CTLM Centillium Communications (MM)

Valuation and amortization method -The Company estimates the fair value of stock options granted using the Black-Scholes option-pricing formula and a multiple option award approach. This fair value is then amortized on an accelerated basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term -The Company's expected term represents the period that the Company's stock-based awards are expected to be outstanding and is based on historical option exercise behavior.

Expected Volatility -The Company's stock price volatility rates are estimated using the historical volatility of the Company's common stock.

Expected Dividend -The Black-Scholes valuation model calls for a single expected dividend yield as an input. The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends in the future.

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.

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Estimated Forfeitures -When estimating forfeitures, the Company considers voluntary termination behavior as well as analysis of actual option forfeitures.

Fair Value -The fair value of the Company's stock options granted to employees for the three and six months ended June 30, 2008 and 2007 was estimated using the following weighted-average assumptions:

Under the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), " Share-Based Payment ," or SFAS 123(R), the Company recorded $273,000 and $495,000 of stock-based compensation expense in its consolidated statement of operations for the three months ended June 30, 2008 and 2007, and $550,000 and $1.1 million for the six months ended June 30, 2008 and 2007, respectively. The Company utilized the Black−Scholes valuation model for estimating the fair value of the stock-based compensation granted both before and after the adoption of SFAS 123(R).

At June 30, 2008 and 2007, the total compensation expense related to unvested stock-based awards granted to employees under the Company's stock option plans but not yet recognized was approximately $1.7 million and $2.3 million, respectively, net of estimated forfeitures of $571,000 and $360,000, respectively. The stock-based compensation expense related to unvested stock options was approximately $0.8 million at June 30, 2008, which will be amortized on an accelerated basis over a weighted−average remaining period of approximately 1.3 years, and will be adjusted for subsequent changes in estimated forfeitures. The stock-based compensation expense related to restricted stock units not yet recognized was approximately $1.5 million at June 30, 2008, which will be amortized on a straight-line basis over a weighted-average remaining period of approximately 3.2 years, and will be adjusted for subsequent changes in estimated forfeitures. Total intrinsic value of options exercised for the three and six months ended June 30, 2008 was approximately $50 and $3,000, respectively. Total intrinsic value of options exercised for the three and six months ended June 30, 2007 was approximately $600 and $2,700 respectively.

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The following is a summary of additional information with respect to the stock option plans as of June 30, 2008:

Restricted Stock Units

The Company issues new shares of common stock upon the vesting of restricted stock units. The Company calculates the fair value of each restricted stock unit based upon the fair market value of the Company stock at the date of grant and recognizes the expense straight line over the requisite period. The stock-based compensation expense related to these awards was $172,000 and $273,000 for the three and six months ended June 30, 2008 and 2007, respectively. The stock-based compensation expense related to these awards was $65,000 and $166,000 for the three and six months ended June 30, 2007. Restricted stock unit activity for the six months ended June 30, 2008 is summarized below:

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The weighted-average fair value on the date of the grant for the outstanding restricted stock units as of June 30, 2008 was $1.05.

The aggregate intrinsic value is hypothetically calculated as the difference between the exercise price of the shares which is zero, as the shares are granted without cost to the recipient and the quoted price of the Company's common stock for the 1.1 million outstanding restricted stock units at June 30, 2008.

To provide employees with an opportunity to purchase common stock of the Company through payroll deductions, the Company established the 2000 Employee Stock Purchase Plan, or ESPP, and initially reserved 500,000 shares of common stock for issuance to participants. In addition, the plan provides for automatic annual increases on the first day of each of the Company's years equal to the lesser of 400,000 shares or 1% of the Company's outstanding common stock on the date of the annual increase, or a lesser number of shares determined by the Board of Directors. Under the plan, the Company's employees, subject to certain restrictions, may purchase shares of common stock at the lesser of 85 percent of the fair market value at either the beginning or end of each six-month offering period.

During the three and six months ended June 30, 2008, the shares issued under the Company's ESPP had no aggregate intrinsic value. During the three and six months ended June 30, 2007, the aggregate intrinsic value of the shares issued under the Company's ESPP was $92,340. No stock based compensation expense was recorded under the plan for the six months ended June 30, 2008. In light of the announced transaction with TranSwitch, the Company has suspended the ESPP plan.

Line of Credit

On September 27, 2007, the Company entered into a Loan and Security Agreement with a financial institution. The loan agreement provides commitments for up to $10 million under a revolving line of credit. The line of credit may also be used for letters of credit. As security for the line of credit, the Company granted the financial institution a security interest in all of its assets, except for the shares of certain of its foreign subsidiaries and certain of its intellectual property rights. The loan agreement requires monthly interest payments. Principal payments are not required on the revolving loan until the maturity date, or sooner if an event of default occurs. The maturity date under the loan agreement is September 24, 2008, unless sooner terminated. The interest rate on any outstanding loans is the financial institution's prime rate as then in effect and any adjustments to the interest rate are effective on the effective date of any prime rate changes. The credit agreement also contains certain financial, operating and reporting covenants, including a quarterly "quick ratio" of at least 1.5 to 1.0 and a tangible net worth ratio, and various negative covenants including, among others, prohibitions on certain dispositions, changes in business, indebtedness, encumbrances, dividends or other distributions, and affiliate transactions. Legal expenses associated with the line of credit are expensed as incurred and other fees are amortized over the life of the line of credit. The Company was in compliance with the loan covenants as of June 30, 2008 and a consent from the bank was received for the sale of the DSL related assets in February 2008.

