Form 10-Q

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 No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act:

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

As of November 9, 2006, 33,915,171 shares of the Registrant’s common stock, par value $0.001 per share, were issued and outstanding.

The accompanying notes are an integral part of these condensed consolidated financial statements.

The Company designs, develops, and sells digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals over their networks. The Company also offers video processing systems that enable private enterprise and government entities to transport video signals over satellite, fiber, radio, or copper networks for surveillance, distance learning, and TV production applications. Additionally, the Company designs, develops and markets private broadband network products that enable the provisioning of high speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

In November 2002, the Company acquired VideoTele.com, referred to in this report as VTC, from Tektronix, Inc. to extend its product offerings to include digital video processing systems. On June 1, 2005, the Company acquired Copper Mountain Networks, Inc., referred to in this report as Copper Mountain, for its additional product and engineering resources to further address the Company’s expanding video market opportunities. Video-based products now represent a majority of the Company’s sales.

Since January 1, 2006 the Company has continued to incur operating losses and negative cash flows from operating activities aggregating $9,076 and $12,850, respectively, for the nine months ended September 30, 2006. These losses were primarily attributed to revenue shortfalls compared to the Company’s 2006 Plan. In addition, the Company has relatively limited liquidity alternatives available to it. On August 23, 2006, the Company sold $7 million of 8% convertible notes. However, even after this debt offering the Company remains cash constrained. As of September 30, 2006, the Company had $2,437 of remaining borrowing capacity under its secured line of credit, which expires September 23, 2007.

The Company is continuing its efforts to increase liquidity, including collecting receivables, and decreasing inventories. The Company also continues to actively pursue additional revenue opportunities. Revenue opportunities for its video processing systems include potential expansion of the number of its local and international telephone customers, upgrade existing customers to current product offerings, and expand its customer base to include large, tier-one telephone companies. Revenue opportunities for its broadband transport and service management products include potential sales of recently upgraded product offerings to new and existing customers. Additionally, the Company is also exploring other alternatives which may include additional financing, strategic alliances, acquisition or merger.

The Company cannot provide any assurance that it will accomplish such operational or strategic actions and if it is unable to do so, it may not be able to achieve its currently contemplated business objectives, or the timing in reaching those objectives may be delayed.

The accompanying condensed consolidated financial statements as of December 31, 2005 and September 30, 2006 and for the three and nine months ended September 30, 2005 and 2006 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements, except for the adoption of Statement of Financial Accounting Standard No. 123R, “Share-Based Payment (Revised 2004)” (SFAS No. 123R) on January 1, 2006, as described in Note 12 - Stock Based Compensation. In the opinion of management, the unaudited interim condensed consolidated financial statements, reflect all adjustments, which include only normal recurring adjustments, necessary to state fairly the Company’s financial position as of December 31, 2005 and September 30, 2006, its results of operations for the three and nine months ended September 30, 2005 and 2006 and its cash flows for the nine months ended September 30, 2005 and 2006. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the Company’s audited financial statements included in the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 5, 2006 which supercedes the audited financial statements included in the Company’s Annual Report on Form 10-K. The balance sheet as of December 31, 2005 was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. The results for the three and nine months ended September 30, 2006 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2006.

The Company generates revenue from the sale of hardware products, including third-party products, through professional services, and through the sale of its software products. The Company sells products through direct sales channels and through distributors. Generally, the Company generates revenue from the sale of video processing systems and components and the sale of private broadband network products.

The Company generates revenue primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support.

The Company also generates revenue from the sale of video processing component products, the sale of private broadband network products, and the sale of certain legacy products acquired with the Copper Mountain merger. The Company sells these products through its own direct sales channels and also through distributors.

The Company’s revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2, and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

In the case of software arrangements which require significant production, modification or customization of software, which encompasses all of the Company’s turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The Company recognizes revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the post contract support (or PCS) element, for which the Company has established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of- completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value of the arrangement prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. In connection with certain contracts, the Company may perform the work prior to when the revenue is billable pursuant to the contract. The termination clauses in most of the Company’s contracts provide for the payment for the fair value of products delivered and services performed in the event of an early termination. In connection with certain of the Company’s contracts, it has recorded unbilled receivables consisting of costs and estimated profit in excess of billings as of the balance sheet date. Many of the contracts which give rise to unbilled receivables at a given balance sheet date are subject to billings in the subsequent accounting period. Management reviews unbilled receivables and related contract provisions to ensure it is justified in recognizing revenue prior to billing the customer and that we have objective evidence which allows it to recognize such revenue. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

For direct sales of video processing systems component products not included as part of turnkey solutions, direct sale of broadband transport products and service management products and the sales of legacy products acquired with the Copper Mountain merger, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

Management must make significant judgments and estimates in connection with the measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, the Company must also make a judgment regarding collectibility of the arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to the Company’s credit review policy. The Company sells to customers with whom the Company has a history of successful collection and to new customers for which no similar history may exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are increased only after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon the Company’s credit review process, revenue is recognized on a cash-collected basis.

The Company also maintains accruals and allowances for cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. The Company’s products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

Should changes in conditions cause us to determine that the criteria for revenue recognition are not met for certain future transactions, revenue recognition for any reporting period could be adversely affected.

Inventories are stated at the lower of cost or market. Cost is computed using standard cost which approximates actual cost on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than those estimated by the Company, additional inventory provisions may be required.

The Company’s short-term investments are stated at fair value, and are principally comprised of corporate debt securities. The Company classifies its investments as available for sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and carries them at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss). The specific identification method is used to determine the cost of securities disposed of, with realized gains and losses reflected in interest and other income (expense), net. A liquid market exists for these short-term investments.

Unbilled receivables (costs and estimated profit in excess of billings) may be recorded in connection with certain turnkey solution contracts. Unbilled receivables are not billable at the balance sheet date but are recoverable over the remaining life of the contract through billings made in accordance with contractual agreements. Management reviews unbilled receivables and related contract provisions to ensure the Company is justified in recognizing revenue prior to billing the customer and that there is objective evidence which allows the Company to recognize such revenue.

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make payments. These estimated allowances are periodically reviewed and take into account customers’ payment history and information regarding customers’ creditworthiness that is known to the Company. The Company assesses individual accounts receivable over a specific aging and amount. If the financial condition of any of the Company’s customers were to deteriorate, resulting in their inability to make payments, the Company would need to record an additional allowance.

Property and equipment are stated at cost less accumulated depreciation. The Company provides for depreciation by charges to expense which are sufficient to write off the cost of the assets over their estimated useful lives on the straight-line basis. Leasehold improvements are amortized over the lesser of the lease term or the estimated useful life of the improvement. Useful lives by principal classifications are as follows:

When assets are sold or otherwise disposed of, the cost and accumulated depreciation are removed from the asset and accumulated depreciation accounts, respectively. Upon the disposition of property and equipment, the accumulated depreciation is deducted from the original cost and any gain or loss on that sale or disposal is credited or charged to income.

Maintenance, repairs, and minor renewals are charged to expense as incurred. Expenditures which substantially increase an asset’s useful life are capitalized.

Intangible assets are stated at cost less accumulated amortization. Intangible assets consist of completed technology and patents, customer lists, maintenance contract renewals and trademarks. These intangible assets are amortized on a straight line basis over the estimated periods of benefit, which are as follows:

The Company periodically assesses the impairment of long-lived assets. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period and the Company’s market capitalization relative to net book value.

When management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment measured is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Company’s current business model.

During 2005, the Company determined that certain long-lived assets and certain intangible long-lived assets were impaired and recorded losses accordingly under SFAS No. 144. No such impairment was recorded in the nine months ended September 30, 2006. Future events could cause the Company to conclude that impairment indicators once again exist. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

Goodwill represents the excess of the purchase price of an acquired business over the fair value of the identifiable assets acquired and liabilities assumed. Management tests for impairment of goodwill on an annual basis and at any other time if events occur or circumstances change that would indicate that it is more likely than not that the fair value of the reporting unit has been reduced below its carrying amount.

The impairment test for goodwill is a two-step process. Step one consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to the reporting unit. Measurement of the fair value of a reporting unit is based on one or more fair value measures including present value techniques of estimated future cash flows and estimated amounts at which the unit as a whole could be bought or sold in a current transaction between willing parties. If the carrying amount of the reporting unit exceeds the fair value, step two requires the fair value of the reporting unit to be allocated to the underlying assets and liabilities of that reporting unit, resulting in an implied fair value of goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss equal to the excess is recorded in net income (loss).

The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, line of credit, note payable and the convertible senior subordinated promissory notes and related derivatives which are stated at fair value. The carrying amount of certain of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, line of credit and note payable approximate fair value due to the short maturity or market rate structure of those instruments. The fair value of the compound derivatives related to the convertible debt and warrants was determined using the Black Scholes valuation model.

The Company’s derivative financial instruments consist of new and existing warrants and compound derivative instruments related to the $7,000 convertible senior subordinated promissory notes. These compound derivatives include certain conversion features and variable interest features. The accounting treatment of derivatives requires that the Company record the compound derivatives at their relative fair values as of the inception date of the agreement, and as of each subsequent balance sheet date and the warrants at their fair value as of the inception date of the agreement and as of each subsequent balance sheet date. Any change in fair value is recorded as a non-operating, non-cash charge or credit at each reporting date. If the fair value of the derivatives is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives is lower at the subsequent balance sheet date, the Company will record a non-operating, non-cash credit. As of September 30, 2006, the derivatives were valued at $3,509. The compound derivatives and warrants were valued using the Black Scholes valuation model with the following assumptions as of September 30, 2006: dividend yield of 0%; annual volatility of 74.63%; expected life of 3 years and risk free interest rate of 4.49%. The derivatives are classified as current liabilities at September 30, 2006. See Note 10.

Effective January 1, 2006, the Company adopted SFAS No. 123R on a modified prospective basis. As a result, the Company has included stock-based compensation costs in its results of operations for the three and nine months ended September 30, 2006, as more fully described in Note 12.

Certain reclassifications have been made to prior year balances in order to conform to the current year presentation. Amortization of intangible assets relating to completed technology and patents have been reclassified from operating expenses to cost of goods sold. This reclassification did not affect cash flows, financial position or net loss.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108 regarding the process of quantifying financial statement misstatements. SAB No. 108 states that registrants should use both a balance sheet approach and an income statement approach when quantifying and evaluating the materiality of a misstatement. The interpretations in SAB No. 108 contain guidance on correcting errors under the dual approach as well as provide transition guidance for correcting errors. This interpretation does not change the requirements within SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB No. 20 and FASB Statement No. 3,” for the correction of an error on financial statements. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. The Company will be required to adopt this interpretation by December 31, 2006. Management is currently evaluating the requirements of SAB No. 108 and the impact this interpretation may have on our financial statements.

In September 2006, the FASB issued statement No. 157, “Fair Value Measurements” (“SFAS 157”). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company will be required to adopt SFAS No. 157 in the first quarter of fiscal year 2008. Management is currently evaluating the requirements of SFAS No. 157 and has not yet determined the impact on the consolidated financial statements.

In March 2006, the Emerging Issues Task Force reached a consensus on Issue No. 06-03 “How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF No. 06-03”). The Company is required to adopt the provisions of EITF No. 06-03 beginning its fiscal year 2007. The Company does not expect the provisions of EITF No. 06-03 to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding. Options, warrants and restricted stock were not included in the computation of diluted net loss per share because the effect would be antidilutive.

Comprehensive loss includes net loss, unrealized gains and losses on investments, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders’ equity. The following table sets forth the components of comprehensive loss:

At December 31, 2005 and September 30, 2006, cash, cash equivalents and short term investments are summarized as follows:

On June 1, 2005, the Company acquired 100% of the outstanding common stock of Copper Mountain for approximately $11,729. The purchase price consisted of 2,467 shares of the Company’s common stock valued in aggregate at $9,787, warrants to purchase the Company’s common stock valued at $58, acquisition related expenses consisting of legal, insurance and other professional fees of $1,503 and employee severance costs of $351. The value of the Company’s common stock was determined based on the average market price over the two day period before and after the acquisition was announced on February 11, 2005. The results of operations of Copper Mountain have been included in the consolidated statement of operations from June 1, 2005. The Company acquired Copper Mountain for its additional product and engineering resources, which are being refocused to address the Company’s expanding video market opportunities. The Company believes that the acquisition of Copper Mountain is accelerating the Company’s plans to address the growing number of opportunities in the market for video processing systems. During the three and nine months ended September 30, 2006, the Company recognized revenue of $211 and $392, respectively, from the sale of legacy Copper Mountain’s products. The Company will honor Copper Mountain’s existing customer support agreements but does not expect significant future revenue from the sale of Copper Mountain’s historical product lines.

