##### Table of Contents




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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





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FORM 10-Q





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|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
|- |  | ------------------------------------------------------------------

| |  | EXCHANGE ACT OF 1934
| |  | --------------------




FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002





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 0-30203





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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, and (2) has been subject to such filing
requirements for the past 90 days. YES  x NO  ̈





33,870,214 shares of the registrants common stock, $0.001 par value, were outstanding as of October 31, 2002.





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##### Table of Contents




NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





FORM 10-Q, SEPTEMBER 30, 2002





CONTENTS





Item Number



PagePART I: FINANCIAL INFORMATIONItem 1.

Financial StatementsCondensed Consolidated Balance Sheets:September 30, 2002 and December 31, 2001

1Condensed Consolidated Statements of Operations:Three and nine months ended September 30, 2002 and 2001

2Condensed Consolidated Statements of Cash Flows:Nine months ended September 30, 2002 and 2001

3Notes to Condensed Consolidated Financial Statements

4Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

13Item 3.

Quantitative and Qualitative Disclosures about Market Risk

29Item 4.

Controls and Procedures

29PART II: OTHER INFORMATIONItem 1.

Legal Proceedings

30Item 2-3.

Not Applicable

30Item 4.

Not Applicable

30Item 5.

Not Applicable

30Item 6.

Exhibits and Reports on Form 8-K

30SIGNATURES

31CERTIFICATIONS

32




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##### Table of Contents




PART I: FINANCIAL INFORMATION





ITEM 1: FINANCIAL STATEMENTS





NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)


(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)








September 30, 2002


December 31, 2001ASSETSCurrent assets:Cash and cash equivalents

$
64,494


$
132,618Short-term investments


65,399



16,230Accounts receivable, net of allowance for doubtful accounts of $714 and $1,312, respectively


8,053



6,399Prepaid expenses and other current assets


4,852



4,920Total current assets


142,798



160,167Property and equipment, net


8,067



8,502Intangible assets


1,541



1,393Restricted cash


12,207



11,983Long-term investments


5,716



25,747Other assets


236



439Total assets

$
170,565


$
208,231LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
1,480


$
1,385Accrued compensation


2,125



2,051Accrued employee benefits


3,043



2,752Accrued liabilities


4,363



5,497Current restructuring accrual


12,179



8,974Deferred revenue


8,932



10,836Total current liabilities


32,122



31,495Long-term restructuring accrual


44,780



20,169Other long-term liabilities


41



1,742Total liabilities


76,943



53,406Commitments (Note 9)Stockholders Equity:Common stock, $.001 par value, 250,000,000 shares authorized; 33,864,346 shares and 33,198,051 shares issued and
outstanding, respectively


34



33Additional paid-in capital


327,751



324,371Deferred stock compensation


(352
)


(1,532
)Accumulated other comprehensive income (loss)


19



(335
)Accumulated deficit


(233,830
)


(167,712
)Total stockholders equity


93,622



154,825Total liabilities and stockholders equity

$
170,565


$
208,231





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




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(UNAUDITED)


(IN THOUSANDS, EXCEPT PER SHARE DATA)





Three Months Ended September
30,


Nine Months Ended September 30,2002


2001


2002


2001Revenue:License

$
5,741


$
5,065


$
19,233


$
15,757Service


2,404



2,023



5,250



8,753Maintenance


2,358



2,093



6,463



5,733Total revenue


10,503



9,181



30,946



30,243Cost of revenue:License


111







406



Service (1)


2,044



2,534



5,453



9,555Maintenance (1)


869



968



2,636



3,106Total cost of revenue


3,024



3,502



8,495



12,661Gross profit


7,479



5,679



22,451



17,582Operating expenses:Sales and marketing (1)


10,879



8,822



31,854



30,934Research and development (1)


3,910



4,360



11,058



14,687General and administrative (1)


3,299



3,089



10,442



10,256Amortization of goodwill






478







1,433Non-cash stock-based compensation


33



1,763



990



4,829Restructuring charges


35,728







37,047



55,028Total operating expenses


53,849



18,512



91,391



117,167Loss from operations


(46,370
)


(12,833
)


(68,940
)


(99,585
)Interest and other income, net


694



1,675



2,215



6,956Loss before income taxes


(45,676
)


(11,158
)


(66,725
)


(92,629
)Provision (benefit) for income taxes


191



218



(607
)


521Net loss

$
(45,867
)

$
(11,376
)

$
(66,118
)

$
(93,150
)Basic and diluted net loss per share

$
(1.36
)

$
(0.35
)

$
(1.97
)

$
(2.88
)Shares used to compute basic and diluted net loss per share


33,807



32,646



33,541



32,334(1) Excludes non-cash stock-based compensation as
follows:Service and maintenance cost of revenue

$
4


$
141


$
45


$
386Sales and marketing


5



388



432



1,185Research and development


13



617



372



1,629General and administrative


11



617



141



1,629Total non-cash stock-based compensation

$
33


$
1,763


$
990


$
4,829





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




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)


(IN THOUSANDS)





Nine Months Ended September 30,2002


2001Cash flows from operating activities:Net loss

$
(66,118
)

$
(93,150
)Adjustments to reconcile net loss to net cash used in operating activitiesTenant improvement asset impairment






20,898Depreciation


12,645



3,284Amortization of goodwill and intangible assets


227



1,433Non-cash stock-based compensation expense


990



4,829Provision for doubtful accounts


(598
)


686Changes in operating assets and liabilities:Accounts receivable


(1,038
)


11,067Prepaid expenses and other current assets


68



1,607Accounts payable


95



(410
)Accrued liabilities and other


(800
)


(40
)Restructuring accrual


27,816



31,362Deferred revenue


(1,904
)


1,296Net cash used in operating activities


(38,617
)


(17,138
)Cash flows from investing activities:Decrease in restricted cash


(224
)


Purchase of investments


(63,842
)


Maturities of investments


34,973



8,728Purchase of property and equipment


(2,138
)


(24,921
)Disposals of property and equipment






87Purchase of technology






(7,000
)Purchase of patent


(375
)


Net cash used in investing activities


(31,606
)


(23,106
)Cash flows from financing activities:Repurchase of common stock


(11
)


(365
)Issuance of common stock


73



Proceeds from exercise of stock options


469



3,583Proceeds from employee stock purchase plan


1,485



2,349Repayment of borrowings






(44
)Net cash provided by financing activities


2,016



5,523Effect of exchange rate fluctuations on cash and cash equivalents


83



(113
)Net decrease in cash and cash equivalents


(68,124
)


(34,834
)Cash and cash equivalents, beginning of period


132,618



219,047Cash and cash equivalents, end of period

$
64,494


$
184,213Supplementary disclosures of cash flow information:Cash paid during the period for:Interest

$
10


$
28Income taxes

$
239


$
60Supplementary disclosures of non-cash transactions:Warrant issued to OnStar

$



$
526Unrealized gain on available-for-sale securities

$
271


$
Issuance of escrow shares

$
1,743


$






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




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


(UNAUDITED)





1.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Basis of Presentation





The unaudited condensed consolidated financial statements have been prepared by Nuance Communications, Inc. (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 using accounting principles generally accepted
in the United States of America have been condensed or omitted pursuant to these instructions and regulations. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany
accounts and transactions have been eliminated. 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 September 30, 2002 and December 31, 2001, the results of operations for the three and nine months ended September 30, 2002 and 2001 and cash flows for the nine months ended September 30, 2002 and 2001. 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 April 1, 2002.





Use of Estimates in the Preparation of Consolidated Financial Statements





The preparation
of 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 financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.





Cash and Cash Equivalents





The Company considers all highly liquid investments with an original maturity of three months or less, when purchased, to be cash equivalents. Cash and cash equivalents consist of money market accounts, certificate of deposits and
deposits with banks. Cash and cash equivalents are recorded at cost which approximates fair value.





Investments





The Companys investments are comprised of U.S. Treasury notes, U.S. Government agency bonds, corporate bonds and
commercial paper. Investments with maturities remaining of less than one year are considered to be short-term. Investments are held in the Companys name primarily at major financial institutions. At September 30, 2002, all of the
Companys investments were classified as available-for-sale and carried at fair value, which is determined based on quoted market price, with net unrealized gain or loss included in the Accumulated Other Comprehensive Income (Loss),
in the accompanying condensed consolidated balance sheets.





Restricted Cash





The Company had $12.2 million and $12.0 million of restricted cash at September 30, 2002 and December 31, 2001, respectively. The restricted cash secures letters of
credit required by landlords to meet rent deposit requirements for certain leased facilities. The restricted cash represents investments in certificates of deposit.





Revenue Recognition





We apply the provisions of Statement
of Position 97-2, Software Revenue Recognition, as amended by Statement of Position 98-9 Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions to all transactions involving the sale of
software products.





Our license revenue consists of license fees for our software products. The license fees for
our software are calculated using two variables, one of which is the maximum number of simultaneous end-user connections to an application running on the software, and the other of which is the value attributed to the functional use of the software.




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)







All revenues generated from our worldwide operations are approved at
our corporate headquarters, located in the United States. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the software has been delivered, the fee is fixed and determinable and collection of
the resulting receivable is probable.





We use a signed contract and purchase order as evidence of an arrangement
for licenses and maintenance renewals. For services, we use a signed contract or statement of work to evidence an arrangement. Software is delivered to customers either electronically or on a CD-ROM. We assess whether the fee is fixed and
determinable based on the payment terms associated with the transaction. We assess collectibility based on a number of factors, including the customers past payment history and its current creditworthiness. If we determine that collection of a
fee is not reasonably assured, we defer the revenue and recognize it at the time collection becomes reasonably assured.





We recognize license revenue either upon issuance of the permanent software license key or on system acceptance, if the customer has established acceptance criteria (which currently occurs only in a minority of cases). Such criteria
typically consist of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or task completion rates.