As of June 30, 2008, the Company had drawn down $0.8 million in letters of credit. The Company repaid $1.3 million of borrowings during the three months ended June 30, 2008 and had no outstanding borrowings under the line of credit as of June 30, 2008, resulting in an available, unused line of credit balance of $9.2 million. Further draws and other extensions of credit under the Loan Agreement are subject to specified conditions, including the continued accuracy of the Company's representations (which include, among others, the absence of specified litigation and of a material deterioration in the Company's financial condition, the absence of certain claims and other conditions in respect of the collateral, continued legal compliance, and the continued absence of specified types of investments and equity interests) and the absence of a material adverse change involving the Company since June 30, 2007.

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Note 5. Commitments and Contingencies

The Company leases its facilities under operating leases, expiring through February 2011. In conjunction with its lease of facilities in Fremont, California, in March 2004 the Company capitalized $731,000 of lease incentives, which are being amortized over the seven year lease period as a reduction of rent expense. Additionally, the Company is obligated to make future payments of $1.0 million in connection with certain software licensing arrangements.

The Company does not own or operate a fabrication facility, and foundries located in Asia currently supply substantially all of its wafer requirements. The Company's purchase obligations to these foundries are based on non-cancelable purchase orders. As of June 30, 2008, the Company's non-cancelable purchase obligations for wafers and masks, all expected to be delivered within the next six months, were $0.9 million.

Under certain circumstances, Centillium provides intellectual property infringement protection to its customers. Centillium indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally to its customers, in connection with certain patent, copyright or other intellectual property infringement claims by any third parties with respect to its products. This indemnification obligation is generally perpetual but is typically subject to an overall cap on liability. Although these indemnification obligations may give rise to material accruals, to date, Centillium has not incurred significant costs to defend itself or settle claims related to these indemnification obligations. However, in accordance with Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies", or FAS 5, the Company had determined certain of these obligations are both probable and reasonably estimable. Centillium had accrued $4.3 million in connection with certain contingent liabilities as of June 30, 2008 and as of December 31, 2007. The indemnification obligations are included in the Company's royalty accrual.

In addition, Centillium responds to other claims arising in the ordinary course of business. Although the ultimate outcome of such claims is not presently determinable, management believes that the resolution of these matters will not have a material adverse effect on Centillium's results of operations, but could have a material adverse effect on its financial position and cash flows. In July 2008, Aware, Inc. filed a suit against the Company in the United States District Court for the District of Massachusetts alleging, among other things, that the Company breached the terms of the Development and License Agreement between Aware and the Company. The Company intends to defend itself vigorously.

Inventories (in thousands):

In the three months ended June 30, 2008 and 2007, the Company recorded charges to cost of revenues for the write-down of excess inventory of $99,000 and $329,000, respectively. Additionally, during the three months ended June 30, 2008 the Company's recorded gross margin did not benefit from unexpected sales of previously written-down inventory compared to $260,000 of such sales in the three months ended June 30, 2007. In the six months ended June 30, 2008 and 2007, the Company recorded charges to cost of revenues for the write-down of excess inventory of $141,000 and $329,000, respectively. Additionally, during the six months ended June 30, 2008 the Company's recorded gross margin benefited from unexpected sales of previously written-down inventory of $336,000, compared to $276,000 of such sales in the six months ended June 30, 2007. The Company sold $2.0 million of inventory to Ikanos Communications, Inc., or Ikanos as part of the sale of its DSL product lines in February 2008.

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Property and equipment, net (in thousands):

Assets held for sale of $0.7 million as of December 31, 2007 included $6.8 million of costs less $6.1 million of accumulated depreciation for equipment related to the DSL product lines sold to Ikanos in February 2008 and were reported at the lower of the carrying amount or fair value less costs to sell. See Note 11 of notes to consolidated financial statements, below. In accordance with the provisions of SFAS 144, "Accounting for the Impairment or Disposal of Long-lived Assets," the Company has not accounted for this transaction as a discontinued operation because the operations and cash flows of these assets could not be clearly distinguished, operationally or for financial reporting purposes, from the rest of the Company's business.

Accrued liabilities and other (in thousands):

The Company periodically evaluates any contingent liabilities in connection with any payments to be made for any potential intellectual property infringement asserted or unasserted claims in accordance with FAS 5, "Accounting for Contingencies". The Company's accrued royalties as of June 30, 2008 and December 31, 2007 reflect the reversal of previously accrued royalties that can no longer be recovered from the Company due to statutory limitations contained in the applicable patent law and represents the remaining amounts previously accrued for certain asserted or unasserted claims for patent royalties.

Our current estimates of future reversals of the amounts of these royalties accrued as of June 30, 2008 are:

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Warranty reserve (in thousands):

Cash equivalents and short-term investments (in thousands):

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See Note 14 for information and related disclosures regarding the Company's fair value measurements.

Note 8. Provision for Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction, California and various state and foreign tax jurisdictions in which the Company has a subsidiary or branch operations. All tax years from inception remain open to examination by the Internal Revenue Service, the State of California and various states until such time as the net operating losses and research credits are either fully utilized or expire. The foreign tax jurisdictions remain open to examination for the years between 2002 to 2007.

The provision for income taxes for the three and six months ended June 30, 2008 and 2007 relates to taxes payable for Centillium's subsidiaries located in foreign jurisdictions. Income tax expense differs from the expected benefit that was derived by applying the applicable U.S. federal statutory rate to the loss from operations primarily due to losses that are not currently available for tax benefit. Due to the Company's loss position, a full valuation allowance has been established against its deferred tax assets, consisting primarily of net operating loss carryforwards.

Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109", or FIN 48. The Company's policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.

The Company's total unrecognized tax benefit as of the January 1, 2007 adoption date and as of June 30, 2008 was $9.7 million and $11.2 million, respectively.

