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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 MARCH 31, 2005



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



FOR THE TRANSITION PERIOD FROM  TO
.



COMMISSION FILE NUMBER 000-30203



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NUANCE COMMUNICATIONS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)



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



1380 WILLOW ROAD

MENLO PARK, CALIFORNIA 94025

(650) 847-0000

(ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO ̈



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



36,175,069 shares of the registrants common stock, $0.001 par value per share, were
outstanding as of April 30, 2005.



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##### Table of Contents

NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES



FORM 10-Q FOR THE THREE MONTHS ENDED MARCH 31, 2005



CONTENTS



|                             |  |                                                                                            |  |     
|---------------------------- |  | ------------------------------------------------------------------------------------------ |  | ----
|ITEMNUMBER                   |  |                                                                                            |  | PAGE
|                             |  | PART I: FINANCIAL INFORMATION                                                              |  |     
|                             |  |                                                                                           
|Item 1.                      |  | Unaudited Financial Statements                                                             |  |     
|                             |  | Condensed Consolidated Balance Sheets:March 31, 2005 and December 31, 2004                 |  | 1   
|                             |  | Condensed Consolidated Statements of Operations:Three months ended March 31, 2005 and 2004 |  | 2   
|                             |  | Condensed Consolidated Statements of Cash Flows:Three months ended March 31, 2005 and 2004 |  | 3   
|                             |  | Notes to Condensed Consolidated Financial Statements                                       |  | 4   
|                             |  |                                                                                           
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations      |  | 13  
|                             |  |                                                                                           
|Item 3.                      |  | Quantitative and Qualitative Disclosures about Market Risk                                 |  | 32  
|                             |  |                                                                                           
|Item 4.                      |  | Controls and Procedures                                                                    |  | 32  
|                             |  |                                                                                           
|                             |  | PART II: OTHER INFORMATION                                                                 |  |     
|                             |  |                                                                                           
|Item 1.                      |  | Legal Proceedings                                                                          |  | 33  
|                             |  |                                                                                           
|Item 6.                      |  | Exhibits                                                                                   |  | 33  
|                             | 
|Signature and certifications |  | 35                                                                                        
|                             | 
|Exhibit Index                |  |                                                                                           



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##### Table of Contents

PART I: FINANCIAL INFORMATION



ITEM 1: FINANCIAL STATEMENTS



NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

(unaudited)



