduce new product solutions and fulfill changing customer requirements~~2003. ~~Acquisitions~~The ~~could~~decrease was ~~adversely~~primarily ~~affect~~due ~~our~~to ~~operating~~liquidating ~~results in the short-term as~~ a ~~result~~portion of ~~dilutive~~ ~~issuances~~the ofmarketable ~~equity~~ securities ~~and the incurrence of debt. The~~portfolio ~~acquired products~~ and ~~technologies~~cash ~~may~~equivalents ~~not~~to ~~result~~pay infor ~~sufficient revenues to offset~~ the ~~expenses~~NAA ~~associated~~acquisition ~~with~~and the ~~acquisition.~~related ~~Goodwill~~decrease ~~arising from acquisitions may result~~ in ~~significant impairment write-downs charged to our~~ ~~operating~~interest ~~results~~income inearned ~~one~~on orthe ~~more~~remaining ~~future periods~~securities. WeThe ~~currently~~decrease ~~have~~was ~~$55.9 million~~also ~~in goodwill related to~~ the result ~~acquisition~~ of ~~AccessLan~~settling inthe ~~2002.~~Cisco Wehedge ~~have limited~~contracts ~~experience~~ in ~~acquiring and integrating companies~~2003. ~~Acquisitions~~The ~~involve numerous~~gains ~~risks~~generated ~~including disruption to our business, exposure to unknown~~by ~~liabilities of acquired companies, and failure to successfully integrate~~ the ~~operations,~~ ~~products,~~hedge ~~technologies~~contracts ormore ~~personnel~~than ofoffset the ~~acquired~~Cisco ~~company. We~~share ~~may~~losses ~~fail~~in ~~to realize the anticipated benefits of an acquisition~~2003, ~~such as~~resulting ~~increased~~in ~~market~~unrealized ~~share and sales or successful development and market acceptance of new products~~gains. ~~We may~~

20Income Taxes. The effective tax rate was a benefit of 17% for the three months ended June 30, 2004 compared with the effective tax rate of 25% for the three months ended June 30, 2003. The 17% tax benefit is based on a revision of the forecasted earnings for the remainder of the year. The effective tax rate was a benefit of 39% for the six months ended June 30, 2004 compared with the effective tax rate of 25% for the six months ended June 30, 2003. The rate in 2004 is attributable to several factors including the phase-out of the research and development tax credit as a result of the related tax law expiring during mid-2004, reduced tax-exempt income resulting from liquidating a portion of the marketable securities portfolio for the cash purchase of NAA, a revision of the forecasted earnings for the remainder of the year, and certain costs related to the Tellabs merger, a portion of which is non-deductible for tax purposes. The lower rate in 2003 was primarily the result of investing the proceeds from the Cisco hedge contract settlements in 2003 in tax-exempt marketable securities.

~~Table of Contents~~Goodwill

~~expose~~We allocated the NAA and AccessLan purchase prices based on valuations ~~ourselves~~performed toby ~~increased~~third ~~competition~~party ~~due~~appraisal tofirms. anGoodwill ~~expanded~~is ~~product~~measured ~~offering~~as the excess of ~~resulting~~the ~~from~~cost anof acquisition. ~~The~~over ~~effects~~the sum of ~~these~~the ~~events~~amounts ~~could~~assigned ~~harm~~to ~~our~~identifiable ~~business,~~assets ~~financial~~acquired ~~condition~~less liabilities assumed. We perform goodwill impairment tests on an annual basis and ~~results~~between annual tests when circumstances warrant. As of June 30, ~~operations~~2004, $133.7 million in goodwill is attributable to the NAA acquisition, and $55.9 million in goodwill is attributable to the AccessLan acquisition.

WeSummary ~~are~~of ~~subject~~Certain toSignificant ~~numerous and changing regulations and industry standards. If~~Items ~~our products do not meet these regulations or are not compatible with these~~ ~~standards, our ability to sell our products could be seriously harmed.~~

~~Our~~AFC ~~products~~management ~~must~~takes ~~comply~~certain ~~with a~~ significant ~~number~~items ofinto ~~voice~~consideration ~~and data~~when ~~regulations~~evaluating ~~and~~internal ~~standards,~~performance ~~which vary between U.S.~~ and ~~international~~results ~~markets, and~~of ~~may vary within specific foreign markets~~operations. We ~~believe~~exclude ~~the final ruling~~certain ~~arising~~significant items from ~~the FCC’s Triennial Review encourages long-term investment in broadband networks and migration to FTTP-based services. We also need to continue to ensure that~~ our ~~products~~GAAP ~~are~~results ~~easily~~of ~~integrated~~operations ~~with various telecommunications systems. Evolving standards~~ for ~~new~~budgeting ~~services require us to~~purposes, ~~continually~~reviewing ~~modify~~business ~~our~~performance ~~products or develop new versions to meet those new standards. Testing to ensure compliance~~ and ~~interoperability~~making ~~requires significant~~investment ~~investments of time and money~~decisions. ~~Our~~We ~~ability to sell products would~~exclude be impaired if we fail to, in a timely manner, ensure our systems are compliant with evolving standards in U.S. and international markets. Additionally, if we fail to obtain compliance on new features or if we fail to maintain interoperability with equipment from other companies, these ~~factors~~items ~~would impair~~because ~~our selling ability. As a result,~~ we ~~could experience customer contract~~ ~~penalties, delayed or lost customer orders, decreased revenues and reduced net~~ ~~income.~~

~~We have maintained compliance with ISO 9001 since we were first certified in~~21 1997, and TL 9000 since we were first certified for hardware, software and services in 2000. TL 9000 contains all ISO 9001 requirements as well as other telecommunications industry requirements. In October 2003, we received TL 9000 certification for the San Jose facility that was acquired in May 2002. There can be no assurance that we will maintain these certifications. The failure to maintain TL 9000 certification may adversely impair the competitiveness of our products.

CongressTable passed the 1996 Telecommunications Act imposing additional regulations that affect telecommunications services, including changes to pricing, access by competitive vendors and other broad changes to data and telecommunications networks and services. These changes have had a major impact on the pricing and availability of services, and may affect the deployment of future services. These changes have also caused greater consolidation in the telecommunications industry, which could result in disruption of our existing customer relationships, delays or loss of customer orders, decreased revenues and lower net income. There can be no assurance that any future legislative and regulatory changes will not have a material adverse effect on our products’ competitiveness. Moreover, uncertainty regarding future legislation and governmental policies combined with emerging new competition may also affect the demand for our product solutions. Contents

Webelieve ~~face~~the ~~risks~~resulting ~~associated~~amounts ~~with~~provide ~~international~~a ~~markets~~more consistent and ~~distribution~~useful ~~channels~~basis for comparison between periods. Significant items excluded from our GAAP results of operations include (in thousands):

International sales constituted 15% and 14% of our revenues in the first nine months of 2003 and 2002, respectively. International sales have fluctuated in absolute dollars and as a percentage of revenues and are expected to continue to fluctuate in future periods.


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Operating:
Amortization of acquired intangibles	$	4,357		$	651		$	6,306		$	1,444
Tellabs merger costs		3,510			—			3,510			—
Workforce reduction and restructuring		1,449			5,182			1,449			5,182
Lease facility write-off		293			292			293			292
In-process research and development		—			—			14,000			—
Securities litigation settlement costs		(5,787	)		—			(5,787	)		—
Non-operating:
Unrealized gains on Cisco investment		—			(30	)		—			(1,386	)

Total	$	3,822		$	6,095		$	19,771		$	5,532

~~Many~~Three ~~international~~Months ~~telecommunications~~Ended companies are owned or strictly regulated by local authorities. Access to international markets is often difficult to achieve due to trade barriers and established relationships between government-owned or government-controlled telecommunications companies and traditional local equipment vendors. Successful expansion of international operations and sales in some of these markets may depend on our ability to establish and maintain productive strategic relationships with established telecommunications companiesJune 30, ~~local equipment vendors or entities successful at~~2004 ~~penetrating international markets. We have closed several sales and~~ ~~representative offices in Asia and Europe in the past. We rely on a number of~~ third party distributors and sales representatives to market and sell our products outside of the U.S. There can be no assurance that third party distributors or sales representatives will provide the support and effort necessary to effectively service our international markets. Our gross profit margins have, in some cases, been lower for sales through some of our third party and indirect distribution channels than for sales through our direct sales efforts. Increased sales through our third party and indirect distribution channels could reduce our overall gross profit margin and net income.

~~Sales~~• ~~activities~~$4.4 million in ~~foreign~~amortization ~~countries~~of ~~may~~intangible ~~subject~~assets usacquired toin ~~taxation~~the inNAA ~~those countries~~and AccessLan acquisitions; • $3.5 ~~Although~~million wein ~~have~~investment ~~attempted~~banking, tolegal, ~~minimize~~accounting ~~our~~and ~~exposure~~other costs expensed related to ~~taxation~~the ~~in foreign~~merger ~~countries,~~with ~~any~~Tellabs; ~~income~~• or$1.4 ~~other~~million ~~taxes~~for ~~imposed~~facility ~~may~~write-offs ~~increase~~stemming ~~our~~from ~~overall effective~~a ~~tax~~workforce ~~rate,~~reduction ~~thereby~~initiated ~~adversely~~in ~~impacting~~April ~~our~~2003; ~~competitiveness~~• in$0.3 ~~those countries~~million for a leased facility write-off; and • $5.8 Wemillion ~~currently~~from ~~intend~~ an arbitration award treated as a reduction to operating expenses.