The Company determined the fair value of the acquired intangibles using established valuation techniques. The purchase price of $11,729 exceeded the fair value of the net assets acquired of $10,057, thereby resulting in goodwill of $1,672. The allocation of the purchase price was as follows:

Completed technology and patents are being amortized over a weighted average life of five years. Amortization of $341 and $1,023, respectively, has been included in cost of goods sold for the three and nine months ended September 30, 2006. The goodwill of $1,672 will not be deductible for tax purposes.

The following unaudited pro forma consolidated information gives effect to the acquisition of Copper Mountain as if it had occurred on January 1, 2005 by consolidating the results of operations of Copper Mountain with the results of operations of the Company for the three and nine months ended September 30, 2005.

The aggregate amortization expense for the three months ended September 30, 2005 and 2006 was $447 and $424, respectively and $1,223 and $1,271 for the nine months ended September 30, 2005 and 2006.

On September 23, 2004, the Company entered into a revolving asset based credit facility (“credit facility”), with Silicon Valley Bank (“the Bank”) which was amended on December 29, 2005 and modified in June 2006. This facility expires on September 23, 2007. Borrowings under the credit facility are formula based and limited to the lesser of $10.0 million or an amount based on a percentage of eligible accounts receivable and eligible inventories. The interest rate on outstanding borrowings is equal to the bank’s prime rate, 8.25% as of September 30, 2006, plus 1.75%. The rate may increase by 1.0% if the Company does not meet certain financial covenants. All of the Company’s assets are pledged as collateral and the credit facility contains various covenants. The Company was in compliance with these financial covenants as of September 30, 2006. Based on the maximum percentages of eligible accounts receivable and eligible inventory levels, the Company had $6,691 of available borrowings under this facility as of September 30, 2006. The Company had outstanding borrowings under this facility of $4,254 at September 30, 2006.

As part of the Company’s acquisition of VTC from Tektronix, Inc. in November 2002, the Company issued a note payable to Tektronix, Inc. for $3,232, with repayment in ninety months, or November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest was added to the principal balance of the note. Thereafter, the Company will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in full. As of September 30, 2006, this note payable balance, including accrued interest, was $4,239. The Company paid $66 and $131 of interest in the three and nine months ended September 30, 2006.

In April 2006, the Company announced a restructuring program that included a workforce reduction and closing of the UK office. As a result of this restructuring program, the Company recorded restructuring costs of $359 consisting of severance payments and office closure costs. As of September 30, 2006, there were $11 of costs remaining to be paid in the fourth quarter of 2006.

NOTE 10—CONVERTIBLE SENIOR SUBORDINATED PROMISSORY NOTES AND RELATED OBLIGATIONS:

On August 22, 2006, the Company entered into a purchase agreement (the “Purchase Agreement”) with institutional investors (the “Investors”) for the private sale of $7.0 million of convertible notes and warrants to purchase common stock. Pursuant to the Purchase Agreement, the Company completed a private placement of 8% Convertible Senior Subordinated Promissory Notes (the “Notes”) and warrants to purchase 2,815,766 shares of common stock (the “New Warrants”). Under the terms of the purchase agreement, interest on the Notes is payable to the Investors at the rate of 8% per annum payable quarterly in cash or stock, in arrears on each three month anniversary of the original issue date of the Note. The Notes are convertible into 5,631,539 shares of Tut Systems’ common stock at a conversion price of $1.243 per share, subject to certain adjustments, at the option of the Investors and are due on August 22, 2009. Following the two year anniversary of the original issue date of the Notes, the Company may prepay the Notes, subject to certain conditions. The New Warrants are exercisable at a price of $1.356 per share at any time after February 22, 2006 and they expire on August 22, 2011.

Under certain circumstances, the Notes may be converted into the Company’s common stock at conversion prices that are low enough that the shares required would be in excess of the shares currently authorized by the Company. If the Company was in a situation where the current shares authorized were not sufficient to cover the conversion amount, a cash payment would be required. Since there is a possibility that a cash payment would be required, certain features of the Note as well as other equity related instruments have been recorded as liabilities on the Company’s consolidated balance sheets.

The $7.0 million of Notes includes certain features that are considered derivative financial instruments, including a conversion option and a contingent put option. These features are described below, as follows:

The Warrants that the Company issued in conjunction with the Notes, also contain certain features that are considered derivative financial instruments, such as the possibility of net cash settlement. In addition, these features also affect the previous warrants that were issued on July 19, 2005 to purchase 2,767,495 of Tut Systems’ common stock at an exercise price of $4.25 per share (the “Old Warrants”).

The accounting treatment of the derivatives, New Warrants and Old Warrants require that the Company record the compound derivatives at their relative fair value as of the inception date of such agreements, and as of each subsequent balance sheet date and the New Warrants and Old Warrants at their fair value as of the inception date of such agreements, and as of each subsequent balance sheet date. Any change in fair value will be recorded as a non-operating, non-cash charge or credit at each reporting date. If the fair value of the derivatives and New Warrants and Old Warrants is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives and New Warrants and Old Warrants is lower at the subsequent balance sheet date, the Company will record a non-operating, non-cash credit. As of September 30, 2006, the derivatives related to the Notes were valued at $1,935 and the derivatives related to the New Warrants and Old Warrants were valued at $1,574. All derivatives were evaluated using the Black Scholes valuation model with the following assumptions as of September 30, 2006, respectively: dividend yield of 0%; annual volatility of 74.63%; expected life of 3 years and risk free interest rate of 4.49%. All derivatives are classified as current liabilities at September 30, 2006. The change in fair value of $2,483 is included in other income (expense) on the consolidated statements of operations.

The initial relative fair value assigned to the compound derivative related to the Notes was $3,181 and the initial fair value assigned to the derivatives related to the New Warrants was $1,940, both of which were recorded as discounts to the Notes and are being recorded at fair market value at each balance sheet date. The initial fair value on the Old Warrants was $871 which was recorded as a reduction to additional paid in capital. In addition, the initial fair value assigned to the derivatives was $5,121 which was recorded as a discount to the Notes which is being amortized to interest expense over the expected term of the debt, using the straight line method. At September 30, 2006, the unamortized discount on the Notes was $4,939. Debt issuance costs of $500 have been recorded in long term other assets and will be amortized over the term of the debt, using the straight line method.

Future principal and interest obligations due under the Notes, assuming the Company will not be in default of the provisions in the Notes as discussed above, are as follows:

The following table presents a reconciliation between the principal amount of the Note and the current and long term carrying amount of the Notes on the consolidated balance sheets:

The Company leases office, manufacturing and warehouse space under noncancelable operating leases that expire in 2007 and 2010. In January 2006, the Company entered into a lease agreement for a facility in San Diego, California that expires in February, 2010. The Company also leases certain office equipment under capitalized lease obligations that expire in 2008.

Minimum future lease payments under operating and capital leases at September 30, 2006 are as follows:

Rent expense for the three months ended September 30, 2005 and 2006 was $366 and $305 respectively and $1,047 and $987 for the nine months ended September 30, 2005 and 2006, respectively. At September 30, 2006, the cost of the leased capital assets was $168 with accumulated amortization of $56 resulting in a net book value of leased capital assets of $112.

The Company had noncancelable commitments to purchase finished goods inventory totaling $450 and $108 in aggregate at December 31, 2005 and September 30, 2006, respectively. These purchase commitments represent outstanding purchase orders submitted to the Company’s third party manufacturers for goods to be produced and delivered to the Company in 2006.

On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the Securities Act. The complaint also names as defendants the underwriters for the Company’s initial public offering and secondary offering. Similar suits were filed in the Southern District of New York challenging over 300 other initial public

offerings and secondary offerings conducted in 1999 and 2000. Therefore, for pretrial purposes, the Whalen action is being coordinated with the approximately 300 other suits before United States District Court Judge Shira Scheindlin of the Southern District of New York under the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’Auria and Matthew Taylor, were dismissed without prejudice by an October 9, 2002 Order of the Court, approving the parties’ October 1, 2002 Stipulation of Dismissal. On February 19, 2003, the Court issued an Opinion and Order denying the Company’s motion to dismiss.

In June 2004, a stipulation of settlement for the claims against the issuer-defendants, including the Company, was submitted to the Court in the In Re Initial Public Offering Securities Litigation. On August 31, 2005, the Court granted preliminary approval of the settlement. The settlement is subject to a number of conditions, most of which are outside of the Company’s control, including final approval by the Court. The underwriters named as defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “underwriter-defendants”), including the underwriters named in the Whalen suit, are not parties to the stipulation of settlement.

The stipulation of settlement provides that, in exchange for a release of claims against the settling issuer-defendants, the insurers of all of the settling issuer-defendants will provide a surety undertaking to guarantee plaintiffs a $1 billion recovery from the non-settling defendants, including the underwriter-defendants. The ultimate amount, if any, that may be paid on behalf of the Company will therefore depend on the final terms of the settlement, including the number of issuer-defendants that ultimately participate in the final settlement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants.

In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation

Copper Mountain, which the Company acquired on June 1, 2005, was in December 2001, along with certain of its officers and directors, named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation, Case No. 01-CV-10943 alleging violations of securities law under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Exchange Act. As a result of the acquisition, the Company has inherited the responsibility and obligations of Copper Mountain to defend the claims in that case and the Company is exposed to any liability that may come out of the claims. The Copper Mountain action described in this paragraph like the Whalen action described above has been coordinated for pretrial purposes under the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Copper Mountain action were also dismissed without prejudice pursuant to the October 9, 2002 Order of the Court approving the parties’ October 1, 2002 Stipulation of Dismissal. On February 19, 2003, the Court issued an Opinion and Order granting in part and denying in part Copper Mountain’s motion to dismiss. Thereafter, Copper Mountain entered into the same stipulation of settlement as the Company did in the Whalen action described above. The Copper Mountain stipulation of settlement is subject to the same terms, conditions and contingencies as the stipulation of settlement the Company entered into with respect to the Whalen action described above.

In the event that all or substantially all of the issuer-defendants participate in the final settlement, the amount that may be paid to the plaintiffs on behalf of the Company could range from zero to approximately $7.0 million which consists of the approximately $3.5 million from the Copper Mountain action described above and approximately $3.5 million from the Whalen action described above, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties and the amount of insurance available under the Company’s applicable insurance policies. If the plaintiffs recover at least $1 billion from the underwriter-defendants, no settlement payments would be made on behalf of the Company under the proposed terms of the settlement. If the plaintiffs recover less than $1 billion, the Company believes that its insurance will likely cover some or its entire share of any payments towards satisfying its share of plaintiffs’ $1 billion recovery amount. Management estimates that its range of loss relative to this matter is zero to $7.0 million. Presently there is no more likely point estimate of loss within this range. As a consequence of the uncertainties described above regarding the amount the Company will ultimately be required to pay, if any, as of September 30, 2006, the Company has not accrued a liability for this matter.

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Company’s management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

In November 1993, the Company adopted the 1992 Stock Plan (the “1992 Plan”), under which the Company may grant both incentive stock options and nonstatutory stock options to employees, consultants and directors. Options issued under the 1992 Plan can have an exercise price of no less than 85% of the fair market value, as defined under the 1992 Plan, of the stock at the date of grant. The 1992 Plan, including amendments, allows for the issuance of a maximum of 178 shares of the Company’s common stock. This number of shares of common stock has been reserved for issuance under the 1992 Plan. The Company is no longer granting stock options from the 1992 Plan. As stock options are terminated or cancelled from the 1992 Plan, the stock options are being retired and are no longer available for future grant.

The Company’s 1998 Stock Plan (the “1998 Plan”) was adopted by the Board of Directors in July 1998 and was approved by the stockholders in September 1998 and has rights and privileges similar to the 1992 Plan. The 1998 Plan allows for the issuance of a maximum of 1,000 shares of the Company’s common stock with annual increases starting in 2000, subject to certain limitations. In

January 2000, the 1998 Plan was amended to increase the maximum number of shares that may be issued to 1,358. In January 2001, January 2002, September 2004, January 2005, August 2005 and January 2006, the 1998 Plan was amended to increase the maximum number of shares that may be issued by 375 to 4,108.

The Company’s 1999 Nonstatutory Stock Option Plan (the “1999 Plan”) was adopted by the Board of Directors in December 1999. The 1999 Plan allows for the issuance of a maximum of 1,000 shares of the Company’s common stock. Additions to the Plan may be approved by the Board of Directors. The 1999 Plan has rights and privileges similar to the 1998 Plan. In April 2000, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 1,425. In October 2000, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 1,825. In October 2002, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 2,625. In August 2005, the 1999 Plan was amended to increase the maximum number of shares that may be issued to 3,125.