The tax jurisdiction in India operates under a tax holiday which will expire at the end of March 2009. No changes to the unrecognized tax benefits were recorded in the three and six months ended June 30, 2008.

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No changes to deferred tax assets for unrecognized tax benefits were recorded in the three and six months ended June 30, 2008.

The Company's policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. The Company had accrued interest and penalties as of June 30, 2008 and December 31, 2007, of $122,000 and $105,000, respectively.

Note 9. Net Loss Per Share

Basic and diluted net loss per share have been computed using the weighted average number of shares of common stock outstanding during the period. The following table presents the computation of basic and diluted net income (loss) per share (in thousands, except per share amounts):

Centillium has excluded all outstanding stock options and restricted stock units from the calculation of diluted net loss per share because these securities are anti-dilutive for all periods presented. These excluded common share equivalents could be dilutive in the future. Options to purchase 6,819,899 and 7,792,935 shares of common stock have been excluded at June 30, 2008 and 2007, respectively. Restricted stock units to purchase 1,105,112 and 498,605 shares of common stock, have been excluded at June 30, 2008 and 2007, respectively.

Note 10. Comprehensive Net Loss

The following table presents the computation of comprehensive net loss (in thousands):

accrual reversal that was associated with the employees transferred to Ikanos. In accordance with the provisions of SFAS 144, "Accounting for the Impairment or Disposal of Long-lived Assets," we did not account for this transaction as a discontinued operation because the operations and cash flows of these assets could not be clearly distinguished, operationally or for financial reporting purposes, from the rest of our business. The following is a summary of the gain on the sale of DSL related assets (in thousands):

In December 2005, Accton Technology Corporation, or Accton, filed a suit against Centillium in the California Superior Court for the County of Alameda alleging a variety of claims, including breach of contract, breach of express warranty, and fraud and concealment in connection with certain products Accton purchased in 2002 and 2003. The parties settled the dispute on July 12, 2007 for a payment by Centillium of $2.5 million which was expensed in 2007. In May 2008, the Company signed a settlement agreement with insurance companies who agreed to pay $2.4 million to Centillium in connection with the Accton settlement and related legal fees. Net of expenses of approximately $0.4 million, $2.0 million gain on settlement was recorded during the three months ended June 30, 2008.

In 2005, the Company recorded $2.2 million in charges for surplus space in its Fremont, California location, which it abandoned. Due to current real estate market conditions, the Company increased the surplus space reserve, to extend the estimated vacant lease period, by $0.8 million during 2007. The Company recorded a $0.4 million charge for additional surplus space in its Fremont, California location, which it abandoned in the three months ended June 30, 2008. The operating lease for this location expires in February 2011. Centillium has no future use for the surplus space as a result of the decrease in personnel in Fremont.

In February 2008, the Company announced a restructuring plan in conjunction with the sale of its DSL product lines, which was intended to further reduce its operating and employee related costs. Restructuring charges of $2.9 million were incurred during the six months ended June 30, 2008 which consisted primarily of $1.6 million of software license termination costs, $0.4 million of surplus space reserve and $0.9 million of employee severance related expenses, net of $0.1 million reversal of sabbatical accrual related to severed employees. Restructuring charges of $0.6 million were incurred during the three months ended June 30, 2008 which consisted of $0.4 million of surplus space reserve and $0.2 million of software license costs.

A summary of the Company's restructuring expenses, accrued surplus space and accrued restructuring expenses is as follows for the six month's ended June 30, 2008 (in thousands):

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* Lease payments offset against reserve liability and leasehold asset reserve applied to accumulated depreciation
** $563 Release of prepaid contract expense

SFAS 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company's adoption of SFAS 157 did not have an impact on our financial position or results of operations. The following table represents the fair value hierarchy for the financial assets (cash equivalents, short-term investments and restricted cash) measured at fair value on a recurring basis as of June 30, 2008 (in thousands):

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Note 15. Business Segment Information and Customer Concentration

Centillium operates in one operating segment, broadband communications. Centillium's foreign operations consist primarily of design centers in India and France, and sales and marketing offices in several locations around the world. Geographic sales information is based on the location of the Company's end customer.

The following customers accounted for more than 10% of net revenues in the periods indicated:

The following is a summary of net revenues by major geographic area (in thousands):

Long-lived assets by geographical area were as follows (in thousands):

On July 9, 2008, the Company announced that it had entered into an Agreement and Plan of Merger, which is referred to in this report as the merger agreement, with TranSwitch Corporation. The merger agreement provides that, upon the terms and subject to the conditions set forth in the agreement, Centillium will ultimately merge with and into a subsidiary of TranSwitch and exist as a wholly owned subsidiary of TranSwitch.

Subject to the terms and conditions of the merger agreement, which has been unanimously approved by the boards of directors of both companies, at the effective time and as a result of the merger, TranSwitch will pay Centillium shareholders and holders of certain Centillium stock options an aggregate of 25 million shares of TranSwitch common stock and $15 million in cash. In the merger agreement, TranSwitch and Centillium have made customary representations, warranties and covenants. Centillium has also agreed to use commercially reasonable efforts to convene and hold a meeting of its stockholders to consider and vote upon the approval of the transaction.

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The foregoing description of the merger agreement and other references to the merger agreement in this Form 10-Q do not purport to be complete and are qualified in their entirety by reference to the full text of the merger agreement, a copy of which has been filed with the SEC and the terms of which are incorporated herein by reference.