21Three Months Ended June 30, 2003

~~Table~~• $0.7 million in amortization of ~~Contents~~intangible assets acquired in the AccessLan acquisition; • $5.2 million in expenses from severance and facility closures from a workforce reduction initiated in April 2003; • $0.3 million for a leased facility write-off; and • $30 thousand in unrealized gains on our Cisco securities holdings and related hedge contract.

~~that~~Six ~~any~~Months ~~earnings~~Ended of our foreign subsidiaries remain permanently invested in these entities to facilitate the potential expansion of our business. Our cash flows could be adversely affected to the extent that these earnings are actually or deemed repatriatedJune 30, ~~resulting in the~~2004 ~~imposition of additional U.S. federal and state income taxes.~~

We• ~~must~~$6.3 ~~comply~~million ~~with~~in ~~various~~amortization ~~country-specific~~of ~~standards~~intangible ~~and~~assets ~~regulations~~acquired ~~to compete~~ in ~~international~~the ~~markets.~~NAA ~~Our~~and ~~product~~AccessLan ~~solutions~~acquisitions; ~~may~~• be$3.5 ~~incompatible with~~million ~~the~~in ~~legacy~~investment ~~infrastructure~~banking, oflegal, ~~some~~accounting ~~international~~and ~~markets.~~other ~~This~~costs ~~could~~expensed ~~impair our~~related ~~ability~~ to ~~sell~~the ~~our~~merger ~~product~~with ~~solutions~~Tellabs; ~~into~~• ~~certain countries~~$1.4 Ifmillion ~~our existing~~for ~~international~~facility ~~customers~~write-offs ~~adopt~~stemming ~~network~~from ~~standards~~a ~~incompatible~~workforce ~~with those~~reduction ~~supported~~initiated byin ~~our~~April ~~product~~2003; ~~solutions,~~• we$0.3 ~~could~~million ~~experience~~for a ~~loss~~leased ~~of revenues~~facility ~~and~~write-off; ~~lowered~~• ~~net~~$14 ~~income.~~million ~~Any~~for ~~inability~~in-process toresearch ~~obtain~~and ordevelopment ~~maintain~~costs ~~local regulatory~~written ~~approval~~off ~~could~~upon ~~delay~~the oracquisition ~~prevent~~of ~~entrance~~NAA; ~~into~~and ~~certain~~• ~~markets~~$5.8 ~~This could~~million ~~result~~from inan ~~delays~~arbitration oraward ~~loss~~treated ofas ~~customer~~a ~~orders,~~reduction ~~decreased~~to ~~revenues~~operating ~~and lower net income~~expenses.

InSix ~~addition,~~Months ~~there~~Ended ~~are~~June 30, ~~economic and political risks that may impact our~~2003 ~~international sales. An example of these risks could be our inability to~~ ~~collect receivables from customers due to currency exchange controls imposed as~~ ~~a result of a country’s economic collapse. Another example could be a loss of customers due to terrorism or war. These problems would decrease our revenues and lower our net income.~~

We• ~~may~~$1.4 bemillion ~~unable~~in toamortization ~~secure~~of ~~necessary~~intangible ~~components~~assets ~~and~~acquired ~~support~~in ~~because~~the weAccessLan ~~depend upon~~acquisition; a• ~~limited~~$5.2 ~~number~~million ofin ~~third~~expenses ~~party~~from ~~manufacturers~~severance and ~~support~~facility ~~organizations, and~~closures from a workforce reduction initiated in ~~some~~April ~~cases~~2003; we• ~~rely~~$0.3 ~~upon~~million ~~sole~~for ora ~~limited~~leased facility write-~~source~~off; ~~suppliers~~and • $1. 4 million in unrealized gains on our Cisco securities holdings and related hedge contracts.

~~Our growth and ability to meet customer demands are also dependent on our~~22 ability to obtain timely deliveries of components from our suppliers. We currently purchase certain key components used in manufacturing from sole or limited-source vendors. These components include our proprietary application specific integrated circuits, codec components and certain surface mount technology components. Most of our component purchases are on a purchase order basis without guaranteed supply arrangements. Some of our sole and limited-source vendors allocate parts to multiple telecommunications equipment manufacturers based on market demand for components and equipment. This may result in shortages of certain key components sold to us because many of our competitors are larger and may be able to obtain priority allocations from these shared vendors, thereby limiting or making unreliable our sources of supply for these components. Although we believe there are alternative sources for these components, in the event of a disruption in supply, we may not be able to identify an alternative source in a timely manner, at favorable prices or of acceptable quality. Such a failure could limit our ability to meet scheduled deliveries to our customers and increase our expenses. This could reduce our gross profit margin and net income.

WeTable have long-term purchase agreements with contract manufacturers (CMs), which allow us to negotiate volume discounts and help assure us of a steady supply of components. The agreements require the CMs to purchase component parts to be used in manufacturing our products and authorize them to make purchases in accordance with agreed-upon lead times. We provide CMs with forecasts of our expected needs and we issue purchase orders covering a certain period of time for specific quantities. As customers increasingly demand shorter delivery timeframes, the difficulty of accurately forecasting component mix and quantity needs creates additional risk. If we overestimate our requirements, the CMs may assess cancellation penalties or we may have excess or obsolete inventory. If we underestimate our requirements, the CMs may have inadequate inventory, which could interrupt manufacturing of our products. Both situations could reduce our gross profit margin and net income. Contents

WeLiquidity ~~cannot be assured that CMs will allocate sufficient resources to the timely completion of our orders in accordance with our quality standards. Qualifying a new CM is costly~~ and ~~time~~Capital ~~consuming and could result in significant~~Resources ~~interruptions in the supply of our products. During 2002, we transitioned some~~ ~~of our contract manufacturing to a new CM.~~

~~Failure~~Liquidity and capital resources refers to ~~develop~~the ability to generate cash to meet existing and ~~introduce~~known ~~new~~or ~~product~~reasonably ~~solutions~~likely ~~that~~future ~~meet~~cash ~~changing~~requirements in the ~~customer~~short-term and foreseeable future. Our forecasts take into account financial resource needs, working capital and capital expenditure requirements, and operating ~~address~~lease ~~technological~~obligations. ~~advances~~We ~~would~~believe ~~limit~~our existing cash and marketable securities and cash flows from operating and financing activities are adequate to support our ~~future~~financial needs in both the short-term and the foreseeable ~~revenues~~future.

~~New~~Cash, ~~product~~Cash ~~development~~Equivalents ~~often requires long-term forecasting of market trends,~~ and ~~development~~Marketable ~~and implementation of new technologies. Market acceptance of~~Securities ~~our product solutions may be significantly reduced or delayed if we fail, or~~ ~~are late to respond to new technological developments, or if we experience~~ ~~delays in product development. The telecommunications equipment market is characterized by rapidly changing technology,~~

22The following table summarizes our cash, cash equivalents and marketable securities (in thousands):


	June 30,		December 31,		Increase/
	2004		2003		(Decrease)
Cash and cash equivalents	$	134,607	$	246,552	$	(111,945	)
Cisco marketable securities		247,407		250,786		(3,379	)
Other marketable securities		478,316		594,230		(115,914	)
Restricted cash equivalents		23,050		20,000		3,050

~~evolving~~Cash ~~industry~~and ~~standards,~~cash equivalents. The $111.9 million decrease was the result of paying ~~changes~~$240.9 million in ~~end~~cash ~~user~~to ~~requirements~~acquire NAA, and ~~frequent~~$1.8 million ~~new~~in ~~product~~cash ~~introductions~~for ~~and~~related ~~enhancements~~acquisition costs. ~~The~~We ~~introduction~~also ofmade ~~products~~a ~~embodying~~$2 million ~~new~~investment ~~technologies~~in ora privately held company during the six months ended June 30, 2004. Additionally, we paid a $2 ~~emergence~~million ofcash ~~new~~PCP ~~industry~~to ~~standards~~Verizon ~~can~~for ~~render~~failing ~~our~~to ~~existing~~timely ~~products~~achieve ~~obsolete~~a product release ormilestone. ~~unmarketable~~These decreases in cash were partially offset by the movement of $112.1 million from other marketable securities into shorter-term cash equivalents and $4.8 million in interest income.

~~Our~~Cisco ~~success~~marketable ~~will~~securities. ~~depend~~The ~~upon~~$3.4 million ~~our~~decrease ~~ability~~was tothe ~~enhance~~result ~~our~~of ~~product solutions~~market ~~through~~price ~~the~~volatility. ~~timely~~At ~~development of new technology~~June 30, ~~ongoing cost reductions~~2004, ~~and~~we ~~the~~owned ~~development~~10.6 million ~~and introduction~~shares of ~~new~~Cisco common ~~feature enhancements~~stock. We ~~must commit~~acquired ~~significant~~these ~~resources~~shares toas ~~develop~~a ~~new~~result ~~product~~of ~~solutions~~an ~~before~~investment ~~knowing~~in ~~whether~~privately ~~our~~held ~~investments~~Cerent ~~will~~Corporation, ~~result~~which inwas ~~solutions~~merged ~~the~~with ~~market~~Cisco ~~will~~in ~~accept~~1999. ~~We,~~In or2000, ~~our~~we ~~competitors,~~entered ~~may~~into ~~announce~~two ~~new~~three-year ~~products~~hedge contracts, ~~product~~pledging ~~enhancements,~~all ~~services or~~of ~~technologies~~our ~~that~~Cisco stock ~~have~~to secure the ~~potential~~obligations tounder ~~replace~~these orcontracts. ~~shorten~~In 2003, the ~~life~~hedge contracts ~~cycle~~matured, ~~of our~~and ~~product~~we ~~family,~~entered ~~causing~~into ~~customers~~stock toloan ~~defer~~agreements ~~purchases~~with ofa ~~our~~lender, borrowing ~~equipment~~10.6 million ~~The competitiveness~~shares of ~~our~~Cisco ~~product~~stock ~~solutions~~to ~~could~~settle bethe ~~impaired~~hedge ifcontracts. weThe fair ~~fail~~market ~~to respond~~value toof ~~technological~~the ~~advances~~Cisco instock ~~the~~loans ~~telecommunications~~is ~~industry~~reflected onas a ~~cost-effective~~ ~~and~~current ~~timely basis~~liability.