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
evidence of the fair value of all undelivered elements exists. If evidence of the fair value of the undelivered elements does not exist, revenue is deferred and recognized when delivery occurs. As a general rule, license revenue from value-added
resellers and OEMs is recognized when product has been sold through to an end user and such sell-through has been reported to the Company. Certain OEM agreements include time-based provisions by which the company recognizes revenue.





The timing of license revenue recognition is affected by whether we perform consulting services in the arrangement and the
nature of those services. In many of the cases, we either perform no consulting services or we perform standard implementation services that are not essential to the functionality of the software. When we perform consulting 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.





Service revenue consists of revenue from providing consulting, training and other revenue consisting primarily of reimbursements for
consulting out-of-pocket expenses incurred, in accordance with the Financial Accounting Standard Boards (FASB) Emerging Issues Task Force (EITF) Issue No. 01-14, Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. 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 updates. We recognize all maintenance revenue
ratably over the contract term. Most customers have the option to renew or decline maintenance agreements annually during the contract term.





Cost of license revenue consists primarily of license fees payable on third-party software products, amortization of software costs, documentation and media costs. Cost of service revenue consists of
compensation and related overhead costs for employees or third parties engaged in consulting and training. Cost of maintenance revenue consists of compensation and related overhead costs for employees engaged in technical support.





Accumulated Other Comprehensive Gain (Loss)





Comprehensive gain (loss) includes net loss and all non-owner charges to stockholders equity, which for the Company, is foreign currency translation and changes in unrealized gains and losses on
investments. The Company had no items of comprehensive loss prior to January 1, 2000. As of September 30, 2002 and December 31, 2001, cumulative foreign currency translation adjustments are $144,000 and $227,000, respectively. As of September 30,
2002, unrealized gain from investments is $163,000. As of December 31, 2001, unrealized loss from investments is $108,000. Comprehensive loss was $45,884,000 and $65,764,000 for the three and nine months ended September 30, 2002 and $11,376,000 and
$93,263,000 for the three and nine months ended September 30, 2001.





Reclassification





Certain prior period amounts have been classified to conform to current period presentation. These reclassifications had no significant
impact on the financial statements for the periods presented.





2.     RECENT ACCOUNTING PRONOUNCEMENTS





On June 29, 2001, the FASB issued SFAS No. 141, Business Combinations, and SFAS No. 142,
Goodwill and Other Intangible Assets. Major provisions of these Statements are as follows: all business combinations initiated after June 30, 2001 must use the purchase




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)




method of accounting; intangible assets acquired in a business combination must be recorded separately from goodwill if they arise
from contractual or other legal rights or are separable from the acquired entity and can be sold, transferred, licensed, rented or exchanged, either individually or as part of a related contract, asset or liability; goodwill and intangible assets
with indefinite lives are not amortized but are tested for impairment annually using a fair value approach, except in certain circumstances, and whenever there is an impairment indicator; other intangible assets will continue to be valued and
amortized over their estimated lives; in-process research and development will continue to be written off immediately; all acquired goodwill must be assigned to reporting units for purposes of impairment testing and segment reporting; effective
January 1, 2002, existing goodwill will no longer be subject to amortization. Goodwill acquired subsequent to June 30, 2001 will not be subject to amortization. Because the Company did not initiate any business combinations after June 30, 2001, the
adoption of SFAS No. 141 did not have a material impact on the Companys financial position or results of operations. SFAS No. 142 had no effect on the nine months ending September 30, 2002 as all goodwill was written off as of December 31,
2001. For the year ended December 31, 2001, we performed an impairment analysis of identifiable assets and goodwill and we recorded a charge of $7.6 million for the impairment of goodwill and other intangible assets. As of September 30, 2002, we
have approximately $1.5 million remaining in intangible assets, which are being amortized over the 4 remaining years of their estimated five year life.





In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 retains the requirements of SFAS No. 121 whereby an impairment loss should be recognized if the carrying value of the asset is not recoverable from its
undiscounted cash flows and develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS No. 144 eliminates goodwill from its scope, therefore it does not require goodwill to be allocated to long-lived assets. SFAS
No. 144 broadens the scope of APB 30 provisions for the presentation of discontinued operations to include a component of an entity (rather than a segment of a business). SFAS No. 144 had no effect on the accompanying financial statements for the
quarter ended September 30, 2002.





In June 2002, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities and supercedes EITF Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This statement requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost, as defined in Issue 94-3, was recognized at the date of an entitys commitment to an exit plan. Accordingly, this statement may
affect the timing of recognizing future restructuring costs as well as the amounts recognized. This statement also establishes that the liability should initially be measured and recorded at fair value. The Company will adopt the provisions of SFAS
No. 146 for exit or disposal activities, if any, that are initiated after December 31, 2002 and the adoption will not have an impact on the historical results of operations, financial position or liquidity of the Company.





In November 2001, the EITF issued Topic No. D-103, Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. Topic No. D-103 requires companies to characterize reimbursements received for out-of-pocket expenses incurred as revenue in the statement of operations. The Company has historically netted
reimbursements received for out-of-pocket expenses against the related expenses in its consolidated statements of operations. In January 2002, the EITF issued Topic No. D-103 as EITF Issue No. 01-14. The Company adopted EITF Issue No. 01-14
beginning January 1, 2002 and comparative financials statements for prior periods have been reclassified to comply with the guidance in Topic D-103. Reimbursed out-of-pocket expenses totaled $31,500 and $51,700 for the three and nine months ended
September 30, 2002, respectively, and $23,700 and $141,300 for the three and nine months ended September 30, 2001, respectively.





In July 2001, the EITF reached final consensus on EITF No. 00-25, Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendors Products. EITF 00-25 generally requires that the
consideration, including equity instruments, given to a customer be classified in a vendors financial statements not as an expense, but as an offset of revenue up to the amount of cumulative revenue recognized or to be recognized. In November
2001, the EITF reached consensus on EITF No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or Reseller of the Vendors Products. EITF 01-09 clarifies and modifies certain items discussed in EITF 00-25. EITF No.
00-25 and EITF No. 01-09 had no effect on the accompanying financial statements for the three and nine months ended September 30, 2002.





3.    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 antidilutive due to the reported net loss. Shares subject to repurchase




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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 and nine months ended September 30, 2002 and 2001, the Company had securities outstanding which could potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted earnings per share in such
periods, as their effect would have been antidilutive due to the net loss reported in such periods. For 2002, such outstanding securities consist of warrants to purchase 100,000 shares of common stock for the three and nine months ended September
30, 2002 and 6,666,000 and 6,835,000 options to purchase shares of common stock at the three and nine months ended September 30, 2002, respectively. For 2001, outstanding securities consisted of warrants to purchase 100,000 shares of common stock
for the three and nine months ended September 30, 2001 and 8,002,000 and 7,196,000 options to purchase shares of common stock at the three and nine months ended September 30, 2001, respectively.





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





Three Months Ended September 30,


Nine Months Ended September 30,2002


2001


2002


2001Net loss

$
(45,867
)

$
(11,376
)

$
(66,118
)

$
(93,150
)Basic and diluted shares:Weighted average shares of common stock outstanding


33,859



32,842



33,623



32,625Less: Weighted average shares of common stock subject to repurchase


(52
)


(196
)


(82
)


(291
)Weighted average shares used to compute basic and diluted net loss per share


33,807



32,646



33,541



32,646Basic and diluted net loss per share

$
(1.36
)

$
(0.35
)

$
(1.97
)

$
(2.88
)





4.    Intangible Assets and Goodwill





There was no goodwill on the financial statements as of September 30, 2002, as no goodwill was acquired during the quarter and all
previously acquired goodwill was written off in the year ended December 31, 2001. The following table presents the impact of SFAS No. 142 on net loss and net loss per share had the standard been in effect for the three and nine months ended
September 30, 2001 (in thousands, except per share amounts):





Three Months Ended September 30,


Nine Months Ended September 30,2002


2001


2002


2001Net loss, as reported

$
(45,867
)

$
(11,376
)

$
(66,118
)

$
(93,150
)Add back amortization of:Goodwill






446







1,335Acquired workforce






32







98Net loss, as adjusted

$
(45,867
)

$
(10,898
)

$
(66,118
)

$
(91,717
)Net loss per share, basic and diluted, as reported

$
(1.36
)

$
(0.35
)

$
(1.97
)

$
(2.88
)Add back amortization of:Goodwill






0.02







0.04Acquired workforce














Net loss per shared, basic and diluted, as adjusted

$
(1.36
)

$
(0.33
)

$
(1.97
)

$
(2.84
)




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)







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





As of September 30, 2002

As of December 31, 2001Gross Amount

Accumulated Amortization


Net

Gross Amount

Accumulated Amortization


NetPatent Purchase

$
375





$
375

$


$



$
Purchased Technology


2,618


(1,452
)


1,166


2,618


(1,225
)


1,393Total

$
2,993

($
1,452
)

$
1,541

$
2,618

($
1,225
)

$
1,393





During August 2002, we purchased a patent for $375,000 and we will
amortize the patent beginning the fourth quarter of fiscal 2002. It will be amortized over its estimated useful life of five years.





We amortized $85,000 and $226,000 of the purchased technology to research and development expense for the three and nine months ended September 30, 2002, respectively and $350,000 and $875,000 for the three and nine months
ended September, 2001, respectively. The estimated amortization of the patent and purchased technology for each of the five fiscal years and thereafter subsequent to December 31, 2001 is as follows:





Year Ended December 31,

Amortization Expense2002 (remaining 3 months)

$
1302003


4132004


4132005


4132006


116Thereafter


56Total

$
1,541





5.    NON-CASH STOCK-BASED COMPENSATION





In connection with the grant of stock options prior to our initial public offering, we recorded deferred stock compensation of
approximately $8.7 million within stockholders equity, representing the difference 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 balance
is presented as a reduction of stockholders equity and is being amortized over the vesting period of the applicable options. We recorded amortization of deferred stock compensation of $33,000 and $416,000 for the three and nine months ended
September 30, 2002, respectively, and $592,000 and $1.8 million for the three and nine months ended September 30, 2001, respectively. For the nine months ended September 30, 2002, we recorded a reversal of approximately $514,000 of deferred stock
compensation on the balance sheet, in which $375,000 represented a reduction to non-cash stock-based compensation expense due to the application of multiple option award valuation approach and $139,000 represented unamortized deferred stock
compensation relating to forfeitures of stock options by terminated employees. There were no reversals of deferred stock compensation recorded for the nine months ended September 30, 2001.





