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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the fiscal quarter ended March 31, 2004

OR

Commission file No. 000-28843

Turnstone Systems, Inc.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

77-0473640

(I.R.S. Employer Identification No.)

7650 MARATHON DRIVE, SUITE A, LIVERMORE, CALIFORNIA 94550

(Address of principal executive offices)

(408) 907-1400

(Issuer’s telephone number)

Indicate by check mark whether the issuer (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 issuer 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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES  x    NO  ¨

As of April 30, 2004, the Issuer had 63,417,130 shares of its Common Stock, par value $.001 per share, issued and outstanding.

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TURNSTONE SYSTEMS, INC.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF NET ASSETS IN LIQUIDATION

(IN THOUSANDS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS IN

LIQUIDATION

(IN THOUSANDS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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TURNSTONE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

On August 6, 2003, our board of directors approved, subject to stockholder approval at our 2003 Annual Meeting of Stockholders, the liquidation and dissolution of Turnstone Systems, Inc. pursuant to a plan of complete liquidation and dissolution. The holders of a majority of our outstanding shares approved the plan of complete liquidation and dissolution on November 11, 2003. The key features of the plan are (1) file a certificate of dissolution with the Secretary of State of the State of Delaware; (2) cease conducting normal business operations, except as may be required to wind up our business affairs; (3) attempt to convert all of our remaining assets into cash or cash equivalents in an orderly fashion; (4) pay or attempt to adequately provide for the payment of all of our known obligations and liabilities; and (5) distribute pro rata in one or more liquidating distributions all of our remaining assets to our stockholders as of the applicable record date.

In connection with the adoption of the plan and the anticipated liquidation, we adopted the liquidation basis of accounting effective November 11, 2003, whereby assets are valued at their estimated net realizable cash values and liabilities are stated at their estimated settlement amounts. Uncertainties as to the precise net value of our non-cash assets, and the ultimate amount of our liabilities make it impracticable to predict the aggregate net value that may ultimately be distributable to stockholders. Claims, liabilities and future expenses for operations, although currently declining in the aggregate, will continue to be incurred with execution of the plan. These costs will reduce the amount of net assets available for ultimate distribution to stockholders. Although we do not believe that a precise estimate of those expenses can currently be made, we believe that available cash and amounts received from sales of non-cash assets will be adequate to provide for our obligations, liabilities, operating costs and claims, and to make cash distributions to stockholders. If available cash and amounts received from sales of non-cash assets are not adequate to provide for our obligations, liabilities, operating costs and claims, estimated future distributions of cash to our stockholders will be reduced.

We filed our certificate of dissolution with the Secretary of State of the State of Delaware effective December 4, 2003. Pursuant to Delaware law, Turnstone Systems, Inc. will continue in existence until at least December 4, 2006. During this period, we will continue to convert our estimated net assets to cash for future distribution to our stockholders. We are not permitted to continue our business as a going concern.

At the close of business on December 4, 2003, we closed our stock transfer books, discontinued recording transfers of our common

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stock, and our common stock was de-listed from the Nasdaq National Market. Any future distributions we make will be made solely to the stockholders of record as of the close of business on December 4, 2003. We intend, in the future, to seek relief from the Securities and Exchange Commission from the reporting requirements under the Exchange Act.

Since we were de-listed from Nasdaq and closed our stock records on December 4, 2003, our shares have continued to trade in the Over the Counter Market’s “pink sheets”. From time to time, trading volume in our shares has been relatively high, and our shares have traded at prices in excess of the highest price we have estimated for potential liquidation distributions. Traders in our shares are cautioned that our shares are highly speculative, and we cannot predict with any accuracy when, or if, additional liquidation distributions will be made.

We may at some point determine that the continued liquidation of Turnstone may be more efficiently handled by retaining a third party liquidator to manage the liquidation process. In particular, we may determine to do so at such time as our outstanding litigation and other significant creditor claims have been resolved. We cannot predict when or if these matters will be resolved, or when or if we will engage a third party liquidator.