Generally, stock options are granted with vesting periods of four years and have an expiration date of ten years from the date of grant. However, in the event of a change in control, as defined in our Change in Control plans eligible employees who terminate employment under various circumstances during the twelve-month period after a change in control will be entitled to certain separation benefits including partial or full accelerated vesting of unvested options and severance pay. Benefits may be limited in certain circumstances due to certain tax code provisions.

At September 30, 2006 options to purchase 5,494 shares of common stock were unexercised. The weighted average exercise price of these options was $4.33 per share and the aggregate intrinsic value was $18. The weighted-average remaining term was 7.17 years.

At September 30, 2006 vested options to purchase 4,108 shares of common stock were unexercised. The weighted average exercise price of these options was $5.11 per share and the aggregate intrinsic value was $18. The weighted-average remaining contractual term was 6.35 years.

Total unrecognized compensation cost as of September 30, 2006 was $1,902. The weighted-average remaining recognition period was 2.81 years.

The weighted average exercise price of options granted during the three and nine months ended September 30, 2006 was $1.13 and $1.99 per share. The total cash received from employees as a result of employee stock option exercises during the three and nine months ended September 30, 2006 was approximately $19 and $684. The intrinsic value of these options for the three and nine months ended September 30, 2006, was $7 and $352, respectively. In connection with these exercises, there was no tax benefit realized by the Company due to the Company’s current loss position. The Company issues new shares of common stock upon exercise of stock options.

The following table summarizes information about stock options outstanding at September 30, 2006:

Effective January 1, 2006, the Company adopted SFAS No. 123R on a modified prospective basis. Under the modified prospective application, prior periods are not revised for comparative purposes. The valuation provisions of SFAS No. 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date will be recognized over the remaining service period using the compensation cost previously calculated for pro forma disclosure purposes under FASB Statement No. 123.

Prior to the adoption of SFAS No. 123R, the Company accounted for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” Financial Accounting Standards Board Interpretation No. 44 (“FIN 44”) “Accounting for Certain Transactions Involving Stock Compensation-an Interpretation of APB 25,” and complies with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” The Company generally did not recognize stock-based compensation expense in its statement of operations for periods prior to the adoption of SFAS No. 123R as most options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company amortized stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and net loss per share is presented and has been determined as if the Company had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to options granted under the Company’s stock-based compensation plans prior to the adoption. For the purposes of this pro forma disclosure, the value of options was estimated using a Black-Scholes valuation model and amortized on a straight-line basis over the vesting periods of the awards. Disclosures for the nine months ended September 30, 2006 are not presented because stock-based payments were accounted for under SFAS No. 123R’s fair value method during this period.

Under SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the awards and is recognized as expense over the employee’s requisite service period. The Company has no awards with market or performance conditions.

As required by SFAS No. 123R, management has made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

On December 29, 2005, the Board of Directors approved full acceleration of unvested stock options with an exercise price of $3.02 or greater, previously granted under the Company’s 1998 Stock Option Plan and 1999 Non-statutory Stock Option Plan held by

Company officers and employees. Options to purchase approximately 876,550 shares of the Company’s common stock, including approximately 126,390 shares held by the Company’s named executive officers, were subject to acceleration effective as of December 29, 2005. The closing market price per share of the Company’s common stock on December 29, 2005 was $3.10 and the exercise price of the approximately 876,550 in unvested options on that date ranged from $3.02 to $6.16, with a weighted exercise price of $3.95. As a result, stock based compensation expense in periods subsequent to the acceleration will be significantly reduced.

During the three and nine months ended September 30, 2006, the Company granted approximately 687 and 1,423 options, respectively, with an estimated total grant-date fair value of $779 and $2,805. During the three and nine months ended September 30, 2006, the Company recorded stock-based compensation related to stock options of $200 and $543, respectively, for the options that vested during the three and nine months ended September 30, 2006. There was no income tax benefit realized because of the Company’s loss position.

As a result of adopting SFAS No. 123R on January 1, 2006, our net loss for the three-and nine month ended September 30, 2006, is $288 and $590, respectively, higher than had we continued to account for stock-based employee compensation under APB No. 25. The adoption of SFAS No. 123R did not have a material impact on basic and diluted net loss per share for the three months ended September 30, 2006. The adoption of SFAS No. 123R had no impact on cash flows from operating or financing activities.

In connection with the adoption of SFAS No. 123R, the Company estimated the fair value of stock options using a Black-Scholes valuation model. The following table outlines the weighted average assumptions for both the stock options granted and the purchase rights issued:

Expected Term: The expected term was calculated in accordance with the simplified method stated in Staff Accounting Bulletin (SAB) 107. The expected term represents the period that the Company’s stock-based awards are expected to be outstanding.

Expected Volatility: The volatility factor was based on the Company’s historical stock prices for the four years from 2002 to 2005.

Expected Dividend: The Company has not paid any dividends and does not anticipate paying any dividends. Accordingly, an expected dividend yield of 0% was used.

Risk-Free Interest Rate: The Company bases the risk-free interest rate used in the Black Scholes valuation method on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of the Company’s stock-based awards do not correspond with the terms for which interest rates are quoted, the Company performed a straight-line interpolation to determine the rate from the available maturities.

Estimated Pre-vesting Forfeitures: When estimating forfeitures, the Company considers historical voluntary and involuntary terminations prior to vesting.

In connection with restricted shares granted upon the acquisition of Copper Mountain, the Company recorded deferred stock compensation which was calculated as the fair market value of the Company’s common shares on the dates the awards were granted. This stock compensation was being amortized on a straight-line basis over the vesting periods of the underlying stock rewards. Through September 30, 2006, the Company had amortized approximately $76 of such compensation expense, with $1 and $12 being recorded in the three and nine months ended September 30, 2006. These restricted shares have been fully amortized as of September 30, 2006.

In May and June 2006, the Company issued restricted shares to the directors of the Company. The stock compensation is being amortized on a straight-line basis over the vesting periods of the underlying stock rewards. Through September 30, 2006, the Company had amortized approximately $27 and $38 of such expense, recorded in the three and nine months ended September 30, 2006. These restricted shares are expected to fully amortize over the next three years.

A summary of the status of the Company’s unvested restricted shares as of September 30, 2006 and changes during the nine months ended September 30, 2006 is presented below:

The Company currently targets its sales and marketing efforts to both public and private service providers and users across two related markets. The Company currently operates in a single business segment as there is only one measurement of profitability for its operations. Revenue relating to the private broadband network products was $1,228 and $1,085 for the three months ended September 30, 2005 and 2006, respectively. Revenue relating to the private broadband network products was $3,630 and $3,235 for the nine months ended September 30, 2005 and 2006, respectively. Revenue related to video processing systems was $8,098 and $6,922 for the three months ended September 30, 2005 and 2006, respectively. Revenue related to video processing systems was $20,911 and $24,208 for the nine months ended September 30, 2005 and 2006, respectively. Revenue related to legacy product sales from the Copper Mountain merger was $713 and $211 for the three months ended September 30, 2005 and 2006, respectively. Revenue related to legacy product sales from the Copper Mountain merger was $2,225 and $392 for the nine months ended September 30, 2005 and 2006, respectively. Revenues are attributed to the following countries based on the location of customers:

No individual customer accounted for greater than 10% of the Company’s revenue for the three or nine months ended September 30, 2006. Cavalier Telephone accounted for 17% and Huawai Technologies Company Ltd. accounted for 10% of the Company’s revenue for the three months ended September 30, 2005. One customer, FTC Management, Inc. accounted for 11% of the Company’s revenue for the nine months ended September 30, 2005.

The Company designs, develops, and sells video processing systems and private broadband network products. Video processing systems include both digital TV headend systems and video systems. The digital TV headend system enables telephony-based service providers to transport broadcast quality digital video signals across their networks and our digital video transmission systems optimize the delivery of video signals across enterprise, government and education networks. The private broadband network products enable the transmission of broadband data over existing hotels and private campus networks.

The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. When used herein, the words “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “seeks,” “should,” “will” or the negative of these terms or similar expressions are generally intended to identify forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The forward-looking statements contained in this quarterly report include statements about the following, among others: (1) our belief that the number of IPTV subscribers will grow significantly by the end of 2010 and that this market space will continue to become more competitive, (2) our expectation that we will compete with larger public companies as we begin to target larger telco customers, (3) our expectation that demand for our products will increase, (4) our expectation that our sales and marketing expenses will decrease in 2006, (5) our expectation that sales of private broadband network products will increase slightly for the remainder of 2006 compared with 2005 (6) our expectation that capital expenditures for research and development will be lower than 2005 expenditures, (7) our expectation that capital expenditures in 2006 will be comparable with 2005 expenditures and that these capital expenditures will be funded from cash, cash equivalents and availability under the credit facility, (8) our expectation that we will incur losses in the near future, (9) our expectation that some competitors will market some of their products for use in TV over DSL applications, (10) our anticipation that our sales and operating margins will continue to fluctuate, (11) our anticipation that we will generally continue to invoice foreign sales in U.S. dollars, (12) our intention to continue to evaluate new acquisition candidates, divesture and diversification strategies, (13) our expectation that customers outside of the United States will represent a significant and growing portion of our revenue, (14) our expectation that research and development expenditures will be less than expenditures in 2005.

The cautionary statements contained under the caption “Additional Risk Factors that Could Affect Our Operating Results and the Market Price of Our Stock” and other similar statements contained elsewhere in this report, identify important factors with respect to such forward-looking statements, including certain risks and uncertainties that could cause our actual results, performance or achievements expressed or implied by such forward-looking statements.

Although we believe that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. We disclaim any obligation or undertaking to disseminate any updates or revision to any forward-looking statement contained herein or reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

We design, develop, and sell digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals across their networks. We refer to these systems as digital TV headends or video content processing systems. We also offer digital video processing systems that enable private enterprise and government entities to transport video signals across satellite, fiber, radio, or copper facilities for surveillance, distance learning, and TV production applications.

We also offer private broadband network products that enable the provisioning of high speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

In November 2002, we acquired VideoTele.com, referred to in this report as VTC, from Tektronix, Inc. to extend our product offerings to include digital video processing systems. On June 1, 2005, we acquired Copper Mountain Networks, Inc., referred to in this report as Copper Mountain, for its technology and engineering resources which we have refocused to further address our expanding video market opportunities for delivering advanced video services over coax and fiber networks.

We earn revenue primarily by selling video content processing systems both directly and through resellers to telecommunications service providers. We also earn revenue by selling video transmission systems to TV broadcasters and governments, and by selling private broadband network products directly and through distributors to the hospitality industry and to owners of private multi-tenant campus facilities.

For the three months ended September 30, 2005 and 2006, international sales represented 27.0%, and 13.0% of our total sales, respectively. For the nine months ended September 30, 2005 and 2006, international sales represented 20.5% and 14.8% of our total sales, respectively.

We pay close attention to and monitor various trends and uncertainties about our business. There is a growing demand by independent operating telephone companies to offer video services to their customer base. According to a recent release from Gartner, Inc. in September 2006, the number of households around the world subscribing to IPTV will reach 48.8 million in 2010. While this growing market presents opportunities to serve a larger customer base, we are also encountering increasing competition as more companies compete to sell digital TV headend products. We expect this market space will continue to become more competitive in the future. Our immediate competitors in the digital TV headend markets have been primarily small private companies that were focused on a narrower product line than ours and thereby may have been able to devote substantially more targeted resources to developing, marketing and selling new products than we are able to. Certain of these companies have become targets for acquisition by larger companies. If such acquisitions were to occur, we may face competitors with substantially greater name recognition, and technical, financial and marketing resources than we have. This increased competitive pressure may adversely affect the amount and timing of our revenue in future periods, thereby making it more difficult for us to accurately forecast our future revenue, and may also adversely affect our product margins.