Consummation of the merger is subject to customary conditions, including (a) approval of the transaction by the stockholders of Centillium, (b) absence of any applicable law prohibiting the merger, (c) subject to certain exceptions, the accuracy of the representations and warranties of each party, (d) performance in all material respects of each party of its obligations under the Merger Agreement and (e) the delivery of customary opinions from counsel to TranSwitch and counsel to Centillium to the effect that the receipt of stock merger consideration by Centillium stockholders will be a tax-free reorganization for federal income tax purposes, subject to the exceptions provided therein.

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

You should read the following discussion and analysis in conjunction with our condensed consolidated financial statements and related notes in Item 1 above, and our consolidated financial statements and the related notes thereto included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 17, 2008. The information in this report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the SEC.

All statements included or incorporated by reference in this report, other than statements or characterizations of historical fact, are "forward-looking statements" that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Examples of forward-looking statements include, but are not limited to, statements concerning the anticipated timing of our pending merger with TranSwitch; the anticipated benefits of the merger; projected net revenues, costs and expenses and gross margin; anticipated cost savings; our anticipated cash flows and future capital resources; our accounting estimates, assumptions and judgments; the impact of accounting rules related to the expensing of stock options on our future reported results; the impact of anticipated market and customer trends and developments; our ability to penetrate the VoIP and FTTP markets and to expand our business after the recent divestiture of our DSL product lines; our ability to control expenses; and the impact of competition and technological change in the telecommunications and networking market. Additional forward-looking statements may be preceded by words that imply a future state such as "expected," "estimated," "planned" or "anticipated" or imply that a particular future event or events will occur such as "will". These forward-looking statements are based on our current expectations, estimates and projections about our industry and business, management's beliefs, and certain assumptions made by us, all of which are subject to change. Investors are cautioned that all forward-looking statements involve risks and uncertainties and actual results could be materially different from those expressed in or implied by any forward-looking statement. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Risks and uncertainties that could cause actual results to differ from those expressed or implied by our forward-looking statements include the risk that the pending merger with TranSwitch may not be consummated; the risk that the closing of the merger will be delayed; uncertainties concerning the effect of the transaction on relationships with customers, employees and suppliers of either or both of the companies; the risk that the two companies will not be integrated successfully and in a timely manner even if the closing occurs as anticipated; the risk that the transaction may involve unexpected costs or unexpected liabilities; and the other risk factors set forth in the section entitled "Risk Factors" under Part II, Item 1A, and similar discussions in our other reports filed with the SEC. Copies of our reports filed with the SEC are available from us without charge and on the SEC's website at www.sec.gov. You should carefully consider those risks, in addition to the other information in this report and in our other filings with the SEC, before deciding to invest in Centillium or to maintain or increase your investment.

We design, develop and supply highly-integrated programmable system-on-a-chip (SoC) solutions that enable high-speed broadband access, which is the delivery of high capacity bandwidth to consumers and enterprises for networking of data, voice and video signals. Our SoC products incorporate digital and mixed-signal semiconductors

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and related software. We serve the Voice over Internet Protocol (VoIP) and Fiber-To-The-Premises (FTTP), which is also known as optical networking, markets. Our customers are systems vendors and original equipment manufacturers, or OEMs, that sell optical network equipment, for deployment in central offices and customer premises, and VoIP equipment, for use in carrier-class and enterprise-class gateways and consumer telephony applications. In February 2008, we sold our digital subscriber line, or DSL, product lines in order to focus exclusively on our VoIP and FTTP businesses. Our DSL product lines had previously accounted for a majority of our revenues but had been declining in recent periods. Our DSL products consisted of Asymmetric DSL (ADSL), and a next generation of DSL products, referred to as VDSL2 products. Our DSL customers also consisted of systems vendors and OEMs.

On July 9, 2008, we entered into an Agreement and Plan of Merger, which we refer to as the merger agreement, with TranSwitch Corporation, a Delaware corporation. The merger agreement provides that, upon the terms and subject to the conditions set forth in the agreement, Centillium will ultimately merge with and into a subsidiary of TranSwitch and exist as a wholly owned subsidiary of TranSwitch.

Subject to the terms and conditions of the merger agreement, which has been unanimously approved by the boards of directors of both companies, at the effective time and as a result of the merger, TranSwitch will pay Centillium shareholders and holders of certain Centillium stock options an aggregate of 25 million shares of TranSwitch common stock and $15 million in cash. In the merger agreement, TranSwitch and Centillium have made customary representations, warranties and covenants. The merger is subject to various closing conditions including the approval of our stockholders. The foregoing is not a complete summary of all of the terms and conditions of the merger agreement; reference is made to the full text of the merger agreement, which is filed as an exhibit to our Current Report on Form 8-K dated July 9, 2008, for more information.

In February 2008, we completed the sale of certain fixed and certain intangible assets comprising our DSL product lines to Ikanos Communications, Inc., a publicly-held company, for total cash consideration of $12.0 million. Upon closing of the transaction, Ikanos paid us net cash proceeds of $10.2 million after placing $1.8 million (or 15%) of the aggregate purchase price in an escrow for one year as security for certain indemnification obligations pursuant to the asset sale agreement, including breaches of our representations and warranties. Additionally, in February 2009 we may be obligated to pay Ikanos up to $0.5 million for certain contingency payments that were stipulated in the asset sale agreement. In addition, we incurred approximately $0.8 million in transaction costs. We recorded a gain on this sale of DSL related assets of $8.1 million in the first quarter of 2008. In accordance with the provisions of SFAS 144, "Accounting for the Impairment or Disposal of Long-lived Assets," we did not account for this transaction as a discontinued operation because the operations and cash flows of these assets could not be clearly distinguished, operationally or for financial reporting purposes, from the rest of our business. This sale significantly reduced the size of our business and revenues, and our business model now focuses exclusively on our optical and VoIP products, which have historically generated fewer revenues than our legacy DSL products. In 2007, optical and VoIP net revenues represented 15% and 25%, respectively, of our total net revenues.