|                                                                                                                                     |  |               |          |   |                  |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------ |  | ------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                     |  | March 31,2005 |          |   | December 31,2004 |  
|ASSETS                                                                                                                               |  |               |          |   |                  |   |          |  
|Current assets:                                                                                                                      |  |               |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                            |  | $             | 69,547   |   |                  | $ | 53,583   |  
|Short-term investments                                                                                                               |  |               | 18,029   |   |                  |   | 37,493   |  
|Accounts receivable, net of allowance for doubtful accounts of $392 and $583, respectively                                           |  |               | 9,072    |   |                  |   | 13,953   |  
|Prepaid expenses and other current assets                                                                                            |  |               | 4,864    |   |                  |   | 3,839    |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Total current assets                                                                                                                 |  |               | 101,512  |   |                  |   | 108,868  |  
|Property and equipment, net                                                                                                          |  |               | 3,742    |   |                  |   | 4,059    |  
|Long-term note receivable                                                                                                            |  |               | 5,035    |   |                  |   | 5,005    |  
|Intangible assets, net                                                                                                               |  |               | 477      |   |                  |   | 580      |  
|Restricted cash                                                                                                                      |  |               | 11,109   |   |                  |   | 11,109   |  
|Deferred income taxes                                                                                                                |  |               | 394      |   |                  |   | 398      |  
|Other assets                                                                                                                         |  |               | 221      |   |                  |   | 238      |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Total assets                                                                                                                         |  | $             | 122,490  |   |                  | $ | 130,257  |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                 |  |               |          |   |                  |   |          |  
|Current liabilities:                                                                                                                 |  |               |          |   |                  |   |          |  
|Accounts payable                                                                                                                     |  | $             | 1,511    |   |                  | $ | 1,328    |  
|Accrued liabilities                                                                                                                  |  |               | 7,827    |   |                  |   | 8,067    |  
|Current restructuring accrual                                                                                                        |  |               | 10,327   |   |                  |   | 10,203   |  
|Current deferred revenue                                                                                                             |  |               | 7,378    |   |                  |   | 8,157    |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Total current liabilities                                                                                                            |  |               | 27,043   |   |                  |   | 27,755   |  
|Long-term deferred revenue                                                                                                           |  |               | 507      |   |                  |   | 544      |  
|Long-term restructuring accrual                                                                                                      |  |               | 50,228   |   |                  |   | 52,705   |  
|Other long-term liabilities                                                                                                          |  |               | 37       |   |                  |   | 37       |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Total liabilities                                                                                                                    |  |               | 77,815   |   |                  |   | 81,041   |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Commitments and contingencies (Note 11)                                                                                              |  |               |          |   |                  |   |          |  
|Stockholders Equity:                                                                                                                |  |               |          |   |                  |   |          |  
|Common stock, $0.001 par value, 250,000,000 shares authorized; 36,157,576 and 36,077,623 shares issued and outstanding,
respectively |  |               | 36       |   |                  |   | 36       |  
|Additional paid-in capital                                                                                                           |  |               | 332,666  |   |                  |   | 332,521  |  
|                                                                                                                                     |  |              
|Accumulated other comprehensive income                                                                                               |  |               | 900      |   |                  |   | 1,035    |  
|Accumulated deficit                                                                                                                  |  |               | (288,927 | ) |                  |   | (284,376 | )
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Total stockholders equity                                                                                                           |  |               | 44,675   |   |                  |   | 49,216   |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                           |  | $             | 122,490  |   |                  | $ | 130,257  |  
|                                                                                                                                     |  |               |          |   |                  |   |          |  



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

(in thousands, except per share amounts)

(unaudited)



|                                                  |  |                             |        |   |      |   |        |  
|------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                  |  | Three Months EndedMarch 31, |       
|                                                  |  | 2005                        |        |   | 2004 |  
|Revenue:                                          |  |                             |        |   |      |   |        |  
|License                                           |  | $                           | 4,163  |   |      | $ | 5,503  |  
|Service                                           |  |                             | 3,634  |   |      |   | 3,562  |  
|Maintenance                                       |  |                             | 4,004  |   |      |   | 3,637  |  
|                                                  |  |                             |        |   |      |   |        |  
|Total revenue                                     |  |                             | 11,801 |   |      |   | 12,702 |  
|                                                  |  |                            
|Cost of revenue:                                  |  |                             |        |   |      |   |        |  
|License                                           |  |                             | 88     |   |      |   | 88     |  
|Service                                           |  |                             | 3,118  |   |      |   | 2,597  |  
|Maintenance                                       |  |                             | 652    |   |      |   | 708    |  
|                                                  |  |                             |        |   |      |   |        |  
|Total cost of revenue                             |  |                             | 3,858  |   |      |   | 3,393  |  
|                                                  |  |                             |        |   |      |   |        |  
|Gross profit                                      |  |                             | 7,943  |   |      |   | 9,309  |  
|                                                  |  |                             |        |   |      |   |        |  
|Operating expenses:                               |  |                             |        |   |      |   |        |  
|Sales and marketing                               |  |                             | 6,942  |   |      |   | 6,189  |  
|Research and development                          |  |                             | 3,192  |   |      |   | 4,170  |  
|General and administrative                        |  |                             | 3,151  |   |      |   | 1,929  |  
|Restructuring credits                             |  |                             | (51    | ) |      |   | (41    | )
|                                                  |  |                             |        |   |      |   |        |  
|Total operating expenses                          |  |                             | 13,234 |   |      |   | 12,247 |  
|                                                  |  |                             |        |   |      |   |        |  
|Loss from operations                              |  |                             | (5,291 | ) |      |   | (2,938 | )
|Interest and other income, net                    |  |                             | 587    |   |      |   | 234    |  
|                                                  |  |                             |        |   |      |   |        |  
|Loss before income taxes                          |  |                             | (4,704 | ) |      |   | (2,704 | )
|Benefit from income taxes                         |  |                             | (153   | ) |      |   | (97    | )
|                                                  |  |                             |        |   |      |   |        |  
|Net loss                                          |  | $                           | (4,551 | ) |      | $ | (2,607 | )
|                                                  |  |                             |        |   |      |   |        |  
|Basic and diluted net loss per share              |  | $                           | (0.13  | ) |      | $ | (0.07  | )
|                                                  |  |                             |        |   |      |   |        |  
|Shares used to compute basic and diluted net loss |  |                             | 36,121 |   |      |   | 35,067 |  
|                                                  |  |                             |        |   |      |   |        |  



