Table of Contents

---

# UNITED STATES 
SECURITIES AND
EXCHANGE COMMISSION 
WASHINGTON, D.C. 20549

# FORM 10-Q

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

# FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004

OR

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

# FOR THE TRANSITION
PERIOD FROM ________________ TO ________________.

COMMISSION FILE
NUMBER 000-30203

# NUANCE COMMUNICATIONS,
INC.

(EXACT NAME OF
REGISTRANT AS SPECIFIED IN ITS CHARTER)

|DELAWARE                 | 94-3208477                          
|------------------------ | ------------------------------------
|(STATE OF INCORPORATION) | (IRS EMPLOYER IDENTIFICATION NUMBER)

1005 HAMILTON AVENUE
MENLO PARK, CALIFORNIA 94025
(650) 847-0000 
(ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)

Indicate by check mark whether
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 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 an accelerate filer (as defined in Rule 12b-2 of the Exchange Act) YES [X]
NO [ ]

35,501,034 shares of the
registrants common stock, $0.001 par value, were outstanding as of April 30, 2004.

---

Table of Contents

# NUANCE COMMUNICATIONS,INC. & SUBSIDIARIES

# FORM 10-Q, MARCH 31, 2004

# CONTENTS

|ITEM  NUMBER  |                                                                                                             | PAGE
|------------- | ----------------------------------------------------------------------------------------------------------- | ----
|              | PART I: FINANCIAL INFORMATION                                                                               |     
|              |                                                                                                             |     
|Item 1.       | Financial Statements                                                                                        |     
|              | Condensed Consolidated Balance Sheets:     March 31, 2004 (unaudited) and December 31, 2003                 | 1   
|              | Condensed Consolidated Statements of Operations:     Three months ended March 31, 2004 and 2003 (unaudited) | 2   
|              | Condensed Consolidated Statements of Cash Flows:     Three months ended March 31, 2004 and 2003 (unaudited) | 3   
|              | Notes to Condensed Consolidated Financial Statements                                                        | 4   
|              |                                                                                                             |     
|Item 2.       | Management's Discussion and Analysis of      Financial Condition and Results of Operations                  | 16  
|              |                                                                                                             |     
|Item 3.       | Quantitative and Qualitative Disclosures about Market Risk                                                  | 32  
|              |                                                                                                             |     
|Item 4.       | Controls and procedures                                                                                     | 32  
|              |                                                                                                             |     
|              | PART II: OTHER INFORMATION                                                                                  |     
|              |                                                                                                             |     
|Item 1.       | Legal Proceedings                                                                                           | 33  
|              |                                                                                                             |     
|Item 6.       | Exhibits and Reports on Form 8-K                                                                            | 33  
|              |                                                                                                             |     
|SIGNATURES    | 35                                                                                                         
|              |                                                                                                             |     
|Exhibit Index
|              |                                                                                                             |     

i

---

Table of Contents

# PART
I:  FINANCIAL INFORMATION

# ITEM 1: FINANCIAL
STATEMENTS

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES 
CONDENSED CONSOLIDATED
BALANCE SHEETS 
(IN THOUSANDS, EXCEPT
SHARE AND PER SHARE AMOUNTS) (Unaudited)

|                                                                                                                                                                         | March 31,2004 | December 31,2003
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------- | ----------------
|ASSETS                                                                                                                                                                   |               |                 
|Current assets:                                                                                                                                                          |               |                 
|Cash and cash equivalents                                                                                                                                                |               | $   46,425      
|Short-term investments                                                                                                                                                   |               | 59,490          
|Accounts receivable, net of allowance for doubtful accounts of $375                  and $837, respectively                                                              |               | 10,016          
|Prepaid expenses and other current assets                                                                                                                                |               | 4,963           
|                                                                                                                                                                         |               |                 
|Total current assets                                                                                                                                                     |               | 120,894         
|Property and equipment, net                                                                                                                                              |               | 4,186           
|Intangible assets, net                                                                                                                                                   |               | 889             
|Restricted cash                                                                                                                                                          |               | 11,136          
|Other assets                                                                                                                                                             |               | 466             
|                                                                                                                                                                         |               |                 
|Total assets                                                                                                                                                             |               | $  137,571      
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                     |              
|Current liabilities:                                                                                                                                                     |              
|Accounts payable                                                                                                                                                         |               | $     1,096     
|Accrued vacation                                                                                                                                                         |               | 1,744           
|Accrued liabilities                                                                                                                                                      |               | 5,643           
|Current portion of deferred revenue                                                                                                                                      |               | 8,096           
|Current portion of restructuring accrual                                                                                                                                 |               | 9,363           
|Current portion of capital lease                                                                                                                                         |               | --              
|Total current liabilities                                                                                                                                                |               | 25,942          
|Long-term deferred revenue                                                                                                                                               |               | 537             
|Long-term restructuring accrual                                                                                                                                          |               | 40,727          
|Other long-term liabilities                                                                                                                                              |               | 24              
|Total liabilities                                                                                                                                                        |               | 67,230          
|Commitments and contingencies (Note 9)                                                                                                                                   |               |                 
|Stockholders Equity                                                                                                                                                     |               |                 
|Common stock, $0.001 par value, 250,000,000 shares authorized;           
    35,114,000 shares and 34,995,000 shares issued and outstanding,   
           respectively |               | 35              
|Additional paid-in capital                                                                                                                                               |               | 330,351         
|Accumulated other comprehensive income                                                                                                                                   |               | 759             
|Accumulated deficit                                                                                                                                                      |               | (260,804)       
|Total stockholders equity                                                                                                                                               |               | 70,341          
|Total liabilities and stockholders equity                                                                                                                               |               | $   137,571     

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

1

---

Table of Contents

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS 
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

|                                                            | Three Months Ended March 31,
|----------------------------------------------------------- | ----------------------------
|                                                            |                             
|Revenue:                                                    |                             
|License                                                     |                             
|Service                                                     |                             
|Maintenance                                                 |                             
|                                                            |                             
|Total revenue                                               |                             
|                                                            |                             
|Cost of revenue:                                            |                             
|License                                                     |                             
|Service (1)                                                 |                             
|Maintenance (1)                                             |                             
|                                                            |                             
|Total cost of revenue                                       |                             
|                                                            |                             
|Gross profit                                                |                             
|                                                            |                             
|Operating expenses:                                         |                             
|Sales and marketing (1)                                     |                             
|Research and development (1)                                |                             
|General and administrative (1)                              |                             
|Non-cash stock-based compensation expense                   |                             
|Restructuring credits                                       |                             
|                                                            |                             
|Total operating expenses                                    |                             
|                                                            |                             
|Loss from operations                                        |                             
|Interest and other income, net                              |                             
|                                                            |                             
|Loss before income taxes                                    |                             
|Benefit from income taxes                                   |                             
|                                                            |                             
|Net loss                                                    |                             
|                                                            |                             
|Basic and diluted net loss per share                        |                             
|Shares used to compute basic and diluted net loss per share |                             
|(1) Excludes non-cash stock-based compensation as follows:  |                             
|Service and maintenance cost of revenue                     |                             
|Sales and marketing                                         |                             
|Research and development                                    |                             
|General and administrative                                  |                             
|Total non-cash stock-based compensation                     |                             

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

2

---

Table of Contents

# NUANCE COMMUNICATIONS
INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)  (UNAUDITED)

|                                                                          | Three Months Ended
|------------------------------------------------------------------------- | ------------------
|                                                                          | March 31,         
|                                                                          | 2004              
|Cash flows from operating activities:                                     |                   
|Net loss                                                                  |                   
|Adjustments to reconcile net loss to net cash used in operating activites |                   
|Depreciation and amortization                                             |                   
|Non-cash stock-based compensation                                         |                   
|Provision for doubtful accounts                                           |                   
|Changes in operating assets and liabilities:                              |                   
|Accounts receivable                                                       |                   
|Prepaid expenses, other current assets and other assets                   |                   
|Accounts payable                                                          |                   
|Accrued and other liabilities                                             |                   
|Restructuring accrual                                                     |                   
|Deferred revenue                                                          |                   
|Net cash used in operating activities                                     |                   
|Cash flows from investing activities:                                     |                   
|Purchase of investments                                                   |                   
|Maturities of investments                                                 |                   
|Purchase of property and equipment                                        |                   
|Increase (decrease) in restricted cash                                    |                   
|Net cash generated from investing activities                              |                   
|Cash flows from financing activities:                                     |                   
|Proceeds from exercise of stock options                                   |                   
|Net cash generated from financing activities                              |                   
|Effect of exchange rate fluctuations on cash and cash equivalents         |                   
|Net increase in cash and cash equivalents                                 |                   
|Cash and cash equivalents, beginning of period                            |                   
|Cash and cash equivalents, end of period                                  |                   
|Supplementary disclosures of cash flow information:                       |                   
|Cash paid during the priod for:                                           |                   
|Interest                                                                  |                   
|Income taxes                                                              |                   
|Suplementary disclosures of non-cash transactions:                        |                   
|Unrealized gain (loss) on available-for-sale securities                   |                   

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

3

---

Table of Contents

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES   NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                                            (UNAUDITED)

# 1.     ORGANIZATION
AND OPERATIONS

Nuance
Communications, Inc. (together with its subsidiaries, the Company) was
incorporated in July 1994 in the state of California, and subsequently reincorporated in
March 2000 in the state of Delaware to develop, market and support software that enables
enterprises and telecommunications carriers to automate the delivery of information and
services over the telephone. The Companys software product lines consist of software
servers that run on industry-standard hardware and perform speech recognition, natural
language understanding and voice authentication. The Company sells its products through a
combination of third-party resellers, original equipment manufacturers (OEM),
system integrators and directly to the end users.

# 2.    SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES

Basis
of Presentation

The
unaudited condensed consolidated financial statements have been prepared by the Company in
accordance with instructions to Form 10-Q and Article 10 of Regulation S-X. Certain
information and footnote disclosures normally included in annual financial statements
prepared under accounting principles generally accepted in the United States of America
have been condensed or omitted pursuant to these instructions and regulations. In the
opinion of management, the financial statements reflect all adjustments, consisting only
of normal recurring adjustments considered necessary for a fair presentation of the
consolidated financial position as of March 31, 2004 and December 31, 2003, the results of
operations for the three months ended March 31, 2004 and 2003 and cash flow for the three
months ended March 31, 2004 and 2003. The results for the periods presented are not
necessarily indicative of the results to be expected for the full year or for any future
periods. The accompanying condensed consolidated financial statements should be read in
conjunction with the audited consolidated financial statements contained in the
Companys Form 10-K filed with the Securities and Exchange Commission on March 24,
2004.

Principles of
Consolidation

The
consolidated financial statements include the accounts of the Company and its
subsidiaries. All significant inter-company transactions and balances have been
eliminated.

Use of Estimates

The
preparation of the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires management 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 consolidated financial
statements and the reported amounts of revenue and expenses during the reporting period.
Such estimates include, but are not limited to: allowance for doubtful accounts,
restructuring accrual, taxes, contingencies and percentage of completion of certain
revenue contracts. Actual results could differ from those estimates.

Revenue
Recognition

Revenues
are generated from licenses, services and maintenance. All revenues generated from our
worldwide operations are approved at its corporate headquarters, located in the United
States. We applied the provisions of Statement of Position (SOP) No. 97-2,
Software Revenue Recognition, as amended by SOP No. 98-9, Modification
of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions
to all transactions involving the sale of software products. We also recognize some
revenue based on SOP No. 81-1, Accounting for Performance of Construction-Type and
Certain Production-Type Contracts and EITF Issue No. 03-05 Applicability of
AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software.

Our
license revenue consists of license fees for our software products. The license fees for
our software products are calculated primarily by determining the maximum number of calls
that may be simultaneously connected to our software.

For
licensed products requiring significant customization, we recognize license revenue using
the percentage-of-completion method of accounting over the period that services are
performed. For all license and service agreements accounted for under the
percentage-of-completion method, we determine progress to completionbased on
actual direct labor hours incurred to date as a percentage of the estimated total direct
labor hours required to complete the project. We periodically evaluate the actual status
of each project to ensure that the estimates to complete each contract remain accurate. A
provision for estimated losses on contracts is made in the period in which the loss
becomes probable and can be reasonably estimated. To date, these losses have not been
significant. Costs incurred in advance of billings are recorded as costs incurred exceed
the related billings on uncompleted contracts. If the amount of revenue recognized exceeds
the amounts billed to customers, the excess amount is recorded as unbilled accounts
receivable. If the amount billed exceeds the amount of revenue recognized, the excess
amount is recorded as deferred revenue. Revenue recognized in any period is dependent on
our percentage completion of projects in progress. Significant management judgment and
discretion are used to estimate total direct labor hours required to complete the project.
Any changes in or deviation from these estimates could have a material effect on the
amount of revenue we recognize in any period.

For
licensed products which do not require significant customization of components, we
recognize revenue from the sale of software licenses when:

4

---

Table of Contents

|. | persuasive evidence of an arrangement exists;                          
|- | -----------------------------------------------------------------------
|  |                                                                        
|. | the software and corresponding authorization codes have been delivered;
|  |                                                                        
|. | the fee is fixed and determinable;                                     
|  |                                                                        
|. | collection of the resulting receivable is probable.                    

We
use a signed contract and either 1) a purchase order, 2) order form or 3) royalty report
as evidence of an arrangement.

Products
delivered with acceptance criteria or return rights are not recognized as revenue until
all revenue recognition criteria are achieved. If undelivered products or services exist
that are essential to the functionality of the delivered product in an arrangement,
delivery is not considered to have occurred. Delivery is accomplished through electronic
distribution of the authorization codes or keys. Occasionally the customer
will require that we secure their acceptance of the system in addition to the delivery of
the keys. Such acceptance, when required, typically consists of a demonstration to the
customer that, upon implementation, the software performs in accordance with specified
system parameters, such as recognition accuracy or transaction completion rates. In the
absence of such required acceptance, we will defer revenue recognition until signed
acceptance is obtained.

We
consider the fee is fixed and determinable when the price is not subject to refund or
adjustments.

We
assess whether collection of the resulting receivable is probable based on a number of
factors, including the customers past payment history and its current financial
position. If we determine that collection of a fee is not probable, we defer recognition
of the revenue until the time collection becomes reasonably assured, which is upon receipt
of the cash payment.

We
use the residual method to recognize revenue when a license agreement includes one or more
elements to be delivered at a future date if VSOE of the fair value of all undelivered
elements exists. VSOE of fair value is based on the price charged when the element is sold
separately, or if not yet sold separately, is established by authorized management. In
situations where VSOE of fair value for undelivered elements does not exist, the entire
amount of revenue from the arrangement is deferred and recognized when VSOE of fair value
can be established for all undelivered elements or when all such elements are delivered.
In situations where the only undelivered element is maintenance and VSOE of fair value for
maintenance does not exist, the entire amount of revenue from the arrangement is
recognized ratably over the maintenance period. As a general rule, license revenue from
third-party resellers is recognized when product has been sold through to an end user and
such sales have been reported to us. However, certain third-party reseller agreements
include time-based provisions on which we base revenue recognition, in these instances,
there is no right of returns possible.