~~Our~~During ~~future~~the ~~operating~~three ~~results~~months ~~will~~ended beJune 30, ~~impacted~~2004, bywe ~~whether~~recorded ~~new~~an ~~product~~income ~~solutions,~~tax ~~including~~receivable ~~TelcoVideo,~~of ~~PacketVoice,~~$210.1 million ~~Telliant,~~based ~~TransMAX,~~on ~~and~~the ~~FiberDirect~~receipt of a Private Letter Ruling from the Internal Revenue Service. This ruling addressed the tax treatment of settling with borrowed shares the two hedge contracts on 10.6 million Cisco shares that matured in 2003. The cash proceeds received from the settlement were approximately $690 million. Because we used borrowed shares rather than our existing Cisco shares to settle the hedge contracts, we believe that current law allows the deferral of taxes on the gain attributable to the hedge contracts until the new Cisco stock loans are settled. The total tax liability ~~widely~~related ~~deployed~~to bythe ~~operators~~gain on the Cisco stock and hedge contracts assuming no deferral would be approximately $265 million. During 2003, estimated federal and state taxes net of applicable credits were paid on the ~~actual~~full ~~timing~~amount of the gain because of concern that the tax authorities could challenge the tax deferral position, and ~~quantity~~payment of ~~orders~~these taxes were accounted for on the balance sheet. In response to our request, the Internal Revenue Service issued a Private ~~solutions~~Letter Ruling that was favorable to deferring taxes on the settlement of the hedge contracts with borrowed shares. Although a Private Letter Ruling from the Internal Revenue Service is not conclusive of all issues, ~~growth~~based inupon ~~demand~~the strength ~~for~~of ~~broadband~~the ~~services~~ruling, we will file federal and ~~our~~state ~~ability~~income tax returns requesting refunds that total $210.1 million. In addition to the income tax receivable, a deferred tax liability of $210.1 million has been recorded. The balance sheet reports a net deferred tax liability of $174.5 million, which is net of the deferred tax assets. Taxes will be due on the gain from the hedge ~~market~~contracts ~~share~~upon ~~and~~termination ~~experience~~of ~~growth~~the Cisco stock loans. We intend to maintain the stock loans for an extended period of time, however, there is no assurance that we will be able to do so.

~~Our~~In ~~products~~connection ~~are~~with ~~complex~~borrowing the Cisco shares under the stock loans, we pay borrowing fees and ~~may~~a ~~contain~~fee ~~undetected~~adjustment ~~errors~~based ~~that~~on ~~could~~the ~~result~~average indaily price of Cisco ~~significant~~stock. ~~unexpected~~The ~~expenses~~majority of the borrowing fees is expensed based on the average share price of Cisco stock during each quarter. A portion of the borrowing fees is expensed on a straight-

~~Our products are complex and despite extensive testing, may contain undetected~~23 defects, errors or failures. These issues may only become apparent after products are shipped, when product features are introduced or as new versions are released. The occurrence of any defects, errors or failures could result in delays or cancellation of orders, product returns, warranty costs or legal actions by our customers or our customers’ end users. Any of these issues could reduce revenues, gross profit margin and net income.

SignificantTable portions of our revenues are generated through sales of the AccessMAX family of products and a decline in demand for these products would result in decreased revenues and net income. Contents

~~Significant~~line ~~portions~~basis ofover ~~our~~the ~~revenues~~lives ~~are~~of ~~derived from~~ the ~~AccessMAX product family~~loans. ~~Any~~We ~~decrease~~expect into ~~market~~incur ~~demand~~approximately ~~for~~$1 million ~~AccessMAX~~annually ~~products would result~~ in ~~decreased~~ ~~revenues~~legal fees and ~~lower~~borrowing fees, net ~~income.~~of ~~Factors that could affect demand for our products include price competition~~taxes, ~~regulatory~~to ~~uncertainty,~~pursue ~~technological~~our ~~change~~tax ~~and new product introductions or announcements by our competitors~~position.

~~Failure~~Provisions orin ~~inability~~the toCisco ~~protect~~stock ~~our~~loans ~~intellectual~~contain ~~property~~“make-whole” fee arrangements. The make-whole fees would ~~adversely~~provide the lender with the discounted net present value ~~affect~~of ~~our~~a ~~ability~~portion of future borrowing fees. The make-whole fees are triggered if we assign the loans to ~~compete~~another lender, ~~which~~or ~~could~~terminate ~~result~~and inenter ~~decreased~~into ~~revenues~~a similar transaction with another lender, or we are acquired by Cisco. The make-whole fees are calculated based on the net present value, discounted at 10% per annum, of a portion of future borrowing fees due up to and including the seventh year. Based on the arithmetic average closing price of Cisco’s stock for the three months ended June 30, 2004, the maximum gross potential amount payable would be $2.4 million over the next six years.

WeOther ~~seek~~marketable ~~to protect our technology through a combination of copyrights, trademarks, trade secret laws, contractual obligations and patents~~securities. ~~We currently~~The ~~hold three patents for our products, and fifteen patent applications are pending~~$115.9 million ~~However,~~decrease ~~these~~was ~~applications~~primarily may not result in issued patents. These intellectual property protection measures may not be sufficient to prevent wrongful misappropriation of our technology. These measures will not prevent competitors from independently developing technologies that are substantially equivalent or superior to our technology. The laws of many foreign countries do not protect our intellectual property rights to the ~~same~~ ~~extent as the laws of the U.S. Failure or inability to protect proprietary information could~~ result ~~in loss~~ of ~~our~~liquidating ~~competitive~~securities ~~advantage,~~for ~~loss~~cash ofrequired ~~customer orders and decreased revenues. Furthermore, policing the unauthorized use of our products is difficult. Litigation may be necessary in the future~~ to ~~enforce our~~purchase ~~intellectual property rights~~NAA. ~~Litigation could result in substantial costs~~ ~~and diversion of management resources, while not guaranteeing a successful~~ ~~result.~~

WeRestricted ~~may~~cash beequivalents ~~subject~~and marketable securities. $20 million in restricted tax-exempt cash equivalents and marketable securities is held as collateral to ~~intellectual~~back ~~property~~a ~~infringement~~three-year ~~claims~~bond ~~that~~posted ~~are~~for ~~costly~~a U.S. customer contract. The bond expires in 2005 and ~~timely~~guarantees toour ~~defend~~performance under the contract. The current earnings rate on these cash equivalents and ~~could~~marketable ~~limit~~securities is approximately 1.12%. $2.5 million in restricted taxable cash equivalents is held as collateral for our ~~ability~~commercial toand ~~use~~standby ~~some~~letters ~~technologies~~of credit facility with our bank. The current earnings rate on these cash equivalents is approximately 1.03%. $0.6 million in restricted taxable cash equivalents is held as collateral for a letter of credit issued to a third party that provides AFC’s workers’ compensation insurance. The current earnings rate on these cash equivalents is approximately 1.08%. These restricted cash equivalents and marketable securities are recorded in other assets on the ~~future~~balance sheets.

WeCash ~~expect to continue being subject to infringement claims and other~~Flows ~~intellectual property disputes. We have been subject to several intellectual~~ ~~property disputes in the past. In the future, we may be subject to additional~~ litigation and may be required to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Litigation could be expensive, lengthy and disrupt management’s

23The following table summarizes our cash flows (in thousands):


	Six Months Ended
	June 30,
	2004			2003
Cash flows provided by operating activities	$	16,026		$	584,128
Cash flows used in investing activities		(145,738	)		(336,108	)
Cash flows provided by financing activities		17,767			10,126

~~attention~~Operating ~~and~~activities ~~detract~~in ~~resources~~the ~~from~~six ~~core~~months ~~business~~ended ~~operations.~~June 30, 2004 provided cash, ~~Adverse~~primarily ~~determinations~~due ~~could~~to ~~result~~an increase in ~~the~~accrued ~~loss~~liabilities ofoffset ~~our~~by ~~proprietary~~increases ~~rights, or~~in ~~prevent~~inventories usas ~~from~~a ~~manufacturing~~result orof ~~selling~~forecasted ~~our~~sales ~~products~~and customers’ expectations of shortened delivery timeframes. ItNon-cash ~~may~~activity ~~also~~included ~~subject~~an usincrease in todeferred ~~significant~~income ~~liabilities~~taxes ~~and~~offset ~~require~~by ~~that~~a wedecrease ~~seek~~in ~~licenses~~current ~~from~~income ~~third~~taxes and the ~~parties~~write-off of in-process research and development. InThe ~~such~~six ~~case~~months ended June 30, we2003 ~~cannot~~included bethe ~~assured~~non-cash ~~that~~effect ~~licenses~~of ~~will~~the beproceeds from ~~available~~the ~~on commercially~~settlement ~~reasonable~~of ~~terms,~~the ifCisco athedge ~~all~~contracts. Investing activities in the six months ended June 30, ~~from~~2004 ~~any~~used ~~third~~cash ~~party~~primarily ~~that~~as ~~asserts intellectual~~a ~~property~~result ~~claims~~of ~~against~~paying us$242.7 million ~~Any~~in ~~inability~~cash and associated costs to ~~obtain~~acquire ~~third~~NAA. ~~party licenses~~This ~~required~~was topartially ~~develop~~offset by ~~new~~sales ~~products~~and ormaturities ~~product~~of ~~enhancements~~marketable ~~could~~securities ~~require~~exceeding purchases. usThe tosix ~~obtain~~months ~~substitute~~ended ~~technology~~June 30, 2003 used cash primarily due to purchases of ~~lower~~marketable ~~quality~~securities orexceeding ~~performance~~sales ~~standards~~and ormaturities. atFinancing ~~greater~~activities ~~cost~~in the six months ended June 30, ~~any~~2004 provided cash as a result of ~~which~~an ~~could~~increase ~~seriously~~in ~~impair~~stock ~~our~~option ~~competitiveness~~exercises as compared with the prior year comparable period.