The emergence of new technologies to serve the digital TV headend market means that we must continue to invest in these technologies to remain competitive. Digital subscriber line, or DSL, technologies use sophisticated signal blending techniques to transmit data through copper wires. The limitations on the amount of data that can be transmitted in a fixed amount of time (such limitations are referred to as bandwidth) and the distance data may be transmitted using copper wire constrain both the number of video channels that may be delivered simultaneously and the number of customers that are reachable from a telco central office over a DSL network. Advancements in video compression technology are now enabling high quality video streams to be transported at lower data transfer rates than has been previously available. These compression advancements also allow for the delivery of high-definition television over bandwidth constrained asymmetric DSL, or ADSL, lines for the first time. ADSL is a technology that allows more data to be transmitted over existing copper telephone lines compared with standard DSL. Additionally, DSL advancements are emerging that expand the available bandwidth from the telco to the subscriber thereby supporting higher DSL data transfer rates over longer distances. As our products continue to incorporate new technological advancements, we expect the demand for our products will increase because our products will enable more telcos to reach more of their customers with a greater number of video channels and features over their DSL networks. However, because of the increasing competition in the markets in which we compete, regardless of our revenue and product margins in future periods, we will continue to devote significant resources to research and development in future periods in order to enable us to offer our customers competitive products that incorporate these emerging technologies. We expect our research and development expenses in 2006 to be less than research and development expenditures we incurred in 2005, since we recently completed a major product development cycle and restructuring.

As we continue to capitalize on the growing number of telcos deploying video services in the United States and abroad, we will continue to aggressively market our new and existing products and expand our marketing and sales efforts domestically and internationally. Nevertheless, our sales activities have been and will continue to be subject to competitive market pressure. We believe that in certain competitive markets, our prospective customer purchase decisions continue to be impacted by lengthening of the purchase decision because of several factors that are affecting the overall digital TV headend market. Such factors include, but are not limited to, the delays in the introduction of advanced compression technology set top boxes, the transition to more efficient data transmission technologies and the emergence of video signal encryption requirements. We expect our sales and marketing expenses to decrease in 2006 compared to our spending in 2005.

Our discussion of our results of operations focuses on the following items from our income statement: Revenue consists of sales of our video processing systems, which includes both digital TV headend and video transmission systems. Revenue also includes sales of our private broadband network products. Since our acquisition of VTC, a large part of our revenue has been associated with the sale of digital TV headends. Furthermore, each individual headend sale has represented a significant portion of our revenue. If we were to sell even one less system than our forecasted number of headend sales, our revenue would be materially impacted. Cost of goods sold, or COGS, consists of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance for products, and the cost of licensed technology included in our products. Raw materials, contract manufacturing and licensed technology are the principal elements of COGS and vary directly with product sales. Sales and marketing expense consists primarily of selling and marketing personnel costs, including sales commissions, travel, trade shows, promotions and outside services. Research and development expense consists primarily of personnel and facilities costs, contract consultants, outside testing services, and equipment and supplies associated with enhancing existing products and developing new products. General and administrative expense consists primarily of personnel costs for administrative officers and support personnel, professional services and insurance expenses. Amortization of intangible assets consists primarily of expenses associated with the amortization of technology and patents related to prior years’ acquisitions.

The following table sets forth items from our statements of operations as a percentage of total revenues for the periods indicated:

Total Revenue: For the three months ended September 30, 2006, our total revenue decreased by 18.1% to $8.2 million from $10.0 million for the three months ended September 30, 2005. For the nine months ended September 30, 2006, our total revenue increased by 4.0% to $27.8 million from $26.8 million for the nine months ended September 30, 2005. Sales of video processing system products decreased from $8.1 million in the third quarter of 2005 to $6.9 million in the third quarter of 2006. The $1.2 million decrease in third quarter video processing system products revenue was due primarily to the adverse effect of several digital TV headend sales not closing during the period expected. Sales of video processing system products increased from $20.9 million in the nine months ended September 30, 2005 to $24.2 million in the nine months ended September 30, 2006. The $3.3 million increase in video processing system products revenue was due primarily to the introduction of our upgraded Astria video processing systems that incorporate recent Motion Pictures Experts Group (MPEG) advanced video compression technologies or MPEG-4. Our upgraded Astria products enable our customers to address a larger percentage of their geographic market and deliver advanced video services. Sales of private broadband network products decreased from $1.2 million in the third quarter of 2005 to $1.1 million in the third quarter of 2006 and decreased from $3.6 million in the nine months ended September 30, 2005 to $3.2 million due primarily to the slower market acceptance of our next generation of service management products for the multiple dwelling unit and enterprise market. We expect product sales of private broadband network products to increase slightly during the remainder of 2006 as these new products gain market acceptance.

Cost of Goods Sold. For the three months ended September 30, 2006, our cost of goods sold decreased by 29.0% or $2.3 million to $5.6 million from $7.9 million for the three months ended September 30, 2005. The decrease in cost of goods sold was due to decreased materials cost of $1.1 million, an impairment charge of $0.2 million of intangibles relating to technology acquired with the VTC acquisition and an increase in inventory reserves of $0.8 million during the three months ended September 30, 2005 and $0.2 million of personnel costs. For the nine months ended September 30, 2006, our cost of good sold increased by $0.3 million to $18.9 million from $18.6 million for the nine months ended September 30, 2005. The increase in cost of goods sold was due to an increase of $1.6 million in materials costs, offset by a $0.5 million charge in the nine months ended September 30, 2005 to amortize backlog acquired in the Copper Mountain merger and a $0.8 million charge to inventory reserves in 2005.

Sales and Marketing. For the three months ended September 30, 2006, our sales and marketing expenses decreased by 30.7% to $1.8 million from $2.7 million for the three months ended September 30, 2005. The $0.8 million decrease for the third quarter of 2006 when compared with the same period in 2005 was due to $0.5 million of personnel costs, $0.1 million of contractor and outside service costs, $0.1 million in travel costs and $0.1 million of demonstration costs. For the nine months ended September 30, 2006, our sales and marketing expenses decreased by 14.5% to $6.8 million from $7.9 million for the nine months ended September 30, 2005. The $1.1 million decrease is due to a decrease in personnel costs of $0.6 million, a decrease in contractors and outside services cost of $0.3 million and $0.4 million decrease in purchases of demonstration equipment offset by an increase of $0.1 million in trade show costs and $0.1 million increase in depreciation of fixed assets.

Research and Development. For the three months ended September 30, 2006, our research and development expense decreased by 24.9% to $2.9 million from $3.9 million for the three months ended September 30, 2005. The $1.0 million decrease in our research and development expense for the third quarter of 2006 when compared with the same period in 2005 was due to a decrease in personnel related costs of $0.8 million, $0.2 million in contractors and outside service costs and $0.1 million in travel costs Partially offsetting these decreases was an increase in purchases of supplies and small equipment of $0.1 million. For the nine months ended September 30, 2006, our research and development expenses decreased by 1.3% million to $9.1 million from $9.2 million for the nine months ended September 30, 2005. The $0.1 million decrease was due to a decrease of $0.1 million in personnel costs. Our capital expenditures for research and development were $0.1 million and $0.2 million for the three months ended September 30, 2005 and 2006, respectively and $0.6 million and $0.5 million for the nine months ended September 30, 2005 and 2006, respectively. We expect capital expenditures for research and development to be less than 2005 expenditures.

General and Administrative. For the three months ended September 30, 2006, our general and administrative expenses increased by 19.0% to $1.3 million from $1.1 million for the three months ended September 30, 2005. The $0.2 million increase in our general and administrative expense for the third quarter of 2006 when compared with the same period in 2005 was due primarily to

$0.1 million in personnel costs from compensation charges relating to SFAS 123, and a bad debt recovery of $0.1 million in the third quarter of 2005. For the nine months ended September 30, 2006, our general and administrative expenses decreased by 5.8% to $4.0 million from $4.2 million for the nine months ended September 30, 2005. The $0.2 million decrease is due to the one time charge of $1.2 million relating to a termination of a merger agreement in 2005 offset by an increase in personnel costs of $0.5 million, an increase in contractors and outside service costs of $0.2 million and $0.3 million of reduced bad debt recoveries.

Amortization of Intangible Assets. Amortization of intangible assets is comprised of intangibles related to the acquisitions of VTC in 2002 and Copper Mountain in 2005. The intangible assets subject to amortization from these acquisitions consist primarily of completed technology and patents. For the three months ended September 30, 2005 and 2006, total amortization of intangible assets remained consistent at $0.4 million. Total amortization of intangible assets was $1.2 million and $1.3 million for the nine months ended September 30, 2005 and 2006, respectively. Amortization expense included in cost of goods sold was $0.4 million for the three months ended September 30, 2005 and 2006 and $1.2 million for the nine months ended September 30, 2005 and 2006.

Restructuring Costs. In April 2006, we announced a restructuring program that included a workforce reduction and the closure of the UK office. As a result of this restructuring program, we recorded costs of $0.4 million consisting of severance payments and office closure costs. As of September 30, 2006, there were $11,000 of costs remaining to be paid out in the fourth quarter of 2006.

Interest and Other Expense, Net. Interest and other income, net consists primarily of interest income and expense and foreign currency exchange gains and losses. For the three months ended September 30, 2005 and 2006, our interest and other income was an expense of $10,000 and $0.2 million, respectively. For the nine months ended September 30, 2005 and 2006, our interest and other income was an expense of $0.1 million and $0.2 million, respectively.

Gain on Convertible Notes Derivative Liabilities and Amortization of Debt Discount. The net credit is primarily due to the increase in the non-operating, non-cash credits in relation to the change in value of the compound derivatives and warrants related to the convertible notes issued in August, 2006. These non-operating, non-cash credits resulted from mark to market changes on derivatives and warrants and interest and debt issuance costs associated with the Notes. Since the fair value of the warrants and derivatives is tied in large part to our stock price, in the future, if our stock price increases between reporting periods, the warrants and derivatives become more valuable. As such, there is no way to forecast what the non-operating, non-cash charges or credits will be in the future or what the future impact will be on our financial statements.

Cash and cash equivalents totaled $4.6 million at September 30, 2006, compared with cash and cash equivalents of $12.1 million at December 31, 2005, reflecting a net reduction in cash and cash equivalents of $7.5 million.

Cash used in operating activities was $12.9 million for the nine months ended September 30, 2006, compared with $16.0 million for the nine months ended September 30, 2005. The decreased cash used in operating activities was primarily due to a decrease in cash used by accounts receivable, and a decrease in net loss. Partially offsetting these decreases in cash usage was an increase in cash used by inventories and accounts payable and accrued liabilities.

Cash provided by investing activities included the sale of short term investments of $1.7 million offset by additions to property and equipment of $0.9 million for the nine months ended September 30, 2006. In 2006, we expect capital expenditures to be comparable with 2005 expenditures. We expect these capital expenditures to be funded from cash and cash equivalents and the availability under the credit facility.

Cash provided by financing activities included proceeds from the convertible debt financing of $7.0 million and from the issuance of common stock related to the exercise of stock options of $0.4 million offset by the repayment of the line of credit of $2.8 million.

As of September 30, 2006, we did not have any off balance sheet arrangements as defined in Regulation S-K Item 303 (a)(4). We did not have any relationships with unconsolidated entities or financial partnerships such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

The following table sets forth our contractual obligations as of September 30, 2006:

On September 23, 2004, we entered into a revolving asset based credit facility (“credit facility”), with Silicon Valley Bank (“the Bank”) which was amended on December 29, 2005 and modified in June 2006. This facility expires on September 23, 2007. Borrowings under the credit facility are formula based and limited to the lesser of $10.0 million or an amount based on a percentage of eligible accounts receivable and eligible inventories. The interest rate on outstanding borrowings is equal to the Bank’s prime rate, 8.25% as of September 30, 2006, plus 1.75%. The rate may increase by 1.0% if we do not meet certain financial covenants. All of our assets are pledged as collateral, and the credit facility contains various covenants. We were in compliance with these financial covenants as of September 30, 2006. Based on the maximum percentages of eligible accounts receivable and eligible inventory levels, the maximum amount of available borrowings was $6.7 million under this facility as of September 30, 2006. We had outstanding borrowings of $4.3 million at September 30, 2006.

As part of our acquisition of VTC from Tektronix in November 2002, we issued a note payable to Tektronix for $3.2 million, with repayment in ninety months, or by November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest is added to the principal balance of the note. Thereafter, we will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in full in November 2007. Principal and accrued interest on the note payable is $4.2 million at September 30, 2006. Accrued interest during the nine months ended September 30, 2006 was $0.2 million. We paid $0.1 million in interest payments during the nine months ended September 30, 2006.

On August 22, 2006, we entered into a purchase agreement (the “Purchase Agreement”) with institutional investors (the “Investors”) for the private sale of $7.0 million of convertible notes and warrants to purchase common stock. Pursuant to the Purchase Agreement, we completed a private placement of 8% Convertible Senior Subordinated Promissory Notes (the “Notes”) and warrants to purchase 2,815,766 shares of common stock (the “New Warrants”). Under the terms of the financing, interest on the Notes is payable to the Investors at the rate of 8% per annum payable quarterly in cash or stock, in arrears on each three month anniversary of the original issue date of the Note. The Notes are convertible into 5,631,539 shares of Tut Systems’ common stock at a conversion price of $1.243 per share, subject to certain adjustments, at the option of the Investors and are due on August 22, 2009. Following the two year anniversary of the original issue date of the Notes, the Company may prepay the Notes, subject to certain conditions. The New Warrants are exercisable at a price of $1.356 per share at any time after February 22, 2006 and they expire on August 22, 2011.