The
timing of license revenue recognition is affected by whether we perform consulting
services in the arrangement and the nature of those services. In the majority of cases, we
either perform no consulting services or we perform services that are not essential to the
functionality of the software. When we perform consulting and implementation services that
are essential to the functionality of the software, we recognize both license and
consulting revenue utilizing contract accounting based on the percentage of the consulting
services that have been completed. This calculation is done in conformity with SOP No.
81-1; however, judgment is required in determining the percentage of the project that has
been completed. Revenue recognized from such contracts was not significant for the three
months ended March 31, 2004 and 2003.

We
have also explored the markets for complete speech solutions and delivering through
combined product and services, where we are required to use contract accounting and
recognize the bundled license and service revenue based upon percentage of completion.
This method of accounting is subject to certain judgments by us regarding amount of
revenue allocated to percentage of work completed. Typically, we would recognize revenue
based upon the proportional level of effort expended to complete certain milestones
defined in the customer contract or statement of work.

Service
revenue consists of revenue from providing consulting, training and other revenue. Other
revenue consists primarily of reimbursements for consulting out-of-pocket expenses
incurred and recognized, in accordance with EITF No. 01-14, Income Statement
Characterization of Reimbursements Received for Out-of-Pocket Expenses
Incurred. For services revenue, we require 1) a signed contract and 2) statement of
work and 3) purchase order or order form prior to recognizing any services revenue. Our
consulting service contracts are bid either on a fixed-fee basis or on a
time-and-materials basis. For a fixed-fee contract, we recognize revenue using the
percentage of completion method. For time-and-materials contracts, we recognize revenue as
services are performed. Training service revenue is recognized as services are performed.
Losses on service contracts, if any, are recognized as soon as such losses become known.

Maintenance
revenue consists of fees for providing technical support and software upgrades and
updates. We generally require a signed contract and purchase order prior to recognizing
any maintenance revenue. We recognize all maintenance revenue ratably over the contract
term for such maintenance. Customers have the option to purchase or decline maintenance
agreements at the time of the license purchase. If maintenance is declined, a
reinstatement fee is generally required when the customer decides to later activate
maintenance. Customers generally have the option to renew or decline maintenance
agreements annually during the contract term.

Our
standard payment terms are generally net 30 to 90 days from the date of invoice. Thus, a
significant portion of our accounts receivable balance at the end of a quarter is
comprised of revenue from that quarter.

5

---

Table of Contents

Restructuring and Asset
Impairment Charges

We
accrue for restructuring costs when management approves and commits to a firm plan.
Historically the main components of our restructuring plans have been related to workforce
reductions, lease losses as a result of a decision not to occupy certain leased property
and asset impairments. Workforce-related charges are accrued based on an estimate of
expected benefits that would be paid out to the employees. To determine the sublease loss,
after our cost recovery efforts from subleasing the building, certain assumptions are made
related to the (1) time period over which the building would remain vacant (2) sublease
terms (3) sublease rates. We establish the reserves at the low end of the range of
estimable cost against outstanding commitments, net of estimated future sublease income.
These estimates are derived using the guidance provided in SAB No. 100,
Restructuring and Impairment Charges, EITF No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(Including Certain Costs Incurred in a Restructuring) and FASB No.146
Accounting for Costs Associated with Exit or Disposal Activities. These
reserves are based upon managements estimate of the time required to sublet the
property and the amount of sublet income that may be generated between the date the
property is not occupied and expiration of the lease for the unoccupied property. These
estimates are reviewed and revised quarterly and may result in a substantial increase or
decrease to restructuring expense should different conditions prevail than were
anticipated in original management estimates.

Valuation Allowance for
Doubtful Accounts

We
perform ongoing credit evaluations of our customers and adjust credit limits based upon
payment history and the customers current creditworthiness, as determined by our
review of their current credit information. We continuously monitor collections and
payments from our customers and maintain a provision for estimated credit losses based on
a percentage of our accounts receivable, our historical experience and any specific
customer collection issues that we have identified. While such credit losses have
historically been within our expectations and appropriate reserves have been established,
we cannot guarantee that we will continue to experience the same credit loss rates that we
have experienced in the past. Material differences may result in the amount and timing of
revenue and or expenses for any period if management made different judgments or utilized
different estimates.

Income
Taxes

In
preparing our condensed consolidated financial statements, we are required to estimate our
income taxes in each of the jurisdictions in which we operate. This process involves
estimating actual current tax exposures together with assessing tax credits and with
assessing temporary differences resulting from differing treatment of items, such as
deferred revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the condensed consolidated balance
sheet. We then assess the likelihood that deferred tax assets will be recovered from
future taxable income, and to the extent we believe that recovery is not likely, we must
establish a valuation allowance. To the extent we establish a valuation allowance or
increase this allowance in a period, we include an expense within the tax provision in our
condensed consolidated statement of operations.

Significant
management judgment is required in determining our provision for income taxes, income tax
credits, our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. We have recorded a valuation allowance due to
uncertainties related to our ability to utilize some of our deferred tax assets, primarily
consisting of the utilization of certain net operating loss carry forwards and foreign tax
credits before they expire. The valuation allowance is based on estimates of taxable
income by the jurisdictions in which we operate and the period over which deferred tax
assets will be recoverable. In the event that actual results differ from these estimates
or we adjust these estimates in future periods, we may need to establish an additional
valuation allowance, which could impact our financial position and results of operations.

Valuation of Long-lived
Assets

We
have assessed the recoverability of long-lived assets, including intangible assets other
than goodwill, by determining whether the carrying value of such assets will be recovered
through undiscounted future cash flows according to the guidance of SFAS No. 144
Accounting for the Impairment of Disposal of Long Lived Assets. SFAS No. 144
superceded SFAS No. 121 Accounting for the impairment or Disposal of Long-lived
Assets in 2002. We assess whether we will recognize the future benefit of long-lived
assets, including intangibles in accordance with the provisions of SFAS No. 144. We assess
the impairment of goodwill in accordance with SFAS No. 142 Goodwill and Other
Intangible Assets, which became effective in 2002. For assets to be held and used,
including acquired intangibles, we initiate our review annually or whenever events or
changes in circumstances indicate that the carrying amount of a long-lived asset may not
be recoverable. Recoverability of an asset is measured by comparison of its carrying
amount to the expected future undiscounted cash flows (without interest charges) that the
asset is expected to generate. Any impairment to be recognized is measured by the amount
by which the carrying amount of the asset exceeds its fair value. Significant management
judgment is required in the forecasting of future operating results which are used in the
preparation of projected discounted cash flows and should different conditions prevail,
material write downs of net intangible assets and/or goodwill could occur.

It
is reasonably possible that the estimates of anticipated future gross revenue, the
remaining estimated economic life of the products and technologies, or both, could differ
from those used to assess the recoverability of these costs and result in a write-down of
the carrying amount or a shortened life of acquired intangibles in the future. As of March
31, 2004, we have no goodwill balance and no impairment of intangibles was recorded.

Certain Significant Risks
and Uncertainties

The
Company operates in a dynamic and highly competitive industry and believes that changes in
any of the following areas could have a material adverse effect on the Companys
future financial position, results of operations or cash flows: ability to obtain future
financing; volatility of and rapid change in the speech software industry; potential
competition from larger, more established companies in the form of newer and better
products; dependence on key employees for technology and support; failure to adopt or
develop products based on new industry standards; changes in the overall demand by
customers and consumers for products offered by the Company; changes in certain strategic
relationships or customer relationships; the loss of significant customers; litigation or
claims against the Company based on intellectual property, patent, product, regulatory or
other factors; risks associated with changes in domestic and international economic and/or
political conditions or regulations; the Companys ability to attract and retain
employees necessary to support its anticipated growth; liability with respect to its
software and related claims if software does not function as intended; a lengthy sales
cycle which could result in it not being able to obtain sales orders; the Companys
inability to protect its proprietary intellectual property rights or to avoid claims from
other companies.

6

---

Table of Contents

Software
Development Costs Software to be sold

Costs
incurred in the research and development of software products are expensed as incurred
until technological feasibility has been established. Once technological feasibility has
been established, these costs are capitalized. The establishment of technological
feasibility and the ongoing assessment of the recoverability of these costs requires
considerable judgment by management with respect to certain external factors, including,
but not limited to, anticipated future gross product revenues, estimated economic life and
changes in software and hardware technologies. Amounts that could have been capitalized
were insignificant and, therefore, no costs have been capitalized to date.

Software Development
Costs  Internal use

The Company purchased software for
internal use. Therefore, external direct costs of software development and payroll and
payroll related costs for time spent by employees to implement the software, are
capitalized after the preliminary project stage is completed. Accordingly, the
Company had capitalized $191,000 and nil related to the software development for internal
use as of March 31, 2004 and December 31, 2003, respectively.

Comprehensive Loss

The
Company reports comprehensive loss by major components and in a single total, the change
in its net assets from non-owner sources, which for the Company, is foreign currency
translation adjustments and changes in unrealized gains and losses on investments.

The
following table presents the components of comprehensive loss for the three months ended
March 31, 2004 and 2003:

|                                         | Three Months Ended March 31,
|---------------------------------------- | ----------------------------
|                                         |                             
|                                         | (In Thousands)              
|                                         |                             
|Net loss                                 |                             
|Unrealized gain (loss) on investments    |                             
|Foreign currency translation gain (loss) |                             
|Comprehensive loss                       |                             

Stock-based
Compensation

The
Company accounts for stock-based compensation in accordance with the provisions of
Accounting Principle Board Opinion (APB) No. 25 Accounting for
Stock Issued to Employees, and complies with the disclosure provisions of SFAS
No. 123 Accounting for Stock-Based Compensation, as amended by SFAS No.
148, Accounting for Stock-Based Compensation  Transition and
Disclosures. Stock-based compensation is amortized under SFAS No. 123 under the
straight-line method. The Companyadopted the disclosure-only provisions of SFAS
No. 123.

Pro
forma net loss and net loss per share information, as required by SFAS No. 123, has been
determined as if the Company had accounted for all employee stock options granted,
including shares issued to employees under the Employee Stock Purchase Plan, under SFAS
No. 123s fair value method. The pro forma effect of recognizing compensation expense
in accordance with SFAS No. 123 is as follows:

|                                                                                                       | Three Months Ended March 31,         
|------------------------------------------------------------------------------------------------------ | -------------------------------------
|                                                                                                       |                                      
|                                                                                                       | (In Thousands, Except Per Share Data)
|                                                                                                       |                                      
|Net loss, as reported                                                                                  |                                      
|Add: Stock-based employee compensation expense           included in net loss                          |                                      
|Less: Total stock-based employee compensation expense under           fair value method for all awards |                                      
|Pro forma net loss                                                                                     |                                      
|Basic and diluted net loss per share - as reported                                                     |                                      
|Basic and diluted net loss per share - pro forma                                                       |                                      

7

---

Table of Contents

As
previously reported in the Annual report on Form 10-K, during the preparation of the
Companys consolidated financial statements for the year ended December 31, 2003,
management determined that the pro forma loss and pro forma basic and diluted net loss per
share had been calculated incorrectly. Accordingly, such pro forma amounts for the three
months ended March 31, 2003 presented above, have been revised. The effect was to increase
the pro forma net loss for the three months ended March 31, 2003 by $6.0 million. This
change did not impact the Companys condensed consolidated financial position,
results of operations, or cash flows for any of the periods presented.

Reclassifications and
Disclosures

Certain
amounts related to financial information presented in the accompanying condensed
consolidated financial statements and related notes as of March 31, 2003 have been
reclassified to conform to the presentation of the three months ended March 31, 2004.

# 3.    RECENT
ACCOUNTING PRONOUNCEMENTS

In
January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities, and a revised interpretation of FIN 46 (FIN 46R) in
December 2003 (collectively FIN 46). FIN 46 addresses consolidation of
variable interest entities. FIN 46 provides guidance for determining when a primary
beneficiary should consolidate a variable interest entity or equivalent structure that
functions to support the activities of the primary beneficiary. The provisions of FIN 46
are effective immediately for all variable interest entities created after January 31,
2003. It applies in the first year or interim period ending after December 15, 2003 to
variable interest entities in which an enterprise holds a variable interest that it
acquired before February 1, 2003. The Company did not have interest in any variable
interest entities as of March 31, 2004, and the adoption of FIN 46 did not have a material
effect on the Companys financial statements.

# 4.     NET LOSS PER SHARE

Net
loss per share is calculated under SFAS No. 128, Earnings Per Share. Basic net
loss per share is computed using the weighted average number of shares of common stock
outstanding. Diluted net loss per share is equal to basic net loss per share for all
periods presented since potential common shares from stock options and warrants are
anti-dilutive due to the reported net loss. Shares subject to repurchase resulting from
early exercises of options that have not vested are excluded from the calculation of basic
and diluted net loss per share. During the three months ended March 31, 2004 and 2003, the
Company had securities outstanding which could potentially dilute basic earnings per share
in the future, but were excluded in the computation of diluted loss per share in such
periods, as their effect would have been anti-dilutive due to the net loss reported in
such periods. The total number of shares excluded from diluted net loss per share was
9,699,000 shares and 9,075,000 shares, respectively, for the three months ended March 31,
2004 and 2003.

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

|                                                                             | Three Months Ended March 31,
|---------------------------------------------------------------------------- | ----------------------------
|                                                                             |                             
|Net loss                                                                     |                             
|Basic and diluted shares:                                                    |                             
|Weighted average shares of common stock outstanding                          |                             
|Less: weighted average shares of common stock
subject to repurchase          |                             
|Weighted average shares used to compute basic and diluted net loss per share |                             
|Basic and diluted net loss per share                                         |                             

8

---

Table of Contents

5.     SHORT-TERM INVESTMENTS

All
our investments are classified as available for sale at March 31, 2004 and December 31, 2003. Available-for-sale investments
with original maturities of greater than three months are classified as short-term
investments, as these investments generally consist of highly marketable securities that
are intended to be available to meet current cash requirements. Investment securities
classified as available-for-sale are reported at market value, and net unrealized gains or
losses are recorded in cumulative other comprehensive income (loss), a separate component
of stockholders equity, until realized. Realized gains and losses on non-equity
investments are computed based upon specific identification and are included in interest
income and other, net.

For all periods presented, realized
gains and losses on available-for-sale investments were not material. Management evaluates
investments on a regular basis to determine if an other-than-temporary impairment has
occurred. The Companys investments in debt instruments of publicly held companies
are generally considered impaired when a decline in the fair value of an investment as
measured by quoted market prices is less than its carrying value, and such a decline is
not considered temporary. For the three months ended March 31, 2004, the Company has
incurred no such impairment.