~~Tax~~Performance ~~authorities may challenge our request for a refund of taxes on the gains~~Metrics ~~from the hedge contracts on our Cisco stock.~~

WeThe ~~acquired~~following ~~10.6 million~~table ~~shares~~summarizes ofcertain ~~Cisco~~performance ~~stock~~metrics ~~as a result of our investment~~ (in ~~privately-held~~ ~~Cerent Corporation~~thousands, ~~which was merged with Cisco in 1999. In~~ ~~February~~except ~~and~~days ~~May~~sales ~~2000~~outstanding, weor ~~entered into two hedge contracts economically equivalent to costless collar arrangements~~DSO, ~~to reduce our risk with respect to this position. In February~~ and ~~May~~inventory ~~2003, the hedge contracts matured and we~~turns): ~~received a total of $690.3 million in cash proceeds. We delivered newly~~ borrowed Cisco shares in settlement of the hedge contracts. By using borrowed shares rather than the existing Cisco shares we own, we believe that under current tax law we are presently obligated to pay taxes only on the excess of the fair market value of Cisco stock on the date of the settlement over our tax basis in the stock. We believe that the payment of taxes on the gain attributable to the hedge contracts will be deferred until we settle the new Cisco stock loans. We intend to maintain these loans for an extended period, although there is no assurance that we will be able to do so.

The tax authorities may challenge our position with respect to deferral of the taxes on the hedge contracts gain. Accordingly, in 2003 we are paying an estimated $265 million in federal and state taxes, less applicable credits, on the full amount of the gain on both the Cisco stock and the hedge contracts in order to avoid potentially significant interest and penalties should we be unable to sustain our tax position. Of the estimated total, we have paid $191 million in taxes during the nine months ended September 30, 2003. On our September 30, 2003 balance sheet, we accounted for the tax liability on the gain from the Cisco stock and hedge contracts based on the value of these financial instruments at that time and the applicable statutory tax rates. We will file our 2003 tax return in 2004 and then seek a refund of approximately $210 million. This refund represents the amount of taxes paid on the portion of the gain that we believe is subject to deferral. There is no assurance as to the timing or amount of any refund, and we will incur modest costs in pursuing this course of action. Final resolution of this matter may take several years. Should we receive the requested refund, the additional cash would be invested for the benefit of stockholders. Because we borrowed the same number of Cisco shares as we own, we will not have any exposure to changes in the per share price for Cisco stock.


	June 30,		December 31,
	2004		2003
DSO		52		58
Inventory turns		6.3		8.9
Working capital	$	653,298	$	863,525

~~Item~~The decrease in DSO as of June 3.30, ~~Quantitative~~2004 ~~and~~was ~~Qualitative~~the ~~Disclosures~~result ~~About~~of ~~Market~~including ~~Risk~~a full quarter’s worth of revenue from NAA.

~~We have a Cisco shares liability for 10.6 million shares of Cisco common stock~~24 borrowed and outstanding at September 30, 2003. The following table shows the changes in fair value of the Cisco shares liability arising from a hypothetical 20% increase or decrease in Cisco’s stock price. Based on the $19.96 closing price at September 26, 2003, the last trading day of our third fiscal quarter, the amounts were (in thousands):

		Valuation -20%				No change				Valuation +20%
Cisco shares liability		$	168,613			$	210,766			$	252,919

24Inventory turns during the three months ended June 30, 2004 decreased primarily due to the increase in cost of revenues, increases in inventories as a result of forecasted sales and customers’ expectations of shortened delivery timeframes and from acquiring NAA’s inventory.

~~Table~~The decrease in working capital as of ~~Contents~~June 30, 2004 was primarily the result of acquiring NAA for $240.9 million in cash and $1.8 million in associated costs, and an increase in net deferred tax liabilities.

~~We have a Cisco shares asset for 10.6 million shares of Cisco common stock as~~Borrowings ~~of September 30, 2003. The following table shows the changes in fair value of~~ ~~the Cisco shares arising from a hypothetical 20% increase or decrease in~~ ~~Cisco’s stock price. Based on the $19.96 closing price at September 26, 2003, the amounts were (in thousands):~~

		Valuation -20%				No change				Valuation +20%
Cisco shares asset		$	168,613			$	210,766			$	252,919

We maintain an uncommitted bank facility for the issuance of commercial and standby letters of credit. At June 30, 2004 we had $2.3 million in letters of credit outstanding under this facility, including $0.5 million issued as a five-year deposit on one of our leased facilities.

We ~~have~~maintain ~~foreign~~agreements ~~currency~~with ~~sales to~~ two ~~international~~banks ~~customers.~~under Wewhich ~~hedge foreign~~we ~~currency~~may ~~risk~~enter oninto ~~certain accounts receivable and accounts payable with~~foreign ~~forward~~exchange contracts ~~that~~up ~~generally~~to ~~expire within 60~~$40 ~~days~~million. ~~These~~There ~~forward currency contracts~~ are ~~not~~no ~~designated~~borrowing asprovisions ~~hedges~~or financial ~~and~~covenants ~~changes~~associated inwith ~~the~~these ~~fair~~facilities. ~~value~~At ofJune 30, ~~the~~2004, there ~~forward~~were ~~contracts~~no ~~are~~foreign ~~recognized~~exchange ~~immediately~~contracts ~~in earnings~~outstanding.

AtWorkforce ~~September 30, 2003, we held a $4.3 million minority interest equity~~Reduction ~~investment in a non-publicly traded company. The company designs and~~ ~~manufactures telecommunications equipment. We began investing in the company~~ in 1999. We maintain this investment on a cost basis and do not have the ability to exercise significant influence over the company’s operations. Our investment carries risk because the products of this company have been in general release for a limited time. This company is also subject to risks resulting from uncertain standards for new products and competition. If these products fail to generate customer interest, the value of the company would likely decline and could result in impairment of our investment. Additionally, macroeconomic conditions and an industry capital spending slowdown are affecting the availability of venture capital funding, and the valuations of development stage companies. We could lose our entire investment in this company and be required to record a charge to operations for any loss. Our ability to earn a return on this investment is largely dependent on the occurrence of an initial public offering, merger, or sale of the company.

~~Item~~In April 42003, we announced a reduction in our workforce to reduce expenses and align our cost structure with our revised business outlook. ~~Controls~~The major components of the reduction included severance and ~~Procedures~~employee related expenses, and consolidation of excess leased facilities. The following table summarizes expenditures from December 31, 2003 through June 30, 2004 related to the workforce reduction (in thousands):

AFC maintains “disclosure controls and procedures,” as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934 (the Exchange Act). These disclosure controls and procedures are designed to ensure that information required to be disclosed by AFC in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. They are also designed to ensure that such information is accumulated and communicated to AFC’s management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating AFC’s disclosure controls and procedures, we recognized that no matter how well conceived and operated, disclosure controls and procedures can provide only reasonable, not absolute, assurance that their objectives are met. Additionally, we evaluated the cost-benefit relationship in the design of our disclosure controls and procedures. Their design is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.


	Reserve										Reserve
	Balance at										Balance at
	December										June 30,
	31, 2003		Charges		Reductions			Reversals			2004
Severance and employee- related expenses	$	76	$	—	$	(23	)	$	—		$	53
Excess leased facilities due to reduction in workforce		1,638		1,451		(718	)		(18	)		2,353

Total	$	1,714	$	1,451	$	(741	)	$	(18	)	$	2,406

~~Subject~~We toanticipate the ~~limitations~~remaining ~~noted~~severance ~~above, our management, with the participation of our CEO~~ and ~~CFO,~~employee-related ~~has~~expenses ~~evaluated~~will ~~the effectiveness of the design and operation~~be ofpaid ~~AFC’s~~in ~~disclosure controls and procedures as of~~ the ~~end~~third ~~of the fiscal~~ quarter ~~covered~~ byof ~~this quarterly report on Form 10-Q~~2004. ~~Based~~The onremaining ~~that~~expenditures ~~evaluation,~~relating to the ~~CEO~~consolidation ~~and~~of ~~CFO~~excess ~~have~~leased ~~concluded~~facilities ~~that~~will ~~AFC’s~~be ~~disclosure~~paid ~~controls~~through ~~and procedures were effective to meet the objectives for which they were designed~~2009.

~~There~~Stock ~~were no changes in our internal control over financial reporting~~Repurchases ~~identified in connection with the foregoing evaluation that occurred during our~~ ~~last fiscal quarter that have materially affected, or are reasonably likely to~~ ~~materially affect, our internal control over financial reporting.~~

25We did not make any stock repurchases during the three months ended June 30, 2004.