In connection with our SpeechFront acquisition, we recorded deferred stock compensation of $4.1 million. This amount was part of the purchase agreement and was payable to
the founders in common stock, equivalent to approximately 38,710 shares at acquisition date, and contingent upon their continued employment. Of that amount, $1.7 million of stock, equivalent to approximately 16,590 shares at acquisition date,
related to retention of the founders of SpeechFront, and was released from escrow on the eighteen-month anniversary of the acquisition date, which was May 2002. The remaining $2.4 million of stock, equivalent to approximately 22,120 shares at
acquisition date, also relates to retention of the founders and was released from escrow on the twelve-month anniversary of the acquisition date, which was November 2001. These amounts were amortized over 18 months and 12 months, respectively. By
May 2002, the SpeechFront founders had been issued all 38,710 shares of common stock. Amortization expense related to these deferred compensation amounts were $0 and $387,000 for the three and nine months ending September 30, 2002, respectively, and
$871,000 and $2.6 million for the three and nine months ending September 30, 2001, respectively.




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)







In December 2000, we issued a warrant to a customer to purchase
100,000 shares of common stock at an exercise price of $138.50 per share subject to certain anti-dilution adjustments. The warrant was exercisable at the option of the holder, in whole or part, at any time between January 17, 2001 and August 2002.
In January 2001, we valued the warrant at $526,000, utilizing the Black-Scholes valuation model using the following assumptions: risk-free interest rate of 5.5%, expected dividend yields of zero, expected life of 1.5 years and expected volatility of
80%. The warrant was fully amortized as of March 31, 2002. We amortized $205,000 in the three months ended March 31, 2002 and $84,000 and $237,000 in the three and nine months ended September 30, 2001, respectively, related to this warrant. We
performed services of $0, $39,000 and $72,000 for this customer during the three and nine months ended September 30, 2002 and the nine months ended September 30, 2001, respectively. We reduced the warrant expense by $18,000 in the three months ended
March 31, 2002 and $73,000 in the nine months ended September 30, 2001, respectively, by these amounts and recorded $21,000 as service revenue in the three months ended June 30, 2002. The warrant expired unexercised in August 2002.





In July 2001, an employee was terminated effective September 2001. The employee vested his stock options following termination
which resulted in a pre-tax non-cash compensation charge of $216,000 in accordance with the FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation.





We expect to amortize a total of $1.1 million, $209,000 and $8,000 of non-cash stock-based compensation in 2002, 2003 and 2004, respectively.





6.    STOCK OPTION EXCHANGE PROGRAM





On March 1, 2002, we announced a voluntary stock option exchange program for all qualified employees. The exchange program was not available to executive officers, directors, consultants or former
employees. Under the program, employees were given the opportunity to elect to cancel outstanding stock options that had an exercise price of $15.00 or greater under the 1998 Stock Plan and 2000 Stock Plan held by them in exchange for new options to
be granted under the 2000 Stock Plan at a future date at the then current fair market value. The new options were to be granted no earlier than the first business day that is six months and one day after the cancellation date of the exchanged
options. The exercise price per share of the new options was to be 100% of the fair market value on the date of grant, as determined by the closing price of our common stock reported by Nasdaq National Market for the last market trading day prior to
the date of grant. These elections were made by March 29, 2002 and were required to include all options granted during the prior six-month period. In April 2002, stock options in the amount of 1,492,389 were cancelled relating to this program. On
October 4, 2002, employees who participated in the stock option exchange program were granted new options under the 2000 Stock Plan with an exercise price of $1.65. There were 967,012 stock option shares granted relating to this program. All the
stock option grants were vested at 1/8 of the shares subject to the option at the date of grant and 1/48 th of the shares subject to the option shall vest each month thereafter.





7.    SEGMENT
REPORTING AND INTERNATIONAL INFORMATION





We have two operating and reportable segments: licenses and services,
which include consulting, training and technical support. Revenue and cost of revenue for the segments are identical to those presented on the accompanying condensed consolidated statements of operations. We do not track operating expenses nor
derive profit or loss based on these segments.







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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)







Sales of licenses and services through September 30, 2002 occurred
through resellers and direct sales representatives located in our headquarters in Menlo Park, California, and in other locations. These sales were supported through the Menlo Park location. We do not separately report costs by region internally.
International revenues are based on the country in which the end-user is located. The following is a summary of license and service and maintenance revenue by geographic region (in thousands):





Three Months Ended September 30,

Nine Months Ended September 30,2002

2001

2002

2001License Revenue:United States

$
2,948

$
3,174

$
11,413

$
9,618Europe


845


976


2,675


2,345Asia


510


216


1,340


903Australia


4


11


394


1,063Canada


508


445


1,475


565Latin America


926


243


1,936


1,263Total

$
5,741

$
5,065

$
19,233

$
15,757Service and Maintenance Revenue:United States

$
3,351

$
2,448

$
7,782

$
8,282Europe


529


738


1,409


2,759Asia


152


188


443


691Australia


167


203


497


838Canada


393


271


1,036


731Latin America


170


268


546


1,185Total

$
4,762

$
4,116

$
11,713

$
14,486





8.    RESTRUCTURING





Second Quarter Fiscal Year 2001





In April 2001, our Board of Directors approved a restructuring plan that was intended to align the Companys expenses with revised anticipated demand and create a more efficient organization. In connection with the restructuring
plan, we 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 for the year ended December 31, 2001.





In connection with the restructuring plan, we 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 from subleasing the building,
certain assumptions were made related to the (1) time period over which the building will remain vacant (2) sublease terms (3) sublease rates. The lease loss is an estimate under SFAS No. 5 Accounting for Contingencies and represents the
low end of the range and will be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, etc.).





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




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)







First Quarter Fiscal Year 2002





During the quarter ended March 31, 2002, we implemented a restructuring plan to reduce our workforce by approximately 8%. The restructuring was primarily to realign
the sales and professional services organizations. We recorded a restructuring charge of $1.3 million for the three months ending March 31, 2002, consisting primarily of payroll and related expenses associated with reducing headcount. During the
nine months ended September 30, 2002, approximately $1.2 million of this amount was paid out with the remainder expected to be paid during the fourth quarter of fiscal year 2002.





Third Quarter Fiscal Year 2002





In August 2002, we
implemented a restructuring plan to reduce our worldwide workforce by approximately 21%, or approximately 85 employees to realign our expense structure with near term market opportunities. In connection with the reduction of workforce, we recorded a
charge of $2.5 million primarily for severance and related employee termination costs. As of September 30, 2002, approximately $0.7 million of this amount was paid out with the remainder expected to be paid by the first quarter of fiscal 2003. The
plan also included the consolidation of facilities through the closing of excess international offices. In addition, we recorded an increase in our previously reported real estate restructuring accrual related to the new leased facility we do not
occupy and which has not been subleased as a result of continued declines in local sub-lease rates in San Mateo County, California. The analysis of the time period of which the property will remain vacant, sub-lease terms and sub-lease rates
resulted in an additional restructuring charge of $33.2 million, reflecting continued softening of the local real estate market.





The activity relating to the restructuring charges accrual through the quarter ended September 30, 2002 are as follows (in thousands):





Lease Loss


Severance and Related Benefits


Total RestructuringTotal charge for the year ending December 31, 2001

$
32,615


$
1,516


$
34,131Amount utilized in the year ended December 31, 2001


(3,572
)


(1,416
)


(4,988
)Accrual balance at December 31, 2001


29,043



100



29,143Total charge for the quarter ended March 31, 2002






1,319



1,319Amount utilized in the quarter ended March 31, 2002


(2,105
)


(846
)


(2,951
)Accrual balance at March 31, 2002


26,938



573



27,511Amount utilized in the quarter ended June 30, 2002


(2,129
)


(336
)


(2,465
)Accrual balance at June 30, 2002


24,809



237



25,046Total charge for the quarter ended September 30, 2002


33,269



2,459



35,728Amount utilized in the quarter ended September 30, 2002


(2,954
)


(861
)


(3,815
)Accrual balance at September 30, 2002


55,124



1,835



56,959Current restructuring accrual


10,344



1,835



12,179Long-term restructuring accrual

$
44,780


$



$
44,780





Total cash outlay for the restructuring plans is expected to be
$71.1 million, of which $14.1 million was paid through September 30, 2002 and $57.0 million remained accrued at September 30, 2002. We expect $10.3 million of the lease loss to be paid out over the next twelve months, and the remaining $44.8 million
to be paid out over the remaining life of the lease of approximately 10 years. We have estimated that the high end of the lease loss could be $69 million if operating lease rental rates continue to decrease in these markets or should it take longer
than expected to find a suitable tenant to sublease the facility. The remainder of the employee severance and related benefits accrual of $1.8 million will be paid out by the first quarter of fiscal year 2003.




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(UNAUDITED)







9.    COMMITMENTS





We lease our facilities under non-cancelable operating leases with various expiration dates through July 2012. Future minimum lease
payments under these agreements, including the Companys facilities lease for the abandoned building, as of December 31, 2001, are as follows (in thousands):





Fiscal Year Ending December 31,2002 (remaining 3 months)

$
2,4572003


9,8092004


9,2532005


8,4772006


8,778Thereafter


52,494Total minimum lease payments

$
91,268





In May 2000, we entered into a lease for a new headquarters
facility. The lease has an eleven-year term, which began in August 2001, and provides for monthly rent payments starting at approximately $600,000. A $12.2 million certificate of deposit secures a letter of credit required by the landlord for a rent
deposit. In conjunction with the April 2001 and August 2002 restructuring plans (see Note 8), we decided not to occupy this new leased facility, as well as close certain international offices and have recorded a lease loss of $65.8 million related
to future lease commitments, net of expected sublease income. The future minimum lease payments table referenced above does not include estimated sublease income as there are no sublease commitments.