6.     INTANGIBLE ASSETS

Information regarding the Companys intangible assets follows (in thousands):

|                     | As of March 31, 2004
|-------------------- | --------------------
|                     |                     
|Purchased Technology |                     
|Patents Purchased    |                     
|Total                |                     

|                     | As of December 31, 2003
|-------------------- | -----------------------
|                     |                        
|Purchased Technology |                        
|Patents Purchased    |                        
|Total                |                        

As
of March 31, 2004, total estimated amortization of the purchased technology and the
patents, for the next five years, is as follows (in thousands):

|Year Ended December 31,   |   | Amortization Expense
|------------------------- | - | --------------------
|2004 (remaining 9 months) | $ | 309                 
|2005                      |   | 413                 
|2006                      |   | 117                 
|2007                      |   | 50                  
|2008                      |   | --                  
|Total                     | $ | 889                 

# 7.     GUARANTEES

Guarantees

As
of March 31, 2004, the Companys financial guarantees consist of standby letters of
credit outstanding, representing the restricted cash requirements collateralizing the
Companys lease obligations. As of March 31, 2004, the maximum amount of potential
future payment under the arrangements was $10.9 million related to the Companys
Pacific Shores lease in California and $228,000 related to the Companys Montreal
lease, totaling $11.1 million presented as restricted cash on the Companys condensed
consolidated balance sheets.

Warranty

The
Company does not maintain a general warranty reserve for estimated costs of product
warranties at the time revenue is recognized due to the effectiveness of the
Companys extensive product quality program and processes.

Indemnifications to
Customers

The
Company defends and indemnifies its customers for specified liabilities incurred in any
suit or claim brought against them, alleging that the Companys products infringe a
U.S. patent (worldwide, in some instances), copyright, trade secret or similar right.
If a product becomes the subject of an infringement claim, the Company has an obligation
to, at its option: (i) replace the product with another non-infringing product that
provides substantially similar performance; (ii) modify the infringing product so
that it no longer infringes but remains functionally equivalent; (iii) obtain the
right for the customer to continue using the product at the Companys expense and for
the third-party reseller to continue selling the product; or (iv) take back the
infringing product and refund to customer the purchase price paid, less depreciation
amortized on a straight line basis. The Company has not, to date, been required to make
material payments pursuant to these indemnification provisions. The Company has not
identified any losses that are probable under these provisions and, accordingly, the
Company has not recorded a liability related to these indemnification provisions.

9

---

Table of Contents

Indemnifications to
Officers and Directors

The
Companys corporate by-laws require that the Company indemnify its officers and
directors, as well as those who act as directors and officers of other entities at the
Companys request, against expenses, judgments, fines, settlements and other amounts
actually and reasonably incurred in connection with any proceedings arising out of their
services to Nuance. In addition, the Company has entered into separate indemnification
agreements with each director and each board-appointed officer of Nuance, which provides
for indemnification of these directors and officers under similar circumstances. The
indemnification obligations are more fully described in the by-laws and the
indemnification agreements. The Company purchases insurance to cover claims or a portion
of the claims made against its directors and officers. Since a maximum obligation is not
explicitly stated in the Companys by-laws or in its indemnification agreements and
will depend on the facts and circumstances that arise out of any future claims, the
overall maximum amount of the obligations cannot be reasonably estimated. Historically,
the Company has not made payments related to these obligations, and the estimated fair
value for these obligations is zero on the condensed consolidated balance sheets as of
March 31, 2004.

Other Indemnifications

As
is customary in the Companys industry and as provided for in local law in the U.S.
and other jurisdictions, many of the Companys standard contracts provide remedies to
others with whom the Company enters into contracts, such as defense, settlement, or
payment of judgment for intellectual property claims related to the use of the
Companys products. From time to time, the Company indemnifies its suppliers,
contractors, lessors, lessees and others with whom the Company enters into contracts,
against combinations of loss, expense, or liability arising from various trigger events
related to the sale and the use of the Companys products and services, the use of
their goods and services, the use of facilities, the state of the assets and businesses
that the Company sells and other matters covered by such contracts, usually up to a
specified maximum amount. In addition, from time to time the Company also provides
protection to these parties against claims related to undiscovered liabilities, additional
product liability or environmental obligations. In the Companys experience, claims
made under such indemnifications are rare and the associated estimated fair value of the
liability is not material. At March 31, 2004, there were no claims for such
indemnifications.

# 8.     RESTRUCTURING
 AND ASSET IMPAIRMENTS

Restructuring on headcount
level

The
Company had approximately 310 full-time employees as of March 31, 2004. In 2001, the
Companys Board of Directors approved a restructuring plan to align the
Companys expenses with revised anticipated demand and create a more efficient
organization. As a result, in 2001, the Company reduced the workforce by 80 employees,
with reductions ranging between 10% and 20% across all functional areas and affecting
several locations. In 2002, in conjunction with the January 2002 and August 2002
restructuring plans approved by its Board of Directors, the Company reduced the workforce
by another 33 and 81 employees, respectively, primarily to realign the sales organization,
to align the cost structure with changing market conditions and to create a more efficient
organization. In August 2003, the Company reduced its general and administrative workforce
by 9%, or 5 employees, to further realign the organization to its structure. The Company
will continue to evaluate its resource and skills requirements and adjust its staffing
appropriately. The Company may, in the future be required to increase its workforce to
respond to changes or growth in its business, and as a result may need to expand its
operational and human resources, as well as information systems and controls, to support
any such growth. Such expansion may place significant demands on its management and
operational resources.

Restructuring charges
based on different plans

Fiscal Year 2001

In
April 2001, with Board of Directors approval, the Company implemented a restructure plan
to align its expenses with revised anticipated demand and create a more efficient
organization. In connection with the restructuring plan, the Company recorded a
restructuring charge of $34.1 million for lease loss and severance costs and an asset
impairment charge of $20.9 million on tenant improvements during the quarter ended
September 30, 2001. The Company decreased the asset impairment charge by $0.5 million in
the quarter ended December 31, 2001.

In
connection with the restructuring plan, the Company decided not to occupy a new leased
facility. This decision has resulted in a lease loss of $32.6 million for the year ended
December 31, 2001, comprised of a sublease loss, broker commissions and other facility
costs. To determine the sublease loss, the loss after the Companys cost recovery
efforts to sublease the building, certain assumptions were made related to the
(1) time period over which the building will remain vacant (2) sublease terms and (3)
sublease rates. The Company established the reserves at the low end of the range of
estimable cost against outstanding commitments, net of estimated future sublease income.
These estimates were derived using the guidance provided in Staff Accounting Bulletin
(SAB) No. 100, Restructuring and Impairment Charges, and EITF No.
94-3, Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)". The
lease loss was increased in August 2002 and September 2003 as described below and will
continue to be adjusted in the future upon triggering events (change in estimate of time
to sublease, actual sublease rates, etc.).

10

---

Table of Contents

The
Company recorded $1.5 million in costs for the year ended December 31, 2001 associated
with severance and related benefits. The Company reduced headcount by approximately 80
employees, with reductions ranging between 10% and 20% across all functional areas and
affecting several locations.

Fiscal Year 2002

In
January 2002, with Board of Directors approval, the Company implemented a restructuring
plan to reduce its workforce. The restructuring was primarily to realign the sales and
professional services structure. The Company recorded a restructuring charge of $1.3
million during the three months ended March 31, 2002, consisting primarily of payroll and
related expenses associated with reducing headcount. This amount was paid out as of
December 31, 2002.

In
August 2002, with Board of Directors approval, the Company implemented a restructuring
plan to reduce its worldwide workforce to realign its expense structure with near term
market opportunities. In connection with the reduction of workforce, the Company recorded
a charge of $2.6 million primarily for severance and related employee termination costs.
It was fully paid off as of December 31, 2003. For the third quarter 2003, it also
reversed an excess accrual for this restructuring plan, which resulted in recording of
$0.2 million as a credit to the restructuring charge line in the condensed consolidated
statement of operations.

The
plan also included the consolidation of facilities through the closing of certain
international offices that resulted in a charge of $0.7 million, which was fully paid out
as of March 31, 2004.

In
addition, the Company recorded an increase in its previously reported real estate
restructuring accrual related to the new leased facility it does not occupy and which has
not been subleased as a result of continued declines in the condition of the San Francisco
Bay Area commercial real estate market. This additional charge of $31.8 million resulted
from an analysis of the time period by which the California property will remain vacant,
sub-lease terms and sub-lease rates, altogether reflecting continued softening of the
local real estate market.

Fiscal Year 2003

In
the third quarter 2003, the Company reviewed the earlier estimate for the lease loss for
the unoccupied leased facility and the condition of the San Francisco Bay Area commercial
real estate market. The Company estimated that it might take an additional 12 months to
sublease this unoccupied facility. The Company also reduced the estimates for the expected
sublease rates. This evaluation resulted in recording an additional lease loss of $10.4
million and was recorded as part of the restructuring charges on the condensed
consolidated statement of operations.

For
the third quarter 2003, the Company reduced its general and administrative workforce to
realign the organizational structure. The Company recorded a restructuring charge of $0.2
million primarily for severance and termination costs relating to the reduction in
workforce. As of December 31, 2003, all severance payments were fully paid. In addition,
the Company revised the estimate for the August 2002 restructuring plan, which resulted in
a $0.2 million credit to the restructuring charge line in the condensed consolidated
statement of operations.

The
restructuring charges and balance as of March 31, 2004 are as follows (in thousands):

|                                                     | Lease Loss | Severance & Related | Asset Write Down | Total Restructuring
|---------------------------------------------------- | ---------- | ------------------- | ---------------- | -------------------
|2001 Plan                                            |            |                     |                  |                    
|Total charges for the year ending December 31, 2001  |            |                     | $                | 32,615             
|Amount utilized in the year ending December 31, 2001 |            |                     |                  | (3,572             
|Accrual balance at December 31, 2001                 |            |                     | $                | 29,043             
|Total charges for the year ending December 31, 2002  |            |                     | $                | 31,829             
|Amount utilized in the year ended December 31, 2002  |            |                     |                  | (9,342             
|Balance at December 31, 2002                         |            |                     | $                | 51,530             
|Total charges for
the year ending December 31, 2003  |            |                     | $                | 11,316             
|Amount utilized
in the year ending December 31, 2003 |            |                     |                  | (10,477            
|Balance at December 31, 2003                         |            |                     | $                | 52,369             
|Total charges for
the quarter ended March 31, 2004   |            |                     | $                | --                 
|Amount utilized
in the quarter ended March 31, 2004  |            |                     |                  | (2,279             
|Balance at March 31, 2004                            |            |                     | $                | 50,090             
|                                                     |            |                     |                  |                    
|Current restructuring accrual                        |            |                     | $                | 9,363              
|Long-term restructuring accrual                      |            |                     | $                | 40,727             

11

---

Table of Contents

As
of March 31, 2004, the Company expects the remaining future net cash outlay for the
restructuring plans to be $50.1 million, in which $9.4 million of the lease loss is to be
paid out over the next 12 months and $40.7 million is to be paid out over the remaining
life of the lease of approximately eight years.

The
Company has recorded a lease loss related to future lease commitments of its Pacific
Shores lease, net of estimated sublease income. However, under the condition of the San
Francisco Bay Area commercial real estate market, the Company may be required to
periodically reevaluate the components of the estimated sublease income, because it
affects the estimated lease loss for the unoccupied leased facility. Specifically, the
Company is required to reevaluate the time that it might take to sublease this unoccupied
facility, as well as the expected sublease rates. This evaluation may result in additional
lease loss, which would increase the restructuring charges on the condensed consolidated
statement of operations.

# 9.     COMMITMENTS AND
CONTINGENCIES

Operating
leases

The
Company leases its facilities under non-cancelable operating leases with various
expiration dates through July 2012. As of March 31, 2004, future minimum lease payments
under these agreements (excluding sublease income), including the Companys
unoccupied leased facility, are as follows(in thousands):

|Year Ended December 31,             |   | Operating leases
|----------------------------------- | - | ----------------
|2004 (remaining 9 months)           | $ | 6,796           
|2005                                |   | 8,399           
|2006                                |   | 8,617           
|2007                                |   | 8,877           
|2008                                |   | 8,980           
|Thereafter                          |   | 34,795          
|Total future minimum lease payments | $ | 76,464          

In
May 2000, the Company entered into a Pacific Shore lease for the new headquarters
facility. The lease has an eleven-year term, which began in August 2001. In conjunction
with the April 2001 restructuring plans, the Company decided not to occupy this new leased
facility. The monthly cash payment for the Pacific Shore lease was approximately $600,000.
For the year ended December 31, 2003, the Company lowered the estimates for the expected
sublease rental rates. This evaluation resulted in recording an additional lease loss of
$10.4 million. For the three months ended March 31, 2004, the Company reviewed its earlier
estimate for the sublease loss and estimated that there may be an additional 12 months
that the property will remain vacant. The future minimum lease payments table referenced
above does not include common area maintenance charges or estimated sublease income, as there are no sublease commitments as
of March 31, 2004.

For
all the occupied buildings, rent expense for the three months ended March 31, 2004 and
2003 was approximately $532,000 and $514,000, respectively.

Employment
Agreements

In
April 2003, the Company entered into an employment agreement with its President and Chief
Executive Officer. This employment agreement provides for annual base salary compensation,
variable compensation, stock option grants, and stock option acceleration and severance
payments in the event of termination of employment under certain defined circumstances or
upon a change in control of the Company. Variable and equity compensation are subject to
adjustments according to the Companys financial performance and other factors.

Legal

On
April 8, 2004, the Company was served with a civil complaint filed by Voice Capture, Inc.
against the Company in the United States District Court for the Southern District of Iowa
(the Complaint). The Complaint, which also names as defendants Intel
Corporation and Dialogic Corporation, alleges that certain software and services of the
Company infringe upon certain claims contained in U.S. Patent No. Re 34,587
(Interactive Computerized Communications Systems with Voice Input and Output).
The plaintiff is seeking unspecified damages. The Company is currently investigating the
allegations raised in the Complaint. However, the Company believes that the allegations of
the Complaint are without merit and intends to defend the litigation vigorously.