Under certain circumstances, the Notes may be converted into the Company’s common stock at conversion prices that are low enough that the shares required would be in excess of the shares currently authorized by the Company. If the Company was in a situation where the current shares authorized were not sufficient to cover the conversion amount, a cash payment would be required. Since there is a possibility that a cash payment would be required, certain features of the Notes as well as other equity related instruments have been recorded as liabilities on our consolidated balance sheets.

The $7.0 million of Notes includes certain features that are considered compound derivative financial instruments, such as a conversion option and a contingent put option.

The New Warrants contain certain features that are considered derivative financial instruments such as the possibility of net cash settlement. In addition, these features also affect the previous warrants that were issued on July 19, 2005 to purchase 2,767,495 of Tut Systems’ common stock at an exercise price of $4.25 per share (the “Old Warrants”).

The accounting treatment of the compound derivatives embedded in the Notes, the New Warrants and the Old Warrants requires that we record the compound derivatives at their relative fair value as of the inception date of the agreement and as of each subsequent balance sheet date and the New Warrants and Old Warrants at their fair value as of the inception date of the agreement and as of each subsequent balance sheet date. Any change in fair value will be recorded as a non-operating, non-cash income or expense at each reporting date. If the fair value of the Notes, the New Warrants and Old Warrants is higher at the subsequent balance sheet date, we will record a non-operating, non-cash charge. If the fair value of the Notes, New Warrants and Old Warrants is lower at the subsequent balance sheet date, we will record a non-operating, non-cash credit. As of September 30, 2006, the derivatives bifurcated from the Notes were valued at $1.9 million and New Warrants and Old Warrants were valued at $1.6 million. All derivatives and the New Warrants and Old Warrants were evaluated using the Black Scholes valuation model with the following assumptions as of September 30, 2006, respectively: dividend yield of 0%; annual volatility of 74.63%; expected life of 3 years and risk free interest rate of 4.49%. The derivatives are classified as current liabilities at September 30, 2006. The change in fair value is included in other income (expense) on the consolidated statements of operations.

The initial relative fair value assigned to the compound derivatives on the Notes was $3.2 million and the initial relative fair value assigned to the New Warrants was $1.9 million, both of which were recorded as discounts to the Notes and are being recorded at fair market value at each balance sheet date. The initial fair value of the Old Warrants was $0.9 million which was recorded as a reduction to additional paid in capital. In addition, the initial relative fair value assigned to the discount on the Notes was $5.1 million which was recorded as discounts to the Notes and is being amortized to interest expense over

the expected term of the debt, using the straight line method. At September 30, 2006, the unamortized discount on the Notes was $4.9 million. Debt issuance costs of $0.5 million have been recorded in long term other assets and will be amortized over the term of the debt, using the straight line method.

Since January 1, 2006 we have continued to incur operating losses and negative cash flows from operating activities aggregating $9,076 and $12,850, respectively, for the nine months ended 2006. These losses were primarily attributed to revenue shortfalls compared to our 2006 Plan. In addition, we have relatively limited liquidity alternatives available to us. On August 23, 2006, we sold $7 million of 8% convertible notes. However, even after this debt offering we remain cash constrained. As of September 30, 2006, we had $2.4 million of remaining borrowing capacity under our secured line of credit, which expires September 23, 2007.

We are continuing our efforts to increase liquidity, including collecting receivables and decreasing inventories. We also continue to actively pursue additional revenue opportunities. Revenue opportunities for our video processing systems include plans to expand the number of our local and international telephone customers, upgrade existing customers to current product offerings, and expand our customer base to include large, tier-one telephone companies. Revenue opportunities for our broadband transport and service management products include plans to increase revenue from new and existing customers from recently upgraded product offerings. Additionally, we are also exploring other alternatives which may include additional financing, strategic alliances, acquisition or merger.

We cannot provide any assurance that we will accomplish such operational or strategic actions and if we are unable to do so, we may not be able to achieve our currently contemplated business objectives, or the timing in reaching those objectives may be delayed.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We have identified the policies below as critical to our business operations and the understanding of our results of operations.

Revenue recognition. We generate revenue primarily from the sale of hardware products, including third-party products, through professional services, and through the sale of our software products. We sell products through direct sales channels and through distributors. Generally, revenue is generated from the sale of video processing systems and components and the sale of private broadband network products.

Revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post contract support.

Revenue is also generated from the sale of video processing component products and the sale of private broadband network products and the sale of certain legacy products related to the acquisition of Copper Mountain. We sell these products through our own direct sales channels and also through distributors. Our revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2 and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

In the case of software arrangements that require significant production, modification or customization of software, which encompasses all of our turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We recognize revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element of the multi-element arrangement, for which we have established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor

effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. In connection with certain contracts, we may perform the work prior to when the revenue is billable pursuant to the contract. The termination clauses in most of our contracts provide for the payment for the fair value of products delivered and services performed in the event of an early termination. In connection with certain of our contracts, we have recorded unbilled receivables consisting of costs and estimated profit in excess of billings as of the balance sheet date. Many of the contracts which give rise to unbilled receivables at a given balance sheet date are subject to billings in the subsequent accounting period. Management reviews unbilled receivables and related contract provisions to ensure we are justified in recognizing revenue prior to billing the customer and that we have objective evidence which allows us to recognize such revenue. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport products and service management products, and the sales of legacy products related to the acquisition of Copper Mountain, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, we may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, we must also make a judgment regarding collectibility. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to our credit review policy. We sell to customers for which there is a history of successful collection and to new customers for which such history may not exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are only increased after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, no credit is extended and revenue is recognized on a cash-collected basis.

We also maintain accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. Our products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

Unbilled Receivables. Unbilled receivables (costs and estimated profit in excess of billings) may be recorded in connection with certain turnkey solution contracts. Unbilled receivables are not billable at the balance sheet date but are recoverable over the remaining life of the contract through billings made in accordance with contractual agreements. Management reviews unbilled receivables and related contract provisions to ensure we are justified in recognizing revenue prior to billing the customer and that we have objective evidence which allows us to recognize such revenue.

Inventories. Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. We record provisions to write down our inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than we estimate, additional inventory provisions may be required.

Derivative financial instruments. Our derivative financial instruments consist of compound derivatives and new and existing warrants related to $7.0 million of convertible senior subordinated promissory note. These compound derivatives include certain conversion features and variable interest features. The accounting treatment of derivatives requires that we record the compound derivatives at their relative fair values as of the inception date of the agreement and as of each subsequent balance sheet date and the Warrants at their fair values as of the inception date of the agreement and as of each subsequent balance sheet date. Any change in fair value is recorded as a non-operating, non-cash charge or credit at each reporting date. If the fair value of the derivatives is higher at the subsequent balance sheet date, we will record a non-operating, non-cash charge. If the fair value of the derivatives is lower at the subsequent balance sheet date, we will record a non-operating, non-cash credit. As of September 30, 2006, the derivatives were valued at $3.5 million. The compound derivatives and warrants were valued using the Black Scholes valuation model with the following assumptions as of September 30, 2006: dividend yield of 0%; annual volatility of 74.63%; expected life of 3 years and risk free interest rate of 4.49%. The derivatives are classified as current liabilities at September 30, 2006.

Stock-based Compensation: Effective January 1, 2006, we adopted SFAS No. 123R on a modified prospective basis. As a result, we have included stock-based compensation costs in our results of operations for the three and nine months ended September 30, 2006, as more fully described in Note 12. We estimate the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. This option-pricing model requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The expected stock price volatility assumption was determined using historical volatility of the Company’s common stock.

Recent Accounting Pronouncements: In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108 regarding the process of quantifying financial statement misstatements. SAB No. 108 states that registrants should use both a balance sheet approach and an income statement approach when quantifying and evaluating the materiality of a misstatement. The interpretations in SAB No. 108 contain guidance on correcting errors under the dual approach as well as provide transition guidance for correcting errors. This interpretation does not change the requirements within SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB No. 20 and FASB Statement No. 3,” for the correction of an error on financial statements. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. We will be required to adopt this interpretation by December 31, 2006. We are currently evaluating the requirements of SAB No. 108 and the impact this interpretation may have on our financial statements.

In September 2006, the FASB issued statement No. 157, “Fair Value Measurements” (“SFAS 157”). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will be required to adopt SFAS No. 157 in the first quarter of fiscal year 2008. We are currently evaluating the requirements of SFAS No. 157 and has not yet determined the impact on the consolidated financial statements.

In March 2006, the Emerging Issues Task Force reached a consensus on Issue No. 06-03 “How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF No. 06-03”). We are required to adopt the provisions of EITF No. 06-03 beginning its fiscal year 2007. We do not expect the provisions of EITF No. 06-03 to have a material impact on the our consolidated financial position, results of operations or cash flows.

RISK FACTORS THAT COULD AFFECT OUR OPERATING RESULTS AND THE MARKET PRICE OF OUR STOCK

While we are engaged in various activities that may provide increased liquidity, we may need to obtain additional capital in the future both to sustain our operations and to fund operating deficits. Were such additional capital required, we can not assure you that we will be successful in obtaining additional capital, or that such additional capital will be sufficient to enable us to sustain operations and achieve our business objectives. Without additional investment, we may be forced to cease operations at an undetermined future date. If we cease operations, the value of our assets may be impaired.

We have a history of significant losses, and we may never achieve profitability.

We have incurred substantial net losses and experienced negative cash flow for each quarter since our inception. As of September 30, 2006, we had an accumulated deficit of $322.2 million. We expect to incur losses in the near future. Moreover, we may never achieve profitability and, even if we do, we may not be able to maintain profitability. We may not be able to generate a sufficient level of revenue to offset our current level of expenses. Moreover, because our expenditures for sales and marketing, research and development, and general and administrative functions are relatively fixed in the short-term, we may be unable to adjust our spending in a timely manner to respond to any unanticipated decline in revenue. If we fail to achieve and maintain profitability within the timeframe expected by securities analysts or investors, then the market price of our common stock will likely decline.

Each sale of our digital headend systems represents a significant portion of our revenue for any given quarter. Our failure to meet our quarterly forecast of sales of digital headend systems in any given quarter could have a material adverse impact on our financial results for a given quarter.

A large part of our quarterly revenue is associated with the sale of digital headend systems. Each sale represents a significant portion of our revenue for each quarter. We base our operating forecast on our historical sales. Because of the high cost per unit of our digital headend systems, if we were to sell even one less system than our forecasted number of headend sales per quarter, such a decrease in sales would have a material and adverse impact on our revenue for that quarter.

We operate in an intensely competitive marketplace, and many of our competitors have greater resources than we do.

Our primary competitors in the digital TV headend market have been small private companies that were focused on a more narrow product line than ours, thereby allowing these competitors to devote substantially more targeted resources to developing and marketing new products than we can. As the market is currently evolving, we are witnessing a consolidation of competitors and in the future, we expect more competition from large public companies like Harmonic, Inc., Tandberg Television ASA, Scientific Atlanta (SA) and Motorola, Inc., all of which have substantially greater financial, technical and other resources than we do. These competitors have achieved success in providing TV headend components for cable multiple system operators and satellite TV providers. Although their products have been designed specifically to meet the needs of cable networks, we expect these competitors to market some of their products for use in TV over DSL applications.

Indirect competition for our video content processing systems may arise from certain satellite service providers such as SES-Americom that intend to offer pre-compressed, constant-bit-rate video delivered via satellite to local terrestrial networks.

Our competition in the market for surveillance and broadcast video transmission systems primarily comes from small private companies and public companies such as Tandberg that together offer a wide array of products with special features and functions. A few of these companies also compete with us in the digital TV headend market.

Our private broadband network products business tends to compete against public network equipment providers, such as Zhone Technologies, and private and foreign companies.

To the extent that any of these current or potential future competitors enter or expand further into our markets, develop superior technology and products or offer superior prices or performance features relative to our products, such competition could result in lost sales and severe downward pressure on our pricing, either of which would adversely affect our revenue and profitability.

Commercial acceptance of any technological solution that competes with technology based on communication over copper telephone wire could materially and adversely impact demand for our products, our revenue and growth strategy.