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

(in thousands)

(unaudited)



|                                                                           |  |                             |        |   |      |   |         |  
|-------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------- | -
|                                                                           |  | Three Months EndedMarch 31, |       
|                                                                           |  | 2005                        |        |   | 2004 |  
|Cash flows from operating activities:                                      |  |                             |        |   |      |   |         |  
|Net loss                                                                   |  | $                           | (4,551 | ) |      | $ | (2,607  | )
|Adjustments to reconcile net loss to net cash used in operating activities |  |                             |        |   |      |   |         |  
|Depreciation and amortization of intangible assets                         |  |                             | 734    |   |      |   | 786     |  
|Loss on fixed asset disposal                                               |  |                             | 103    |   |      |   |        |  
|Non-cash compensation expense                                              |  |                             |       |   |      |   | 73      |  
|Reduction in allowance for doubtful accounts                               |  |                             | (191   | ) |      |   | (462    | )
|Deferred income taxes                                                      |  |                             | 4      |   |      |   | 2       |  
|Changes in operating assets and liabilities:                               |  |                             |        |   |      |   |         |  
|Accounts receivable                                                        |  |                             | 5,072  |   |      |   | 4,380   |  
|Prepaid expenses, other current assets and other assets                    |  |                             | (1,038 | ) |      |   | (716    | )
|Accounts payable                                                           |  |                             | 183    |   |      |   | 10      |  
|Accrued liabilities and other long-term liabilities                        |  |                             | (240   | ) |      |   | 436     |  
|Restructuring accrual                                                      |  |                             | (2,353 | ) |      |   | (2,355  | )
|Deferred revenue                                                           |  |                             | (816   | ) |      |   | 203     |  
|                                                                           |  |                             |        |   |      |   |         |  
|Net cash used in operating activities                                      |  |                             | (3,093 | ) |      |   | (250    | )
|                                                                           |  |                             |        |   |      |   |         |  
|Cash flows from investing activities:                                      |  |                             |        |   |      |   |         |  
|Purchase of investments                                                    |  |                             | (5,068 | ) |      |   | (15,201 | )
|Maturities of investments                                                  |  |                             | 24,514 |   |      |   | 22,324  |  
|Purchase of property and equipment                                         |  |                             | (417   | ) |      |   | (931    | )
|Increase in restricted cash                                                |  |                             |       |   |      |   | (23     | )
|                                                                           |  |                             |        |   |      |   |         |  
|Net cash provided by investing activities                                  |  |                             | 19,029 |   |      |   | 6,169   |  
|                                                                           |  |                             |        |   |      |   |         |  
|Cash flows from financing activities:                                      |  |                             |        |   |      |   |         |  
|Proceeds from exercise of common stock options                             |  |                             | 145    |   |      |   | 303     |  
|                                                                           |  |                             |        |   |      |   |         |  
|Net cash provided by financing activities                                  |  |                             | 145    |   |      |   | 303     |  
|                                                                           |  |                             |        |   |      |   |         |  
|Effect of exchange rate fluctuations                                       |  |                             | (117   | ) |      |   | (3      | )
|                                                                           |  |                             |        |   |      |   |         |  
|Net increase in cash and cash equivalents                                  |  |                             | 15,964 |   |      |   | 6,219   |  
|Cash and cash equivalents, beginning of period                             |  |                             | 53,583 |   |      |   | 40,206  |  
|                                                                           |  |                             |        |   |      |   |         |  
|Cash and cash equivalents, end of period                                   |  | $                           | 69,547 |   |      | $ | 46,425  |  
|                                                                           |  |                             |        |   |      |   |         |  
|Supplementary disclosures of cash flow information:                        |  |                             |        |   |      |   |         |  
|Cash paid during the period for:                                           |  |                             |        |   |      |   |         |  
|Interest                                                                   |  | $                           |       |   |      | $ | 2       |  
|Income taxes                                                               |  | $                           | 17     |   |      | $ | 72      |  
|Supplementary disclosures of non-cash transactions:                        |  |                             |        |   |      |   |         |  
|Unrealized gain (loss) on available-for-sale securities                    |  | $                           | (18    | ) |      | $ | 14      |  