12

---

Table of Contents

In
August 2001, the first of a number of complaints was filed, in the United States District
Court for the Southern District of New York, on behalf of a purported class of persons who
purchased the Companys stock between April 12, 2000, and December 6, 2000. Those
complaints have been consolidated into one action. The complaint generally alleges that
various investment bank underwriters engaged in improper and undisclosed activities
related to the allocation of shares in the Companys initial public offering of
securities. The complaint makes claims for violation of several provisions of the federal
securities laws against those underwriters, and also against the Company and some of
directors and officers. Similar lawsuits, concerning more than 250 other companies
initial public offerings, were filed in 2001. In February 2003, the Court denied a motion
to dismiss with respect to the claims against the Company. In the third quarter of 2003, a
proposed settlement in principle was reached among the plaintiffs, issuer defendants
(including the Company) and the issuers insurance carriers. The settlement calls for
the dismissal and release of claims against the issuer defendants, including the Company,
in exchange for a contingent payment to be paid, if necessary, by the issuer
defendants insurance carriers and an assignment of certain claims. The timing of the
conclusion of the settlement remains unclear, and the settlement is subject to a number of
conditions, including finalization of appropriate documentation and approval of the Court.
The settlement is not expected to have any material impact upon the Company, as payments,
if any, are expected to be made by insurance carriers, rather than by the Company. In the
event a settlement is not concluded, the Company intends to defend the litigation
vigorously. The Company believes that it has meritorious defenses to the claims against
itself.

In
mid 2001, putative shareholder derivative actions were filed in the state of California,
alleging breaches of fiduciary duty and insider trading by various directors and officers
of the Company. As the Company is named as a nominal defendant, the actions did not appear
to seek any recovery against it. The Court approved the settlement and dismissal of these
actions in November 2003. The settlement did not require any payments by the Company.

In
March 2001, the first of a number of stockholder class action complaints were filed, in
the United States District Court for the Northern District of California, against the
Company and certain of its officers and directors. The lawsuits were consolidated and an
amended complaint was filed on behalf of a purported class of people who purchased the
Companys stock during the period January 31, 2001, through March 15, 2001, alleging
false and misleading statements and insider trading in violation of the federal securities
laws. The plaintiffs were seeking unspecified damages. In November 2003, the Court
approved a settlement and dismissal of the action. The settlement was funded entirely by
the Companys insurers in August and September 2003.

In
January 2001, the Company filed an opposition proceeding in the European community against
a Community Trade Mark application for NUANCE, owned by Nuance Global Traders, Ltd. The
opposition is still pending. The parties have agreed upon a settlement, which will become
final upon, among other things, completion of final settlement documents.

The
Company is subject to various other legal proceedings, claims and litigation that arise in
the normal course of business. While the outcome of these matters is currently not
determinable, management does not expect that the ultimate costs to resolve these matters
will have a material adverse effect on its consolidated financial position, results of
operations, or cash flows.

# 10.     STOCK - BASED
COMPENSATION

Approximately
3,152,000 stock options were granted by the Company before its initial public offering in
2000, at a weighted average exercise price of $8.58. The Company records deferred stock
compensation equal to the difference, if any, between the grant price and fair value of
the Companys common stock on the date of grant. The Company recorded deferred stock
compensation of approximately $8.7 million within stockholders equity, representing
the difference, if any, between the estimated fair value of the common stock for
accounting purposes and the option exercise price of these options at the date of grant.
This amount was presented as a reduction of stockholders equity and was being
amortized over the vesting period of the applicable options. For the three months ended
March 31, 2003, the Company recorded amortization of deferred compensation of $76,000 and
reversed excess amortization of deferred stock compensation due to termination of
employees ($2,000), resulting in net expense of deferred compensation of $74,000. Deferred
stock-based compensation was fully amortized as of December 31, 2003.

In
the first quarter of 2004, the Company accelerated options to purchase 12,500 shares of
common stock to one officer who left the Company on February 9, 2004. In connection with
this acceleration, the Company recorded $73,000 as Non-cash stock-based compensation
expense, which was calculated by taking the difference between the fair value of the
common stock on the date of acceleration less the option exercise price times the number
of options accelerated, in its condensed consolidated statement of operations for the
quarter ended March 31, 2004.

# 11.     SEGMENT REPORTING

The
Companys operating segments are defined as components of the Company about which
separate financial information is available that is evaluated regularly by the chief
operating decision maker, or decision making group, in deciding how to allocate resources
and in assessing performance. The Companys chief operating decision maker is the
Chief Executive Officer of the Company.

13

---

Table of Contents

The
Company derives revenues from three primary sources: 1) license, 2) service and 3)
maintenance. Revenue and cost of revenue for the segments are identical to those presented
on the accompanying condensed consolidated statement of operations. The Company does not
track expenses nor derive profit or loss based on these segments. The Company also does
not track assets by segments.

Sales
of licenses, as well as services and maintenance through March 31, 2004, occurred through
third-party resellers and direct sales representatives located in the Companys
headquarters in Menlo Park, California, and in other locations. These sales were supported
through the Menlo Park location. The Company does not separately report costs by region
internally.

Revenues
are based on the country in which the end-user is located. The following is a summary of
license, service and maintenance revenue by geographic region (in thousands):

14

---

Table of Contents

|                          | Three Months Ended March 31,
|------------------------- | ----------------------------
|                          |                             
|License Revenue:          |                             
|United States             |                             
|Canada                    |                             
|Europe                    |                             
|Asia Pacific              |                             
|Latin America             |                             
|Total license revenue     |                             
|Service Revenue:          |                             
|United States             |                             
|Canada                    |                             
|Europe                    |                             
|Asia Pacific              |                             
|Latin America             |                             
|Total service revenue     |                             
|Maintenance Revenue:      |                             
|United States             |                             
|Canada                    |                             
|Europe                    |                             
|Asia Pacific              |                             
|Latin America             |                             
|Total maintenance revenue |                             
|Total revenue:            |                             
|United States             |                             
|Canada                    |                             
|Europe                    |                             
|Asia Pacific              |                             
|Latin America             |                             
|Total revenue             |                             

15

---

Table of Contents

# ITEM 2: MANAGEMENTS
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The
following discussion should be read in conjunction with the condensed consolidated
financial statements and related notes included elsewhere in this report. The results
shown herein are not necessarily indicative of the results to be expected for any future
periods.

This
section contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including,
but not limited to, statements regarding revenue and expense trends and cash positions,
sales and marketing, hiring activities, product development and product capabilities and
performance, as well as the Companys expectations, beliefs, intentions or strategies
regarding the future. Words such as anticipates, expects,
intends, may, will, plans,
believes, seeks, projected, assumes and
estimates and other similar expressions are intended to identify
forward-looking statements. These statements are not guarantees of future performance and
actual actions or results may differ materially. These statements are based on information
available to us on the date hereof, and the Company assumes no obligation to update any
such forward-looking statements. These statements involve risks and uncertainties and
actual results could differ materially from those anticipated in these forward-looking
statements as a result of a number of factors, including, but not limited to, those set
forth in Risk Factors below and elsewhere in this Report on Form 10-Q and in
other reports or documents filed by us from time to time with the Securities and Exchange
Commission.

# OVERVIEW

We
develop, market and support speech software products for automating interactions over the
telephone for a range of industries and applications. Our products include: speech
recognition software, which is used to recognize what a person says, deliver responses and
information and perform transactions; text-to-speech synthesis software, which converts
text, for example, from a database, email or web page into an audio signal to deliver
speech over the telephone; voice authentication software, which can be used to verify the
identity of speakers by the unique qualities of their voices; grammars, which define the
dictionary of possible caller responses for use in applications; and a standards-based
software platform designed as a foundation for speech application deployment and
management and a packaged speech routing application product. Two of these products are
new and were released in 2003: Nuance Voice Platform (NVP), an open,
standards-based software platform optimized for speech solutions, was released in the
first quarter 2003 and Nuance Call Steering (NCS), a packaged application
designed to accurately and cost-effectively route phone calls to the correct customer care
destinations, was released in the second quarter of 2003. We plan to add additional
applications for key industries, which, like NCS, will be designed to leverage the
features inherent in our engines and platform while reducing deployment time and cost.

We
seek to actively support both emerging industry standards as well as proprietary
development environments. Our software is designed to work with VoiceXML, the recognized
industry standard language for the creation of voice-driven products and services.

We
also offer a range of consulting, support and education services that enable our customers
and third-party resellers to develop and maintain voice-driven applications that use our
software products.

We
sell our products both directly through our sales force and indirectly through third-party
resellers. We sell our products to customers in the United States, Canada, the United
Kingdom and other countries in Europe, China and other countries in Asia, and Latin
America. We anticipate that markets outside of the United States will continue to
represent a significant portion of total future revenue.

# OVERVIEW OF OPERATIONS

Our
growth and anticipated profitability are heavily dependent upon general economic
conditions and demand for information technology. Our growth has traditionally been fueled
by sales to the telecommunications and financial services industries. Some industries have
sustained slowdowns over the past several years. Even though information technology
spending appears to be increasing , it is difficult to predict the trend in information
technology spending trend for the foreseeable future.

In
response to the challenging business environment, we have evolved and continue to evolve
our strategic direction in a way that we believe will improve our business performance.
Our strategic objectives include:

|. | focusing resources on geographic and industry targets believed to have the highest
potential for revenue,                                                                                          
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                    
|. | evolving  our voice  platform  and  developing supporting  applications  designed to  increase  the speed and ease of
         deployment and reduce the total cost of ownership of speech systems,
|  |                                                                                                                                                                                                    
|. | developing and strengthening a multi-channel selling model,                                                                                                                                        
|  |                                                                                                                                                                                                    
|. | developing  advanced speech  technologies  that deliver  customer value and maintain our leadership  position in the speech
         industry.                                                     

16

---

Table of Contents

Some
specific operating changes have already been accomplished, such as the restructuring
actions taken in 2002 and 2003, two newly released products in 2003, NVP in March 2003 and
NCS in June 2003, the sales execution with a multi-channel strategy, the development of
the new platform Value Added Reseller (VAR) channel, and our focus on driving
complete speech solutions into the large telecom and enterprise call center markets. We
plan to introduce certain new applications in the future. Other operating activities,
including new products and changes to selling and delivery channels, will continue to
evolve over the next several years. We are making these strategic shifts because we
believe that they will enhance our business performance, however, some of the actions we
are taking, such as the introduction of new products, present inherent risks. We believe
that these new products will make speech systems faster and easier to deploy, and will
create value for our customers. The success of these products depends upon certain market
factors such as information technology spending, market acceptance of packaged software
applications and industry adoption of VoiceXML and related standards.

In
addition, we are responding to customers requests to work more directly with them
and provide them greater access to Nuances speech expertise across all levels of
their speech solutions. We believe that increasing our direct relationships with end users
and delivering more complete solutions will allow us to reap greater value from these
sales transactions. However, this new sales and delivery model may also present increased
costs and risks such as increased liability for complete solution delivery, costs and
risks of subcontractors, and possible delays in recognition of revenue. Further, we may
experience periodic fluctuations in our consulting services revenues when long-term
consulting projects come to completion. In addition, while we are actively working to
manage potential channel conflicts and maintain strong third-party reseller relationships,
certain third-party reseller relationships may be adversely affected by our introduction
of our own platform product and application product and/or our direct sales activities,
which may have an unfavorable impact on revenue from certain third-party resellers.

We
are committed to a multi-channel sales approach and third-party resellers have been and
will continue to be instrumental in delivering speech engines, applications and services
to our end customers. We are actively working to maintain and build strong relationships
with existing third-party resellers as well as new third-party resellers. We will continue
to focus efforts on fostering a strong third-party reseller channel, particularly to
leverage complementary capabilities in order to speed and ease deployment of speech
solutions. We may encounter difficulties or delays in finding third-party reseller
partners having such complementary capabilities and/or establishing third-party reseller
partner relationships with such entities.

In
addition, competition exists in the speech technology market. We believe that our business
and technology has the ability to compete effectively, however, the speech market is
relatively new and susceptible to change. Our competitors may be able to develop superior
technologies or may combine with each other to leverage complimentary technologies or
relationships. Current and potential competitors may be larger than Nuance and may be able
to invest greater resources in competitive efforts and/or may establish relationships
among themselves or with third parties to increase their technological and/or selling and
marketing abilities.

# CRITICAL ACCOUNTING
POLICIES AND ESTIMATES

Critical
accounting policies are those that are most significant to the portrayal of the
Companys condition and results of operations and require difficult, subjective and
complex judgments by management in order to make estimates about the effect of matters
that are inherently uncertain.  As previously reported in the Companys Annual
Report on Form 10-K for the year ended December 31, 2003, the Companys most critical
accounting policies pertain to revenue recognition, restructuring and impairment charges,
valuation allowance for doubtful accounts, income taxes and valuation of long-lived
assets. In applying such policies management must record income and expense amounts that
are based upon informed judgments and best estimates.  Because of the uncertainty
inherent in these estimates, actual results could differ from estimates used in applying
critical accounting policies.  Changes in estimates, based on more accurate future
information, may affect amounts reported in future periods.  Management is not aware
of any reasonably likely events or circumstances that would result in different amounts
being reported that would materially affect the Companys financial condition or
results of operation.

# RESULTS OF OPERATIONS

Revenues
are generated from three primary sources: (1) sale of new software licenses, (2) services,
which include consulting services and training services, and (3) maintenance, which
includes software license updates and customer technical support.

Software
license revenues represent all fees earned from granting customers licenses to use our
technology and applications software and exclude revenues derived from software license
updates, which are included in maintenance revenue. The vast majority of our software
license arrangements include software license updates and product support, which are
recognized ratably over the terms of the arrangement, typically one year. Software license
updates provide customers with rights to unspecified software product upgrades,
maintenance releases and patches released during the term of the support period. Product
support services include Internet access to technical content, as well as Internet and
telephone access to technical support personnel. Software license updates and product
support are priced as a percentage of the net new software license fees. Most of our
customers renew the software license updates and product support rights annually.

17

---

Table of Contents

Cost
of license revenue consists primarily of fees payable on third party software, and
amortization of purchased technology. Cost of service revenue consists primarily of
compensation and related overhead costs from employees engaged in consulting services and
amounts paid to subcontractors. Cost of maintenance revenue consists primarily of
compensation and related overhead costs for employees engaged in customer technical
support.

Our
operating expenses are classified into five general categories: sales and marketing,
research and development, general and administrative, non-cash compensation and
restructuring credits. We classify all charges to these operating expense categories based
on the nature of the expenditures. The sales and marketing, research and development,
general and administrative categories consist primarily of the following expenses:
compensation, employee benefits, recruiting costs, equipment costs, travel and
entertainment costs, insurance, facilities costs and third-party professional services
fees. We allocate the total costs for information technology services and facilities to
each functional area that uses information technology services and facilities based on
headcount. These allocated costs include rent and other facility-related costs for our
offices, communication charges and depreciation expense for property and equipment, and
computer hardware and software maintenance.

From
our inception through March 31, 2004, we have incurred approximately $457.0 million of
operating expenses, including $80.8 million of restructuring charges (before restructuring
credit of $0.9 million resulting from a refund). Approximately $98.9 million of research
and development expenditures were used to develop our current and future software
products. Costs incurred in the research and development of software products are expensed
as incurred until technological feasibility has been established, which usually occurs
close to the completion of the software. Once technological feasibility has been
established, these costs would be capitalized. Amounts that could have been capitalized
were insignificant and, therefore, no software development costs have been capitalized to
date. As a result of these and other operating expenditures, we have incurred net
operating losses in each year since inception.