~~Table of Contents~~25

PARTTable II.of OTHER INFORMATION Contents

~~Item 1.~~Contractual ~~Legal Proceedings~~Obligations

~~None~~The following table summarizes our known contractual obligations as of June 30, 2004 that will affect our liquidity and cash flows in future periods (in thousands):

Item 2. Changes in Securities and Use of Proceeds


	Payments Due by Period
					1 Year or		3 Years
					More,		or More,
					But Less		But Less
			Less Than 1		Than 3		Than 5		5 Years or
Contractual Obligations	Total		Year		Years		Years		More
Cisco stock loans (1)	$	247,407	$	—	$	—	$	—	$	247,407
Operating lease obligations		56,433		9,703		17,538		13,573		15,619
Purchase commitments to contract manufacturers		46,529		46,529		—		—		—
Cisco stock loan borrowing fees (1)		10,524		1,496		3,589		3,514		1,925

Total	$	360,893	$	57,728	$	21,127	$	17,087	$	264,951

~~None~~ (1) See below for an explanation of Cisco’s share closing prices used to calculate the contractual obligations.

~~Item 3.~~We ~~Defaults~~do ~~Upon~~not ~~Senior~~have ~~Securities~~contractual obligations related to:

~~None~~ • Long-term debt obligations; • Capital lease obligations; or • Significant other long-term liabilities.

~~Item~~The Cisco stock loan obligations are repayable with 10.6 4million shares of Cisco stock. ~~Submission~~There is no contractual dollar obligation under the loan agreements. We intend to settle the loans using the 10.6 million Cisco shares we own. For purposes of ~~Matters~~the contractual obligations disclosure only, we used Cisco’s share price of $23.43 as of June 25, 2004 to adetermine ~~Vote~~the hypothetical value of ~~Security~~the ~~Holders~~loan obligations assuming the loans are settled in 2010.

~~None~~We sublease three of our facilities. The total future minimum lease payments above have not been reduced by $11.6 million of future sublease payments to be received under non-cancelable subleases.

~~Item~~ In 2001, we vacated an engineering facility in Largo, Florida and entered into a sublease agreement for the entire space. Our lease term continues through 2007, while the sublease agreement extends through the end of 2004. We accrued $1.5 million to short-term and long-term liabilities for this operating lease in 2001. ~~Other~~The ~~Information~~amount represents the present value of the loss we expect to incur for the ongoing shortfall between our sublease income and operating lease obligation. If the sublessee does not renew their lease agreement with us, and we are unable to enter into another sublease agreement through the March 31, 2007 term of the lease obligation, the amount of the ultimate loss based on the lease could increase by up to $1 million before tax.

~~Trading~~We ~~Plans.~~have ~~Our~~purchase ~~Chairman,~~agreements ~~President~~with ~~and~~contract ~~Chief~~manufacturers. ~~Executive~~Under ~~Officer, John~~these ~~Schofield~~agreements, ~~and~~the ~~our~~maximum ~~Chief~~liability ~~Financial Officer, Keith Pratt, have established written plans in accordance with Securities and Exchange Commission Rule 10b5-1~~ for ~~gradually~~purchase ~~liquidating~~commitments aas ~~portion~~ of ~~their~~June 30, ~~holdings~~2004 was ~~of our common stock~~$46.5 million, ~~Mr. Schofield~~of ~~and~~which Mr$1.1 ~~Pratt~~million ~~established~~was ~~the~~accrued ~~plans~~on ~~to diversify their investment portfolios while avoiding conflict of interest or~~ the ~~appearance~~balance ~~of any such conflict that might arise from their positions with AFC~~sheet.

~~Mr. Schofield~~The ~~has~~Cisco ~~informed~~stock usloans ~~that~~borrowing hefees ~~intends~~are topartially ~~exercise~~based ~~options~~on ~~covering~~Cisco’s upaverage toshare ~~5,000~~price ~~shares~~at ofthe ~~stock~~end ~~per~~of ~~month~~each ~~and~~quarter. toFor ~~sell~~purposes of the ~~resulting~~contractual obligations ~~shares~~disclosure, inwe used the $22.77 arithmetic average of Cisco’s share ~~public~~closing ~~market,~~price ~~subject~~during toour ~~certain~~second ~~contingencies~~fiscal ~~relating~~quarter to ~~continuation~~determine ofthe hypothetical ~~employment~~value ~~and~~of ~~prevailing~~the ~~stock~~borrowing ~~price.~~fees ~~This~~assuming ~~plan~~the isloans ~~effective~~are ~~from~~settled ~~January 1, 2004~~in ~~through December 31, 2004~~2010.

~~Mr. Pratt has informed us that he intends to exercise options covering up to~~26 20,000 shares of stock per quarter and to sell the resulting shares in the public market, subject to certain contingencies relating to continuation of employment and prevailing stock price. This plan is effective from January 1, 2004 through December 31, 2004.

AnnualTable Meeting. Our 2004 Annual Meeting of Stockholders is currently scheduled for May 20, 2004. Contents

~~Item 6.~~Based ~~Exhibits~~on past performance and ~~Reports~~current onexpectations, ~~Form~~we believe that our cash and cash equivalents, marketable securities and cash generated from operating and financing activities will be adequate to support our financial resource needs, working capital and capital expenditure requirements, and operating lease obligations, for at least the next 12 ~~8-K~~months.

~~(a)~~Off-Balance Sheet Arrangements

Exhibit No.		Description
31		Certifications.
32		Furnished Statements of the Chief Executive Officer and Chief Financial Officer Under 18 U.S.C. Section 1350.

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.

~~(b) One~~Risk ~~Current~~Factors ~~Report~~That onMight ~~Form 8-K~~Affect ~~was~~Future ~~furnished~~Operating onResults ~~October 21,~~and ~~2003~~Financial ~~reporting~~Condition ~~the issuance of a press release announcing third quarter 2003 financial~~ ~~results.~~

26You should carefully consider the following risk factors and the other information included in this Quarterly Report on Form 10-Q before investing in our common stock. Our business and results of operations could be seriously impaired by any of the following risks. The trading price of our common stock could decline due to any of these risks and investors could lose part or all of their investment. In addition, if our pending merger with Tellabs is completed, the combined company will face additional risks. For information about these risks, refer to the Form S-4 registration statement filed with the SEC by Tellabs (SEC File No. 333-116794), including the disclosures under the heading “Risk Factors.” Listed below are risk factors specific to AFC.

~~Table~~Risks ofrelated ~~Contents~~to the pending merger transaction:

~~SIGNATURE~~The value of Tellabs shares to be received by our stockholders will fluctuate.

~~Pursuant~~Upon toconsummation of the ~~requirements~~merger, each share of our common stock will be converted into the ~~Securities~~right ~~Exchange~~to ~~Act~~receive 1.55 shares of ~~1934,~~Tellabs ~~the~~common stock and ~~Registrant~~$7.00 ~~has~~in ~~duly~~cash, ~~caused~~without ~~this~~interest. ~~report~~The number of shares of Tellabs common stock to be ~~signed~~issued onpursuant to the merger for each share of our common stock is fixed. The market price of Tellabs common stock when the merger is completed may fluctuate significantly from its ~~behalf~~market byprice at the date of the joint ~~undersigned~~proxy ~~thereunto~~statement/ ~~duly~~prospectus ~~authorized~~and at the date of the special meetings of Tellabs and AFC. Future fluctuations in the price of Tellabs common stock may be the result of various factors, including:

	ADVANCED FIBRE COMMUNICATIONS, INC.
Date: November 7, 2003		By:	/s/ Keith E. Pratt
		Name:	Keith E. Pratt
		Title:	Senior Vice President,
			Chief Financial Officer,
			and Assistant Secretary
			(Duly Authorized Signatory and
			Principal Financial Officer)

•		Changes in the business, operations or prospects of Tellabs or AFC;

•		General market and economic conditions; and

•		Litigation and/or regulatory developments.

27Many of these factors are beyond Tellabs’ control. The merger may not be completed until a significant period of time has passed after the Tellabs and AFC special meetings. At the time of their respective special meetings, Tellabs and AFC stockholders will not know the exact market value of the Tellabs common stock that will be issued in connection with the merger. The value of the merger consideration to be received by AFC stockholders will fluctuate with changes in the price of Tellabs common stock. We urge our stockholders to obtain current market quotations for Tellabs and AFC common stock.

~~Table~~Tellabs ofand ~~Contents~~AFC will incur significant transaction and merger-related integration costs in connection with the merger.

~~Index~~Tellabs and AFC expect to incur costs associated with consummating the merger and integrating the operations of ~~Exhibits~~the two companies, as well as $23.8 million in transaction fees. The estimated $10.3 million of transaction costs incurred by Tellabs will be included as a component of the purchase price for purposes of purchase accounting. The amount of transaction fees expected to be incurred is a preliminary estimate and subject to change. Tellabs is in the early stages of assessing the magnitude of the integration costs that will be required and, therefore, is unable to provide an estimate of these costs at this time. Additional unanticipated costs may be incurred in the integration of the businesses of Tellabs and AFC. Although Tellabs and AFC expect that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, may offset incremental transaction, merger-related costs over time, we cannot give any assurance that this net benefit will be achieved in the near term, or at all.

Exhibit Number		Document Description
31		CERTIFICATIONS.
32		STATEMENT OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER UNDER 18 U.S.C. SECTION 1350.

28 Table of Contents

We will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees and customers may have an adverse effect on AFC and consequently on the combined company. These uncertainties may impair our ability to attract, retain and motivate key personnel until the merger is consummated, and could cause customers, distributors and others that deal with us to defer purchases or other decisions concerning AFC, or to seek to change existing business relationships with us. Employee retention may be particularly challenging during the pendency of the merger, as employees may experience uncertainty about their future roles with the combined company. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the combined company, the combined company’s business could be seriously harmed. In addition, the merger agreement restricts us from making certain acquisitions and taking other specified actions until the merger occurs or the merger agreement terminates. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger or termination of the merger agreement. See the section titled “The Merger Agreement — Covenants” of Tellabs’ Form S-4 for a description of the restrictive covenants applicable to AFC.