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



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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



1. ORGANIZATION AND OPERATIONS



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



2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Basis of Presentation.The Company has prepared the accompanying financial data for the three months ended March 31, 2005 and 2004 pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the U.S. have been
condensed or omitted pursuant to such rules and regulations. The following discussion should be read in conjunction with our 2004 Annual Report on Form 10-K.



Use of Estimates.The preparation of the condensed consolidated financial statements in conformity with Generally Accepted Accounting Principles
(GAAP) 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 condensed consolidated financial statements,
and the reported amounts of revenue and expenses during the reporting period. Such estimates include, but are not limited to, allowance for doubtful accounts, restructuring accrual, income taxes, contingencies and percentage of completion estimates
of certain revenue contracts. Actual results could differ from those estimates.



Certain Significant Risks and Uncertainties.The Company operates in a dynamic and highly competitive industry and believes that any of the following potential factors could have a material adverse effect on
the Companys future financial position, results of operations or cash flows: the volatility of, and rapid change in, the speech software industry; potential competition, including competition from larger, more established companies with newer,
better, or less expensive products or services; the Companys dependence on key employees for technology and support; the Companys failure to adopt, or develop products based on, new industry standards; changes in the overall demand by
customers and consumers for speech software products generally, and for the Companys products in particular; changes in, or the loss of, certain strategic relationships (particularly reseller relationships); the loss of a significant
customer(s) or order(s); litigation or claims against the Company related to intellectual property, products, regulatory obligations or other matters; the Companys inability to protect its proprietary intellectual property rights; adverse
changes in domestic and international economic and/or political conditions or regulations; the Companys inability to attract and retain employees necessary to support growth; liability with respect to the Companys software and related
claims if such software is defective or otherwise does not function as intended; a lengthy sales cycle which could result in the delay or loss of potential sales orders; seasonal variations in the Companys sales due to patterns in the
budgeting and purchasing cycles of our customers; the Companys inability to manage its operations and resources in accordance with market conditions; the need for an increase in the Companys restructuring accrual for the Pacific Shores
facility; the failure to realize anticipated benefits from any potential acquisition of companies, products, or technologies; the Companys inability to collect amounts owed to it by its customers; and the Companys inability to develop
localized versions of its products to meet international demand.



In the opinion of management, the accompanying condensed consolidated financial statements contain all normal and recurring adjustments necessary to present fairly our condensed consolidated financial position as of March 31, 2005 and
December 31, 2004, condensed consolidated results of operations for the three months ended March 31, 2005 and 2004, and cash flow activities for the three months ended March 31, 2005 and 2004.