We
believe that period-to-period comparisons of our historical operating results are not
necessarily meaningful and should not be relied upon as being indicative of future
performance. Our prospects must be considered in light of the risks, expenses and
difficulties frequently experienced by companies in early stages of development,
particularly companies in new and rapidly changing markets. We have experienced both
significant revenue growth and revenue declines in the past. Furthermore, we may not
achieve or maintain profitability in the future.

|                                          | Three Months Ended March 31,
|----------------------------------------- | ----------------------------
|                                          |                             
|Revenue:                                  |                             
|License                                   |                             
|Service                                   |                             
|Maintenance                               |                             
|Total revenue                             |                             
|Cost of revenue:                          |                             
|License                                   |                             
|Service                                   |                             
|Maintenance                               |                             
|Total cost of revenue                     |                             
|Gross profit                              |                             
|Operating expenses:                       |                             
|Sales and marketing                       |                             
|Research and development                  |                             
|General and administrative                |                             
|Non-cash stock-based compensation expense |                             
|Restructuring credits                     |                             
|Total operating expenses                  |                             
|Loss from operations                      |                             
|Interest and other income, net            |                             
|Loss before income taxes                  |                             
|Benefit from income taxes                 |                             
|Net loss                                  |                             

The
following table presents selected financial data for the periods indicated as a percentage
of total revenue:

18

---

Table of Contents

|                                          | Three Months Ended March 31,
|----------------------------------------- | ----------------------------
|                                          |                             
|Revenue:                                  |                             
|License                                   |                             
|Service                                   |                             
|Maintenance                               |                             
|Total revenue                             |                             
|Cost of revenue:                          |                             
|License                                   |                             
|Service                                   |                             
|Maintenance                               |                             
|Total cost of revenue                     |                             
|Gross profit                              |                             
|Operating expenses:                       |                             
|Sales and marketing                       |                             
|Research and development                  |                             
|General and administrative                |                             
|Non-cash stock-based compensation expense |                             
|Restructuring credits                     |                             
|Total operating expenses                  |                             
|Loss from operations                      |                             
|Interest and other income, net            |                             
|Loss before income taxes                  |                             
|Benefit from income taxes                 |                             
|Net loss                                  |                             

|                                 | For Three Months Ended March 31,
|-------------------------------- | --------------------------------
|                                 |                                 
|Gross profits:                   |                                 
|License revenue gross profit     |                                 
|Service revenue gross profit     |                                 
|Maintenance revenue gross profit |                                 
|Total revenue gross profit       |                                 

Summary

During
the three months ended March 31, 2004, we responded to the market demand for
standards-based voice automation solutions and delivered a range of updated products,
including new versions of our speech recognition and authentication engines and an updated
version of the NVP. For the three months ended March 31, 2003 compared with the
three months ended March 31, 2004, total revenue increased 10%. This increase was
attributable to increases in service and maintenance revenue. Service revenue increased
27%, mainly from revenues generated in Canada and Europe. Maintenance revenue increased
36%, mainly from revenues generated from the United States and Asia-Pacific. These
increases were partially offset by a 9% decrease in license revenue, mainly from license
revenue generated in Canada. For the three months ended March 31, 2004 and 2003, our top
10 customers represented approximately 50% and 61%of our revenue, respectively.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
gross profit remained relatively constant. Total revenue increased 10% and cost of sales
increased 9%. Service revenue gross profit increased substantially from 13 to 26% as a
result of improved utilization of our service employees and maintenance revenue gross
profit increased from 76% to 80%, which is relatively constant with growing maintenance
revenue.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
operating expenses decreased 8%, primarily due to lower employee-related expenses and net
incremental savings from our restructuring efforts. Operating expenses also decreased
significantly due to the reduction in variable costs relative to decrease in license
revenue. We have attempted to reduce expenses to better align resources with revenue
opportunities anticipated in the current economic environment.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
loss from operations as a percentage of total revenues improved from (42%) to (23%),
primarily due to the increase in service revenue and maintenance revenue, as well as the
reduced expenses.

Comparison of Three Months Periods Ended March 31,
 2004 and 2003

19

---

Table of Contents

Revenue and Cost of Revenue

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
total revenue increased 10%, with license revenue decreasing 9%, service revenue
increasing 27% and maintenance revenue increasing 36%.

License revenue and cost
of license revenue

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
license revenue decreased 9%. This decrease was primarily due to a large NVP purchase that
was made in the first quarter of 2003 that was not repeated in the first quarter of 2004.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
direct license revenue decreased from $2.5 million to $0.9 million. Indirect license
revenue, primarily our speech engine products sold through our third-party resellers,
increased from $3.6 million to $4.6 million.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
the cost of license revenue and gross profit from license revenue remained relatively
constant.

Service revenue and cost
of service revenue

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
service revenue increased by 27%. This revenue grew primarily from a few large service
contracts in Canada that span multiple quarters. Most of these service contracts are with
customers in the telecommunications sector.

Cost
of service revenue as a percentage of service revenue was 74% for the three months ended
March 31, 2004 and 87% for the three months ended March 31, 2003. For the three
months ended March, 31, 2004 compared with the three months ended March 31, 2003, service
revenue gross profit improved to 26% from 13%, primarily due to the increase in
utilization of our professional service employees and the effective use of subcontractors
to deliver consulting work for our customers.

Maintenance revenue and
cost of maintenance revenue

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
maintenance revenue increased 36%. The increased maintenance revenue was primarily due to
the technical support associated with the license revenue in 2003, increased emphasis on
getting customers to renew their technical support contracts and one-time benefits from
fees paid by customers or third-party resellers to reinstate support contracts.

For the three months ended March 31,
2004 compared with the three months ended March 31, 2003, the cost of maintenance revenue
increased slightly. Technical support personnel required to provide customers with product
support remained at a relatively constant headcount. Maintenance gross profit increased to
80% from 76% for the three months ended March 31, 2003.

Operating Expenses

Sales and marketing

Sales
and marketing expenses consist primarily of compensation and related costs for sales and
marketing employees, travel costs and promotional expenditures, including public
relations, advertising, trade shows and marketing materials.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
sales and marketing expense decreased approximately $0.8 million. This decrease was almost
all attributable to a decrease in payroll and related expenses as a result of previous
headcount reductions in the sales organization and the decrease in incentive-based
compensation as a result of the relative decrease in license revenue. Headcount of sales
and marketing personnel decreased by 15 employees, or 14%, from 104 employees at March 31,
2003 to 89 employees at March 31, 2004.

Research and
development

Research
and development expenses consist primarily of compensation and related costs for research
and development employees and contractors.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
research and development expenses increased approximately $0.3 million. Majority of the
increase is the result of severance payments related to two officers who left the Company
in the first quarter of 2004. Headcount for research and development personnel increased
by 3 employees, or approximately 3%, from 93 employees at March 31, 2003 to 96 employees
at March 31, 2004.

20

---

Table of Contents

General and administrative

General
and administrative expenses consist primarily of compensation and related costs for
administrative employees, legal services, accounting services and other general corporate
expenses.

For
the three months ended March 31, 2004 compared with the three months ended March 31, 2003,
general and administrative expenses decreased approximately $1.4 million. This decrease
was primarily attributable to a $0.6 million decrease in payroll and related overhead
costs as a result of the headcount reduction, $0.5 million decrease in bad debt allowance
and a decrease in insurance premiums of $0.1 million. In addition, there were transition
expenses associated with the new and former CEO for the three months ended March 31, 2003,
which were not incurred in the three months ended March 31, 2004. Headcount for general
and administrative personnel decreased by 9 employees, a reduction of approximately 16%,
from 58 employees at March 31, 2003 to 49 employees at March 31, 2004.

Non-cash compensation

We
have elected to follow the accounting provisions of APB No. 25, Accounting for Stock
Issued to Employees for stock-based compensation granted to employees. Accordingly,
compensation expense is recognized in our condensed consolidated statement of operations
only when options are granted at an exercise price that is less than the market price of
the underlying stock on the date of the grant.

Approximately
3,152,000 stock options were granted by us before our initial public offering in
2000, at a weighted average exercise price of $8.58. We record deferred stock
compensation equal to the difference, if any, between the grant price and fair value of
our common stock on the date of grant. We recorded deferred stock
compensation of approximately $8.7 million within stockholders equity, representing
the difference, if any, between the estimated fair value of the common stock for
accounting purposes and the option exercise price of these options at the date of grant.
This amount was presented as a reduction of stockholders equity and was being
amortized over the vesting period of the applicable options. For the three months ended
March 31, 2003, we recorded amortization of deferred compensation of $76,000 and
reversed excess amortization of deferred stock compensation due to termination of
employees ($2,000), resulting in net expense of deferred compensation of $74,000. Deferred
stock-based compensation was fully amortized as of December 31, 2003.

In
the first quarter of 2004, we accelerated options to purchase 12,500 shares of common
stock to one officer who left Nuance on February 9, 2004. In connection with this
acceleration, we recorded $73,000 as Non-cash stock-based compensation expense, which was
calculated by taking the difference between the fair value of the common stock on the date
of acceleration less the option exercise price times the number of options accelerated, in
our condensed consolidated statement of operations for the quarter ended March 31, 2004.

Restructuring credits

For
the three months ended March 31, 2004, the restructuring credit of $41,000 resulted from
the partial reversal of the severance accrual recorded for the restructuring plan during
the three month period ended March 31, 2003. The severance was fully paid as of March 31,
2004.

For
the three months ended March 31, 2003, the restructuring credit of $943,000 resulted from
a refund received related to an asset impairment previously recorded for tenant
improvement costs for the building we do not occupy, following the landlords
reconciliation of tenant improvement costs.

Interest and Other Income, Net

Interest
and other income, net, consists primarily of interest income earned on cash and cash
equivalents, short-term and long-term investments, interest expense, currency gain (loss)
related to the remeasurement of certain balance sheet accounts, and other miscellaneous
items.

The
decrease in interest and other income, net was mainly caused by the reduction of interest
income, resulting from lower cash balances and decreased interest rates.

Benefit from Income Taxes

21

---

Table of Contents

For
the three months ended March 31, 2004 and 2003, we recorded a tax provision of $95,000 and
$86,000, respectively, mainly related to our international subsidiaries. These were offset
by credits of approximately $192,000 and $150,000, respectively, due to the recognition of
research and development tax credits from our Canadian operations.

Liquidity and Capital Resources

Overall

As
of March 31, 2004, we had cash and cash equivalents of $46.4 million and short-term
investments of approximately $59.5 million. We believe that our current cash, cash
equivalents, short-term investment and other financing capabilities will be sufficient to
satisfy our working capital, capital expenditure and other liquidity needs through at
least the next 12 months.

We
have incurred losses since our inception, including a net loss of approximately $2.6
million for the three months ended March 31, 2004. As of March 31, 2004, we had an
accumulated deficit of approximately $260.8 million.

Cash, cash equivalents and
short-term investments

Cash
and cash equivalents consist of highly liquid investments in time deposits held at major
banks, commercial paper, United States government agency notes and bonds, money market
mutual funds and other money market securities with original maturities of 90 days or
less. Short-term investments include similar highly liquid investments that mature by
March 31, 2005.

The
decrease in cash, cash equivalents and short-term investments in the three months ended
March 31, 2004 was primarily due to the use of cash for our operating activities. The
largest use of cash from investing activity was $15.2 million for purchase of investments,
offset by the maturities of certain portion of investments of $22.3 million. The largest
generation of cash from financing activity was the proceeds of $0.3 million through the
exercise of stock options.

Net cash used in operating
activities

Our
operating activities used cash of $0.3 million and $5.2 million during the three months
ended March 31, 2004 and 2003, respectively. For the three months ended March 31, 2004,
accounts receivables generated cash of $4.4 million, increasing $3.5 million from $0.9
million for the three months ended March 31, 2003. This was mainly due to improved
collection cycles and lower revenues towards the end of the three months ended March 31,
2004. Restructuring accrual used cash of $2.4 million and $2.7 million for the three
months ended March 31, 2004 and 2003, respectively, primarily due to Pacific Shore lease
payments and cash paid out for the severance resulting from the restructuring actions
taken in 2001, 2002 and 2003. Provision for doubtful accounts decreased $0.5 million due
to better collection and improved customer credit management and prepaid expenses
increased approximately primarily due to the prepayment of insurance expenses.

Net cash provided by
investing activities

Our
investing activities provided cash of $6.2 million and $5.1 million for the three months
ended March 31, 2004 and 2003, respectively. The use of cash for investing activities was
primarily the purchase of investments, offset by the maturities of certain portion of
investments. Another use of cash was related to the purchase of property and equipment.
Investments in property and equipment increased slightly from $0.6 million for the three
months ended March 31, 2003 to $0.9 million for the three months ended March 31, 2004,
primarily resulting from an internal software upgrade of our financial reporting system.

Net cash provided by financing activities

Our
financing activities generated cash of $0.3 million and nil for the three months ended
March 31, 2004 and 2003, respectively. Net cash provided by financing activities in 2004
related primarily to the proceeds from the exercise of stock options.

Contractual commitments

In
May 2000, we entered into a Pacific Shore lease for the new headquarters
facility. The lease has an eleven-year term, which began in August 2001. In conjunction
with the April 2001 restructuring plans, we decided not to occupy this new leased
facility. The monthly cash payment for the Pacific Shore lease was approximately $600,000.
For the year ended December 31, 2003, we lowered the estimates for the expected
sublease rental rates. This evaluation resulted in recording an additional lease loss of
$10.4 million. For the three months ended March 31, 2004, we reviewed our earlier
estimate for the sublease loss and estimated that there may be an additional 12 months
that the property will remain vacant. The future minimum lease payments table referenced
above does not include common area maintenance charges or estimated sublease income, as there are no sublease commitments as
of March 31, 2004.

We
have contractual commitments for non-cancelable operating leases. We provide letters of
credit as guarantees on these leases. The letter of credits underlying amount are
presented as Restricted cash on condensed consolidated balance sheet. As of
March 31, 2004, restricted cash balance was $11.1 million. It consisted of a $10.9 million
certificate of deposit required by the landlord as a rent deposit for our Pacific Shore
lease in California and $228,000 related to our Montreal lease. Except for this, we had no
material guarantees or commitments.

22

---

Table of Contents

As
of March 31, 2004, we have no capital lease obligations. Capital lease obligations
previously recorded have been fully paid.

We
have recorded a lease loss related to future lease commitments of our Pacific Shores
lease, net of expected sublease income. However, as a result of the condition of the San
Francisco Bay Area commercial real estate market, we may be required to periodically
reevaluate the components of the expected sublease income, because it affects the
estimated lease loss for the unoccupied leased facility. Specifically, we are required to
reevaluate the time that it might take to sublease this unoccupied facility, as well as
the expected sublease rates. This evaluation may result in additional lease losses.