Failure to complete the merger will subject us to financial risks and could cause our stock price to decline.

If the merger is not completed for any reason, we will be subject to a number of material risks, including:

•		Under the merger agreement, we could be required to pay Tellabs up to $10 million as reimbursement of expenses relating to the merger, and a termination fee of $57.6 million if either party terminates the merger agreement where the AFC board of directors has withdrawn, qualified, amended or modified its recommendation of the merger adversely to Tellabs or if we sign a letter of intent, agreement in principle, acquisition agreement or similar agreement for or consummate another acquisition transaction within 12 months of the termination. These fees could deter another interested party from seeking to negotiate such a transaction with AFC after termination;

•		As a result of investors’ expectations regarding the merger, our stock price may decline to the extent that our shares are trading at a higher level than they might have been in the absence of the merger;

•		Customers, suppliers and others may believe that we cannot compete effectively in the marketplace without the merger;

•		Costs related to the merger, such as legal and accounting fees and a portion of our investment banking fees, must be paid even if the merger is not completed;

•		The benefits that we expect to realize from the merger would not be realized, and we may have foregone attractive business opportunities as a result of the covenants in the merger agreement; and

•		The diversion of management attention and the possible disruption of our relationships with employees, customers and other business partners between the signing of the merger agreement and its termination, may make it difficult for our company to regain its financial and market position if the merger does not occur.

Risks related to AFC’s business and results of operations:

A number of factors could cause our operating results to fluctuate significantly and cause volatility in our stock price.

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate in the future due to a variety of factors, many of which are outside our control. These factors include, but are not limited to:

•		Telecommunications market conditions and general economic conditions;

•		The level of capital spending and financial strength of our customers;

•		Changes in revenues, cost of revenues and gross margins resulting from changes in our sales and distribution mix;

•		Changes in revenues, cost of revenues and gross margins resulting from variations in the mix of products sold;

•		Our ability to successfully introduce new technologies and products ahead of our competitors;

•		Introductions or announcements of new products by our competitors;

•		The timing, size and mix of the orders we receive;

•		Adequacy of supplies for key components and assemblies;

•		Financial strength of our customers and vendors;

•		Our ability to effectively and efficiently produce and ship orders promptly on a price-competitive basis;

•		Our ability to accurately forecast and execute our strategy and operating plans;

•		Our ability to integrate and operate acquired businesses and technologies; and

•		Changes in accounting rules, such as expensing employee stock option grants.

Any of these factors could result in a significant negative impact on our operating results. Volatility in the price of our common stock may occur as the result of operating results not meeting the expectations of the investment community. In such event, the market price of our common stock could significantly decline. A significant market price decline could result in litigation. Litigation could be costly, lengthy and divert management’s attention and resources from our core business operations.

We rely on a limited number of customers for a substantial portion of our revenues. If we lose one or more of our significant customers or experience a decrease in the level of sales to any of these customers, our revenues and net income could decline.

BellSouth, Sprint and Verizon accounted for 31.6%, 23.4% and 12.3%, respectively, of revenues in the three months ended June 30, 2004. Sprint and Alltel accounted for 32.9% and 14.1%, respectively, of revenues in the three months ended June 30, 2003. Sprint and BellSouth accounted for 25% and 24.6%, respectively, of revenues in the six months ended June 30, 2004. Sprint and Alltel accounted for 31.8% and 13.3%, respectively, of revenues in the six months ended June 30, 2003. No other customer accounted for 10% or more of revenues in any of these periods.

Sales to our five largest customers accounted for 71% of revenues in the six months ended June 30, 2004, an increase from 62% in the same period a year ago. We anticipate that results of operations in any given period will continue to depend to a great extent on sales to a small number of large accounts. This dependence may increase due to our strategy of growing several large accounts. There can be no assurance that significant existing customers will continue to purchase products from us at current levels, if at all. In the event that a significant existing customer merges with another company, there can be no assurance that such customer will continue to purchase our products. The loss of one or more significant existing customers or a decrease in the level of purchases from these customers could result in a decrease in revenues and net income, an increase in excess and obsolete inventory, and increase our dependency on our remaining significant customers.

In mid June 2004 Verizon informed us that it believes our failure to deliver product features by specified milestone dates, for which we paid PCPs of $2 million to Verizon in the three months ended March 31, 2004, and our failure to subsequently deliver some of these product features in accordance with our corrective plans, constitute a default and a breach of our obligations under our agreement with Verizon. Verizon has reserved all of its legal rights and remedies under the agreement, which includes termination of the agreement without the required advance notice. We believe that the FTTP project with Verizon is still intact and note that Verizon has continued to order a range of products, including FTTP systems, following its notice of default. We also failed to timely meet an additional product release milestone on June 30, 2004 (which Verizon anticipated in its mid June letter to us) for which we have accrued a $1 million PCP payment to Verizon.

Sprint and Alltel are distribution subsidiaries of Sprint Corporation and Alltel Corporation, respectively. These subsidiaries distribute our products to their respective affiliates for deployment in their own networks and resell our products to third party IOC customers. Historically, we believe that products representing approximately 20% to 40% of our sales to Sprint and Alltel have been sold to IOC customers.

Significant portions of our revenues are generated through sales of the AccessMAX family of products and a decline in demand for these products would result in decreases in revenues and net income.

Significant portions of our revenues are derived from our AccessMAX product family. Any decrease in market demand for AccessMAX products would result in decreased revenues and lower net income. Factors that could

affect demand for our products include price competition, regulatory uncertainty, technological change and new product introductions or announcements by our competitors.

Recent and future acquisitions may compromise our operations and financial results.

We recently completed the acquisition of NAA. We have limited experience in acquiring and integrating companies. The merger agreement with Tellabs currently restricts AFC from pursuing additional acquisitions of companies, products and technologies, which in the past has been, and may in the future be, part of our efforts to enhance our existing product solutions, introduce new product solutions and fulfill changing customer requirements.

Acquisitions could adversely affect our operating results in the short-term. The NAA acquisition, and acquisitions in general, involve numerous risks including disruption of our business, exposure to unknown liabilities of the acquired company, and failure to successfully integrate the operations, products, technologies or personnel of the acquired company. We may not realize the anticipated benefits of our acquisition of NAA, such as increased market share and sales or successful development and market acceptance of new products. The acquired products and technologies in the NAA acquisition for example, or in other future acquisitions, may not result in sufficient revenues to offset the expenses associated with the acquisition.

Goodwill arising from acquisitions may become impaired and result in significant impairment write downs charged to our operating results. As of June 30, 2004, we had $189.6 million in goodwill related to the acquisitions of NAA in February 2004 and AccessLan in 2002. The effect of an impairment write down could harm our business, financial condition and results of operations.

We operate in a rapidly changing competitive and economic environment. If we are unable to adapt quickly to these changes, our business and results of operations could be seriously harmed.

The telecommunications equipment market is characterized by rapid change and converging technology, the full scope and nature of which is difficult to predict. We believe that technological and regulatory change will continue to attract new entrants to the access market. Industry consolidation among our competitors may increase their financial resources, enabling them to reduce their prices. This could require us to either reduce our product prices or risk losing market share. Moreover, industry consolidation may result in stronger competitors that are better able to compete as sole-source suppliers for their customers.

Some of our competitors have broader product portfolios and market share, and may not be as susceptible to downturns in the telecommunications industry. These competitors’ offerings compete directly with our product solutions and provide comprehensive ranges of other products.

Our principal established competitors include Alcatel and Lucent. Some of our competitors enjoy superior name recognition in the market or have more extensive financial, marketing and technical resources than we do. We expect to face increased competition with our established and newly launched product solutions, from both established and emerging competitors.

Continued growth in the access market is highly dependent on a strong level of capital investments in broadband access solutions and a positive regulatory environment for larger ILEC customers. Future reductions in capital expenditures by companies in the telecommunications industry, including some of our customers, could seriously harm our revenues, net income and cash flows.

Our revenues depend on the capital spending programs and financial capabilities of our customers and ultimately on the demand for new telecommunications services from end users.

Our customers are public carriers and, in the U.S., include ILECs, IOCs and RBOCs. Our ability to generate future revenues depends upon the capital spending patterns and financial capabilities of our customers, continued demand by our customers for our product solutions and services, and end user demand for advanced telecommunications services. The financial problems affecting the telecommunications industry in general could continue to cause a slowdown in our sales and result in slower payments or in customer payment defaults. Further, there can be no

assurance that carriers, foreign governments or other customers will pursue infrastructure upgrades that will necessitate the implementation of advanced product solutions such as ours. Infrastructure improvements may be delayed or prevented by a variety of factors including cost, regulatory obstacles, the lack of consumer demand for advanced telecommunications services and alternative approaches to service delivery. The economic slowdown impacting the telecommunications industry has affected customers’ capital spending patterns for deploying new services and we cannot provide assurance as to when, or if, capital spending will improve.

Failure to develop and introduce new product solutions that meet changing customer requirements and address technological advances would limit our future revenues.

The telecommunications equipment market is characterized by rapidly changing technology, changes in end user requirements, and frequent new product introductions and enhancements. Our success will depend upon our ability to accurately forecast market trends, enhance our product solutions through the timely development of new technology, develop and introduce new feature enhancements, and implement ongoing cost reductions. We must commit significant resources to develop new product solutions before knowing whether our investments will result in solutions the market will accept. Market acceptance of our product solutions may be significantly reduced or delayed if we fail or are late to respond to new technological developments, or if we experience delays in product development.