The preparation of financial statements in accordance with accounting
principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in our condensed consolidated financial statements and accompanying notes. Management bases its estimates on historical
experience and various other assumptions believed to be reasonable. Although these estimates are based on managements best knowledge of current events and actions that may impact the company in the future, actual results may be different from
the estimates. Our critical accounting policies are those that affect our financial statements materially and involve difficult, subjective or complex judgments by management. Those policies are revenue recognition, valuation allowance for doubtful
accounts, valuation of long-lived assets, restructuring and asset impairment charges and accounting for income taxes.



Reclassification$73,000 of non-cash stock compensation in 2004 was combined with Research and development in the condensed consolidated statements
of operations to conform to the 2005 presentation.



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3. RECENT ACCOUNTING PRONOUNCEMENTS



In December 2004, the FASB issued SFAS No. 123 (Revised 2004) Share-Based Payment (SFAS No. 123R).
SFAS No. 123R addresses all forms of share-based payment (SBP) awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. SFAS No. 123R will require the Company to
expense SBP awards with compensation cost for SBP transactions measured at fair value. SFAS No. 123R requires the Company to adopt the new accounting provisions effective for the Companys first quarter of fiscal 2006. The Company has not yet
quantified the effects of the adoption of SFAS 123R, but the Company expects that the new standard may result in significant stock-based compensation expense. The pro forma effects on net income and earnings per share if the fair value recognition
provisions of the original SFAS 123, which differs from the effect of SFAS 123R, had been applied to stock compensation awards (rather than applying the intrinsic value measurement provisions of Opinion 25) are disclosed in Note 4 of the condensed
consolidated financial statements.



In December 2004, the FASB
issued FASB Staff Position No. FAS 109-2 (FAS 109-2), Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creations Act (AJCA) of 2004. The AJCA introduces a
limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP 109-2 provides accounting and disclosure guidance for the repatriation
provision. Although FSP 109-2 is effective immediately, the Company does not expect to be able to complete its evaluation of the repatriation provision until after Congress or the Treasury Department provides additional clarifying language on key
elements of the provision.



4. STOCK-BASED COMPENSATION



The Company accounts for stock-based awards to employees and directors using
the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees. Under the intrinsic value method, the Company records compensation
expense related to stock options in the consolidated statement of operations when the exercise price of its employee stock-based award is less than the market price of the underlying stock on the date of the grant. Pro forma net loss and net loss
per share information, as required by SFAS No. 123, Accounting for Stock-Based Compensation, has been determined as if the Company had accounted for all employee stock options granted, including shares issuable to employees under the
Employee Stock Purchase Plan, under SFAS No. 123s fair value method. The Company amortizes the fair value of stock options on a straight-line basis over the required periods.



The pro forma effect of recognizing compensation expense in accordance with SFAS No. 123 is as follows



|                                                                                             |  |                              |        |   |      |   |         |  
|-------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------- | -
|                                                                                             |  | Three Months Ended March 31, |       
|                                                                                             |  | 2005                         |        |   | 2004 |  
|Net loss, as reported                                                                        |  | $                            | (4,551 | ) |      | $ | (2,607  | )
|Add: Stock-based employee compensation expense included in net loss                          |  |                              |       |   |      |   | 73      |  
|Less: Total stock-based employee compensation expense under fair value method for all awards |  |                              | (4,325 | ) |      |   | (8,221  | )
|                                                                                             |  |                              |        |   |      |   |         |  
|Pro forma net loss                                                                           |  | $                            | (8,876 | ) |      | $ | (10,755 | )
|                                                                                             |  |                              |        |   |      |   |         |  
|Basic and diluted net loss per shareas reported                                             |  | $                            | (0.13  | ) |      | $ | (0.07   | )
|                                                                                             |  |                              |        |   |      |   |         |  
|Basic and diluted net loss per sharepro forma                                               |  | $                            | (0.25  | ) |      | $ | (0.31   | )
|                                                                                             |  |                              |        |   |      |   |         |  