10.    LITIGATION





In March 2001, the first of a number of stockholder complaints was filed in the United States District Court for the Northern District of California against Nuance and certain of its officers. Those lawsuits were
consolidated and an amended complaint was filed on behalf of a purported class of people who purchased our 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 are seeking unspecified damages. We believe that these allegations are without merit and we are defending the litigation vigorously. Recently, in response to our motion to dismiss, certain of the
Plaintiffs claims were dismissed with prejudice. However, Plaintiffs were permitted to file a further amended complaint with respect to several remaining claims. We intend to move to dismiss such amended complaint. An unfavorable
resolution of this litigation could have a material adverse effect on our business, results of operations, and financial condition.





In June and July 2001, putative shareholder derivative actions were filed in California state court alleging breaches of fiduciary duty and insider trading by various of our directors and officers. While we are named as a
nominal defendant, the lawsuits do not appear to seek any recovery against us. Proceedings in these actions have been stayed.





In August 2001, the first of a number of complaints was filed in federal district court for the Southern District of New York on behalf of a purported class of persons who purchased Nuance stock between April 12, 2000 and December 6,
2000. In April 2002, plaintiffs filed a consolidated amended complaint. The consolidated amended complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares
in our initial public offering of securities, the conduct of our secondary offering, and the issuance of analyst reports. The complaints bring claims for violation of several provisions of the federal securities laws against those underwriters, and
also against us and some of our directors and officers. Similar lawsuits have been filed concerning more than 300 other companies public offerings. We believe that the allegations against us are without merit and intend to defend the
litigation vigorously.





We are subject to certain 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 current matters will have a material adverse effect on our consolidated financial position,
results of operations, or cash flows.







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##### 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 the full year or any future periods.





This Report on Form 10-Q contains forward-looking statements, within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including but not
limited to our expectations for results over the balance of the year regarding expense trends, capital requirements, sources of revenue and our current outlook for the Company, as well as our expectations, beliefs, intentions or strategies regarding
the future. All forward-looking statements included in this Report on Form 10-Q are based on information available to us on the date hereof, and we assume 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 described in the section below entitled Factors
That Affect Future Results and elsewhere in this Report on Form 10-Q.





OVERVIEW





Nuance develops, distributes and supports speech software that enables enterprises and telecommunications carriers to automate the
delivery of information and services over the telephone. We were incorporated in July 1994 and began operations in October 1994. Prior to 1996, our revenue was derived from technical consulting services. In 1996, we deployed the first version of our
software product and began to generate software license revenue. Today, we offer a range of speech software products and related services. To support the sale, deployment and operation of our products, we provide a number of services that include
consulting, development and implementation, training, maintenance updates and technical support.





We sell products
to our customers both directly through our sales force and indirectly through resellers and systems integrators. One customer, acting as reseller, accounted for less than 10% and 11% of total revenue for the three and nine months ended September 30,
2002, respectively and 12% and 20% of total revenue for both the three and nine months ended September 30, 2001, respectively. No other customers or resellers accounted for more than 10% of our revenue for the three and nine months ended September
30, 2002 and September 30, 2001, respectively. We anticipate that sales through resellers will continue to account for a significant percentage of our revenue, however, percentage of our total revenue attributable to sales through resellers may vary
in the future.





We sell our products and services primarily to customers in North America, South America, Europe,
Asia and Australia. International sales accounted for approximately 40% and 38% of our total revenue for the three and nine months ended September 30, 2002, respectively. We anticipate that markets outside the United States will continue to
represent a substantial portion of total future revenue. International sales are currently denominated in U.S. dollars. However, we may denominate sales in foreign currencies in the future.





Our growth and profitability are heavily dependent upon global economic conditions and demand for information technology, particularly within markets where we offer speech
specific applications and services. Traditionally, our revenue has been derived from customers in the telecommunications and financial sectors, which markets have sustained dramatic slowdowns over the past several quarters.





In response to the current challenging business environment, we are evolving our business direction in order to better align resources and
expenses with revenue opportunities. In addition, we are developing products and services designed to speed deployments and accelerate return on investment for customers, and we are working to enhance our existing partner channel.





Some specific operating changes have already been accomplished, such as, the restructuring actions taken in August, 2002. Other
activities, including introduction of new products and refinements to existing direct and indirect selling and delivery channels, will continue to evolve over the next several quarters.




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##### Table of Contents




The evolution of our business direction presents risks inherent to the
transitions we are undertaking. We will be introducing new products, new reseller partners, and new selling and delivery arrangements both directly and with existing and new reseller partners. These changes could potentially disrupt existing selling
and delivery relationships and in general, these transitions may not create immediate results for the Company, and may create new risks for the Company. We believe however that this evolution is necessary for the well being of our business, and that
we have planned adequately to manage these transitions successfully.








RESULTS OF OPERATIONS





The following table sets forth, for the periods indicated, the percentage of net revenue represented by
certain items in our statements of operations for the three and nine months ended September 30, 2002 and 2001.





Three Months Ended September 30


Nine months Ended September 302002


2001


2002


2001Revenue:License

55
%

55
%

62
%

52
%Service

23


22


17


29Maintenance

22


23


21


19Total revenue

100


100


100


100Cost of revenue:License

1





1


Service

20


28


18


32Maintenance

8


10


9


10Total cost of revenue

29


38


28


42Gross profit

71


62


72


58Operating expenses:Sales and marketing

104


96


102


101Research and development

37


48


36


49General and administrative

32


34


34


34Amortization of goodwill




5





5Non-cash stock-based compensation




19


3


16Restructuring charges

340





120


182Total operating expenses

513


202


295


387Loss from operations

(442
)

(140
)

(223
)

(329
)Interest and other income, net

7


18


7


23Loss before income taxes

(435
)

(122
)

(216
)

(306
)Provision (benefit) for income taxes

2


2


(2
)

2Net loss

(437
)%

(124
)%

(214
)%

(308
)%




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##### Table of Contents




COMPARISON OF THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001





Revenue





Total
revenue for the three months ended September 30, 2002 was $10.5 million, compared with $9.2 million in the three months ended September 30, 2001, an increase of 14%. Total revenue for the nine months ended September 30, 2002 was $30.9 million,
compared with $30.2 million in the nine months ended September 30, 2001, an increase of 2%.





License revenue for
the three months ended September 30, 2002 was $5.7 million, compared with $5.1 million in the three months ended September 30, 2001, an increase of 13%. License revenue for the nine months ended September 30, 2002 was $19.2 million, compared with
$15.8 million in the nine months ended September 30, 2001, an increase of 22%. This increase is primarily due to the growth in the North American enterprise marketplace. License revenue represented 55% and 62% of total revenue for the three and nine
months ended September 30, 2002, respectively, and 55% and 52% of total revenue for the three and nine months ended September 30, 2001, respectively.





Service revenue for the three months ended September 30, 2002 was $2.4 million, compared with $2.0 million for the three months ended September 30, 2001, an increase of 19%. Service revenue for the
nine months ended September 30, 2002 was $5.3 million, compared with $8.8 million for the nine months ended September 30, 2001, a decrease of 40%. This decrease in service revenue was due primarily to the decline in demand for these services and the
associated reduction of professional service personnel to bring capacity in line with the reduced demand. Service revenue represented 23% and 17% of total revenue for the three and nine months ended September 30, 2002 and 22% and 29% of total
revenue for the three and nine months ended September 30, 2001, respectively.





Maintenance revenue for the three
months ended September 30, 2002 was $2.4 million, compared with $2.1 million for the three months ended September 30, 2001, an increase of 13%. Maintenance revenue for the nine months ended September 30, 2002 was $6.5 million, compared with $5.7
million for the nine months ended September 30, 2001, an increase of 14%. This increase in maintenance revenue was due to the relative increase in license revenue. Maintenance revenue represented 22% and 21% of total revenue for the three and nine
months ended September 30, 2002, respectively, and 23% and 19% of total revenue for the three and nine months ended September 30, 2001, respectively.





Cost of Revenue





Cost of license revenue consists primarily of third-party royalties, media
and documentation costs. Cost of license revenues were $0.1 million and $0.4 million for the three and nine months ended September 30, 2002, respectively, and $0 for both three and nine months ended September 30, 2001. We anticipate that cost of
license revenue will slightly decrease in absolute dollars, but will vary as a percentage of total revenue from period to period.





Cost of service revenue for the three months ended September 30, 2002 was $2.0 million, compared with $2.5 million in the three months ended September 30, 2001, a decrease of 20%. Cost of service revenue for the nine months ended
September 30, 2002 was $5.5 million, compared with $9.6 million in the nine months ended September 30, 2001, a decrease of 43%. The decrease was due to a reduction of employees resulting from the August 2002, January 2002 and April 2001 reductions
in force, as well as realignment of the professional services employees to support the sales and marketing organization. Headcount for professional service personnel decreased by approximately 46 employees, a reduction of approximately 55%, in the
quarter ended September 30, 2002 compared with the quarter ended September 30, 2001. Most of the headcount reductions were the result of the reduction in force program from January 2002. Cost of service revenue as a percentage of service revenue was
85% and 104% in the three and nine months ended September 30, 2002, respectively, compared with 125% and 109% for the three and nine months ended September 30, 2001, respectively. We will provide consulting services both through the use of our own
employees as well as through the use of contracted third party services. Cost of service revenue run rates are expected to slightly increase from $2.0 million in the third quarter of 2002 to a range between $2.3 million to $2.4 million due to an
increase in the utilization of third party contracted services. While we anticipate that cost of service revenue will increase in absolute dollars, it will vary as a percentage of total revenue from period to period.