In February 2008, we also announced a restructuring plan in conjunction with the sale of our DSL product lines, which was intended to further reduce our operating and employee related costs. Restructuring charges of $2.9 million were incurred during the six months ended June 30, 2008 which consisted primarily of $1.6 million of software license termination costs, $0.4 million of surplus space reserve and $0.9 million of employee severance related expenses. Restructuring charges of $0.6 million were incurred during the three months ended June 30, 2008 which consisted primarily of $0.4 million of surplus space reserve and $0.2 million of software license termination costs. Further execution of our restructuring plan in the third quarter of 2008 will result in additional estimated restructuring charges of $0.9 million related to contract termination costs and severance related expenses.

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Reversal of Accrued Royalties

Operating expenses for the three and six months ended June 30, 2008 include $990,000 and $1.8 million benefit, respectively, from partial reversals of certain royalty accruals. We periodically evaluate any contingent liabilities in connection with asserted or unasserted claims for intellectual property infringement in accordance with FAS 5, "Accounting for Contingencies". Our accrued royalties as of December 31, 2007 and June 30, 2008 reflect the partial reversal of certain royalties that were previously accrued. Based on the applicability of statutory limitations contained in the patent law, however, these particular royalties could no longer be recovered from us. We currently expect to further reverse such liabilities as the statutory limitations become applicable to future periods. The actual amounts of reversals in any future period will depend upon factors including the then-applicable law and accounting standards.

Our current estimates of future reversals of the amounts of these royalties accrued as of June 30, 2008 are:

Our products are components of broadband access infrastructure equipment, and we rely on OEMs to select our products over our competitors' products to be designed into their equipment. These "design wins" are an integral part of the long sales cycle for our products. The sales cycle of our products is lengthy and typically involves a detailed initial technical evaluation of our products by our prospective customers, followed by the design, construction and testing of prototypes incorporating our products. Our focus is on design, development, sales and marketing. We outsource our semiconductor fabrication, assembly and test functions.

We currently market and sell through our direct sales force, through independent sales representatives and through an independent distributor in Europe and Russia.

We have not reported an operating profit for any year since inception and experienced a net loss of $0.4 million and $14.8 million for the six months ended June 30, 2008 and 2007, respectively. We incurred a net loss of $17.6 million for the year ended December 31, 2007. We expect to continue to incur operating losses and negative cash flows in the near term.

Our revenues were $12.5 million compared with $20.6 million for the six months ended June 30, 2008 and 2007, respectively, a decrease of 39%. Furthermore, in 2007 our net revenues were $39.2 million, compared with $64.6 million in 2006, a decrease of 39%. We experienced a significant revenue decline in the DSL market in 2007 and 2006. We expect that our net revenues in 2008 will be substantially lower than in 2007, due to the sale of our DSL product lines in February 2008. Revenues for the first quarter of 2008 included $522,000 of DSL revenues. Our net loss for the six months ended June 30, 2008 was $0.4 million, which included the gain on the sale of the DSL related assets, in comparison to a net loss of $14.8 million for the six months ended June 30, 2007. Our net loss in 2007 was $17.6 million, compared with $10.7 million and $11.3 million in 2006 and 2005, respectively.

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From inception through the sale of our DSL product lines in February 2008, the majority of our net revenues were derived primarily from the sale of our ADSL products to two customers in Japan. These two customers were NEC Corporation, or NEC, and Sumitomo Electric Industries, Ltd., or Sumitomo. The ADSL new subscriber market in Japan shrank dramatically in 2007, 2006 and 2005. Our Japan ADSL revenues declined 55%, 35% and 17% in 2007, 2006 and 2005, respectively. We consummated the sale of our DSL product lines to Ikanos in February 2008 and as a result, we will no longer generate any future revenues from the sale of our DSL products. Revenues for the first quarter of 2008 included $522,000 of DSL revenues.

Our VoIP revenues were $5.9 million and $5.2 million in the six months ended June 30, 2008 and 2007, respectively. Our VoIP revenues were $9.9 million and $10.8 million for the years ended December 31, 2007 and 2006, respectively, and can vary significantly from quarter to quarter. This is largely due to the variable nature of the growth of this market and the related deployments of VoIP equipment by telecommunications service providers. Moreover, sales of our VoIP products are concentrated with a relatively limited number of customers, which may cause our sales to vary widely depending on changes even in a single customer's deployment schedule and testing requirements. We expect our net revenues from VoIP in the third quarter of 2008 to decline slightly, compared to the second quarter of 2008.

Our FTTP revenues were $6.1 million and $649,000 in the six months ended June 30, 2008 and 2007, respectively, and $5.9 million and $4.0 million for the years ended December 31, 2007 and 2006, respectively. We have been heavily engaged in the development of a gigabit Ethernet passive optical networking, or GEPON, solution for the FTTP market. We introduced our newest generation of GEPON chips, called ME300, in 2007. We also entered into an agreement with a third party in May 2007 that gives us exclusive rights to an EPON chip that they developed. This EPON chip was an improvement on a previous solution of this third party that had already been tested by service providers in Japan. It was designed specifically to meet the requirements of the targeted service providers. Obtaining these exclusive rights to this chip allows us to improve our chances of success by providing us with additional technology to penetrate our primary target market, Japan. We refer to this EPON chip as the ME250.