5. NET LOSS PER SHARE



Net loss per share is calculated under SFAS No. 128,
Earnings per Share. Basic net loss per share on a historical basis is computed by dividing the net loss attributable to common shareholders by the weighted average number of shares of common stock outstanding for the period, excluding
the weighted average common shares subject to repurchase. Diluted net loss per share is equal to basic net loss per share for all periods presented since potential common shares from conversion of the convertible preferred stock, stock options,
warrants and exchangeable shares held in escrow are anti-dilutive. Shares subject to repurchase resulting from early exercises of options that have not vested are excluded from the calculation of basic net loss per share.



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During the three months ended March 31, 2005 and 2004, the Company had securities outstanding which could
potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted loss per share in such periods, as their effect would have been anti-dilutive due to the net loss reported in such periods. The total number
of shares excluded from diluted net loss per share was 10,067,000 and 9,699,000 shares, for the three months ended March 31, 2005 and 2004.



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



|                                                                             |  |                              |        |   |      |   |        |  
|---------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                             |  | Three Months Ended March 31, |       
|                                                                             |  | 2005                         |        |   | 2004 |  
|Net loss                                                                     |  | $                            | (4,551 | ) |      | $ | (2,607 | )
|                                                                             |  |                              |        |   |      |   |        |  
|Basic and diluted shares:                                                    |  |                              |        |   |      |   |        |  
|Weighted average shares used to compute basic and diluted net loss per share |  |                              | 36,121 |   |      |   | 35,067 |  
|                                                                             |  |                              |        |   |      |   |        |  
|Basic and diluted net loss per share                                         |  | $                            | (0.13  | ) |      | $ | (0.07  | )
|                                                                             |  |                              |        |   |      |   |        |  



6. INVESTMENTS



The Company classifies investment securities based on
managements intention on the date of purchase and reevaluates such designation as of each balance sheet date. Securities are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with
net unrealized gains and losses included in Accumulated other comprehensive income in the accompanying consolidated balance sheets.



The Companys investments are comprised of U.S. Treasury notes, U.S. Government agency bonds, corporate bonds and commercial paper. Investments with
remaining maturities of less than one year are considered to be short-term. All investments are held in the Companys name at major financial institutions. The Companys investment policy allows maturities of investments not in excess of
14 months. As of March 31, 2005, the Company had no investment subject to other-than-temporary impairment.



7. INTANGIBLE ASSETS



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



|                     |  |                         |       |                         |   |        |     |  |               |     |  |          
|-------------------- |  | ----------------------- | ----- | ----------------------- | - | ------ | --- |  | ------------- | --- |  | ---------
|                     |  | As of March 31, 2005   
|                     |  | Gross Amount            |       | AccumulatedAmortization |   |        | Net |  | RemainingLife
|Patents Purchased    |  | $                       | 375   |                         | $ | (194   | )   |  | $             | 181 |  | 30 months
|Purchased Technology |  |                         | 2,618 |                         |   | (2,322 | )   |  |               | 296 |  | 11 months
|                     |  |                         |       |                         |   |        |     |  |               |     |  |          
|Total                |  | $                       | 2,993 |                         | $ | (2,516 | )   |  | $             | 477 |  |          
|                     |  |                         |       |                         |   |        |     |  |               |     |  |          
|                     | 
|                     |  | As of December 31, 2004
|                     |  | Gross Amount            |       | AccumulatedAmortization |   |        | Net |  | RemainingLife
|Patents Purchased    |  | $                       | 375   |                         | $ | (175   | )   |  | $             | 200 |  | 33 months
|Purchased Technology |  |                         | 2,618 |                         |   | (2,238 | )   |  |               | 380 |  | 14 months
|                     |  |                         |       |                         |   |        |     |  |               |     |  |          
|Total                |  | $                       | 2,993 |                         | $ | (2,413 | )   |  | $             | 580 |  |          
|                     |  |                         |       |                         |   |        |     |  |               |     |  |          