Off Balance Sheet
Arrangements

In
the normal course of business, we enter into contractual commitments to purchase materials
and components from suppliers in exchange for favorable pricing or more beneficial terms.
These non-cancelable purchase obligations for materials were not material as of March 31,
2004.

Capital expenditures

Our
capital requirements depend on numerous factors. We may continue to report significant
quarterly operating losses resulting in future negative operating cash flows. As of March
31, 2004, we do not plan to spend more than $3.5 million on capital expenditures in the
next 9 months. We believe that our cash, cash equivalents and short-term investments will
be sufficient to fund our activities for at least the next 12 months. Thereafter, we may
need to raise additional funds in order to fund more rapid expansion, including increases
in employees and office facilities; to develop new or enhance existing products or
services; to respond to competitive pressures; or to acquire or invest in complementary
businesses, technologies, services or products. Additional funding may not be available on
favorable terms or at all. In addition, we may, from time to time, evaluate potential
acquisitions of other businesses, products and technologies. We may also consider
additional equity or debt financing, which could be dilutive to existing investors.

# Code of Business Conduct
and Ethics

We
maintain a code of business conduct and ethics for directors, officers and employees, and
will promptly disclose any waivers of the code for directors or executive officers. Our
code of business practices addresses conflicts of interest, confidentiality, compliance
with laws, rules and regulations (including insider trading laws), and related matters.

# RISK FACTORS

Investing in our common stock involves
a high degree of risk.  The risks described below are not the only ones facing our
company.  Additional risks not presently known to us, or that we deem immaterial, may
also impair our business operations.  Any of the following risks could materially
adversely affect our business, operating results and financial condition.

OUR ABILITY TO ACCURATELY FORECAST
OUR QUARTERLY SALES IS LIMITED, OUR SHORT TERM COSTS ARE RELATIVELY FIXED, AND WE EXPECT
OUR BUSINESS TO BE AFFECTED BY SEASONALITY. AS A RESULT, OUR QUARTERLY OPERATING RESULTS
MAY FLUCTUATE.

Our quarterly operating results have
varied significantly in the past and we expect that they will vary significantly from
quarter to quarter in the future. As a result, our quarterly operating results are
difficult to predict. These quarterly variations are caused by a number of factors,
including:

 United States and global
economic and political conditions;

 delays or cancellations in
expected orders by customers who are reducing or deferring spending or adjusting project
plans;

 delays in orders due to the
complex nature of large telephony systems and the associated implementation projects;

 timing of product deployments
and completion of project phases, particularly for large orders and large solution
projects;

 delays in recognition of
revenue in accordance with applicable accounting principles;

 our ability to develop,
introduce, ship and support new and/or enhanced products, such as new versions of our
software platform and applications, that respond to changing technology trends in a timely
manner, and our ability to manage product transitions;

23

---

Table of Contents

 rate of market adoption for speech technology
and our products, such as our software platform and applications;

 changes in our selling model,
including focus of certain sales representatives on direct sales to end user customers and
the resulting potential for channel conflict;

 unexpected customer non-renewal
of maintenance contracts or lower renewal instances than anticipated;

 delays in the negotiation and
documentation of orders, particular large orders and orders from large companies;

 the amount and
timing of our expenses; and

 the utilization rate of our
professional services personnel, which is dependent upon acquisition of new projects as
large scale, multi-quarter projects near completion.

Due in part to these factors, and
because the market for our software is relatively new and rapidly changing, and our
business model is evolving, our ability to accurately forecast our quarterly sales is
limited. In addition, most of our costs are relatively fixed in the short term, even as we
endeavor to manage these costs. We do not know whether our business will grow rapidly
enough to absorb our expenses. If we have a shortfall in revenue in relation to our
expenses, we may be unable to reduce our expenses quickly enough to avoid lower quarterly
operating results. As a result, our quarterly operating results could fluctuate
significantly and unexpectedly from quarter to quarter.

We also expect to experience
seasonality in the sales of our products. For example, we anticipate that sales may be
lower in the first and third quarters of each year due to patterns in the capital
budgeting and purchasing cycles of our current and prospective customers. We also expect
that sales may decline during summer months. These seasonal variations in our sales may
lead to fluctuations in our quarterly operating results. It is difficult for us to
evaluate the degree to which this seasonality may affect our business.

WE DEPEND ON A LIMITED NUMBER OF
CUSTOMERS FOR A SUBSTANTIAL PORTION OF OUR REVENUE DURING ANY GIVEN PERIOD. THE LOSS OF,
OR DELAY IN, A SUBSTANTIAL ORDER COULD SUBSTANTIALLY REDUCE OUR REVENUE IN ANY GIVEN
PERIOD AND HARM OUR BUSINESS.

We derive a significant portion of our
revenue in each period from a limited number of direct and indirect customers. We expect
that a small number of customers with significant orders for software product and
professional services will continue to account for a substantial portion of our revenue in
any given period. Generally, customers who make significant purchases from us are not
expected to make subsequent, equally large purchases in the short term, and therefore we
must attract new customers or new significant orders from other customers in order to
maintain or increase our revenues in future quarters. If we experience delays or
cancellations in orders from a major customer, if an anticipated sale is not made or is
deferred, if our professional services team does not complete the work on large projects
ratably over one or more quarters or if we fail to regularly obtain major new customers,
our revenue in a given period could be impacted negatively and our business could be
harmed.

WE DEPEND UPON THIRD-PARTY
RESELLERS FOR A SIGNIFICANT PORTION OF OUR SALES. THE LOSS OF KEY THIRD-PARTY RESELLERS,
OR A DECLINE IN THIRD-PARTY RESELLERS RESALE OF OUR PRODUCTS AND SERVICES, COULD
LIMIT OUR ABILITY TO SUSTAIN AND GROW OUR REVENUE.

The percentage of our revenue obtained
through indirect sales was 74% in 2002, 58% in 2003, and was 65% in the first quarter of
2004. Although this percentage may decrease in the future, we intend to continue to rely
on third-party resellers for a substantial portion of our future sales. As a result, our
revenues are dependent upon the viability and financial stability of our third-party
resellers, as well as upon their continued interest and success in selling our products.
In addition, some of our third-party resellers are thinly capitalized or otherwise
experiencing financial difficulties. The loss of a significant third-party reseller or our
failure to develop new and viable third-party reseller relationships could limit our
ability to sustain and grow our revenue. Furthermore, expansion, or changes in the focus
of a portion, of our internal sales force, in an effort to increase third-party reseller
sales or replace the loss of a significant third-party reseller, could require increased
management attention and higher expenditures.

Our contracts with third-party
resellers do not require a third-party reseller to purchase our products or services. In
fact, many of the third-party resellers with whom we do business offer the products of
some of our competitors, as well as our products. We cannot guarantee that any of our
third-party resellers will continue to market our products or devote significant resources
to doing so. In addition, although we are actively working to manage potential channel
conflicts and maintain strong third-party reseller relationships, certain third-party
reseller relationships may have been adversely affected by the introduction of our own
platform product or our direct sales activities, which may have an unfavorable impact on
revenue from certain third-party resellers. Furthermore, we will, from time to time,
terminate or adjust some of our relationships with third-party resellers in order to
address changing market conditions, adapt such relationships to our business strategy,
resolve disputes, or for other reasons. Any such termination or adjustment could have a
negative impact on our relationships with third-party resellers and our business, and
result in decreased sales through third-party resellers or threatened or actual
litigation. If our third-party resellers do not successfully market and sell our products
or services for these or any other reasons, our sales could be adversely affected and our
revenue could decline. In addition, our third-party resellers possess confidential
information concerning our products and services, product release schedules and sales,
marketing and third party reseller operations. Although we have nondisclosure agreements
with our third-party resellers, we cannot guarantee that any third-party reseller would
not use our confidential information to compete with us.

24

---

Table of Contents

SPEECH SOFTWARE PRODUCTS GENERALLY,
AND OUR PRODUCTS AND SERVICES IN PARTICULAR, MAY NOT ACHIEVE WIDESPREAD ACCEPTANCE, WHICH
COULD REQUIRE US TO MODIFY OUR SALES AND MARKETING EFFORTS AND COULD LIMIT OUR ABILITY TO
SUCCESSFULLY GROW OUR BUSINESS.

The market for speech software
products is relatively new and rapidly changing. In addition, some of our products are new
to the market or, once released, will be new to the market. Our ability to increase
revenue in the future depends on the acceptance by our customers, third-party resellers
and end users of speech software solutions generally and our products and services in
particular. The adoption of speech software products could be hindered by the perceived
costs and deployment time and risks of this relatively new technology, as well as the
reluctance of enterprises that have invested substantial resources in existing call
centers or touch-tone-based systems to replace their current systems with our products.
Accordingly, in order to achieve commercial acceptance, we may have to educate prospective
customers, including large, established enterprises and telecommunications companies,
about the uses and benefits of voice interface software in general and our products in
particular. We may need to modify or increase our sales and marketing efforts, or adopt
new marketing strategies, to achieve such education. If these efforts fail, prove
excessively costly or otherwise unmanageable, or if speech software generally does not
achieve commercial acceptance, our business could be harmed.

The continued development of the
market for our products will depend upon the following factors, among others:

 acceptance by businesses of the
benefits of speech technology;

 widespread and successful
deployment of speech software applications;

 customer demand for services
and solutions having a voice user interface;

 demand for new uses and
applications of speech software technology, including adoption of voice user interfaces by
companies that operate web-based and touch tone IVR self service solutions;

 adoption of industry standards
for speech software and related technologies; and

 continuing improvements in
hardware and telephony technology that may reduce the costs and deployment time of speech
software solutions.

OUR PRODUCTS CAN HAVE A LONG SALES
AND IMPLEMENTATION CYCLE AND, AS A RESULT, OUR QUARTERLY REVENUES AND OPERATING RESULTS
MAY FLUCTUATE.

The sales cycles for our products have
typically ranged from three to twelve months, depending on the size and complexity of the
order, the amount of services to be provided by us and whether the sale is made directly
by us or indirectly through a third-party reseller.

Speech products often require a
significant expenditure by a customer. Accordingly, a customers decision to purchase
our products typically requires a lengthy pre-purchase evaluation. We may spend
significant time educating and providing information to prospective customers regarding
the use and benefits of our products. During this evaluation period, we may expend
substantial sales, technical, marketing and management resources in such efforts. Because
of the length of the evaluation period, we are likely to experience a delay, occasionally
significant, between the time we incur these expenditures and the time we generate
revenues, if any, from such expenditures. Furthermore, the incurring of such expenditures
may not result in a sale of our products.

After purchase by a customer, it may
take time and resources to implement our software and to integrate it with the
customers existing systems. If we are performing services that are essential to the
functionality of the software, in connection with its implementation, we recognize license
and service revenues based on the percentage of services completed, using contract
accounting. In cases where the contract specifies milestones or acceptance criteria, we
may not be able to recognize either license or service revenue until these conditions are
met. We have in the past experienced, and may in the future experience, such delays in
recognizing revenue. Consequently, the length of our sales and implementation cycles, the
scheduled implementation of our products and the terms and conditions of our license and
service arrangements often make it difficult to predict the quarter in which revenue
recognition may occur and may cause license and service revenue and our operating results
to vary significantly from period to period.

25

---

Table of Contents

OUR CURRENT AND POTENTIAL
COMPETITORS, SOME OF WHOM HAVE GREATER RESOURCES AND EXPERIENCE THAN WE DO, MAY MARKET OR
DEVELOP PRODUCTS, SERVICES AND TECHNOLOGIES THAT MAY CAUSE DEMAND FOR, AND THE PRICES OF,
OUR PRODUCTS TO DECLINE.

A number of companies have developed,
or are expected to develop, products that compete with our products. Competitors with
respect to speech technologies include SpeechWorks International and Scansoft, which have
merged, IBM and Microsoft. With respect to our software platform, there are many vendors,
including some of our third-party resellers and channel partners, who market and sell
platforms for voice systems. We expect additional competition from other companies in the
platform market. We also have competition in the applications market. Our competitors may
combine with each other, and other companies may enter our markets by acquiring or
entering into strategic relationships with our competitors. Current and potential
competitors may have established, or may establish, cooperative relationships among
themselves or with third parties to increase the abilities of their advanced speech and
language technology products, platforms and applications to address the needs of our
prospective customers.

Many of our current and potential
competitors have longer operating histories, significantly greater financial, technical,
product development and marketing resources, greater name recognition and larger customer
bases than we do. Our present or future competitors may be able to develop products
comparable or superior to those we offer, adapt more quickly than we do to new
technologies, evolving industry trends and standards or customer requirements, or devote
greater resources than we do to the development, promotion and sale of speech products.
Accordingly, we may not be able to compete effectively in our markets, competition may
intensify and future competition may cause us to reduce prices and/or otherwise harm our
business.

USE OF OUR PRODUCTS MAY INFRINGE
THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS. INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS
AGAINST OUR CUSTOMERS OR US COULD BE COSTLY TO US. SUCH CLAIMS COULD ALSO SLOW OUR SALES
CYCLE OR MARKET ADOPTION GENERALLY.

The software industry in general, and
the field of speech and voice technologies in particular, are characterized by the
existence of a significant number of patents. Litigation and threats of litigation based
on allegations of patent infringement and the violation of intellectual property rights
are normal in software markets and appear to be increasing. We attempt to avoid infringing
known proprietary rights of third parties. However, we may be subject to claims and legal
proceedings for alleged infringement of third-party proprietary rights, such as patents,
trade secrets, trademarks or copyrights, with respect to our products either by our
customers or us. In addition, former employers of our employees may assert that these
employees have improperly disclosed confidential or proprietary information to us.

We typically indemnify our customers
against claims by third parties that our products infringe their intellectual property
rights. Any claims relating to the infringement of third-party proprietary rights, even if
not successful or meritorious, could result in costly litigation, divert managements
attention to our business and require us and our customers to enter into royalty or
license agreements that are costly and otherwise disadvantageous to us. Any such claims
could also require us to defend our customer against the claim and indemnify our customer
for all of its damages as a result of the claim. Any of these effects could have a
material adverse effect on our business and results of operations. Further, parties making
these claims may be able to obtain injunctions, which could prevent us from selling our
products. These types of claims could also slow our sales cycle and/or market adoption
generally with respect to the affected product, which could harm our business. We may be
increasingly subject to infringement claims as the number and features of our products
grow, we extend our speech application business and the speech market grows.