Cost of maintenance revenue for the three months ended September 30, 2002 was $0.9 million, compared with $1.0 million in the three months
ended September 30, 2001, a decrease of 10%. Cost of maintenance revenue for the nine months ended September 30, 2002 was $2.6 million, compared with $3.1 million in the nine months ended September 30, 2001, a decrease of 16%. The decrease was due
to a reduction of employees resulting from the August 2002, January 2002 and April 2001 reductions in force. Headcount for maintenance personnel decreased by approximately 9 employees, a reduction of approximately 30%, in the quarter ended September
30, 2002 compared with the quarter ended September 30, 2001. Cost of maintenance revenue as a percentage of maintenance revenue was 37% and 41% in the three and nine months ended September 30, 2002, respectively, compared with 46% and 54% for the
three and nine months ended September 30, 2001, respectively. Cost of maintenance revenue run rates are expected




15




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##### Table of Contents

to remain constant in absolute dollars but will slightly vary as a percentage of total revenue in the fourth quarter of 2002. However, this will
depend upon our revenue growth, among other factors. Accordingly, there can be no assurance that we will be successful in maintaining our cost of maintenance revenues as a percentage of total revenues.





Operating Expenses





We have reduced costs and expenses to better align resources with revenue opportunities anticipated in the current information technology market. In August 2002, our Board of Directors approved a global restructuring plan to reduce
headcount by 85 employees, or 21%, from 398 at the end of June 30, 2002. We achieved only nominal savings in the third quarter of 2002 due to the late timing of the workforce reduction action within the quarter. Total cost of revenue and expense run
rates are expected to decline from $21.1 million in the third quarter of 2002 to a range between $17.4 million and $18.1 million in the fourth quarter of 2002. Most of the savings resulting from the workforce reduction will be reflected in sales and
marketing expense.





Sales and MarketingSales and marketing expenses primarily consist of compensation and
related costs for sales, marketing and business development personnel and promotional expenditures, including public relations, advertising, trade shows and marketing collateral materials. Sales and marketing expenses for the three months ended
September 30, 2002 were $10.9 million, compared with $8.8 million in the three months ended September 30, 2001, an increase of 23%. This increase was primarily attributable to an increase in commission-based compensation and incentives to sales
personnel resulting from the increase in sales revenue between the three months ended September 30, 2002 and 2001, as well as increases in trade shows, training and seminars, consulting and travel-related expenses for this period. Sales and
marketing expenses for the nine months ended September 30, 2002 were $31.9 million, compared with $30.9 million in the nine months ended September 30, 2001, an increase of 3%. This increase was primarily attributable to the increase in
commission-based compensation and incentives to sales personnel resulting from an increase in sales revenue between the nine months ended September 30,2002 and 2001. Headcount for sales and marketing personnel, in total, increased by 4 employees, an
increase of approximately 3%, in the quarter ended September 30, 2002 compared with the quarter ended September 30, 2001. As a percentage of total revenue, sales and marketing expenses were 104% and 102% for both the three and nine month periods
ended September 30, 2002, respectively, and 96% and 101% in the three and nine month periods ended September 30, 2001, respectively. Sales and marketing expense run rates are expected to decline from $10.9 million in the third quarter of 2002 to a
range between $7.0 million to $7.2 million in the fourth quarter of 2002, resulting primarily from the workforce reduction. We anticipate that sales and marketing expenses will vary as a percentage of total revenue from period to period.





Research and DevelopmentResearch and development expenses primarily consist of compensation and related
costs for research and development personnel and contractors. Research and development expenses for the three months ended September 30, 2002 were $3.9 million, compared with $4.4 million in the three months ended September 30, 2001, a decrease of
11%. Research and development expenses for the nine months ended September 30, 2002 were $11.1 million, compared with $14.7 million in the nine months ended September 30, 2001, a decrease of 24%. This decrease was attributable to a reduction of
personnel and related expenses associated with product development activities resulting from the August 2002, January 2002 and April 2001 restructuring plans, as well as decreases in travel and related expenses. Headcount for research and
development personnel decreased by approximately 11 employees, a reduction of approximately 10%, in the quarter ended September 30, 2002 compared with the quarter ended September 30, 2001. In addition, purchased technology amortization costs
declined following the December 31, 2001 writedown of the impaired intangible assets. As a percentage of total revenue, research and development expenses were 37% and 36% in the three and nine months ended September 30, 2002, respectively, and 48%
and 49% in the three and nine months ended September 30, 2001, respectively. Research and development expense run rates are expected to increase from $3.9 million in the third quarter of 2002 to a range between $4.1 million to $4.3 million in the
fourth quarter of 2002 due to internal employee transfers from technical business development personnel. While we anticipate that research and development expenses will increase in absolute dollars, it will vary as a percentage of total revenue from
period to period.





General and AdministrativeGeneral and administrative expenses primarily consist of
compensation and related costs for administrative personnel, legal services, accounting services and other general corporate expenses. General and administrative expenses for the three months ended September 30, 2002 were $3.3 million, compared with
$3.1 million in the three months ended September 30, 2001, an increase of 6%. This increase was primarily due to an increase in temporary personnel and computer maintenance costs. General and administrative expenses for the nine months ended
September 30, 2002 were $10.4 million, compared with $10.3 million in the nine months ended September 30, 2001, an increase of 1%. This increase was primarily due to an increase in consulting costs and corporate insurance costs. Headcount for
administrative personnel decreased by approximately 11 employees, a reduction of approximately 16%, in the quarter ended September 30, 2002 compared with the quarter ended September 30, 2001. As a percentage of total revenue, general and
administrative expenses were 32% and 34% in the three and nine months ended September 30, 2002, respectively, and both 34% in the three and nine months ended September 30, 2001. General and administrative expense run rates are expected to decline
from $3.3 million in the third quarter of 2002 to a range between $3.1 million and $3.3 million in the fourth quarter of 2002. We anticipate that general and administrative expenses will remain relatively constant in absolute dollars, but will vary
as a percentage of total revenue from period to period.




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Amortization of GoodwillGoodwill of $5.5 million was recorded in connection
with the acquisition of SpeechFront in November 2000. There was no amortization of goodwill for the three and nine months ended September 30, 2002 as all goodwill was written off as of December 31, 2001. Amortization expense was $478,000 and $1.4
million for the three and nine months ended September 30, 2001.





Non-Cash Stock-Based CompensationIn
connection with the grant of stock options prior to our initial public offering, we recorded deferred stock compensation of approximately $8.7 million within stockholders equity, representing the difference 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 balance is presented as a reduction of stockholders equity and is being amortized over the vesting period of the applicable
options. We recorded net amortization of deferred stock compensation of $33,000 and $416,000 for the three and nine months ended September 30, 2002, respectively, and $592,000 and $1.8 million for the three and nine months ended September 30, 2001,
respectively. For the three and nine months ended September 30, 2002, we recorded a reversal of approximately $188,000 and $375,000 of deferred stock compensation expense relating to forfeitures of stock options by terminated employees. There were
no reversals of deferred stock compensation expense for the three and nine months ended September 30, 2001.





In
connection with our November 2000 SpeechFront acquisition, we recorded deferred stock compensation of $4.1 million. This amount was part of the purchase agreement and was payable to the founders in common stock, approximately 38,710 shares,
contingent upon their continued employment. Of that amount, $1.7 million of stock, approximately 16,590 shares, related to retention of the founders of SpeechFront, and was released from the escrow account on the eighteen-month anniversary of the
acquisition date, which was May 2002. The remaining $2.4 million of stock, approximately 22,120 shares, also related to retention of the founders and was released from the escrow account on the twelve-month anniversary of the acquisition date, which
was November 2001. By May 2002, the SpeechFront founders had been issued all 38,710 shares of common stock. These amounts have been amortized over 18 months and 12 months, respectively. Approximately $0 and $387,000 were amortized in the three and
nine months ended September 30, 2002, respectively, and approximately $871,000 and $2.6 million were amortized in the three and nine months ended September 30, 2001, respectively, related to these deferred compensation amounts.





In December 2000, we issued a warrant to a customer to purchase 100,000 shares of common stock at an exercise price of $138.50
per share subject to certain anti-dilution adjustments. The warrant is exercisable at the option of the holder, in whole or part, at any time between January 17, 2001 and August 2002. In January 2001, we valued the warrant at $526,000, utilizing the
Black-Scholes valuation model using the following assumptions: risk-free interest rate of 5.5%, expected dividend yields of zero, expected life of 1.5 years and expected volatility of 80%. The warrant was fully amortized as of March 31, 2002. We
amortized $205,000 in the three months ended March 31, 2002 and $84,000 and $236,000 in the three and nine months ended September 30, 2001, respectively, related to this warrant. We performed services of $0 and $39,000 for this customer during the
three and nine months ended September 30, 2002 and $72,000 for the nine months ended September 30, 2001, respectively. We reduced the warrant expense by $18,000 in the three months ended March 31, 2002 and $72,000 in the nine months ended September
30, 2001, respectively, by these amounts and recorded $21,000 as service revenue in the nine months ended September 30, 2002. The warrant expired unexercised in August 2002.





We expect to amortize a total of $1.1 million, $209,000 and $8,000 of non-cash stock-based compensation in 2002, 2003 and 2004, respectively.





Restructuring Charges





During the quarter ended September 30, 2002, we implemented a restructuring plan to reduce our workforce by approximately 21%. The restructuring was primarily to realign our expense structure with near term market opportunities. In
connection with the reduction of workforce, we recorded a charge of $2.5 million primarily for severance and related employee termination costs. The plan also included the consolidation of facilities through the closing of excess international
offices. In addition, we recorded an increase in our previously reported real estate restructuring accrual related to an office property we do not occupy and which has not been subleased as a result of continued declines in local sub-lease rates.
The analysis of the time period of which the property will remain vacant, sub-lease terms and sub-lease rates resulted in an additional adjustment of $33.2 million, reflecting continued softening of the local real estate market.





Interest and Other Income, Net





Interest and other income, net, consists primarily of interest earned on cash and cash equivalents and short-term and long-term investments. Interest and other income, net was $694,000 and $2.2 million in the three and nine
months ended September 30, 2002, respectively, and $1.7 million and $7.0 million in the three and nine months ended September 30, 2001, respectively, a decrease of 59% and 68% in the three month period and nine month period, respectively. This
decrease was due to a reduction in interest income, resulting from lower cash balances and decreased interest rates.