The introduction of products embodying new technologies or the emergence of new industry standards can render our existing products obsolete or unmarketable. Competitors’ new products, product enhancements, services or technologies that replace or shorten the life cycle of our products could impair the competitiveness of our product solutions.

Our future operating results will be impacted by whether new products and solutions, including AdvancedVoice, AFC FiberDirect, TelcoVideo and UniversalDSL, are widely deployed by operators, the actual timing and quantity of orders for our solutions, growth in demand for broadband services, and our ability to gain market share and experience growth. In January 2004, we signed a multiyear agreement with Verizon, to be the primary FTTP project vendor in providing the central office and premises electronics, also known as the active elements of FTTP technology. We are incurring costs and expenses associated with preparation for the deployment of our FTTP systems and we are generating revenues from the FTTP systems. Our revenues and expenses are affected by the degree to which Verizon invests in FTTP systems and the timing of any such investment.

The FTTP systems are comprised of various components. Our revenue and profitability are affected by the timing and mix of components in the deployment of FTTP systems under the Verizon contract. As part of our agreement with Verizon, we recognized that one component of the FTTP systems, the Single Family ONT, would be sold at a negative gross profit margin to Verizon until volume increases and unit cost declines. A Single Family ONT is deployed at a residence as a network interface device for connecting fiber to services in the home. We have an active remediation program in place to address the profitability of the ONT component. The other components of the FTTP systems are also expected to sell at a profit to customers, including Verizon.

Further, we have failed to meet various key development milestones in a timely manner under our agreement with Verizon for which we have paid or accrued a total of $3 million in penalties in the six months ended June 30, 2004. These penalty payments are accounted as a corresponding reduction in revenue in the quarter they are incurred. Our future revenues, gross profit and net income will be affected by the degree to which Verizon invests in FTTP systems, the mix of products ordered, the timing of any such investment and our ability to meet key development milestones and avoid penalty payments under our agreement.

We may be unable to secure necessary components and support because we depend upon a limited number of third party manufacturers and support organizations, and in some cases we rely upon sole or limited-source suppliers.

Our growth and ability to meet customer demands are dependent on our ability to obtain timely deliveries of components from our suppliers. We currently purchase certain key components from sole or limited-source vendors. Most of our component purchases are on a purchase order basis without guaranteed supply arrangements.

Some of our sole and limited-source vendors allocate parts to multiple telecommunications equipment manufacturers based on market demand for components and equipment. This may result in shortages of certain key components sold to us. In the event of a disruption in supply, we may not be able to identify an alternative source in a timely manner, at favorable prices or of acceptable quality. Such a failure could limit our ability to meet scheduled deliveries to our customers and increase our expenses. This could reduce our gross profit margin and net income. For example, during the three months ended June 30, 2004, a shortage of components used in the manufacture of our FTTP system negatively impacted our ability to ship product and recognize revenue.

We have purchase agreements with contract manufacturers, or CMs, which allow us to negotiate volume discounts and help assure us of a steady supply of components. The agreements require the CMs to purchase component parts to be used in manufacturing our products and authorize them to make purchases in accordance with agreed upon lead times. We provide CMs with forecasts of our expected needs and we issue purchase orders covering a certain period of time for specific quantities. As customers increasingly demand shorter delivery timeframes, the difficulty of accurately forecasting component mix and quantity needs creates additional risk. If we overestimate our requirements, the CMs may assess cancellation penalties or we may have excess or obsolete inventory. If we underestimate our requirements, the CMs may have inadequate inventory, which could interrupt manufacturing of our products. Both situations could reduce our gross profit margin and net income.

We cannot be assured that CMs will allocate sufficient resources to the timely completion of our orders in accordance with our quality standards. Qualifying a new CM is costly and time consuming and could result in significant interruptions in the supply of our products.

We may be unable to sell customer-specific inventory, which could result in lower gross profit margins and net income.

Some of our customers’ order specifications require us to design and build systems and purchase parts that are unique to a customer. In many cases, we forecast and purchase components in advance and allocate resources to design and manufacture the systems. If our customers’ requirements change or if we experience delays or cancellation of orders, we may be unable to cost-effectively rework system configurations or return parts to inventory as available-for-sale. Write downs and accruals for unrealizable inventory negatively impact our gross profit margins and net income.

Failure or inability to protect our intellectual property would adversely affect our ability to compete, which could result in decreased revenues.

We seek to protect our technology through a combination of copyrights, trademarks, trade secret laws, contractual obligations and patents. These intellectual property protection measures may not be sufficient to prevent wrongful misappropriation of our technology. These measures will not prevent competitors from independently developing technologies that are substantially equivalent or superior to our technology. The laws of many foreign countries do not protect our intellectual property rights to the same extent as the laws of the U.S. Failure or inability to protect proprietary information could result in loss of our competitive advantage, loss of customer orders and decreased revenues. Furthermore, policing the unauthorized use of our products is difficult. Litigation may be necessary in the future to enforce our intellectual property rights. Litigation could result in substantial costs and diversion of management resources, while not guaranteeing a successful result.

We may be subject to intellectual property infringement claims that are costly and time consuming to defend and could limit our ability to use some technologies in the future.

We have been subject to several intellectual property disputes in the past, and due to the intensely competitive nature of our industry, we expect to continue being subject to infringement claims and other intellectual property disputes. As a result, we may be subject to additional litigation and may be required to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Litigation could be expensive, lengthy and divert management’s attention and resources from core business operations. Adverse determinations could result in the loss of our proprietary rights, or prevent us from manufacturing or selling our products. They may also subject us to significant liabilities and require that we seek licenses from third parties. In such case, we cannot be assured that licenses will be available on commercially

reasonable terms, if at all, from any third party that asserts intellectual property claims against us. Any inability to obtain third party licenses required to develop new products or product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, any of which could seriously impair our competitiveness.

We must attract, retain and motivate key technical and management personnel in order to sustain or grow our business.

Our success depends in large part on our ability to attract and retain key technical and management personnel. Despite the economic slowdown, competition for some specific skill sets remains intense. The process of identifying and attracting key employees is often a lengthy and costly process. Our key employees generally do not have employment agreements. The Financial Accounting Standards Board’s exposure draft to expense stock options could adversely affect our policy of issuing stock options to all employees. This could have a direct effect on our ability to retain key employees. There can be no assurance that we will succeed in retaining key employees. We expect continued challenges in recruiting, assimilating, motivating and retaining the key technical and management personnel necessary to effectively manage our operations.

Our products are complex and may contain undetected errors that could result in significant unexpected expenses.

Our products are complex, and despite extensive testing, may contain undetected defects or errors. These issues may only become apparent after products are shipped, when product features are introduced or as new versions are released. The occurrence of any defects, errors or failures could result in delays or cancellation of orders, product returns, warranty costs or legal actions by our customers or our customers’ end users. Any of these issues could reduce revenues, gross profit margin and net income.

We are subject to numerous and changing regulations and industry standards. If our products do not meet these regulations or are not compatible with these standards, our ability to sell our products could be seriously harmed.

Our products must comply with a significant number of voice and data regulations and standards, which vary between U.S. and international markets. Our ability to sell products would be impaired if we fail to ensure our systems are compliant with evolving standards and regulations in a timely manner. Testing to ensure compliance and interoperability requires significant investments of time and money. Additionally, our selling ability would be impaired if we fail to obtain compliance on new features or fail to maintain interoperability with equipment from other companies. As a result, we could experience customer contract penalties, delayed or lost customer orders, decreased revenues and reduced net income.

In our work with large customers such as RBOCs, our agreements may contain provisions for PCPs that are tied to key milestones related to the availability of product releases containing certain product features. Completion of such milestones requires timely and successful R&D efforts, and on converting the results of those R&D efforts into usable, cost effective products. R&D efforts involve large and complicated projects, which rely in part on the work of third parties over which we have limited control, and on which there can be no assurance of success. For example, our agreement with Verizon to provide FTTP systems has several provisions requiring PCPs for failure to meet key milestones or provide product features by specified dates. While we have met a number of these milestones on time, we have also failed to meet some milestones. We have paid or accrued a total of $3 million in PCPs to Verizon for two milestones and offset the cash payment and accrual against revenue during the six months ended June 30, 2004. We could experience an offset to revenues and reduced net income in future quarters due to penalties imposed under such agreements as a result of failures to comply with strict contractual terms.

We have maintained compliance with ISO 9001 since we were first certified in 1997, and TL 9000 since we were first certified for hardware, software and services in 2000. TL 9000 contains all ISO 9001 requirements as well as other telecommunications industry requirements. There can be no assurance that we will maintain these certifications. The failure to maintain TL 9000 certification may adversely impair the competitiveness of our products.

Government actions will continue to have a direct impact on the telecommunications industry and our business. From a regulatory standpoint, we believe the Federal Communications Commission’s, or FCC’s, Triennial Review Order encourages long-term investment in broadband networks and migration to FTTP-based services by reducing the incumbent carriers’ unbundling obligations for broadband facilities, and the Court of Appeals upheld those portions of the FCC’s Order. The FCC, moreover, currently has before it requests for reconsideration that we believe would further enhance incentives to invest in FTTC and Fiber-to-Multi-Dwelling-Units. The 1996 Telecommunications Act imposed additional regulations that affect telecommunications services, including changes to pricing, access by competitive vendors and other broad changes to data and telecommunications networks and services. These changes have had a major impact on the pricing and availability of services, and may affect the deployment of future services. There can be no assurance that any future legislative and regulatory changes will not have a material adverse effect on our products’ competitiveness. Moreover, uncertainty regarding future legislation and governmental policies combined with emerging new competition may also affect the demand for our product solutions.