We understand that holders of a
substantial number of patents have alleged that certain of their patents cover a wide
range of automated services in the call center and computer telephony areas. We believe
that one of such holders has sent letters to many providers of such automated services,
including some of our customers, suggesting that a license under its portfolio is required
in order to provide the automated services. That holder has also sued a number of such
entities, alleging patent infringement. A number of the entities against which that holder
has made such claims have entered into license agreements with respect to the
holders patents. None of our customers have notified us that any of such holders has
claimed that any of our products or service deliverables infringes any claims of any of
its patents. Nor have any of such holders made any such claim against us. It is possible,
however, that one or more of our customers, in response to an infringement claim by any of
such holders, might assert indemnity rights against us, whether or not meritorious. It is
also possible that one or more of such holders might make a claim against us directly,
even if not meritorious. The costs associated with resolving any such disputes, regardless
of the legal outcome, could be substantial and could materially and adversely affect our
operating results.

WE HAVE A HISTORY OF LOSSES. WE
EXPECT TO CONTINUE TO INCUR LOSSES IN THE NEAR TERM, AND WE MAY NOT ACHIEVE OR MAINTAIN
PROFITABILITY.

We have incurred losses aggregating in
excess of $260 million since our inception, including a net loss of approximately $19.3
million for the fiscal year ended December 31, 2003 and a net loss of approximately $2.6
million for the first quarter ended March 31, 2004. We expect to continue to spend
significant amounts to develop and enhance our products, services and technologies and to
enhance our delivery capabilities. As a result, we will need to generate increasing
revenue to achieve profitability. Even if we achieve profitability, we may not be able to
sustain or increase profitability on a quarterly or annual basis. No assurances can be
given that we will be profitable or have positive cash flow at any time in the future.

26

---

Table of Contents

SALES TO CUSTOMERS OUTSIDE THE
UNITED STATES ACCOUNT FOR A SIGNIFICANT PORTION OF OUR REVENUE, WHICH EXPOSES US TO RISKS
INHERENT IN INTERNATIONAL OPERATIONS.

International sales represented
approximately 39% of our total revenue in 2003 and approximately 40% of our total revenue
for the first quarter of 2004. We anticipate that revenue from markets outside the United
States will continue to represent a meaningful portion of our total revenue for the
foreseeable future. We are subject to a variety of risks associated with conducting
business internationally, any of which could harm our business. These risks include:

 difficulties and costs of
staffing and managing foreign operations;

 the difficulty in establishing
and maintaining an effective international third-party reseller network;

 the burden of complying with a wide
variety of foreign laws, particularly with respect to tax, intellectual property and
license requirements;

 longer sales and payment cycles
than we experience in the United States;

 political and economic
instability outside the United States;

 import or export licensing and
product certification requirements;

 tariffs, duties, price controls
or other restrictions on foreign currencies or trade barriers imposed by foreign
countries;

 potential adverse tax
consequences, including higher marginal rates and withholding taxes;

the impact of foreign exchange translations on the expense of our foreign operations; and

 a limited ability, and
significant costs, to enforce agreements, intellectual property rights and other rights in
most foreign countries.

# WE ARE EXPOSED TO GENERAL
ECONOMIC CONDITIONS, WHICH MAY CONTINUE TO HARM OUR BUSINESS.

There has been a global economic
downturn over the past several years, which did not begin to improve until late in 2003.
If United States or global economic conditions deteriorate in the future, it is likely
that capital spending will decline and our sales will be adversely affected. If such
unfavorable economic conditions persist or worsen in the United States or internationally,
such conditions will have a material adverse impact on our business, operating results and
financial condition.

# OUR STOCK PRICE MAY BE
VOLATILE, DUE TO FACTORS OUTSIDE OF OUR CONTROL.

Since our initial public offering in
April 2000, our stock price has been extremely volatile. During that time, the stock
market in general, and The NASDAQ National Market and the securities of technology
companies in particular, have experienced extreme price and trading volume fluctuations.
These fluctuations have often been unrelated or disproportionate to the operating
performance of individual companies. The following factors, among others, could cause our
stock price to fluctuate:

 actual or anticipated
variations in operating results;

 announcements of operating
results and business conditions by our customers, suppliers or competitors;

 announcements by our
competitors relating to new customers, technological innovations or new services;

 announcements by us of new
product lines and/or shifts in business focus or sales and distribution models;

 material increases in our plans
for, or actual rate of, capital expenditures for infrastructure, information technology
and other similar capital expenditures;

 economic developments in our
industry as a whole;

 general market and economic
conditions; and

 general decline and other
changes in information technology and capital spending plans.

These broad market fluctuations may
materially adversely affect our stock price, regardless of our operating results.
Furthermore, our stock price may fluctuate due to variations in our operating results.

27

---

Table of Contents

ANY DEFECTS IN OR OTHER PROBLEMS
WITH OUR PRODUCTS COULD HARM OUR BUSINESS AND RESULT IN LITIGATION.

Complex software products such as ours
may contain errors, defects and bugs. During the development of any product, we may
discover errors, defects and bugs and, as a result, our products may take longer than
expected to develop. In addition, we may discover that remedies for errors, defects or
bugs may be technologically unfeasible. Delivery of products with undetected errors,
defects or bugs, or reliability, quality, or compatibility problems, could damage our
reputation. The existence of errors, defects or bugs, or reliability, quality or
compatibility problems, could also cause interruptions, delays or cessations of sales to
our customers. We could, as well, be required to expend significant capital and other
resources to remedy these problems. In addition, customers whose businesses are disrupted
by these errors, defects and bugs, or reliability, quality or compatibility problems,
could bring claims against us, the defense of which, even if successful, would likely be
time-consuming and costly for us. Furthermore, if such defense was not successful, we
might be obligated to pay substantial damages, which could materially and adversely affect
our operating results.

IF WE ARE UNABLE TO EFFECTIVELY
MANAGE OUR OPERATIONS AND RESOURCES IN ACCORDANCE WITH MARKET AND ECONOMIC CONDITIONS, OUR
BUSINESS COULD BE HARMED.

Our operations have changed
significantly over time, due in part to volatility in our business, and may continue to
change in the future. We experienced significant growth in the past. However, between
April 2001 and August 2003, in four separate restructuring actions, we reduced our
workforce by approximately 45%. We may be required to expand or contract our business
operations in the future to adapt to the market environment, and as a result may need to
expand or contract our management, operational, sales, marketing, financial, engineering
or other human resources, as well as management information systems and controls, to align
and support any such growth or contraction. Our failure to successfully manage these types
of changes would place a substantial burden on our business, our operations and our
management team, and could negatively impact sales, customer relationships and other
aspects of our business.

# WE COULD BE ADVERSELY
IMPACTED BY THE NEED FOR AN INCREASE IN OUR RESTRUCTURING ACCRUAL FOR OUR PACIFIC SHORES
FACILITY

A significant portion of our
restructuring accrual is represented by a lease loss created by our decision not to occupy
our leased Pacific Shores facility. The accrual assumptions for such loss are based upon
estimates of real estate market conditions and values. These market conditions are subject
to wide fluctuations, and market values could decline further, which may require an
additional restructuring accrual. We have attempted to sublease the Pacific Shores
facility, but, to date, have not been successful in those efforts. There can be no
assurances that we will be able to sublease the facility at a lease rate approximating our
estimate of its lease value, or at all. If we are unable to sublease, we may have to record an additional
restructuring charge of up to $40 milion, which represents the sublease income we have estimated to
receive, over the remaining life of the lease of approximately eight years.

WE RELY ON THE SERVICES OF OUR KEY
PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE DIFFICULT TO
REPLACE.

We rely upon the continued service and
performance of a relatively small number of key technical and senior management personnel.
Our future success will be impacted by our ability to retain these key employees. We
cannot guarantee that we will be able to retain all key personnel. Other than Charles
Berger, our President, none of our key technical or senior management personnel have
employment agreements with us, and, as a result, are more likely to leave with little or
no prior notice. If we lose any of our key technical and senior management personnel,
replacing them could be difficult and costly. If we are not able to successfully and
rapidly replace such personnel, our business could be materially harmed. We do not have
key personnel life insurance policies covering any of our employees.

OUR FAILURE TO SUCCESSFULLY RESPOND
TO AND MANAGE RAPID CHANGE IN THE MARKET FOR SPEECH SOFTWARE COULD CAUSE US TO LOSE
REVENUE AND HARM OUR BUSINESS. IT IS ESSENTIAL THAT WE CONTINUE TO DEVELOP NEW PRODUCTS
THAT ACHIEVE COMMERCIAL ACCEPTANCE.

The speech software industry is
relatively new and rapidly changing. Our future success will depend substantially upon our
ability to enhance our existing products and to develop and introduce, on a timely and
cost-effective basis, new products and features that meet changing third-party reseller
and end-user requirements and incorporate technological advancements, such as products
that speed deployment and accelerate customers return on investment, as well as
achieve commercial acceptance. Commercial acceptance of new products and technologies we
may introduce will depend, among other things, on: the ability of our services, products
and technologies to meet and adapt to the needs of our target markets; the performance and
price of our products and services and our competitors products and services; and
our ability to deliver speech solutions, customer service and professional services
directly and through our third-party resellers. If we are unable to develop new products
and enhance functionalities or technologies to adapt to these changes, we may be unable to
retain existing customers or attract new customers, which could materially harm our
business. In addition, as we develop new products, sales of existing products may
decrease. If we cannot offset a decline in revenue from existing products with sales of
new products, our business would be adversely affected.

28

---

Table of Contents

SPEECH PRODUCTS ARE NOT 100%
ACCURATE AND WE COULD BE SUBJECT TO CLAIMS RELATED TO THE PERFORMANCE OF OUR PRODUCTS. ANY
CLAIMS, WHETHER SUCCESSFUL OR UNSUCCESSFUL, COULD RESULT IN SIGNIFICANT COSTS AND COULD
DAMAGE OUR REPUTATION.

Speech recognition natural language
understanding and authentication technologies, including our own, are not able to perform
accurately in every instance. Our customers, including several financial institutions, use
our products to provide important services to their customers, including transferring
funds to accounts and buying and selling securities. Any misrecognition of voice commands
or incorrect authentication of a users voice in connection with these financial or
other transactions could result in claims against our customers or us for losses incurred.
Although our contracts usually contain provisions designed to limit our exposure to such
liability claims, a claim brought against us based on misrecognition or incorrect
authentication, even if unsuccessful, could be time-consuming, divert managements
attention, result in costly litigation and harm our reputation. If any such claim is
successful, we could be exposed to an award of substantial damages and our reputation
could be harmed greatly. Moreover, existing or future laws or unfavorable judicial
decisions could limit the enforceability of limitations of liability, disclaimers of
warranty or other protective provisions contained in our contracts.

WE MAY INCUR A VARIETY OF COSTS TO
ENGAGE IN FUTURE ACQUISITIONS OF COMPANIES, PRODUCTS OR TECHNOLOGIES, AND THE ANTICIPATED
BENEFITS OF THOSE ACQUISITIONS MAY NEVER BE REALIZED.

As a part of our business strategy, we
may make acquisitions of, or significant investments in, complementary companies, products
or technologies. For instance, in November 2000 we acquired SpeechFront, a Canadian
company. In February 2001, we acquired non-exclusive intellectual property rights from a
third-party. For the year ended December 31, 2001, we performed an impairment analysis and
determined that our asset related to the SpeechFront acquisition was impaired and was
subsequently written down to its estimated fair value. Any future acquisitions of
companies or technologies would be accompanied by risks such as:

 difficulties in assimilating
the operations, personnel and technologies of acquired companies;

 diversion of our
managements attention from ongoing business concerns;

 our potential inability to
maximize our financial and strategic position through the successful incorporation of
acquired technology and rights into our products and services;

 additional expense associated
with impairments of acquired assets, such as goodwill or acquired workforce;

 increases in the risk of claims
against us, related to the intellectual property we acquire;

 maintenance of uniform
standards, controls, procedures and policies; and

 impairment of existing relationships
with employees, suppliers and customers as a result of the integration of new management
personnel.

We cannot guarantee that we will be
able to successfully integrate any business, products, technologies or personnel that we
might acquire in the future. Our inability to integrate successfully any business,
products, technologies or personnel we may acquire in the future could materially harm our
business.

WE ARE EXPOSED TO THE LIQUIDITY
PROBLEMS OF OUR CUSTOMERS. WE MAY HAVE DIFFICULTY COLLECTING AMOUNTS OWED TO US.

Certain of our customers and third-party resellers have experienced, and may in
the future experience credit-related issues. We perform ongoing credit evaluations of
customers, but do not require collateral. We grant payment terms to most customers ranging
from 30 to 90 days. However, in some instances we may provide longer payment terms. Should
more customers than we anticipate experience liquidity issues, or if payment is not
received on a timely basis, we may have difficulty collecting amounts owed to us by such
customers and our business, operating results and financial condition could be adversely
impacted.

29

---

Table of Contents

DUE TO CHANGED REQUIREMENTS
RELATING TO ACCOUNTING TREATMENT FOR EMPLOYEE STOCK OPTIONS, WE MAY BE FORCED TO CHANGE
OUR BUSINESS PRACTICES.

We currently account for the issuance
of stock options under APB No. 25, Accounting for Stock Issued to Employees.
The Financial Accounting Standards Board has issued an exposure draft that requires
companies to include a compensation expense in their statement of operations relating to
the issuance of employee stock options. The change in accounting for stock options is
presently anticipated to become effective for public companies in the first fiscal year
beginning after December 15, 2004. As a result, we could decide to decrease the number of
employee stock options that we would grant. This could affect our ability to retain
existing employees and attract qualified candidates for open positions, and increase the
cash compensation we would have to pay to them. Conversely, issuing a number of stock
options comparable to the number we have issued in the past to new or existing employees
could adversely impact our results of operations under the new accounting requirements,
once they take effect.

INTERNATIONAL SALES OPPORTUNITIES
MAY REQUIRE US TO DEVELOP LOCALIZED VERSIONS OF OUR PRODUCTS. IF WE ARE UNABLE TO DO SO
TIMELY, OUR ABILITY TO GROW OUR INTERNATIONAL REVENUE AND EXECUTE OUR INTERNATIONAL
BUSINESS STRATEGY WILL BE ADVERSELY AFFECTED.

International sales opportunities may
require investing significant resources in creating and refining different language models
for particular languages or dialects. These language models are required to create
versions of our products that allow end users to speak the local language or dialect and
be understood and authenticated. If we fail to develop needed localized versions of our
products on a timely basis, our ability to address international market opportunities and
to grow our international business will be adversely affected. However, even if we expend
resources to develop localized versions of our products, there can be no assurance that we
will be able to recognize sufficient revenues from these localized versions to make them
profitable.

IF THE INDUSTRY STANDARDS WE HAVE
SELECTED TO SUPPORT ARE NOT ADOPTED AS THE STANDARDS FOR SPEECH SOFTWARE, CUSTOMERS MIGHT
NOT USE OUR SPEECH SOFTWARE PRODUCTS FOR DELIVERY OF APPLICATIONS AND SERVICES.