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Provision for Income Taxes





We have incurred operating losses for all periods from inception through September 30, 2002 and therefore have not recorded a provision for U.S. federal income taxes for
any period through September 30, 2002. We recorded income tax expense relating to foreign taxes of $191,000 and $461, 000 for the three and nine months ended September 30, 2002, respectively, and $218,000 and $521,000 for the three and nine months
period ended September 30, 2001, respectively. The income tax expense has been reduced by tax credits associated with research and development activities from our Canadian technology center. These tax credits, which result in cash payments to us,
are based on qualified salaries paid and capital equipment purchases. Tax credits of approximately $0 and $1.1 million were recorded against income tax expense for the three and nine months ended September 30, 2002, respectively, and are related to
qualified expenditures made in 1999, 2000 and 2001. We do not expect these tax credits to be substantial in future quarters.





LIQUIDITY AND CAPITAL RESOURCES





From inception to our initial public offering, we financed
our operations primarily from private sales of convertible preferred stock totaling $70.0 million through March 31, 2000 and, to a lesser extent, from bank financing. On April 18, 2000, we raised approximately $80 million through the completion of
our initial public offering of common stock. On October 2, 2000, we raised approximately $144 million through the completion of our follow-on public offering. As of September 30, 2002, we had cash and cash equivalents aggregating $64.5 million and
investments totaling $71.1 million.





Our operating activities used cash of $38.6 million for the nine months ended
September 30, 2002, and used cash of $17.1 million during the nine months ended September 30, 2001. This negative operating cash flow in the nine months ended September 30, 2002 was largely the result of our net loss and the lease payments
associated with unoccupied space. The negative operating cash flow in the nine months ended September 30, 2001 resulted principally from our net loss, partially offset by a decrease in accounts receivable.





Investing activities used cash of $31.6 million during the nine months ended September 30, 2002, and $23.1 million during the nine months
ended September 30, 2001. The use of cash in investing activities for the nine months ended September 30, 2002 resulted from the net purchases of short-term investments offset by maturities of short-term investments. The use of cash for the nine
months ended September 30, 2001 resulted primarily from additions to property and equipment and purchased technology, partially offset by maturities of short-term investments.





Our financing activities generated cash of $2.0 million during the nine months ended September 30, 2002, and $5.5 million for the nine months ended September 30, 2001. The
generation of cash was largely the result of proceeds from the exercise of stock options and employee stock purchase plan contributions from employees for both the nine months ended September 30, 2002 and 2001.





Our capital requirements depend on numerous factors. We may continue to report significant quarterly operating losses resulting in future
negative operating cash flows. We do not plan to spend more than $5 million on capital expenditures in the next 12 months. We believe that our cash and cash equivalents, our short-term and long-term investments, and our borrowing capacity 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.





The following table summarizes our obligations and commercial commitments to make future payments under contracts:





Contractual Obligations

TOTAL

Current

1-3 years

4-5 years

After 5 yearsOperating leases

$
91,268

$
2,457

$
27,539

$
17,487

$
43,785Other Commercial Commitments

TOTAL

Less than 1 year

1-years

4-5 years

After 5 yearsStandby Letters of Credit

$
12,207

$


$


$


$
12,207





The restricted cash secures our letters of credit of approximately
$12.2 million and is invested with a bank, as required by landlords to meet rent deposits requirements for our leases on facilities (see Note 1).




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CRITICAL ACCOUNTING POLICIES





Our critical accounting policies are as follows:





 revenue recognition;





 estimating allowance for doubtful accounts receivable and
lease loss;





 accounting for income taxes; and





 valuation of intangible assets and goodwill





Revenue Recognition





We apply the provisions of Statement of Position 97-2, Software
Revenue Recognition, as amended by Statement of Position 98-9 Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions to all transactions involving the sale of software products and sales of
hardware where the software is not incidental.





Our license revenue consists of license fees for our software
products. The license fees for our software products are calculated using two variables, one of which is the estimated maximum number of simultaneous end-user connections to an application running on our software and the other of which is the value
attributed to the functional use of the software.





All revenues generated from our worldwide operations are
approved at our corporate headquarters, located in the United States. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the software has been delivered, the fee is fixed and determinable and
collection of the resulting receivable is probable.





We use a signed contract and purchase order as evidence of an
arrangement for licenses and maintenance renewals. For services, we use a signed contract or statement of work to evidence an arrangement. Software is delivered to customers either electronically or on a CD-ROM. We assess whether the fee is fixed
and determinable based on the payment terms associated with the transaction. We assess collectibility based on a number of factors, including the customers past payment history and its current creditworthiness. If we determine that collection
of a fee is not reasonably assured, we defer the revenue and recognize it at the time collection becomes reasonably assured.





We recognize license revenue either upon issuance of the permanent software license key or on system acceptance, if the customer has established acceptance criteria (which currently occurs only in a minority of cases). Such criteria
typically consist of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or task completion rates.





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
evidence of the fair value of all undelivered elements exists. If evidence of the fair value of the undelivered elements does not exist, revenue is deferred and recognized when delivery occurs. As a general rule, license revenue from value-added
resellers and OEMs is recognized when product has been sold through to an end user and such sell-through has been reported to the Company. Certain OEM agreements include time-based provisions by which the company recognizes revenue.





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 standard implementation services that are not essential to the functionality of the software. When we perform consulting 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.





Service revenue consists of revenue from providing consulting, training and other revenue consisting primarily of reimbursements for
consulting out-of-pocket expenses incurred, in accordance with the Financial Accounting Standard Boards (FASB) Emerging Issues Task Force (EITF) Issue No. 01-14, Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. 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.




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Maintenance revenue consists of fees for providing technical support and software
updates. We recognize all maintenance revenue ratably over the contract term. Most customers have the option to renew or decline maintenance agreements annually during the contract term.





Our standard payment terms are 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
primarily comprised of revenue from that quarter.





We record deferred revenue primarily as a result of payments
from customers received in advance of recognition of revenue. As of September 30, 2002, deferred revenue was $8.9 million. The deferred revenue amount includes unearned license, prepaid maintenance and professional services that will be recognized
as revenue in the future as we deliver licenses and perform services.





Estimating Allowance for Doubtful Accounts Receivable and Lease
Loss





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.





We restructured our business and have established
reserves at the low end of the range of estimable cost (as required by accounting standards) against outstanding commitments for leased property that we have not occupied. These reserves are based upon managements estimate of the time required
to sublet the property and the amount of sublet income that might be generated between the date the property was not occupied and expiration of the lease for each of 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.





Accounting For Income Taxes





In preparing our 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 liabilities together 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 consolidated balance sheet. We then assesses 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 Consolidated Statement of Operations.





Significant management judgment is required
in determining our provision for income taxes, 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 carryforwards 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 Intangible Assets and Goodwill





We periodically assess the realizability of long-lived assets, including intangibles in accordance with the
provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets. 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 market 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 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. In 2002, SFAS No. 142, Goodwill and Other Intangible Assets became effective. This did not have an impact on our financial statements as all goodwill had been previously amortized or impaired.




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The above listing is not intended to be a comprehensive list of all of our
accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for managements judgment in their application.
There are also areas in which the exercise of managements judgment in selecting an available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto in our Annual Report
on Form 10-K and which contain accounting policies and other disclosures required by generally accepted accounting principles.





FACTORS THAT AFFECT FUTURE RESULTS





WE HAVE A HISTORY OF LOSSES. WE EXPECT TO CONTINUE TO INCUR LOSSES AND WE
MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY.





We have incurred losses since our inception, including a loss of
approximately $45.9 million in the three months ended September 30, 2002. As of September 30, 2002, we had an accumulated deficit of approximately $233.9 million. We expect to have net losses and negative cash flow for at least the next 12 to 18
months. We expect to spend significant amounts to develop or enhance our products, services and technologies and to enhance delivery capabilities. As a result, we will need to generate significant increases in 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.





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. For example, in March 2001, we announced our revised expectations for our first quarter financial results based upon our then-current outlook, including a
revenue shortfall and a larger than expected net loss for the quarter due to general economic conditions which had led customers and customer prospects to postpone capital investment in Nuance products and service offerings based on Nuance products.
These quarterly variations are caused by a number of factors, including:





| |  |  | general economic downturn and delays or cancellations in orders by customers who are reducing spending;
| | - |  | -------------------------------------------------------------------------------------------------------




| |  |  | delays in customer 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 software license revenue in accordance with applicable accounting principles;
| | - |  | ------------------------------------------------------------------------------------------------------




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




| |  |  | the amount and timing of expenses; and
| | - |  | --------------------------------------




| |  |  | the utilization rate of our professional services personnel.
| | - |  | ------------------------------------------------------------




Due to these factors, because the market for our software is new and rapidly changing and because 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. 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. We do not know whether our business will grow rapidly enough to absorb the costs of our expenses, even as we endeavor to manage these costs. 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.




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





In
1999, 56% of our revenue was achieved by indirect sales through resellers. The percentage of revenue through indirect sales increased to 72% in 2000, to 75% in 2001 and to 82% and 83% in the three and nine months ended September 30, 2002. Though
this percentage may vary or decrease in the future, we intend to continue to rely on resellers for a substantial portion of our sales in the future. As a result, we are dependent upon the viability and financial stability of our resellers, as well
as upon their continued interest and success in selling our products. The loss of a key reseller or our failure to develop new and viable reseller relationships could limit our ability to sustain and grow our revenue. Significant expansion of our
internal sales force to replace the loss of a key reseller would require increased management attention and higher expenditures.