After discussions with a major customer, we decided to move forward with the ME250 for this customer as the principal telecommunications service provider in Japan has already accepted this customer's internal ME250 test results and has begun its own validation of this customer's FTTP system with that chip. We also signed a strategic agreement with this customer for the delivery of the ME250 EPON chips. This customer's FTTP system with the ME250 has been validated by the principal telecommunications service provider but we must obtain the anticipated market share of that service provider's business for us to grow our FTTP revenues from this product in 2008 and beyond. There can be no assurance that this service provider will purchase our customer's FTTP systems with the ME250 in the anticipated quantities or that the remainder of these orders will not be canceled, or the anticipated delivery delayed.

Our other FTTP product, the ME300, is also currently being validated internally by another customer. If the ME300 is validated, we anticipate that it will be the platform that we will generally market going forward with other customers, due to its more aggressive integration and ease of roadmap migration. There can be no assurance that the ME300 will be validated or selected by any customer and even if it is, that it will meet our customers' requirements or that our customers will purchase this product and generate any revenues from it. Moreover, even if all this occurs, there can be no assurance that any of our customers' FTTP systems with the ME300 will be validated by the principal telecommunications service provider and even if it is, that this service provider will purchase any customer's FTTP systems with the ME300 in the anticipated quantities, if at all.

We have traditionally sold our products on the basis of our standard terms and conditions. We are increasingly being required to enter into purchase agreements with key customers and potential customers as a condition to doing business with them. These agreements shift significantly more risk and cost on to us. Doing business under terms of this nature could increase our costs, cause us to bear greater inventory risk and increase our liabilities, which could materially affect our business, results of operations and financial condition.

Our planned actions for 2008 and beyond are based on certain assumptions concerning the timing and progress of our pending merger with TranSwitch, the adoption of broadband technologies, the successful qualification and deployment of our FTTP products in Japan, the extent of demand for our VoIP products and the cost and expense structure of our business. These assumptions could prove to be inaccurate. If economic or market conditions

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deteriorate to an unexpected degree, if our products and technologies are not accepted and deployed to the extent we currently assume, if the pending TranSwitch merger does not occur as currently assumed or causes unexpected disruption or expense until it is consummated, or if our planned actions are not successful in achieving our goals, there could be additional adverse impact on our revenues, profitability, financial position and cash flows. In that case, we might need to modify our strategic focus or take other corrective actions.

We anticipate that we will continue to incur operating losses and use cash for the foreseeable future. While we believe that existing cash and short-term investments will be sufficient to support our current operations for the next twelve months, that cannot be assured. This belief is based on a variety of assumptions that are subject to risks and uncertainties, and if any of those assumptions proves to be inaccurate or if our cash flows from operations do not meet our expectations, our cash and short-term investments could be inadequate to meet our liquidity requirements. For example, we have assumed that new product introductions will occur on a timely basis and will achieve market acceptance, but there is no guarantee that this will happen. We also have significant litigation risk, and if we are required to make any substantial payments due to adverse results in litigation, this could seriously affect our liquidity and materially affect our business, results of operations and financial condition. Other risks that could cause our actual cash position to vary are set forth below, under item 1A, "Risk Factors," of this report.

Our operating results have been and will continue to be materially affected by additional stock-based compensation expense. Pursuant to Statement of Financial Accounting Standards No. 123 (revised 2004), or SFAS 123(R), which we adopted effective January 1, 2006, we must reflect the fair value of stock options and other stock-based awards as an expense in our financial statements. We anticipate that these stock-based compensation charges will continue to be material to our future operating results. As of June 30, 2008 and 2007, the total unrecognized compensation expense related to unvested stock-based awards, as determined by SFAS 123(R), using the assumptions we had in effect as of that date, was approximately $1.8 million and $2.3 million, net of estimated forfeitures of $571,000 and $360,000, respectively. That total expense is expected to be recognized over an estimated weighted average period of 1.2 years for unvested stock-based awards to 3.1 years for restricted stock units.

Net Revenues. VoIP and FTTP revenues accounted for 96% of our net revenues and DSL accounted for 4% for the six months ended June 30, 2008. We no longer generate any revenues from the sale of DSL products. Our DSL revenues accounted for 4%, 60%, 77% and 79% of our net revenues for the six months ended June 30, 2008 and for the years ended December 31, 2007, 2006 and 2005, respectively.

For the six months ended June 30, 2008, OKI Electric Industry Co., Ltd. (OKI) accounted for 24% of our net revenues. For the six months ended June 30, 2008 and for the years ended December 31, 2007, 2006, and 2005, Lucent Technologies accounted for 27%, 15%, 12% and 13% of net revenues, and Sumitomo Electric Industries, Ltd (Sumitomo) accounted for 24%, 26%, 26% and 35% of net revenue, respectively. For the years ended December 31, 2007, 2006, and 2005 NEC Corporation (NEC) accounted for 15%, 23% and 26% of net revenue, respectively. Ericsson accounted for 23% and 16% of net revenues in 2007 and 2006, respectively. No other customer accounted for 10% or more of our net revenues during the six months ended June 30, 2008 and the years ended December 31, 2007, 2006 and 2005.

The following is a summary of net revenues by product family for sales to NEC, Sumitomo, Lucent and Ericsson as a percentage of revenue we generated from the sale of our product to that customer in 2007:

While our sales have historically been denominated in U.S. dollars, major fluctuations in foreign currency exchange rates could materially impact our customers' demand for our products as most of our major customers are foreign entities.