The market for speech software is
relatively new and emerging and industry standards are still being established. We may not
be competitive unless our products support changing industry standards. The emergence of
industry standards, whether through adoption by official standards committees or
widespread usage, could require costly and time-consuming redesign of our products. If
these standards become widespread and our products do not support them, our customers and
potential customers may not purchase our products. Multiple standards in the marketplace
could also make it difficult for us to ensure that our products will support all
applicable standards, which could in turn result in decreased sales of our products.
Furthermore, the existence of multiple standards could chill the market for speech
software in general, until a dominant standard emerges.

Our pre-packaged applications,
V-Builder applications-building tool and our Nuance Voice Platform software are each
designed to work with the recently adopted VoiceXML standard. There are currently other,
similar standards in development, some of which may become more widely adopted than
VoiceXML. If VoiceXML is not widely accepted by our target customers or if another
competing standard were to become widely adopted, then sales of our products could decline
and our business would be materially harmed. In that case, we may find it necessary to
redesign our existing products or design new products that are compatible with alternative
standards that are widely adopted or that replace VoiceXML. This design or redesign could
be costly and time-consuming. If a third party proprietary technology were to become a
standard, we might be precluded from developing products to conform to that standard
unless we are able to enter into agreements to license the rights to develop such
products. Any such license could require us to pay substantial royalties, whether upfront
or based on sales of such products, which could materially adversely affect our margins
for such products and, as a result, our results of operations.

# ANY INABILITY TO
ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HARM OUR ABILITY TO COMPETE.

Our future success and ability to
compete depends in part upon our proprietary technology and our trademarks, which we
attempt to protect with a combination of patent, copyright, trademark and trade secret
laws, as well as with our confidentiality procedures and contractual provisions. These
legal protections afford only limited protection and may be time-consuming and expensive
to obtain, maintain or enforce. Further, despite our efforts, we may be unable to prevent
third parties from infringing upon or misappropriating our intellectual property or to
recover adequate compensation from any such infringers.

Although we have filed multiple U.S.
patent applications, we have currently only been issued a small number of patents. There
is no guarantee that more patents will be issued with respect to our current or future
patent applications. Any patents that are issued to us could be circumvented or
challenged. If challenged, a patent might be invalidated or its claims might be
substantially narrowed. Our intellectual property rights may not be adequate to provide us
with a competitive advantage and, in any event, are not likely to prevent competitors from
entering the markets for our products. Additionally, our competitors could independently
develop non-infringing technologies that are competitive with, equivalent to, or superior
to our technology.

30

---

Table of Contents

Monitoring infringement and
misappropriation of intellectual property can be difficult, and there is no guarantee that
we would detect any infringement or misappropriation of our proprietary rights. Even if we
do detect infringement or misappropriation of our proprietary rights, litigation to
enforce these rights could cause us to divert financial and other resources away from our
business operations. Further, we license our products internationally, and the laws of
some foreign countries do not protect our proprietary rights to the same extent as the
laws of the United States.

OUR CHARTER AND BYLAWS AND DELAWARE
LAW CONTAIN PROVISIONS WHICH MAY DELAY OR PREVENT A CHANGE OF CONTROL OF NUANCE.

Our Shareholder Rights Plan, as well
as provisions of our charter and bylaws, may make it more difficult for a third party to
acquire, or may discourage a third party from attempting to acquire, control of Nuance.
These provisions could limit the price that investors might be willing to pay in the
future for shares of our common stock. These provisions include:

 our Shareholder Rights Plan
adopted in December 2002;

 the division of the board of
directors into three separate classes;

 the elimination of cumulative
voting in the election of directors;

 prohibitions on our stockholders
acting by written consent and calling special meetings;

 procedures for advance
notification of stockholder nominations and proposals; and

 the ability of the board of
directors to alter our bylaws without stockholder approval.

In addition, our board of directors
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.

Since the completion of our initial
public offering in April 2000, we have been subject to the anti-takeover provisions of the
Delaware General Corporation Law, including Section 203, which may deter potential
acquisition bids for our company. Under Delaware law, a corporation may opt out of Section
203. We do not presently intend to opt out of the provisions of Section 203.

OUR FACILITIES ARE LOCATED NEAR
KNOWN EARTHQUAKE FAULT ZONES, AND THE OCCURRENCE OF AN EARTHQUAKE OR OTHER NATURAL
DISASTER COULD CAUSE DAMAGE TO OUR FACILITIES AND EQUIPMENT, WHICH COULD REQUIRE US TO
CURTAIL OR CEASE OPERATIONS.

Our facilities are located in the San
Francisco Bay Area, near known earthquake fault zones, and are vulnerable to damage from
earthquakes. In October 1989, a major earthquake struck this area, causing significant
property damage and a number of fatalities. We are also vulnerable to damage from other
types of disasters, including fire, floods, power loss, communications failures and
similar events. If any disaster were to occur, our ability to operate our business at our
facilities could be seriously, or completely, impaired.

WE RELY ON A CONTINUOUS POWER
SUPPLY TO CONDUCT OUR OPERATIONS, AND AN ENERGY CRISIS COULD DISRUPT OUR OPERATIONS AND
INCREASE OUR EXPENSES.

We currently do not have backup
generators or alternate sources of power in the event of a blackout, and our current
insurance does not provide coverage for any damages we, or our customers, may suffer as a
result of any interruption in our power supply. If blackouts interrupt our power supply,
we would be temporarily unable to continue operations at our facilities. If such
interruption became lengthy or occurred repeatedly, it could adversely affect our ability
to conduct operations, which could damage our reputation, harm our ability to retain
existing customers and to obtain new customers, and result in lost revenue, any of which
could substantially harm our business and results of operations.

INFORMATION THAT WE MAY PROVIDE TO
INVESTORS FROM TIME TO TIME IS ACCURATE ONLY AS OF THE DATE WE DISSEMINATE IT AND WE
UNDERTAKE NO OBLIGATION TO UPDATE THE INFORMATION.

From time to time, we may publicly
disseminate forward-looking information or guidance in compliance with Regulation FD
promulgated by the Securities and Exchange Commission. This information or guidance
represents our outlook only as of the date that we disseminated it, and we undertake no
obligation to provide updates to this information or guidance in our filings with the
Securities and Exchange Commission or otherwise.

31

---

Table of Contents

# ITEM 3. QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The
following section describes our exposure to market risk related to changes in foreign
currency exchange rates and interest rates. This section contains forward-looking
statements that are subject to risks and uncertainties. Actual results could vary
materially as a result of a number of factors, including those set forth in the risk
factors section of this Report on Form 10-Q. We believe there have been no significant
changes in our market risk exposures during the three months ended March 31, 2004 as
compared to what was previously disclosed in our annual report on Form 10-K for the year
ended December 31, 2003.

# Foreign Currency Exchange
Rate Risk

To
date, almost all of our recognized revenues have been denominated in U.S. dollars, with a
majority of revenues coming from customers in the United States, and our exposure to
foreign currency exchange rate changes has been immaterial. We expect, however, that
future product license and services revenues derived from international markets may be
denominated in the currency of the applicable market. As a result, our operating results
may become subject to significant fluctuations based upon changes in the exchange rates of
certain currencies in relation to the U.S. dollar. Furthermore, to the extent that we
engage in international sales denominated in U.S. dollars, an increase in the value of the
U.S. dollar relative to foreign currencies could make our products less competitive in
international markets. Although we will continue to monitor our exposure to currency
fluctuations and, when appropriate, may use financial hedging techniques to minimize the
effect of these fluctuations, we can not assure that exchange rate fluctuations will not
adversely affect our financial results in the future.

# Interest Rate Risk

As
of March 31, 2004, we had cash, cash equivalents and short-term investments of $105.9
million. Interest rates are presently at the historic lows. In the event that rates
increase in the future, any subsequent decline in interest rates over time would
materially reduce our interest income from our short-term investments. Based upon our
balance of cash and cash equivalents and short-term investments, an absolute reduction in
interest rates of 0.5% would cause a corresponding decrease in our annual interest income
by approximately $0.5 million.

# ITEM 4. CONTROLS AND
PROCEDURES

Based
on our managements evaluation (with the participation of our principal executive
officer and principal financial officer) as of the end of the period covered by this
quarterly Report on Form 10-Q, our principal executive officer and our principal financial
officer have conducted that 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
(the Exchange Act)) are effective to ensure that information required to be
disclosed by us in reports that we file, or submit, under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the Securities and
Exchange Commission rules and forms. Except as described below, there has been no change
in our internal control over financial reporting that occurred during the period covered
by this Report on Form 10-Q that materially affected, or is reasonably likely to
materially affect, our financial reporting.

As
previously reported, during the preparation of our consolidated financial statements for
the year ended December 31, 2003, we discovered that our pro-forma footnote disclosures
required by FAS No.148 Accounting for Stock-Based Compensation-Transition and
Disclosure, with respect to the fair value of its stock-based awards for the year
ended December 31, 2003 and the quarters ended March 31, 2003, June 30, 2003 and September
30, 2003, were not calculated correctly. We have corrected the disclosure for the quarter
ended Mach 31, 2003, as described in Note 2 of Notes to the condensed consolidated
financial statements included in this Report on Form 10-Q. In response to the discovery of
this calculation error during the first quarter of 2004, we have implemented processes and
procedures intended to ensure that this calculation error is not repeated.

32

---

Table of Contents

# PART II: OTHER
INFORMATION

# ITEM 1. LEGAL PROCEEDINGS

On
April 8, 2004, the Company was served with a civil complaint filed by Voice Capture, Inc.
against the Company in the United States District Court for the Southern District of Iowa
(the Complaint). The Complaint, which also names as defendants Intel
Corporation and Dialogic Corporation, alleges that certain software and services of the
Company infringe upon certain claims contained in U.S. Patent No. Re 34,587
(Interactive Computerized Communications Systems with Voice Input and Output).
The plaintiff is seeking unspecified damages. The Company is currently investigating the
allegations raised in the Complaint. However, the Company believes that the allegations of
the Complaint are without merit and intends to defend the litigation vigorously.

In
August 2001, the first of a number of complaints was filed, in the United States District
Court for the Southern District of New York, on behalf of a purported class of persons who
purchased the Companys stock between April 12, 2000, and December 6, 2000. Those
complaints have been consolidated into one action. The complaint generally alleges that
various investment bank underwriters engaged in improper and undisclosed activities
related to the allocation of shares in the Companys initial public offering of
securities. The complaint makes claims for violation of several provisions of the federal
securities laws against those underwriters, and also against the Company and some of
directors and officers. Similar lawsuits, concerning more than 250 other companies
initial public offerings, were filed in 2001. In February 2003, the Court denied a motion
to dismiss with respect to the claims against the Company. In the third quarter of 2003, a
proposed settlement in principle was reached among the plaintiffs, issuer defendants
(including the Company) and the issuers insurance carriers. The settlement calls for
the dismissal and release of claims against the issuer defendants, including the Company,
in exchange for a contingent payment to be paid, if necessary, by the issuer
defendants insurance carriers and an assignment of certain claims. The timing of the
conclusion of the settlement remains unclear, and the settlement is subject to a number of
conditions, including finalization of appropriate documentation and approval of the Court.
The settlement is not expected to have any material impact upon the Company, as payments,
if any, are expected to be made by insurance carriers, rather than by the Company. In the
event a settlement is not concluded, the Company intends to defend the litigation
vigorously. The Company believes that it has meritorious defenses to the claims against
itself.

In
2001, putative shareholder derivative actions were filed in the California state, alleging
breaches of fiduciary duty and insider trading by several of the Companys directors
and officers. As the Company is named as a nominal defendant, the actions did not appear
to seek any recovery against the Company. The Court approved the settlement and dismissal
of these actions in November 2003. The settlement did not require any payments by the
Company.

In
March 2001, the first of a number of stockholder class action complaints were filed, in
the United States District Court for the Northern District of California, against the
Company and certain of its officers and directors. The lawsuits were consolidated and an
amended complaint was filed on behalf of a purported class of people who purchased the
Companys stock during the period January 31, 2001, through March 15, 2001, alleging
false and misleading statements and insider trading in violation of the federal securities
laws. The plaintiffs were seeking unspecified damages. In November 2003, the Court
approved a settlement and dismissal of the action. The settlement was funded entirely by
the Companys insurers in August and September 2003.

In
January 2001, the Company filed an opposition proceeding in the European community against
a Community Trade Mark application for NUANCE, owned by Nuance Global Traders, Ltd. The
opposition is still pending. The parties have agreed upon a settlement, which will become
final upon, among other things, completion of final settlement documents.

In
addition, The Company is subject to various other legal proceedings, claims and litigation
that arise in the normal course of business. While the outcome of these matters is
currently not determinable, management does not expect that the ultimate costs to resolve
these matters will have a material adverse effect on its consolidated financial position,
results of operations, or cash flows.

# ITEM 6. EXHIBITS AND
REPORTS ON FORM 8-K:

33

---

Table of Contents

(a) Exhibits

|Exhibit Index Exhibit number | Description                                                                                                                                             
|---------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1*                         | Restated Certificate of Incorporation
of the Company, as currently in effect.                                                                           
|                             |                                                                                                                                                         
|3.2**                        | Bylaws of the Company, as currently in effect.                                                                                                          
|                             |                                                                                                                                                         
|31.1                         | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302(a)of the Sarbanes-Oxley Act of 2002.
|                             |                                                                                                                                                         
|31.2                         | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302(a)of the Sarbanes-Oxley Act of 2002.
|                             |                                                                                                                                                         
|32.1                         | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  
|                             |                                                                                                                                                         
|32.2                         | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  

---

* Incorporated by reference to the
registrants Registration Statement on Form S-1 (File no. 333-96217) as declared
effectively by the Securities and Exchange Commission on February 4, 2000.

** Incorporated by reference to the
Companys Form 8-K (file No. 000-30203), as filed on December 13, 2002.

(b) Reports on Form 8-K

|Date Furnished      | Item No.       | Description                                                                                                                                                                                                                                                                                                                                                                                                                     
|------------------- | -------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|January 27, 2004*** | Items 7 and 12 | On Janaury 27, 2004, the Company furnished a report on Form 8-K to report under
Item 12 its financial results for the quarter and fiscal year ended December 31, 2003, and to list under Item 7 a press release furnished
with the filing. The Company's statement of operations and balance sheet for the quarter and fiscal year ended December 31, 2003 were included
with the press release that is an exhibit to the report

*** This furnished 8-K shall not be
deemed filed or incorporated by reference into any filing.

34

---

Table of Contents

# SIGNATURES

Pursuant to the requirements of the
Securities Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

|                  |  | NUANCE COMMUNICATIONS, INC.                            
|----------------- |  | -------------------------------------------------------
|                  |  | (Registrant)                                           
|                  |  |                                                        
|                  |  |                                                        
|                  |  |                                                        
|                  |  |                                                        
|Date: May 7, 2004 |  | By:           /s/ KAREN BLASING                        
|                  |  | Karen BlasingVice President and
Chief Financial Officer
|                  |  |                                                        

35

---

Table of Contents

# End of Filing

36

---