Our contracts with resellers generally do not require a reseller to purchase our products. We cannot guarantee that any of our resellers will continue to market our products or devote significant resources to doing so. In addition,
we will, from time to time, terminate or adjust some of our relationships with resellers in order to address changing market conditions, improve our business, resolve disputes, or for other reasons. Any such termination or adjustment could have a
negative impact on our relationships with resellers and our business and result decreased sales through resellers or threatened or actual litigation. Finally, our resellers possess confidential information concerning our products, product release
schedules and sales, marketing and reseller operations. Although we have nondisclosure agreements with our resellers, we cannot guarantee that any reseller would not use our confidential information in competition with us or otherwise. If our
resellers do not successfully market and sell our products for these or any other reasons, our sales could be adversely affected and our revenue could decline.





WE DEPEND ON A LIMITED NUMBER OF CUSTOMER ORDERS FOR A SUBSTANTIAL PORTION OF OUR REVENUE DURING ANY GIVEN PERIOD. THE LOSS OF, OR DELAYS IN, A KEY 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
customers. For example, in the three months ended September 30, 2002, five customers made up 34% of our total revenue, and one customer, acting as a reseller, accounted for approximately 10% of our total revenue.





We expect that a limited number of customers and customer orders will continue to account for a substantial portion of our revenue in any
given period. Generally, customers who make large purchases from us are not expected to make subsequent, equally large purchases in the short term, and therefore we must attract new customers in order to maintain or increase our revenues. As a
result, if we do not acquire a major customer, if a contract is delayed, cancelled or deferred, or if an anticipated sale is not made, our business could be harmed.




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SPEECH SOFTWARE PRODUCTS GENERALLY, AND OUR PRODUCTS AND SERVICES IN PARTICULAR, MAY NOT ACHIEVE
WIDESPREAD ACCEPTANCE BY BUSINESSES AND TELECOMMUNICATIONS CARRIERS, 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
will be new to the market once released. Our ability to increase revenue in the future depends on the acceptance by our customers, 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 of this 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 this new technology. 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. This may require shifts in our sales and marketing efforts and strategies to achieve such education. If these efforts fail or prove excessively costly or otherwise
unmanageable, or if speech software generally do 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:





| |  |  | 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 self service
solutions;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------




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




| |  |  | continuing improvements in hardware technology that may reduce the costs of speech software solutions.
| | - |  | ------------------------------------------------------------------------------------------------------




OUR PRODUCTS CAN HAVE A LONG SALES AND IMPLEMENTATION CYCLE AND, AS A RESULT, OUR QUARTERLY 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 value added reseller, a voice application service provider or a systems integrator.





Purchase of our products requires a significant expenditure by a customer. Accordingly, the decision to purchase our products typically requires significant
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, marketing and
management resources. Because of this lengthy evaluation cycle, we may experience a delay between the time we incur these expenditures and the time we generate revenues, if any, from such expenditures.





In addition, during any quarter we may receive a number of orders that are large relative to our total revenues for that quarter or
subsequent quarters.





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





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 40% and 38% of our total revenue for the three and nine months ended September 30, 2002, respectively, 42% of our revenue in 2001, 47% of our revenue in 2000 and 21% of our revenue in
1999, and we anticipate that revenue from markets outside the United States will continue to represent a significant portion of our total revenue. 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 reseller network;
| | - |  | -------------------------------------------------------------------------------------------




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




| |  |  | longer sales cycles;
| | - |  | --------------------




| |  |  | 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;
| | - |  | --------------------------------------------------------------------




| |  |  | unfavorable fluctuations in currency exchange rates; and
| | - |  | --------------------------------------------------------




| |  |  | limited ability to enforce agreements, intellectual property rights and other rights in some foreign countries.
| | - |  | ---------------------------------------------------------------------------------------------------------------



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OUR FAILURE TO RESPOND TO AND SUCCESSFULLY MANAGE RAPID CHANGE IN THE MARKET FOR SPEECH SOFTWARE
COULD CAUSE US TO LOSE REVENUE AND HARM OUR BUSINESS.





The speech software industry is relatively new and
rapidly changing. Our 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 end-user requirements, gain
commercial acceptance and incorporate technological advancements such as products that speed deployment and accelerate customers return on investment. If we are unable to develop new products and enhanced functionalities or technologies to
adapt to these changes, we may be unable to retain existing customers or attract new customers, which could 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 suffer.





Commercial acceptance of any 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 resellers.
| | - |  | -----------------------------------------------------------------------------------------------------------------------




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 in the speech software market include IBM, Microsoft, SpeechWorks International, AT&T and Scansoft. We expect additional competition from other
companies, 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 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 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 to the development, promotion and sale of their products than we do. 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.





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





International sales opportunities may require investing significant resources in creating and refining different language models for each particular language or dialect.
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 localized versions of our products, our ability to address
international market opportunities and to grow our business will be limited. We must also expend resources to develop localized versions of our products, and we may not be able to recognize adequate revenues from these localized versions of our
products to make them profitable.





WE ARE CURRENTLY ENGAGED IN VARIOUS SECURITIES CLASS ACTION LITIGATIONS, WHICH, IF RESOLVED
UNFAVORABLY, COULD ADVERSELY AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL CONDITION.





We have been
sued in various shareholder lawsuits in federal district court in California and New York (See  Part IIItem 1Legal Proceedings). We believe that the allegations against us are without merit and intend to continue to defend
the litigations vigorously. An unfavorable resolution of the lawsuits could have a material adverse effect on our business, results of operations, and/or financial condition.




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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, and in February 2001, we acquired
non-exclusive intellectual property rights from a third-party. Any future acquisitions would be accompanied by risks such as:





| |  |  | difficulties in assimilating the operations and personnel 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 amortization of acquired assets;
| | - |  | -------------------------------------------------------------------




| |  |  | 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. For example, the SpeechFront assets and text to speech technology we acquired have been impaired (see notes to the consolidated financial statements). Our inability to integrate successfully any
business products, technologies or personnel we may acquire in the future could harm our business.





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





As a result of recent unfavorable economic conditions
and reduced capital spending, it is possible that our sales will decline. This economic downturn became particularly acute following the events of September 11, 2001. We experienced a decline in revenues during 2001 due in part to delays in
purchases by our customers and to prevailing economic conditions. If unfavorable economic conditions continue or worsen in the United States or, we may experience 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 on April 13, 2000, our stock price has been extremely volatile. During that time, the stock market in general, 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 and suppliers;
| | - |  | ------------------------------------------------------------------------------------------




| |  |  | announcements by our competitors relating to new customers, technological innovation or new services;
| | - |  | -----------------------------------------------------------------------------------------------------




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




| |  |  | increases in our plans for, or 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 in information technology and capital spending plans.
| | - |  | ---------------------------------------------------------------------




These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results. Our stock price may fluctuate due to variations in our
operating results. For example, on March 15, 2001, we announced our revised expectations for our first-quarter revenues based upon our then-current outlook. As a result, the trading price of our common stock declined rapidly and significantly.





IF WE DO NOT EFFECTIVELY MANAGE OUR OPERATIONS AND RESOURCES IN ACCORDANCE WITH MARKET AND ECONOMIC CONDITIONS, OUR BUSINESS COULD BE
HARMED.





Our operations have changed significantly due to volatility in our business and may continue to
change in the future. We experienced significant growth in the past; however, in April 2001, we reduced our workforce by approximately 20%. Additionally, during the quarter ended March 31, 2002, we implemented a restructuring plan to reduce our
workforce by approximately another 8% and in August 2002 we reduced our workforce by approximately 20%. We may be required to expand or contract our business operations and workforce 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 and 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 burden on our business, our operations and our management team, and could negatively impact sales, customer relationships and other aspects of our business performance and could cause our business to
suffer.





IF WE ARE UNABLE TO HIRE AND RETAIN SELECT PERSONNEL, OUR BUSINESS COULD BE HARMED.





We intend to hire select personnel during the year. Competition for these individuals can be intense, and we may not be able to attract,
assimilate, or retain additional highly qualified personnel in the future. The failure to attract, integrate, motivate and retain these employees could harm our business. The decline in the value of our common stock may also make it more difficult
to retain our employees.





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 of these key employees. We cannot guarantee that we will be able to retain all key personnel. For example, in July 2002, our President and
Chief Financial Officer, Ronald Croen, became the Chairman of Companys Board of Directors and announced plans to step down from his position as CEO. In addition, in January 2002 Graham Smith resigned from his position with the company as Chief
Financial Officer. Mr. Croen has remained engaged as CEO pending selection of his successor, however, we may encounter difficulties or further delays in hiring a new Chief Executive Officer and such difficulties or delays could harm our business.
None of our key technical or senior management personnel are bound by employment agreements, and, as a result, any of these employees could leave with little or no prior notice. If we lose any of our key technical and senior management personnel,
replacement of such personnel could be difficult and costly, and if we are unable to successfully and swiftly replace such personnel and effectively transition to new management personnel, our business could be harmed. We do not have key person life
insurance policies covering any of our employees.




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OUR PRODUCTS MAY INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, AND RESULTING CLAIMS AGAINST US COULD BE COSTLY AND REQUIRE US TO ENTER
INTO DISADVANTAGEOUS LICENSE OR ROYALTY ARRANGEMENTS.





The software industry and the field of speech and voice
technologies are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of intellectual property rights. Although we attempt to avoid infringing known
proprietary rights of third parties we may be subject to legal proceedings and claims for alleged infringement by us or our licensees of third-party proprietary rights, such as patents, trade secrets, trademarks or copyrights, from time to time in
the ordinary course of business. Any claims relating to the infringement of third-party proprietary rights, even if not successful or meritorious, could result in costly litigation, divert resources and managements attention or require us to
enter into royalty or license agreements which are not advantageous to us. In addition, parties making these claims may be able to obtain injunctions, which could prevent us from selling our products. Furthermore, former employers of our employees
may assert that these employees have improperly disclosed confidential or proprietary information to us. Any of these results could harm our business. We may be increasingly subject to infringement claims as the number of, and number of features of,
our products grow.





OUR 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 100% accurate. 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 us or our customers for losses incurred. Although our contracts typically contain provisions designed to limit our exposure to liability claims, a claim brought against us for misrecognition or incorrect authentication, even
if unsuccessful, could be time-consuming, divert managements attention, result in costly litigation and harm our reputation. Moreover, existing or future laws or unfavorable judicial decisions could limit the enforceability of the limitation
of liability, disclaimer of warranty or other protective provisions contained in our contracts.