As of March 31, 2005,
total estimated amortization of the Patents Purchased and the Purchased Technology, for the next three years, is as follows (in thousands):



|                          |  |                      |    
|------------------------- |  | -------------------- | ---
|Year Ended December 31,   |  | Amortization Expense
|2005 (remaining 9 months) |  | $                    | 310
|2006                      |  |                      | 117
|2007                      |  |                      | 50 
|                          |  |                      |    
|Total                     |  | $                    | 477
|                          |  |                      |    



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8. COMPREHENSIVE LOSS



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



The following table presents the components of comprehensive loss for the three months ended March 31, 2005 and 2004:



|                                      |  |                              |        |   |      |   |        |  
|------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                      |  | Three Months Ended March 31, |       
|                                      |  | 2005                         |        |   | 2004 |  
|                                      |  | (In Thousands)               |       
|Net loss                              |  | $                            | (4,551 | ) |      | $ | (2,607 | )
|Unrealized gain (loss) on investments |  |                              | (18    | ) |      |   | 14     |  
|Foreign currency translation loss     |  |                              | (117   | ) |      |   | (3     | )
|                                      |  |                              |        |   |      |   |        |  
|Comprehensive loss                    |  | $                            | (4,686 | ) |      | $ | (2,596 | )
|                                      |  |                              |        |   |      |   |        |  



9. GUARANTEES, WARRANTIES AND
INDEMNITIES



Guarantees



As of March 31, 2005, the Companys financial guarantees consist of
standby letters of credit outstanding, representing the restricted cash requirements collateralizing the Companys lease obligations. The maximum amount of potential future payment under the arrangement at March 31, 2005, was $10.9 million
related to the Companys Pacific Shores lease in California and $201,000 related to the Companys Montreal lease, totaling $11.1 million presented as restricted cash on the Companys condensed consolidated balance sheet at March 31,
2005.



Warranty



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



Indemnifications to Customers



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



Indemnifications to Officers
and Directors



The Companys corporate by-laws
require that the Company indemnify its officers and directors, as well as those who act as directors and officers of other entities at its request, against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred in
connection with any proceedings arising out of their services to the Company. In addition, the Company has entered into separate indemnification agreements with each director, each board-appointed officer of the Company and certain other key
employees of the Company and certain other key employees of the Company that provides for indemnification of these directors, officers and employees under similar circumstances. The indemnification obligations are more fully described in the by-laws
and the indemnification agreements. The Company purchases insurance to cover claims, or a portion of claims, made against its directors and officers. Since a maximum obligation of the Company is not explicitly stated in the Companys by-laws or
in its indemnification agreements and will depend on the facts and circumstances that arise out of any future claims, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, the Company has not made payments
related to these obligations, and the estimated fair value for these obligations is zero on the condensed consolidated balance sheet as of March 31, 2005.



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Other Indemnifications



As is customary in the Companys industry and as provided for in local law in the U.S. and other jurisdictions, many of
its standard contracts provide remedies to others with whom the Company enters into contracts, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of its products. From time to time, the Company
indemnifies its suppliers, contractors, lessors, lessees and others with whom the Company enters into contracts, against combinations of loss, expense, or liability arising from various trigger events related to the sale and the use of its products
and services, the use of their goods and services, the use of facilities, the state of the assets and businesses that the Company sells and other matters covered by such contracts, usually up to a specified maximum amount. In addition, from time to
time the Company also provides protection to these parties against claims related to undiscovered liabilities, additional product liability or environmental obligations. In the Companys experience, claims made under such indemnifications are
rare and the associated estimated fair value of the liability is not material. At March 31, 2005, there were no outstanding claims for such indemnifications.