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The cycle for test, evaluation and adoption of our products by customers can range from three to more than six months with an additional three to more than nine months before a customer commences volume production of equipment incorporating our products. Additionally, this cycle may be as long as 18 to 24 months for certain VoIP and FTTP products. Due to this lengthy sales cycle, we may experience significant delays from the time we incur expenses for research and development, marketing and selling, and investment in inventory, to the time we generate corresponding revenues, if any. We anticipate that the rate of orders will vary significantly from quarter to quarter. If anticipated shipments in any quarter do not occur when expected, expenses and inventory levels could be disproportionately high or low, and our results of operations for that quarter, and potentially for future quarters, would be materially and adversely affected. This volatility may become more pronounced as our sales for the remainder of 2008 will be generated entirely by our VoIP and FTTP products.

Competition and technological change in the rapidly evolving VoIP and optical networking markets have influenced, and may continue to influence our quarterly and annual net revenues and results of operations. Average selling prices of our products tend to be higher at the time of introduction and decline over time due to competitive pressures. We expect this pattern to continue with existing and future products. Our average selling prices are also impacted by our customer and product mix. We are increasingly selling into certain markets where pricing is very competitive. As a result, our gross margins are lower in these markets. If the gross profit generated from these markets is not sufficient to offset the cost of business in these markets, this may have a negative impact on our financial results.

Cost of Revenues: We are a fabless semiconductor company: we outsource the wafer fabrication, assembly and testing of our products. Our cost of revenues primarily consists of purchased finished wafers, assembly and test services, royalties, overhead associated with procurement and production engineering, provisions for excess and obsolete inventories, and product warranty costs.

Research and Development Expenses: Research and development (R&D) expenses consist primarily of employee compensation including stock-based compensation expense and related personnel expenses, fees paid to consultants, new product development costs, evaluation and testing of pre-production parts and engineering design tools. We expense our research and development costs as they are incurred. Several components of our research and development effort require significant expenditures, the timing of which can cause significant quarterly variability in our expenses.

Selling, General and Administrative Expenses: Selling, general and administrative (SG&A) expenses include employee compensation including stock-based compensation expense and related personnel expenses in sales and marketing, product marketing, applications engineering, and corporate functions including accounting, finance, legal, human resources and information systems.

Gain on Sale of DSL Related Assets: In February 2008, we completed the sale of certain fixed and certain intangible assets comprising our product lines serving DSL customers to Ikanos Communications, Inc., a publicly-held company, for total cash consideration of $12.0 million. Upon closing of the transaction, Ikanos paid us net cash proceeds of $10.2 million after placing $1.8 million (or 15%) of the aggregate purchase price in an escrow for one year as security for certain indemnification obligations pursuant to the asset sale agreement, including breaches of our representations and warranties. Additionally, in February 2009 we may be obligated to pay Ikanos up to $0.5 million for certain contingency payments that were stipulated in the asset sale agreement. In addition, we incurred approximately $0.8 million in transaction costs. We recorded a gain on this sale of DSL related assets of $8.1 million in the first quarter of 2008. In accordance with the provisions of SFAS 144, "Accounting for the Impairment or Disposal of Long-lived Assets ," we did not account for this transaction as a discontinued operation because the operations and cash flows of these assets could not be clearly distinguished, operationally or for financial reporting purposes, from the rest of our business.

Gain/(Loss) on Settlement: In December 2005, Accton Technology Corporation, or Accton, filed a suit against us in the California Superior Court for the County of Alameda alleging a variety of claims, including breach of contract, breach of express warranty, and fraud and concealment in connection with certain products Accton purchased in 2002 and 2003. We settled the dispute on July 12, 2007 for a payment by Centillium of $2.5 million which was expensed in 2007.

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In May 2008, we signed a settlement agreement with insurance companies who agreed to pay $2.4 million to us in connection with the Accton settlement and related legal fees. Net of expenses of approximately $0.4 million, $2.0 million gain on settlement was recorded during the three months ended June 30, 2008.

Restructuring Charges: In February 2008, we announced a restructuring plan to reduce operating and employee related costs. Restructuring charges of $2.9 million were incurred during the six months ended June 30, 2008, which consisted primarily of $1.6 million of software license termination costs, $0.4 million of surplus space reserve and $0.9 million of employee severance related expenses. Restructuring charges of $0.6 million were incurred during the three months ended June 30, 2008 which consisted primarily of $0.4 million of surplus space reserve and $0.2 million of software license termination costs. Further execution of our restructuring plan in the third quarter of 2008 will result in an additional restructuring charge, which we estimate will be approximately $0.9 million. In 2005, we recorded restructuring charges for surplus space in our Fremont, California location, which we abandoned. Due to current real estate market conditions, we increased the surplus space reserve in 2007, to extend the estimated vacant lease period through February 2011.

Reversal of Accrued Royalties: Operating expenses include benefits from partial reversals of accrued royalties in the first six months of 2008. We periodically evaluate any contingent liabilities in connection with any payments to be made for any asserted or unasserted potential intellectual property infringement asserted or unasserted claims in accordance with FAS 5, "Accounting for Contingencies". Our accrued royalties as of December 31, 2007 and June 30, 2008 reflect the partial reversal of certain royalties that were previously accrued with respect to sales during a past period of time. However, because of the applicability of statutory limitations contained in the patent law, these particular royalties can no longer be recovered from us. We currently expect to further reverse additional royalty accruals as this statutory limitation becomes applicable to subsequent periods of time.

Interest and Other Income: Interest income consists of interest earned on cash and cash equivalent balances and short-term investments.

Interest and Other Expense: Interest and other expense primarily consist of foreign currency losses.

Provision for Income Taxes: The provisions for income taxes relate to current taxes payable for income generated by our subsidiaries located in foreign jurisdictions. Income tax expense differs from the expected benefit that was derived by applying the applicable U.S. federal statutory rate to the loss from operations primarily due to losses that are not currently available for tax benefit. Due to our loss position, a full valuation allowance has been established against our deferred tax assets, consisting primarily of net operating loss carry-forwards, research and development tax credits and reserves and accruals not currently deductible.