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ANY SOFTWARE DEFECTS IN OUR PRODUCTS COULD HARM OUR BUSINESS AND RESULT IN LITIGATION.





Complex software products such as ours may contain errors, defects and bugs. With the planned release of any
product, we may discover these 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 or bugs may be technologically unfeasible. Delivery of products
with undetected production defects or reliability, quality, or compatibility problems could damage our reputation. Errors, defects or bugs could also cause interruptions, delays or a cessation of sales to our customers. We could 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 could bring claims against us which, even if unsuccessful, would likely be
time-consuming and could result in costly litigation and payment of damages.





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 and/or maintain. Further, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property.





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 invalidated, circumvented or challenged. If challenged, our patents might not be
upheld or their claims could be narrowed. Our intellectual property may not be adequate to provide us with competitive advantage or 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, and/or
superior to our technology. Monitoring infringement and/or 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 do the laws of the United States.





THIRD
PARTIES COULD OBTAIN LICENSES FROM SRI INTERNATIONAL RELATING TO SPEECH SOFTWARE TECHNOLOGIES AND DEVELOP TECHNOLOGIES TO COMPETE WITH OUR PRODUCTS, WHICH COULD CAUSE OUR SALES TO DECLINE.





Upon our incorporation in 1994, we received a license from SRI International to a number of patents and other proprietary rights, including rights in software,
relating to speech software technologies developed by SRI International. This license was exclusive until December 1999, when we chose to allow the exclusivity to lapse. As a result, SRI International may have, or may in the future, license these
patents and proprietary rights to our competitors. If a license from SRI International were to enable third parties to enter the markets for our products and services or to compete more effectively, we could lose market share and our business could
suffer.





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





The market for speech software is new
and emerging and industry standards have not yet been 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.





Our V-Builder applications-building tool and our Voice Web Server software are each designed to work with the recently emerged 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 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.




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CERTAIN STOCKHOLDERS MAY DISAGREE WITH HOW NUANCE USES THE
PROCEEDS FROM ITS PUBLIC OFFERINGS.





Management retains broad discretion over the use of proceeds from our
April 2000 initial public offering and September 2000 secondary public offering. Stockholders may not deem these uses desirable and our use of the proceeds may not yield a significant return or any return at all. Because of the number and
variability of factors that determine our use of the net proceeds from these offerings, we cannot guarantee that these uses will not vary substantially from our currently planned uses.





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





Provisions of our charter and bylaws may make it more difficult for a third party to acquire, or 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:





| |  |  | 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 from 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 on April 13, 2000, we have been subject to the antitakeover 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 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 that caused significant property damage and a number of fatalities struck this area. 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 potentially completely, impaired. The insurance we maintain may not be adequate to cover our
losses resulting from disasters or other business interruptions.





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





California recently
experienced an energy crisis that increased our expenses and could have disrupted our operations. In the event of an acute power shortage, that is, when power reserves for the State of California fall below 1.5%, California has on some occasions
implemented, and may in the future continue to implement, rolling blackouts throughout California. 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 California
experiences a similar energy crisis in the future, any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could 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.




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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





The following discusses our exposure to market risk related to changes in interest rates, equity prices and foreign currency exchange rates. This discussion 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 Quarterly Report on Form 10-Q.





Foreign Currency Exchange Rate Risk





To date, all of our
recognized revenues have been denominated in U.S. dollars and primarily 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 may also be derived from international markets and 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 cannot assure you that
exchange rate fluctuations will not adversely affect our financial results in the future.





Interest Rate Risk





As of September 30, 2002, we had cash and cash equivalents, short-term investments and long-term investments of $135.6 million.
Any decline in interest rates over time would reduce our interest income from our cash and cash equivalents, short-term and long-term investments. Based upon our balance of cash and cash equivalents, short-term investments and long-term investments
at September 30, 2002, a decrease in interest rates of 0.5% would cause a corresponding decrease in our annual interest income by approximately $660,000.





ITEM 4.    CONTROLS AND PROCEDURES





The Chief Executive Officer and
the Chief Financial Officer have evaluated the Companys system of disclosure controls and procedures within ninety days of the date of this report, and based on such evaluation have determined that they are satisfactory in connection with the
preparation of this quarterly report. There have been no significant changes to the system of internal controls or in other factors that affect internal controls subsequent to the date of their evaluation.




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PART II:    OTHER INFORMATION





ITEM 1.    LEGAL PROCEEDINGS:





In March 2001, the first of a number
of stockholder complaints was filed in the United States District Court for the Northern District of California against Nuance and certain of its officers. Those lawsuits were consolidated and an amended complaint was filed on behalf of a purported
class of people who purchased our 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 are seeking unspecified
damages. We believe that these allegations are without merit and we are defending the litigation vigorously. Recently, in response to our motion to dismiss, certain of the Plaintiffs claims were dismissed with prejudice. However,
Plaintiffs were permitted to file a further amended complaint with respect to several remaining claims. We intend to move to dismiss such amended complaint. An unfavorable resolution of this litigation could have a material adverse effect on
our business, results of operations and financial condition.





In June and July 2001, putative shareholder
derivative actions were filed in California state court alleging breaches of fiduciary duty and insider trading by various of our directors and officers. While we are named as a nominal defendant, the lawsuits do not appear to seek any recovery
against us. Proceedings in these actions have been stayed.





In August 2001, the first of a number of complaints
was filed in federal district court for the Southern District of New York on behalf of a purported class of persons who purchased Nuance stock between April 12, 2000 and December 6, 2000. In April 2002, plaintiffs filed a consolidated amended
complaint. The consolidated amended complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities, the conduct of
our secondary offering, and the issuance of analyst reports. The complaints bring claims for violation of several provisions of the federal securities laws against those underwriters, and also against us and some of our directors and officers.
Similar lawsuits have been filed concerning more than 300 other companies public offerings. We believe that the allegations against us are without merit and intend to defend the litigation vigorously.





We are subject to certain 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 our consolidated financial position, results of operations, or cash flows.





ITEM 2.    CHANGES IN SECURITIES





Not applicable





ITEM 3.    DEFAULTS UPON SENIOR SECURITIES





Not applicable





ITEM 4.    SUBMISSION OF MATTERS TO A NOTE BY SECURITY HOLDERS





Not applicable





ITEM 5.    OTHER INFORMATION





Not applicable





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





(a)    Exhibit 99.1 is incorporated as part of this document.





(b)    Reports on Form 8-K





On July 23, 2002, the Company filed a report on
Form 8-K relating to its announcement that Ronald Croen will become the Chairman of the Companys Board of Directors and will step down from his position as the Companys President and Chief Executive Officer once a successor has been
identified.




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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.





Date: November 14, 2002


By:

/S/    KAREN
BLASINGKaren Blasing Vice President and Chief
Financial Officer (Principal Financial and Accounting Officer)




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CERTIFICATIONS





I, Ronald A. Croen, Chief Executive Officer of the Company, certify
that:





(1) I have reviewed this quarterly report of Nuance Communications, Inc. on Form 10-Q (the Report);





(2) Based on my knowledge, the Report does not contain any untrue statements of a material fact or omit to state
a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report;





(3) Based on my knowledge, the financial statements, and other financial information included in the Report, fairly present in all material respect the financial condition,
results of operations and cash flows of the Company as of, and for, the periods presented in the Report;





(4) The
Companys other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15b-14) for the Company and we have:





a. Designed such disclosure controls and procedures to ensure that material information relating to the Company is made
known to us by others in the Company particularly during the period in which the Report is being prepared;





b. Evaluated the effectiveness of the Companys disclosure controls and procedures as of a date within 90 days prior to the filing date of the Report (the Evaluation Date); and





c. Presented in the Report our conclusions about the effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;





(5) The registrants other certifying officer and I have disclosed,
based on our most recent evaluation, to the Companys auditors and the Audit Committee of the Companys Board of Directors:





a. All significant deficiencies in the design or operation of internal controls which could adversely affect the Companys ability to record, process, summarize, and report financial data and have
identified for the Companys auditors any material weaknesses in internal controls; and





b.
Any fraud, whether or not material, that involves management or other employees who have a significant role in the Companys internal controls; and





(6) The registrants other certifying officer and I have indicated in the Report whether or not there were significant changes in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.





/S/    RONALD A. CROENRonald A. Croen Chief Executive Officer November 14, 2002




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I, Karen Blasing, Chief Financial Officer of the Company, certify that:





(1) I have reviewed this quarterly report of Nuance Communications, Inc. on Form 10-Q (the Report);





(2) Based on my knowledge, the Report does not contain any untrue statements of a material fact or omit to state a material
fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report;





(3) Based on my knowledge, the financial statements, and other financial information included in the Report, fairly present in all material respect the financial condition,
results of operations and cash flows of the Company as of, and for, the periods presented in the Report;





(4) The
Companys other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15b-14) for the Company and we have:





a. Designed such disclosure controls and procedures to ensure that material information relating to the Company is made
known to us by others in the Company particularly during the period in which the Report is being prepared;





b. Evaluated the effectiveness of the Companys disclosure controls and procedures as of a date within 90 days prior to the filing date of the Report (the Evaluation Date); and





c. Presented in the Report our conclusions about the effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;





(5) The registrants other certifying officer and I have disclosed,
based on our most recent evaluation, to the Companys auditors and the Audit Committee of the Companys Board of Directors:





a. All significant deficiencies in the design or operation of internal controls which could adversely affect the Companys ability to record, process, summarize, and report financial data and have
identified for the Companys auditors any material weaknesses in internal controls; and





b.
Any fraud, whether or not material, that involves management or other employees who have a significant role in the Companys internal controls; and





(6) The registrants other certifying officer and I have indicated in the Report whether or not there were significant changes in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.





/S/    KAREN BLASINGKaren Blasing Chief Executive Officer November 14, 2002




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