The markets for video content processing, transmission and high-speed data access systems and services are characterized by several competing communication technologies, including fiber optic cables, coaxial cables, satellites and other wireless facilities. Many of our products are based on communication over copper telephone wire. Because there are physical limits to the speed and distance over which data can be transmitted over copper wire, our products may not be a viable solution for customers requiring service at performance levels beyond the current limits of copper telephone wire. Our customer base is concentrated on telephone service providers that have a large investment in copper wire technology. If these customers lose market share to their competitors who use competing technologies that are not as constrained by physical limitations as copper telephone wire, and that are able to provide faster access, greater reliability, increased cost-effectiveness or other advantages, demand for our products will decrease. Moreover, to the extent that our customers choose to install fiber optic cable or other transmission media as part of their infrastructure, or to the extent that homes and businesses install other transmission media within buildings, demand for our products may decline. The occurrence of any one or more of these events would harm demand for our products, which would thereby adversely affect our revenue and growth strategy.

If the projected growth in demand for video services from telephone service providers does not materialize or if our customers find alternative methods of delivering video services, future sales of our video content processing systems will suffer.

We manufacture video content processing systems that enable telephone service providers to offer video services to their customers. Our customers, the telephone service providers, face competition from cable companies, satellite service providers and wireless companies. For some users, these competing solutions provide fast access, high reliability and cost-effective solutions for delivering data, including video services. Telephone service providers hope to maintain their market share in their core business of voice telephony as well as increase their revenue per customer by offering their customers more services, including video services and high-speed data services. However, if the telephone service providers find alternative ways of maintaining and growing their market share in their core business that do not require that they offer video services, demand for our products will decrease substantially. Moreover, if technological advancements are developed that allow our customers to provide video services without upgrading their current system infrastructure, or that offer our customers a more cost-effective method of delivering video services, sales of our video content processing systems will suffer. Alternatively, even if the telephone service providers choose our video content processing systems, the service providers may not be successful in marketing video services to their customers, in which case our sales would decrease substantially.

Our operating results fluctuate significantly from quarter to quarter, and this may cause the price of our stock to decline.

Over the last 12 quarters, our revenue per quarter has fluctuated between $5.1 million and $11.5 million. Over the same periods, our losses from operations as a percentage of revenue have fluctuated between approximately 5.2% and 71.1% of revenue. We anticipate that our sales and operating margins will continue to fluctuate. We expect this fluctuation to continue for a variety of reasons, including:

Fluctuations in our sales and operating margins will make it more difficult for us to accurately forecast our results of operations and this could negatively impact the market price of our stock.

We depend on international sales for a significant portion of our revenue, which subjects our business to a number of risks. If we are unable to generate significant international sales, our revenue, profitability and share price could be materially and adversely affected.

Sales to customers outside of the United States accounted for approximately 20.5% and 14.8% of revenue for the nine months ended September 30, 2005 and 2006 respectively. Sales and operating activities outside of the United States are subject to inherent risks, including fluctuations in the value of the United States dollar relative to foreign currencies; tariffs, quotas, taxes and other market barriers; political and economic instability; restrictions on the export or import of technology; potentially limited intellectual property protection; difficulties in staffing and managing international operations and potentially adverse tax consequences. Any of these factors may have a material adverse effect on our ability to grow or maintain international revenue.

We expect sales to customers outside of the United States to represent a significant and growing portion of our revenue. However, we cannot assure you that foreign markets for our products will develop at the rate or to the extent that we anticipate. If we fail to generate significant international sales, our revenue, profitability and share price could be materially and adversely affected.

The sales cycle for video content processing systems is long and unpredictable, which requires us to incur high sales and marketing expenses with no assurance that a sale will result.

The sales cycle for our headend systems can be as long as 12-18 months. Additionally, with respect to the sale of our products to U.S. and foreign government organizations, we may experience long sales cycles as a result of government procurement processes. As a result, while we continue to incur costs associated with a particular sale prior to payment from the customer, we may not recognize revenue from efforts to sell particular products for extended periods of time. As a result, our quarter-to-quarter comparisons of our revenue and operating results may not be meaningful and may not provide an accurate indicator of our future performance. Our operating results in one or more future quarters may fail to meet the expectations of investment research analysts or investors, which could cause an immediate and significant decline in the market price of our common stock.

If we fail to accurately forecast demand for our products, our revenue, profitability and reputation could be harmed.

We rely on contract manufacturers and third-party equipment manufacturers, or OEMs, to manufacture, assemble, test and package our products. We also depend on third-party suppliers for the materials and parts that constitute our products. Our reliance on contract manufacturers, OEMs and third-party suppliers requires us to accurately forecast the demand for our products and coordinate our efforts with those of our contract manufacturers, OEMs and suppliers. We often make significant up-front financial commitments with our contract manufacturers, OEMs and suppliers in order to procure the raw materials and begin manufacturing and assembly of the products. If we fail to accurately forecast demand or coordinate our efforts with our suppliers, OEMs and contract manufacturers, we may face supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products, which could lead to the loss of existing or potential customers and could thereby result in lost sales and damage to our reputation, which would adversely affect our revenue and profitability. Further, we outsource the manufacturing of our products based on forecasts of sales. If orders for our products exceed our forecasts, we may have difficulty meeting customers’ orders in a timely manner, which could damage our reputation or result in lost sales. Conversely, if our forecasts exceed the orders we actually receive and we are unable to cancel future purchase and manufacturing commitments in a timely manner, our inventory levels would increase. This could expose us to losses related to slow moving and obsolete inventory, which would have a material adverse effect on our profitability.

If we fail to develop and introduce new products in response to the rapid technological changes in the markets in which we compete, we will not remain competitive.

The markets for video content processing, transmission and high-speed data access systems are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, changes in end-user requirements and evolving industry standards. To remain competitive, we must continually improve the performance, features and reliability of our products. For example, advances in compression technology are leading the video content processing industry to begin the transition to next generation compression standards. These advances will allow for further reductions in the bandwidth required to deliver standard definition video channels and introduce the capability of delivering high-definition television over asymmetrical digital subscriber lines or ADSL, for the first time. ADSL is a new technology that allows more data to be transmitted over copper telephone lines than standard DSL. Further advances in compression technology, or the emergence of new industry standards would require that we modify or redesign our products to incorporate, and remain compatible with, emerging technologies and industry standards.

We cannot assure you that we will be able to respond quickly and effectively to technological change. We may have only limited time to enter certain markets, and we cannot assure you that we will be successful in achieving widespread acceptance of our products before competitors can offer products and services similar or superior to our products. If we fail to introduce new products that address technological changes or if we experience delays in our product introductions, our ability to compete would be adversely affected, thereby harming our revenue, profitability and growth strategy.

Fluctuations in interest and currency exchange rates may decrease demand for our products.

Substantially all of our foreign sales are invoiced in U.S. dollars. As a result, fluctuations in currency exchange rates could cause our products to become relatively more expensive for international customers, thereby reducing demand for our products. We anticipate that we will generally continue to invoice foreign sales in U.S. dollars. We do not currently engage in foreign currency hedging transactions. However, as we expand our current international operations, we may allow payment in foreign currencies and, as a result, our exposure to foreign currency transaction losses may increase. To reduce this exposure, we may purchase forward foreign exchange contracts or use other hedging strategies. However, we cannot assure you that any currency hedging strategy would be successful in avoiding exchange-related losses. Any such losses would adversely impact our profitability.

If our contract manufacturers, third-party OEMs and third-party suppliers fail to produce quality products or parts in a timely manner, we may not be able to meet our customers’ demands.

We do not manufacture our products. We rely on contract manufacturers and OEMs to manufacture, assemble, package and test substantially all of our products and to purchase most of the raw materials and components used in our products. Additionally, we depend on third-party suppliers to provide quality parts and materials to our contract manufacturers and OEMs, and we obtain some of the key components and sub-assemblies used in our products from a single supplier or a limited group of suppliers. Neither we nor our contract manufacturers or OEMs have any guaranteed supply arrangements with the suppliers. If our suppliers fail to provide a sufficient supply of key components, we could experience difficulties in obtaining alternative sources at reasonable prices, if at all, or in altering product designs to use alternative components. Moreover, if our contract manufacturers or OEMs fail to deliver quality products in a timely manner, such failure would harm our ability to meet our scheduled product deliveries to customers. Delays and reductions in product shipments could increase our production costs, damage customer relationships and harm our revenue and profitability. In addition, if our contract manufacturers and OEMs fail to perform adequate quality control and testing of our products, we would experience increased production costs for product repair and replacement, and our profitability would be harmed. Moreover, defects in products that are not discovered in the quality assurance process could damage customer relationships and result in product returns or product liability claims, each of which could harm our revenue, profitability and reputation.

Design defects in our products could harm our reputation, revenue and profitability.

Any defect or deficiency in our products could reduce the functionality, effectiveness or marketability of our products. These defects or deficiencies could cause customers to cancel or delay their orders for our products, reduce revenue or render our product designs obsolete. In any of these events, we would be required to devote substantial financial and other resources for a significant period of time to develop new product designs. We cannot assure you that we would be successful in addressing any design defects in our products or in developing new product designs in a timely manner, if at all. Any of these events, individually or in the aggregate, could harm our revenue, profitability and reputation.

Our business depends on the integrity of our intellectual property rights. If we fail to adequately protect our intellectual property, our revenue, profitability, reputation or growth strategy could be adversely affected.

We attempt to protect our intellectual property and proprietary technology through patents, trademarks and copyrights, by generally entering into confidentiality or license agreements with our employees, consultants, vendors, strategic partners and customers as needed, and by generally limiting access to and distribution of our trade secret technology and proprietary information. However, any of our pending or future patent or trademark applications may not ultimately be issued as patents or trademarks of the scope that we sought, if at all, and any of our patents, trademarks or copyrights may be invalidated, deemed unenforceable, or otherwise challenged. In addition, other parties may circumvent or design around our patents and other intellectual property rights, may misappropriate our proprietary technology, or may otherwise develop similar, duplicate or superior products. Further, the intellectual property laws and our agreements may not adequately protect our intellectual property rights and effective intellectual property protection may be unavailable or limited in certain foreign countries in which we do business or may do business in the future.

The telecommunications and data communications industries are characterized by the existence of extensive patent portfolios and frequent intellectual property litigation. From time to time, we have received, and may in the future receive, claims that we are infringing third parties’ intellectual property rights. Any present or future claims, with or without merit, could be time-consuming, result in costly litigation, divert management time and attention and other resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us. In addition, any such litigation could force us to cease selling or using certain products or services, or to redesign such products or services. Further, we may in the future, initiate claims or litigation against third-parties for infringement of our intellectual property rights or to determine the scope and validity of our intellectual property rights or those of competitors. Such litigation could result in substantial costs and diversion of resources. Any of the foregoing could have an adverse effect upon our revenue, profitability, reputation or growth strategy.

If we fail to provide our customers with adequate and timely customer support, our relationships with our customers could be damaged, which would harm our revenue and profitability.

Our ability to achieve our planned sales growth and retain customers will depend in part on the quality of our customer support operations. Our customers generally require significant support and training with respect to our products, particularly in the initial deployment and implementation stage. As our systems and products become more complex, we believe our ability to provide adequate customer support will be increasingly important to our success. We have limited experience with widespread deployment of our products to a diverse customer base, and we cannot assure you that we will have adequate personnel to provide the levels of support that our customers may require during initial product deployment or on an ongoing basis. Our failure to provide sufficient support to our customers could delay or prevent the successful deployment of our products. Failure to provide adequate support could also have an adverse impact on our reputation and relationship with our customers could prevent us from gaining new customers and could harm our revenue and profitability.

We routinely evaluate acquisition candidates and other diversification strategies.

We have completed a number of acquisitions as part of our efforts to expand and diversify our business. For example, we acquired our video content processing and video transmission businesses from Tektronix in November 2002 when we purchased its subsidiary, VTC. In addition, on June 1, 2005, we completed an acquisition with Copper Mountain Networks, Inc.

We intend to continue to evaluate new acquisition candidates, divestiture and diversification strategies, and if we fail to manage the integration of acquired companies, it could adversely affect our operations and growth strategy. Any acquisition involves numerous risks, including difficulties in the assimilation of the acquired company’s employees, operations and products, uncertainties associated with operating in new markets and working with new customers, and the potential loss of the acquired company’s key employees. Additionally, we may incur unanticipated expenses, difficulties and other adverse consequences relating to the integration of technologies, research and development, and administrative and other functions. Any future acquisitions may also result in potentially dilutive issuances of our equity securities, acquisition or divestiture related write-offs and the assumption of debt and contingent liabilities. Any of the above factors could adversely affect our revenue, profitability, operations or growth strategy.