General: Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires that we make assumptions, estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities reported in the condensed consolidated financial statements and accompanying notes. On an on-going basis, we evaluate our estimates and assumptions related to revenue recognition, sales returns and allowances, allowance for doubtful accounts, inventories, warranty and litigation and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition : Revenues related to product sales are generally recognized when the products have been shipped and risk of loss has passed to the customer, collection of the resulting receivable is reasonably assured, persuasive evidence of an arrangement exists, and the price is fixed or determinable. Certain royalty payments to a customer are recorded as a reduction in revenue. If sales arrangements contain customer-specific acceptance

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requirements, revenue is deferred and is recognized upon receipt of customer acceptance. Revenue from maintenance and support is deferred and recognized on a straight line basis over the life of the related agreement.

Stock-Based Compensation : We adopted Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share-Based Payment," or SFAS 123(R), effective January 1, 2006. SFAS 123(R) requires the recognition of the fair value of stock-based compensation in operating results. SFAS 123(R) is a new and very complex accounting standard. Applying this standard requires significant judgment and the use of estimates, particularly surrounding Black-Scholes option pricing model assumptions, such as stock price volatility and expected option lives, as well as expected option forfeiture rates to value equity-based compensation. These assumptions and estimates are subject to change over time, which may affect the related stock-based compensation expenses that we recognize in our financial statements. The fair value of our restricted stock units is calculated based upon the fair market value of Company stock at the date of grant in accordance with SFAS 123(R). The stock-based compensation expense related to stock options is amortized on an accelerated basis. The stock-based compensation expense related to restricted stock units is amortized on a straight-line basis.

Sales Returns and Allowances: Upon shipment of our products, we establish a provision for estimated returns. Under certain circumstances, we allow our customers to return products and a provision is made for such returns. Our estimate of product returns is based on contractual terms or sales agreements, historical experience and expectation of future conditions. Additional provisions and allowances may be required, resulting in decreased net revenues and gross profit, should we experience increased product returns.

Allowance for Doubtful Accounts: We perform ongoing credit evaluations of our customers and adjust credit limits, as determined by our review of current credit information. We record allowances for doubtful accounts for estimated losses based upon specifically identified amounts that we believe to be uncollectible. We record additional allowances based on certain percentages of our aged receivables, which are determined based on historical experience and our assessment of the general financial condition of our customer base. If our actual collections experience changes, revisions to our allowances may be required. We have a limited number of customers with individually large amounts due at any given balance sheet date. Any unanticipated change in one of those customers' creditworthiness or other matters affecting the collectibility of amounts due from such customers could have a material effect on our results of operations in the period in which such changes or events occur.

Inventories: Inventories are stated at the lower of standard cost, which approximates actual cost, or net realizable value. Cost is based on a first-in, first-out basis. We perform detailed reviews of the net realizable value of inventories, both on hand and those we are committed to purchase, with consideration given to deterioration, obsolescence, and other factors. Currently, we use a nine- month rolling forecast based on the type of products, anticipated product orders, product order history, forecasts and backlog. We compare our current or committed inventory levels to these forecasts on a regular basis and any adverse changes to our future product demand may result in increased write-downs, resulting in decreased gross profit. In the event we experience unanticipated demand and are able to sell previously written down inventories, gross profit will increase.

Warranty: A limited warranty is provided on our products, generally for a period of one year, and allowances for estimated warranty costs are recorded during the period of sale. While we engage in product quality programs and processes, including monitoring and evaluating the quality of our suppliers, our warranty obligation is affected by product failure rates, the cost of replacing chipsets, rework costs and freight incurred in replacing a chipset after failure. We monitor chipset returns for warranty and maintain a reserve for the related warranty expenses based on historical experience of similar products. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty. We periodically assess the adequacy of the warranty liability and adjust such amounts as necessary.

Accounting for Uncertainty in Income Taxes: Effective January 1, 2007, we adopted the provisions of Financial Accounting Standards Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109", or FIN 48, which prescribes how a company should recognize, measure, present and disclose uncertain tax positions that such company has taken or expects to take in its income tax returns. FIN 48 requires that only income tax benefits that meet the "more likely than not" recognition threshold be recognized or continue to be recognized on its effective date. Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.

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Litigation and Contingencies: From time to time, we receive various inquiries or claims or are involved in litigation in connection with patent and other intellectual property rights as well as breach of contract and other claims. When the liability is probable and estimable, we have accrued estimates of the amounts we expect to pay upon resolution of such matters. Based on the applicable patent law and depending on developments and new information in these matters, these estimates may change and may result in increased accruals, resulting in decreased profit or decreased accruals, resulting in increased profit, respectively.

The above items are not a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. generally accepted accounting principles with no need for our management's judgment in their application. There are also areas in which our management's judgment in selecting any available alternative would not produce a materially different result.

Results of Operations for the Three and Six Months Ended June 30, 2008 and 2007

The following table sets forth, for the periods presented, certain data from our unaudited condensed consolidated statements of operations expressed as a percentage of net revenues.

_________________________
* Less than 1%

Net Revenues . The following tables present net revenues, cost of revenues and gross profit for the three and six months ended June 30, 2008 and 2007 (in thousands except for percentages):

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During 2007 and 2006, our revenues were generated principally from sales of our DSL, VoIP and FTTP products. As noted above, we sold our DSL product lines in February 2008. Our revenues are derived from sales of our VoIP and FTTP products. The following tables present net revenues from each of our major product lines for the three and six months ended June 30, 2008 as compared to the three and six months ended June 30, 2007 (in thousands except for percentages):