We face risks associated with international markets and distribution channels.

International sales accounted for 11% and 15% of our revenues in the six months ended June 30, 2004 and 2003, respectively. International sales have fluctuated in absolute dollars and are expected to continue to fluctuate in future periods.

Access to international markets is often difficult to achieve due to trade barriers and established relationships between government-owned or government-controlled carriers and traditional local equipment vendors. We rely on a number of third party distributors and sales representatives to market and sell our products outside of the U.S. There can be no assurance that third party distributors or sales representatives will provide the support and effort necessary to effectively service our international markets. In some cases, our gross profit margins have been lower for sales through third party and indirect distribution channels than for sales through our direct sales efforts. Increased sales through our third party and indirect distribution channels could reduce our overall gross profit margin and net income.

Although we have attempted to minimize our exposure to taxation in foreign countries, any income or other taxes imposed may increase our overall effective tax rate, thereby adversely impacting our competitiveness in those countries. We currently intend that any earnings of our foreign subsidiaries remain permanently invested in these entities to facilitate the potential expansion of our business. Our cash flows could be adversely affected to the extent that these earnings are actually or deemed repatriated, resulting in the imposition of additional U.S. federal and state income taxes.

We must comply with various country-specific standards and regulations to compete in international markets. Our product solutions may be incompatible with the legacy infrastructure of some international markets. If our existing international customers adopt network standards incompatible with those supported by our product solutions, we could experience a loss of revenues and lowered net income. Any inability to obtain or maintain local regulatory approval could delay or prevent entrance into certain markets. These factors could result in delays or loss of customer orders, decreased revenues and lower net income.

Economic risks that may impact our international sales include the inability to collect receivables from customers due to a country’s economic collapse and resulting currency exchange controls. This would negatively impact our cash flow and result in receivable write-offs.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We have a Cisco shares liability for 10.6 million shares of Cisco common stock borrowed and outstanding at June 30, 2004. The following table shows the changes in fair value of the Cisco shares liability arising from a hypothetical 20% increase or decrease in Cisco’s stock price. Based on the $23.43 closing price at June 25, 2004, the last trading day of our second fiscal quarter, the amounts were (in thousands):


	Valuation -20%		No change		Valuation +20%
Cisco shares liability	$	197,925	$	247,407	$	296,888

We have a Cisco shares asset for 10.6 million shares of Cisco common stock as of June 30, 2004. The following table shows the changes in fair value of the Cisco shares arising from a hypothetical 20% increase or decrease in Cisco’s stock price. Based on the $23.43 closing price at June 25, 2004, the amounts were (in thousands):


	Valuation -20%		No change		Valuation +20%
Cisco shares asset	$	197,925	$	247,407	$	296,888

We have foreign currency sales to two international customers. When circumstances warrant, we hedge foreign currency risk on certain accounts receivable and accounts payable with forward contracts that generally expire within 60 days. These forward currency contracts are not designated as hedges and changes in the fair value of the forward contracts are recognized immediately in earnings.

At June 30, 2004, we held a $3.3 million investment in a privately held company. The investment represents 2% ownership of the company on a fully diluted basis. The company designs and manufactures telecommunications equipment. We began investing in the company in 1999. We maintain this investment on a cost basis and do not have the ability to exercise significant influence over the company’s operations. Our investment carries risk because the products of this company have been in general release for a limited time. This company is also subject to risks resulting from uncertain standards for new products and competition. If these products fail to generate customer interest, the value of the company would likely decline and could result in impairment of our investment. Additionally, macroeconomic conditions and an industry capital spending slowdown are affecting the availability of venture capital funding, and the valuations of private companies. We could lose our entire investment in this company and be required to record a charge to operations for any loss. Our ability to earn a return on this investment is largely dependent on the occurrence of an initial public offering, merger, or sale of the company.

At June 30, 2004, we held a $2 million investment in a privately held company. The investment represents 7% ownership of the company on a fully diluted basis. The company is a supplier of optical components. We maintain this investment on a cost basis and do not have the ability to exercise significant influence over the company’s operations. Our investment carries risk because the products of this company are specialized and have a limited market. We could lose our entire investment in this company and be required to record a charge to operations for any loss. Our ability to earn a return on this investment is largely dependent on the occurrence of an initial public offering, merger, or sale of the company.

Item 4. Controls and Procedures

AFC maintains “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, or the Exchange Act. These disclosure controls and procedures are designed to ensure that information required to be disclosed by AFC in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. They are also designed to ensure that such information is accumulated and communicated to AFC’s management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating AFC’s disclosure controls and procedures, we recognized that no matter how well conceived and operated, disclosure controls and procedures can provide only reasonable, not absolute, assurance that their objectives are met. Additionally, we evaluated the cost-benefit relationship in the design of our disclosure controls and procedures. Their design is also

based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Subject to the limitations noted above, our management, with the participation of our CEO and CFO, has evaluated the effectiveness of the design and operation of AFC’s disclosure controls and procedures as of the end of the fiscal quarter covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the CEO and CFO have concluded that AFC’s disclosure controls and procedures were effective to meet the objectives for which they were designed.

There were no changes in our internal control over financial reporting identified in connection with the foregoing evaluation that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On June 1, 2004, a complaint was filed on behalf of a putative class of AFC stockholders against AFC, certain of its current officers and directors, and Tellabs, in the Court of Chancery in the State of Delaware in and for New Castle County. The complaint alleges that the individual defendants breached their fiduciary duties to AFC’s public stockholders by acting to cause or facilitate the merger of Tellabs and AFC for inadequate consideration, and that each of the defendants, including AFC and Tellabs, acted to aid and abet the alleged breaches of fiduciary duty. In particular, plaintiff alleges that the merger consideration for AFC’s public stockholders is unfair and inadequate because, according to the plaintiff, “(a) the intrinsic value of the stock of AFC is materially in excess of the $21.24 per share being proposed, giving due consideration to the possibilities of growth and profitability of AFC in light of its business, earnings and earnings power, present and future; (b) the $21.24 per share price is inadequate and offers an inadequate premium to the public shareholders of AFC; and (c) the $21.24 per share price is not the result of any structure[d] auction process by which AFC sought to obtain the best deal possible for its shareholders.” The plaintiff seeks to enjoin the merger, and if the merger is consummated, to rescind the transaction. The plaintiff also asserts claims for unspecified compensatory and/or rescissory damages, and an award of costs, including attorneys’ fees. AFC believes that these claims are without merit and intends to vigorously defend itself in this action.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

There were no changes in securities or use of proceeds. During the three months ended June 30, 2004, AFC did not repurchase any of its equity securities.

Item 3. Defaults Upon Senior Securities

Not applicable

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

Our 2004 Annual Meeting of Stockholders was held on May 20, 2004. The stockholders voted upon the following matters:

•		Election of three Class II Directors: Ruann F. Ernst, Frank Ianna and John A. Schofield were elected to serve terms continuing through the third Annual Meeting of Stockholders following their election, or their earlier resignation or removal. The result of the voting was as follows: 78,340,898 shares in favor of Ruann F. Ernst, with 1,895,870 shares withheld, 78,679,598 shares in favor of Frank Ianna, with 1,557,170 shares withheld, and 78,328,849 shares in favor of John A. Schofield, with 1,907,919 shares withheld. The terms of office of Dan Rasdal and Martin R. Klitten continue until the 2005 Annual Meeting of Stockholders, and the terms of office of Clifford H. Higgerson and William L. Keever continue until the 2006 Annual Meeting of Stockholders.

•		Ratification of the selection of KPMG LLP as independent public accountants for AFC for the fiscal year ending December 31, 2004. The result of the vote was 79,428,490 shares in favor, 699,778 shares against, and 108,500 shares abstaining.

Item 5. Other Information

Not applicable

Item 6. Exhibits and Reports on Form 8-K

(a)


Exhibit No.		Description
31		Certifications.

32		Furnished Statements of the Chief Executive Officer and Chief Financial Officer Under 18 U.S.C. Section 1350.

(b) Current Reports on Form 8-K were furnished or filed with the SEC on:

•		April 28, 2004 reporting, under Item 12 of Form 8-K, the issuance of a press release announcing the financial results of the first quarter ended March 31, 2004;

•		May 20, 2004 reporting, under Item 5 of Form 8-K, the issuance of a joint press release with Tellabs announcing the execution of an Agreement and Plan of Merger, dated as of May 19, 2004 among Tellabs, Chardonnay Merger Corp. a Delaware corporation and a wholly owned subsidiary of Tellabs and AFC, and the amendment to its Rights Agreement, dated May 13, 1998, as amended, in connection with the execution of the Agreement and Plan of Merger; and

•		June 3, 2004 reporting, under Item 5 of Form 8-K, the receipt of a copy of complaint filed by a purported stockholder against AFC, its current directors and Tellabs, Inc. regarding the proposed merger between Tellabs and AFC.

SIGNATURE

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.


	ADVANCED FIBRE COMMUNICATIONS, INC.


Date: August 4, 2004	By:	/s/ Keith E. Pratt

	Name:	Keith E. Pratt
	Title:	Chief Financial Officer, Senior Vice President, Finance and Administration and Assistant Secretary (Duly Authorized Signatory and Principal Financial Officer)

Index of Exhibits


Exhibit No.		Description
31		Certifications.

32		Statements of Chief Executive Officer and Chief Financial Officer Under 18 U.S.C. Section 1350.

Filing Compare · ADVANCED FIBRE COMMUNICATIONS INC