Failure to integrate acquired businesses into our operations successfully could adversely affect our business.

As part of our strategy to develop and identify new products and technologies, we have made acquisitions, such as our acquisition of Copper Mountain. We are likely to make more acquisitions in the future. Our integration of the operations of acquired businesses requires significant efforts, including the coordination of information technologies, research and development, sales and marketing, operations, manufacturing and finance. These efforts result in additional expenses and involve significant amounts of management’s time that cannot then be dedicated to other projects. Our failure to manage successfully and coordinate the growth of the combined company could also have an adverse impact on our business. In addition, there is no guarantee that any of the businesses we acquire will become profitable or remain so. If our acquisitions do not reach our initial expectations, we may record unexpected impairment charges. Factors that will affect the success of our acquisitions include but are not limited to:

These factors, among others, will affect whether our recent and proposed acquisitions are successfully integrated into our business. Additionally, any future acquisitions may also result in potentially dilutive issuances of our equity securities, acquisition or divestiture related write-offs and the assumption of debt and contingent liabilities. If we fail to integrate acquired businesses into our operations successfully, we may be unable to achieve our revenue, profitability, operations, strategic goals and our competitive position in the marketplace could suffer.

If we fail to manage our expanding operations, our ability to increase our revenues and improve our results of operations could be harmed.

We anticipate that, in the future, we may need to expand certain areas of our business to grow our customer base and exploit market opportunities. In particular, we expect to face numerous challenges in the implementation of our business strategy to focus on selling our products to the larger, more established service providers. To manage our operations, we must, among other things, continue to implement and improve our operational, financial and management information systems, hire and train additional qualified personnel, continue to expand and upgrade core technologies and effectively manage multiple relationships with various customers, suppliers and other third-parties. We cannot assure you that our systems, procedures or controls will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to exploit fully the market for our products or systems. If we are unable to manage our operations effectively, our revenue, results of operations and share price could be harmed.

If material weaknesses in our internal control over financial reporting were to develop and we were unable to remedy such weaknesses in an effective and timely manner, such weaknesses could materially and adversely affect our ability to provide the public with timely and accurate material information about Tut Systems.

In order for investors and the equity analyst community to make informed investment decisions and recommendations about our securities, it is important that we provide them with accurate and timely information in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the rules promulgated thereunder. Material weaknesses in our internal control over financial reporting and our disclosure controls and procedures would hinder the flow of timely and accurate information to investors. If such material weaknesses were to develop and we did not address them in a timely matter, investors might sell our shares and industry analysts might either make incorrect recommendations about Tut Systems or else end coverage of Tut Systems altogether, any of which results could harm our reputation and adversely impact our share price.

We are currently engaged in a securities class action lawsuit which, if it were to result in an unfavorable resolution, could adversely affect our reputation, profitability and share price.

We are currently engaged as a defendant in a lawsuit (i.e., Whalen v. Tut Systems, Inc. et al.) that alleges securities law violations against us and certain of our current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Exchange Act. Additionally, our subsidiary Copper Mountain, which we acquired on June 1, 2005, was in December 2001, along with certain of its officers and directors, named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Copper Mountain Networks, Inc. Initial Public Offering Securities Litigation, Case No. 01-CV-10943 alleging violations of securities laws under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Exchange Act. As a result of the

acquisition, we have inherited the responsibility and obligations of Copper Mountain to defend the claims in that case and we are exposed to any liability that may come out of the claims. The Whalen action and the Copper Mountain action are being coordinated with approximately 300 suits before United States District Judge Shira Scheindlin of the Southern District of New York under the matter In re Initial Public Offering Securities Litigation. While we have reached a settlement with the plaintiffs in the Whalen lawsuit, and prior to the acquisition Copper Mountain reached a settlement in the Copper Mountain action, the settlements are subject to certain contingencies, including court approval of the terms of settlements. If the court does not approve the settlements, or any other applicable contingencies are not resolved or otherwise addressed, we would be required to resume litigation in these matters.

If our products do not comply with complex government regulations, our product sales will suffer.

We and our customers are subject to varying degrees of federal, state and local as well as foreign governmental regulation. Our products must comply with various regulations and standards defined by the Federal Communications Commission, or FCC. The FCC has issued regulations that set installation and equipment standards for communications systems. Our products are also required to meet certain safety requirements. For example, Underwriters Laboratories must certify certain of our products in order to meet federal safety requirements relating to electrical appliances to be used inside the home. In addition, certain products must be Network Equipment Building Standard certified before certain of our customers may deploy them. Any delay in or failure to obtain these approvals could harm our business, financial condition or results of operations. Outside of the United States, our products are subject to the regulatory requirements of each country in which our products are manufactured or sold. These requirements are likely to vary widely. If we do not obtain timely domestic or foreign regulatory approvals or certificates, we would not be able to sell our products where these regulations apply, which could prevent us from maintaining or growing our revenue or achieving profitability. In addition, regulation of our customers may adversely impact our business, operating results and financial condition. For example, FCC regulatory policies affecting the availability of data and Internet services and other terms on which telecommunications companies conduct their business may impede our entry into certain markets. In addition, the increasing demand for communications systems has exerted pressure on regulatory bodies worldwide to adopt new standards, generally following extensive investigation of competing technologies. The delays inherent in this governmental approval process may cause the cancellation, postponement or rescheduling of the installation of communications systems by our customers, which in turn may harm our sale of products to these customers.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to manage our business successfully, which could materially and adversely affect our growth strategy, reputation and share price.

We depend on the performance of Salvatore D’Auria, our President, Chief Executive Officer and Chairman of the Board, and on other senior management and technical personnel with experience in the video and data communications, telecommunications and high-speed data access industries. The loss of any one of them could harm our ability to execute our business strategy, which could adversely affect our reputation and share price. Additionally, we do not have employment contracts with any of our executive officers. We believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

Our stock price is volatile, and, if you invest in Tut Systems, you may suffer a loss of some or all of your investment.

The market price and trading volume of our common stock has been subject to significant volatility, and this trend may continue. In particular, trading volume historically has been low and the market price of our common stock has decreased dramatically in recent months. Since the announcement of our acquisition of VTC, the closing price of our common stock, as traded on The Nasdaq National Market, has fluctuated from a low of $0.91 to a high of $7.49 per share. The value of our common stock may decline regardless of our operating performance or prospects. Factors affecting our market price include:

Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance. The general economic, political and stock market conditions that may affect the market price of our common stock are beyond our control. The market price of our common stock at any particular time may not remain the market price in the future. In the past, securities class action litigation has been instituted against companies following periods of volatility in the market price of their securities. Any such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources.

Future sales of shares of our common stock could cause our stock price to decline.

Substantially all of our common stock may be sold without restriction in the public markets, subject only in the case of shares held by our officers and directors and affiliates to volume and manner of sale restrictions (other than as described in the following sentence). The approximately 3.3 million shares of common stock that we issued to Tektronix in connection with our November 2002 acquisition of VTC were restricted securities, as that term is defined in Rule 144 under the Securities Act, and therefore subject to certain restrictions. However, we are contractually obligated to file and keep effective a registration statement in order to allow Tektronix to sell these shares to the public. Likewise, Tektronix has the right (subject to certain exceptions) to include these shares in certain registration statements pursuant to which we may sell shares of our common stock. During 2006, Tektronix sold 0.4 million shares of common stock. At September 30, 2006, Tektronix owns 1.9 million shares of common stock.

Sales of a substantial number of shares of common stock in the public market, whether or not in connection with this offering, or the perception that these sales could occur could materially and adversely affect our stock price and make it more difficult for us to sell equity securities in the future at a time and price we deem appropriate.

Our charter, bylaws, retention and change of control plans and Delaware law contain provisions that could delay or prevent a change in control.

Certain provisions of our charter and bylaws and our retention and change of control plans, referred to as the “Plans,” may have the effect of making it more difficult for a third-party to acquire, or of discouraging a third- party from attempting to acquire, control of us. The provisions of the charter and bylaws and the Plans could limit the price that certain investors may be willing to pay in the future for shares of our common stock. Our charter and bylaws provide for a classified board of directors, eliminate cumulative voting in the election of directors, restrict our stockholders from acting by written consent and calling special meetings, and provide for procedures for advance notification of stockholder nominations and proposals. In addition, our board has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third-party to acquire a majority of our outstanding voting stock. The Plans provide for severance payments and accelerated stock option vesting in the event of termination of employment following a change of control. The provisions of the charter and bylaws, and the Plans, as well as Section 203 of the Delaware General Corporation Law, to which we are subject, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management.

Recent and proposed regulations related to equity compensation could adversely affect earnings, affect our ability to raise capital and affect our ability to attract and retain key personnel.

Since our inception, we have used stock options as a fundamental component of our employee compensation packages. We believe that our stock option plans are an essential tool to link the long-term interests of stockholders and employees, especially executive management, and serve to motivate our employees to make decisions that will, in the long run, give the best returns to stockholders. Effective January 1, 2006, we have adopted SFAS No. 123R. The adoption of this standard may negatively impact our earnings and may affect our ability to raise capital on acceptable terms. To the extent that new accounting standards make it more difficult or expensive to grant options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business.

We are exposed to additional costs and risks associated with complying with increasing and new regulation of corporate governance and disclosure standards.

We are spending an increased amount of management time and external resources to comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules. Particularly, Section 404 of the Sarbanes-Oxley Act, when it becomes applicable to us, will require management’s annual review and evaluation of our internal control over financial reporting, and attestation of the effectiveness of our internal control over financial reporting by management. We expect that our independent registered public accounting firm will be required to attest to the design and effectiveness of our internal controls over financial reporting beginning with the filing of the annual report on Form 10-K for the fiscal year ending December 31, 2007, and with each subsequently filed annual report on Form 10-K. We expect to incur significant additional accounting and legal expenses in the process of documenting and testing our internal control systems and procedures and in making improvements in order for us to comply with the requirements of Section 404. We cannot predict the outcome of our assessment of our internal control over financial reporting. If we conclude in future periods that our internal control over financial reporting is not effective or if our independent registered public accounting firm is unable to provide an unqualified opinion as of future year-ends, investors may lose confidence in our financial statements, and the price of our stock may suffer.

We are exposed to changes in interest rates primarily from our investments in certain cash equivalents. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest-sensitive financial instruments at September 30, 2006.

We have no investments, nor are any significant sales, expenses, or other financial items denominated in foreign country currencies. All of our international sales are denominated in U.S. dollars. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, reduce the demand for our products.

We have multiple derivatives included in the Convertible Senior Subordinated Promissory Notes (“the Notes”) entered into in August 2006. Pursuant to the Note agreement, Warrants to purchase an aggregate of 2.8 million shares of our common stock was issued to private investors. The compound derivatives in the agreement, have been recorded at their relative fair value at the inception date of the agreement, August 22, 2006, and will be updated as of each subsequent balance sheet date. The Warrants issued in August 2006 and Warrants issued in July 2005 were recorded at fair value at the inception date of the agreement, August 22, 2006 and will be updated as of each subsequent balance sheet date. Any change in value between reporting periods will be recorded as a non-operating, non-cash charge or credit at each reporting date. The impact of these non-operating, non-cash charges or credits could have an adverse effect on our stock price in the future.

The fair value of the Warrants and derivatives are tied in a large part to our stock price. If our stock price increases between reporting periods, the Warrants and derivatives become more valuable. As such, there is no way to forecast what the non-operating, non-cash charges or credits will be in the future or what the future impact will be on our financial statements.

Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to the Company’s management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting which occurred during the third quarter of 2006 and which have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

There have been no material changes from the risk factors disclosed in Item 1A – “Risk Factors that Could Affect our Operating Results and the Market Price of our Stock” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, other than the following risk factors:

We will most likely need to obtain additional capital in the future both to sustain our operations and to fund operating deficits that we anticipate will continue until we can realize revenue from current accounts receivable. We can not assure you that we will be successful in obtaining sufficient additional capital, or that such additional capital will be sufficient to enable us to sustain operations and improve our business so as to have a material positive effect on our operations and cash flow. Without additional investment, we may be forced to cease operations at an undetermined future date. It is uncertain whether our assets will retain any value if we cease operations. We can not assure you that additional funding will be available to us before we can realize revenue from current accounts receivable or are forced to cease operations.

Recent and proposed regulations related to equity compensation could adversely affect earnings, affect our ability to raise capital and affect our ability to attract and retain key personnel.