Basis Of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The unaudited interim financial statements, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation.

These financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2003 and footnotes thereto, included in the Company’s Annual Report on Form 10-K.

The condensed consolidated financial statements for the three months ended March 31, 2003 were prepared on the going concern basis of accounting, which contemplates realization of assets and satisfaction of liabilities in the normal course of business. As a result of the stockholders’ approval of the Plan and the imminent nature of the liquidation, the Company adopted the liquidation basis of accounting effective November 11, 2003. This basis of accounting is considered appropriate when, among other things, liquidation of a company is probable and the net realizable value of assets are reasonably determinable. Under

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this basis of accounting, assets are valued at their estimated net realizable values and liabilities are stated at their estimated settlement amounts.

The conversion from the going concern to liquidation basis of accounting required management to make significant estimates and judgments. In order to record assets at estimated net realizable value and liabilities at estimated settlement amounts under the liquidation basis of accounting, the Company recorded the following adjustments to record its assets and liabilities to fair value as of November 11, 2003, the date of adoption of the liquidation basis of accounting:

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with an original maturity of less than three months at the date of purchase to be cash equivalents. Cash equivalents at March 31, 2004 and December 31, 2003 consisted primarily of money market funds.

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Stock-Based Compensation

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. Beginning in fiscal 2003, the Company adopted the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment to SFAS No. 123, Accounting for Stock-Based Compensation. Compensation expense on fixed stock options was based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price of the option. The Company accounted for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation (in thousands, except per share amounts):

The pro forma diluted net income per share for the three months ended March 31, 2003 was calculated based on 63,018,000 weighted-average shares of common stock outstanding. During the three months ended March 31, 2003, adjustments to eliminate compensation cost previously recognized for options that were subsequently forfeited due to employee terminations exceeded compensation cost recognized during that same period resulting in a net recovery of stock-based compensation expense.

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Basic net loss per share was computed using the weighted-average number of outstanding shares of common stock excluding the weighted-average number of shares of restricted stock subject to repurchase. Diluted net loss per share was computed using the weighted-average number of shares of common stock outstanding and, when dilutive, shares of restricted common stock subject to repurchase, potential shares of common stock from options and warrants using the treasury stock method and from convertible securities using the “as-if converted basis”.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

Options to purchase 8,280,000 shares of common stock and 23,000 shares of common stock subject to repurchase have been excluded from the computation of diluted net loss per share as of March 31, 2003, as their effect would have been antidilutive.

There were no stock options outstanding or exercisable at March 31, 2004 since the Company had terminated its options plans, de-listed its stock and closed its transfer books.

The components of comprehensive loss are as follows (in thousands):

SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information, establishes standards for the manner in

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which public companies report information about operating segments, products and services, geographic areas and major customers in annual and interim financial statements. The method of determining what information to report is based on the way that management organizes the operating segments within the enterprise for making operating decisions and assessing financial performance.

The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (CEO). Prior to the adoption of the Complete Plan of Liquidation and Dissolution on November 11, 2003, the Company’s operations comprised one product line. The CEO reviewed financial information on a single entity level basis for purposes of making operating decisions and assessing financial performance. The entity level financial information was the same as the information presented in the accompanying condensed consolidated statement of operations. Accordingly, the Company determined that it was engaged in a single operating segment.

For the three months ended March 31, 2003, approximately 39% of revenues were derived from sales to customers located outside the United States. Product revenues for the three months ended March 31, 2003 were derived from sales of loop management products. Service revenues for the three months ended March 31, 2003 were derived primarily from the Company’s maintenance programs for loop management products.

In January 2003, the company reduced its headcount by approximately 40%, or 29 employees, and incurred related severance costs of $367,000, which are included in operating expenses for the three months ended March 31, 2003.

In January 2003, in an effort to retain key employees, the Company entered into agreements with its officers and employees which entitle such officers and employees to receive certain retention bonus payments upon the completion of providing employment services to the Company for a specified period of time. The Company recorded retention bonuses of $816,000 to operating expenses in the three months ended March 31, 2003.