Since our inception, we have used stock options as a fundamental component of our employee compensation packages. We believe that our stock option plans are an essential tool to link the long-term interests of stockholders and employees, especially executive management, and serve to motivate our employees to make decisions that will, in the long run, give the best returns to stockholders. Effective January 1, 2006 we have adopted SFAS No. 123R. The adoption of this standard may negatively impact our earnings and may affect our ability to raise capital on acceptable terms. To the extent that new accounting standards make it more difficult or expensive to grant options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business.

We have provided updated Risk Factors in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, contained in Item 2 of Part 1 of this report. This description includes any changes to and supersedes the description of the risk factors associated with our business previously disclosed in Item 1A of our 2005 Annual Report on Form 10-K and is incorporated herein by reference.

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.


TUT SYSTEMS, INC.

By:		/s/ SCOTT SPANGENBERG
		Scott Spangenberg Vice-President, Finance and Administration, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer and Duly Authorized Officer)


Delaware		94-2958543
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

6000 SW Meadows Rd, Suite 200 Lake Oswego, Oregon		97035
(Address of principal executive offices)		(Zip Code)


PART I.	FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (unaudited):

	Condensed Consolidated Balance Sheets as of December 31, 2005 and September 30, 2006	3

	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and September 30, 2006	4

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and September 30, 2006	5

	Notes to Unaudited Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	35

Item 4.	Controls and Procedures	35

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	36

Item 1A	Risk Factors	37

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	37

Item 3.	Defaults Upon Senior Securities	37

Item 4.	Submission of Matters to a Vote of Security Holders	37

Item 5.	Other Information	37

Item 6.	Exhibits	38

Signatures		39


	December 31, 2005			September 30, 2006
ASSETS
Current assets:
Cash and cash equivalents	$	12,111		$	4,593
Short term investments		1,693			—
Accounts receivable, net of allowance for doubtful accounts of $56 and $42 in 2005 and 2006, respectively		14,873			14,907
Inventories, net		6,719			11,986
Prepaid expenses and other		983			1,116

Total current assets		36,379			32,602
Property and equipment, net		2,827			2,512
Intangibles and other assets		6,305			5,514
Goodwill		1,672			1,672

Total assets	$	47,183		$	42,300

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Line of credit	$	7,080		$	4,254
Accounts payable		5,678			5,300
Accrued liabilities		3,274			4,626
Deferred revenue		527			613
Convertible note derivative liabilities		—			3,509

Total current liabilities		16,559			18,302
Note payable		4,122			4,239
Other liabilities		100			53
Convertible senior subordinated promissory notes		—			2,081

Total liabilities		20,781			24,675

Commitments and contingencies (Note 11)
Stockholders’ equity:
Preferred stock, $0.001 par value, 5,000 shares authorized, no shares issued and outstanding in 2005 and 2006, respectively		—			—
Common stock, $0.001 par value, 100,000 shares authorized, 33,474 and 33,782 shares issued and outstanding in 2005 and 2006, respectively		33			34
Additional paid-in capital		339,692			339,975
Accumulated other comprehensive loss		(165	)		(150	)
Accumulated deficit		(313,158	)		(322,234	)

Total stockholders’ equity		26,402			17,625

Total liabilities and stockholders’ equity	$	47,183		$	42,300


	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2006			2005			2006
Revenue	$	10,039		$	8,218		$	26,766		$	27,835
Cost of goods sold		7,863			5,586			18,572			18,858

Gross margin		2,176			2,632			8,194			8,977
Operating expenses:
Sales and marketing		2,663			1,846			7,895			6,751
Research and development		3,892			2,921			9,229			9,106
General and administrative		1,063			1,265			4,187			3,945
Restructuring costs		130			—			130			359
Amortization of intangible assets		18			17			51			51

Total operating expenses		7,766			6,049			21,492			20,212

Loss from operations		(5,590	)		(3,417	)		(13,298	)		(11,235	)
Gain on convertible note derivative liabilities		—			2,483			—			2,483
Amortization of debt discount		—			(182	)		—			(182	)
Interest and other (expense), net		(10	)		(181	)		(139	)		(142	)

Net loss	$	(5,600	)	$	(1,297	)	$	(13,437	)	$	(9,076	)

Net loss per share, basic and diluted (Note 3)	$	(0.17	)	$	(0.04	)	$	(0.48	)	$	(0.27	)

Shares used in computing net loss per share, basic and diluted (Note 3)		32,042			33,782			27,773			33,662


	Nine Months Ended September 30,
	2005			2006
Cash flows from operating activities:
Net loss	$	(13,437	)	$	(9,076	)
Adjustments to reconcile net loss to net cash used in operating activities:
Derivative and warrant fair value adjustments		—			(2,483	)
Amortization of debt discount		—			182
Depreciation		843			1,137
Recovery of doubtful accounts		(25	)		(15	)
Provision for excess and obsolete inventory and abandoned products		820			13
Loss on disposal of assets		—			34
Impairment of intangibles		192			—
Amortization of intangibles		1,223			1,271
Deferred interest on note payable		226			27
Non cash compensation		248			736
Change in operating assets and liabilities, net of business acquired:
Accounts receivable		(7,810	)		(19	)
Inventories		(2,692	)		(5,280	)
Prepaid expenses and other assets		380			(125	)
Accounts payable and accrued liabilities		3,860			1,134
Deferred revenue		154			86

Net cash used in operating activities		(16,018	)		(12,378	)

Cash flows from investing activities:
Acquisition of Copper Mountain, net of cash acquired		1,529			—
Purchase of short term investments		—			(7	)
Sale of short term investments		—			1,700
Purchase of property and equipment		(1,640	)		(856	)

Net cash provided by (used in) investing activities		(111	)		837

Cash flows from financing activities:
Proceeds from (repayment of) line of credit		7,000			(2,826	)
Repayment of capital lease		—			(97	)
Proceeds from issuance of convertible debt, net of issuance costs					6,527
Proceeds from issuances of common stock, net		14,302			419

Net cash provided by financing activities		21,302			4,023

Net increase (decrease) in cash and cash equivalents		5,173			(7,518	)
Cash and cash equivalents, beginning of period		12,440			12,111

Cash and cash equivalents, end of period	$	17,613		$	4,593

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Office equipment		3-5 years
Computers and software		3-7 years
Test equipment		3-5 years
Leasehold improvements		1-7 years


Completed technology and patents		3-5 years
Customer lists		7 years
Maintenance contract renewals		5 years
Trademarks		7 years


	As of December 31, 2005
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
Corporate debt securities	$	1,693	$	—	$	—	$	1,693

	As of September 30, 2006
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
Corporate debt securities	$	—	$	—	$	—	$	—


Current assets	$	4,285
Property and equipment		706
Completed technology and patents		6,221
Goodwill		1,672

Total assets acquired		12,884
Total liabilities assumed		1,155

Net assets acquired	$	11,729


	Three Months Ended September 30, 2005			Nine Months Ended September 30, 2005
Revenue	$	10,039		$	27,231
Net loss	$	(5,600	)	$	(21,762	)
Basic and diluted net loss per share	$	(0.17	)	$	(0.78	)


	December 31, 2005			September 30, 2006
Accounts Receivable:
Accounts receivable	$	10,574		$	10,341
Unbilled revenue		4,355			4,607
Allowance for doubtful accounts		(56	)		(41	)

	$	14,873		$	14,907

Inventories, net:
Finished goods	$	7,794		$	11,488
Raw materials		843			2,428
Allowance for excess and obsolete inventory and abandoned product		(1,918	)		(1,930	)

	$	6,719		$	11,986

Property and equipment:
Computers and software	$	1,853		$	1,844
Test equipment		4,837			5,414
Office equipment		68			188

		6,758			7,446
Less: accumulated depreciation		(3,931	)		(4,934	)

	$	2,827		$	2,512

Accrued liabilities:
Professional Services	$	590		$	743
Accrual for purchase commitments		568			1,814
Restructuring accrual		—			11
Compensation		1,518			1,402
Other		598			656

	$	3,274		$	4,626


	As of December 31, 2005
	Gross Carrying Amount		Accumulated Amortization			Net Intangibles
Amortized intangible assets:
Completed technology and patents	$	13,681	$	(7,769	)	$	5,912
Customer list		86		(39	)		47
Maintenance contract renewals		50		(32	)		18
Trademarks		315		(142	)		173

	$	14,132	$	(7,982	)		6,150

Other non-current assets							155

						$	6,305


	September 30, 2006
Principal notes balance	$	7,000
Accrued interest		20
Unamortized discount on notes		(4,939	)

Total senior subordinated promissory note		2,081
Derivative valuation		1,935
Warrant valuation		1,574

Total senior subordinated promissory note and related obligations	$	5,590


	Operating Leases		Capital Leases
2006	$	309	$	15
2007		1,076		59
2008		330		44
2009		404		—
2010		61		—

	$	2,180		118

Less amount representing interest				(9	)

				109
Less current portion				(56	)

			$	53


				Outstanding Options
	Shares Available For Grant		Options Exercised	Number of Shares		Price Per Share		Aggregate Price			Weighted Average Exercise Price
Balance, December 31, 2005	1,168		2,015	4,753		$	0.52-68.25	$	23,404		$	4.92
Options authorized	375		—	—			—		—			—
Options granted	(1,423	)	—	1,423			0.99-3.27		2,852			1.99
Options exercised	—		235	(235	)		0.92-3.52		(331	)		1.41
Options expired	—		—	—			—		—			—
Options terminated	447		—	(447	)		1.21-41.75		(2,133	)		4.77

Balance, September 30, 2006	567		2,250	5,494		$	0.52-68.25	$	23,792		$	4.33


2006	$	424
2007		1,649
2008		1,247
2009		1,115
2010		444

	$	4,879


2006	$	140
2007		560
2008		560
2009		7,400

Total	$	8,680


	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life (years)	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
$0.52 - 1.09	119	5.27	$	0.86	115	$	0.85
1.12 - 1.12	624	9.88		1.12	52		1.12
1.16 - 1.41	666	6.43		1.28	607		1.29
1.43 - 1.49	780	5.20		1.48	775		1.48
1.55 - 2.50	583	5.58		2.10	541		2.08
2.54 - 2.90	665	9.59		2.80	79		2.89
2.92 - 3.02	685	8.71		2.99	585		3.00
3.04 - 5.01	663	7.15		4.32	645		4.35
5.07 - 28.00	557	6.08		11.10	557		11.10
31.38 - 68.25	152	3.62		44.73	152		44.73

	5,494				4,108


	Restricted Stock
	Number of shares		Weighted- average grant- dated fair value
Unvested at December 31, 2005	5		$	3.97
Awards granted	125			2.57
Awards vested	(17	)		2.81
Awards cancelled/expired/forfeited	(2	)		3.97

Unvested at September 30, 2006	111		$	2.57


	Three Months Ended September 30, 2005			Nine Months Ended September 30, 2005
Net loss – as reported	$	(5,600	)	$	(13,437	)

Stock based employee compensation expense included in net loss		27			249
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects		(503	)		(1,550	)

Net loss – pro forma	$	(6,076	)	$	(14,738	)

Basic and diluted net loss per share – as reported	$	(0.17	)	$	(0.48	)

Basic and diluted net loss per share – pro forma	$	(0.19	)	$	(0.53	)


	Stock Option Plans Three Months Ended September 30,				Employee Stock Purchase Plan Three Months Ended September 30,
	2005		2006		2005		2006
Expected dividend yield	0.0	%	0.0	%	0.0	%	0.0	%
Risk-free interest rate	3.7	%	4.8	%	3.7	%	5.0	%
Expected volatility	87.0	%	100.0	%	87.0	%	39.0	%
Expected life (in years)	4.0		6.25		0.5		0.5


	Payments due by period (in thousands)
Contractual Obligations	Total		Remainder of 2006		2007 to 2008		2009 to 2010		Thereafter
Line of credit	$	4,254	$	4,254	$	—	$	—	$	—
Long-Term Debt Obligations, including interest		4,239		86		4,153		—		—
Convertible Notes		7,000		—		—		7,000		—
Interest on Convertible Notes		1,680		140		1,120		420		—
Operating Lease Obligations		2,180		309		1,406		465		—
Capital Lease Obligations		118		15		103
Purchase Obligations		108		108		—		—		—

Total	$	19,579	$	4,912	$	6,782	$	7,885	$	—


Exhibit Number		Description
2.1		Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of October 28, 2002.(1)

2.3		Agreement and plan of Merger and Reorganization by and among the Company, Wolf Acquisition Corp and Copper Mountain Networks, Inc. dated February 11, 2005 (2)

3.1		Second Amended and Restated Certificate of Incorporation of the Company.(3)

3.2		Bylaws of the Company, as currently in effect. (4)

4.1		Specimen Common Stock Certificate.(3)

11.1		Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements).

31.1		Certification of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.