In October 2003, the retention agreements for the Company’s two remaining employees expired and the Company paid the earned retention bonuses to these employees. Concurrently, the Company entered into an employment agreement with the two remaining employees which provides that in the event the Company terminates the employees without cause, the employees will be entitled to receive a severance payment equal to six months annual base salary. These severance obligations are included in estimated net costs during liquidation as of March 31, 2004.

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Warranty Obligations

The Company has no warranty obligations remaining as of March 31, 2004. Accrued warranty was zero as of March 31, 2004 and December 31, 2003.

Indemnification Agreements

The Company and the underwriters of its September 2000 secondary stock offering previously entered into an underwriting agreement, whereby each party agreed, under certain specific circumstances applicable to such party, to indemnify and reimburse the other party for litigation costs and expenses related to claims arising out of the secondary offering. During the second fiscal quarter of 2003, the Company received a request for reimbursement of approximately $250,000 in legal fees purportedly incurred by those underwriters in connection with their defense of a class action lawsuit filed against the Company, certain of its current officers and directors, and those underwriters which alleged that the defendants made false and misleading statements in violation of the Securities Act of 1933 as part of the September 2000 secondary stock offering. In February 2004, in exchange for the Company’s payment of $150,000 of legal fees incurred by the underwriters, the Company and the underwriters agreed to mutually release each other from any further indemnification and reimbursement obligations related to the secondary offering class action lawsuit.

In addition to the indemnification provisions contained in our certificate of incorporation and bylaws, we have entered into separate indemnification agreements with each of our directors. These agreements require us, among other things, to indemnify such director against expenses (including attorneys’ fees), judgments, fines and settlements paid by such individual in connection with any action, suit or proceeding arising out of such individual’s status or service as our director or officer (other than such liabilities arising from willful misconduct or conduct that is knowingly fraudulent or deliberately dishonest) and to advance expenses incurred by such individual in connection with any proceeding against such individual with respect to which such individual may be entitled to indemnification by us. In September 2003, we purchased a six-year directors and officers run-off insurance policy.

The Company has standard indemnification clauses contained within its various customer contracts. To date, there have been no known events or circumstances that have resulted in an indemnification-related liability to the Company pursuant to these customer contracts.

On November 9, 2001, Arthur Mendoza filed a securities class action lawsuit in the United States District Court for the Southern District of New York alleging claims against the Company, certain of its current and former officers and directors, and the underwriters of the Company’s initial public

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offering of stock as well as the Company’s secondary offering of stock. The complaint is purportedly brought on behalf of a class of individuals who purchased common stock in the Company’s initial public offering and secondary stock offering between January 31 and December 6, 2000. The complaint alleges generally that the prospectuses under which such securities were sold contained false and misleading statements with respect to discounts and commissions received by the underwriters. The case has been coordinated for pre-trial purposes with over 300 cases raising the same or similar issues and also currently pending in the Southern District of New York. On April 18, 2002, Michael Szymanowski was appointed lead plaintiff in the action. On April 22, 2002, an amended complaint was filed. On July 1, 2002, the underwriter defendants filed an omnibus motion to dismiss. On July 15, 2002, the Company, collectively with the other issuer defendants, also filed an omnibus motion to dismiss. The lead plaintiff filed an opposition to the underwriters’ motion to dismiss on August 15, 2002 and to the issuers’ motion to dismiss on August 27, 2002. The underwriters’ reply to the opposition was filed on September 13, 2002, and the Company’s reply to the opposition was filed on September 27, 2002. On February 19, 2003, the court issued an order denying the motions to dismiss with respect to substantially all of the plaintiffs’ claims, including those against us. Limited discovery is currently underway. A proposal has been made for the settlement and release of claims against the issuer defendants, including Turnstone. The settlement is subject to a number of conditions, including approval of the proposed settling parties and the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously. The Company does not estimate that there will be future costs associated with this case and has not included costs associated with this case in estimated litigation settlement costs at March 31, 2004.