10. RESTRUCTURING



In 2001, the Company decided not to occupy its Pacific Shores facility. This decision resulted in a lease loss comprised of sublease loss, broker
commissions and other facility costs. To determine the sublease loss, the loss after the Companys cost recovery efforts to sublease the building, certain assumptions were made relating to the (1) time period over which the building will remain
vacant, (2) sublease terms and (3) sublease rates. The Company established the reserves at the low end of the range of estimable cost against outstanding commitments, net of estimated future sublease income. These estimates were derived using the
guidance provided in SAB No. 100, Restructuring and Impairment Charges, and EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring). The lease loss may be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, or other factors as these changes become known). The restructuring balance as of December 31,
2004 was $50.2 million. For the three months ended March 31, 2005, the Company incurred $79,000 as consulting expense in order to get property tax refund of $130,000, resulting in restructuring credit of $51,000.



In September 2004, with the approval of its Board of Directors, the Company
reduced its headcount in engineering, product management by 16 employees, to lower its overall cost structure and to allow the Company to reallocate resources to its sales operations and outbound marketing efforts. This resulted in a severance
charge of $574,000 recorded as restructuring expense on the consolidated statement of operations. For the three months ended March 31, 2005, severance in the amount of $41,900 was paid.



The restructuring charges and balance are as follows (in thousands):



|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|---------------------------------------------------------- |  | --------- | ------ | - | ------------------- | - | --- | -------------- |  | ------------------ | - |  | - | ------ | -
|                                                           |  | LeaseLoss |        |   | SeveranceandRelated |   |     | AssetWriteDown |  | TotalRestructuring |  
|2001 Plan                                                  |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at December 31, 2004                               |  | $         | 62,827 |   |                     | $ |    |                |  | $                  |  |  | $ | 62,827 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Total charges for the quarter ended March 31, 2005         |  |           | (51    | ) |                     |   |    |                |  |                    |  |  |   | (51    | )
|Amount utilized in the quarter ended March 31, 2005        |  |           | (2,390 | ) |                     |   |    |                |  |                    |  |  |   | (2,390 | )
|Adjustment related to property tax refund                  |  |           | 130    |   |                     |   |    |                |  |                    |  |  |   | 130    |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at March 31, 2005                                  |  | $         | 60,516 |   |                     |   |    |                |  |                    |  |  | $ | 60,516 |  
|As of March 31, 2005:                                      |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Current restructuring accrual                              |  | $         | 10,288 |   |                     | $ |    |                |  | $                  |  |  | $ | 10,288 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Long-term restructuring accrual                            |  | $         | 50,228 |   |                     | $ |    |                |  | $                  |  |  | $ | 50,228 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Q3 2004 Plan                                               |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at December 31, 2004                               |  | $         |       |   |                     | $ | 81  |                |  | $                  |  |  | $ | 81     |  
|Total charges for the quarter ended March 31, 2005         |  |           |       |   |                     |   |    |                |  |                    |  |  |   |       |  
|Amount utilized in the quarter ended March 31, 2005        |  |           |       |   |                     |   | (42 | )              |  |                    |  |  |   | (42    | )
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at March 31, 2005 - current                        |  | $         |       |   |                     | $ | 39  |                |  | $                  |  |  | $ | 39     |  
|                                                           |  |           |        |  
|Summary for balance at March 31, 2005 (two plans together) |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Restructuring accrual: Current                             |  | $         | 10,288 |   |                     | $ | 39  |                |  | $                  |  |  | $ | 10,327 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Restructuring accrual: Long-term                           |  | $         | 50,228 |   |                     | $ |    |                |  | $                  |  |  | $ | 50,228 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  



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11. COMMITMENTS AND CONTINGENCIES



Operating leases



In May 2000, the Company entered into a lease for its Pacific Shore facility. The lease has an eleven-year term, which began in August 2001. A $10.9
million certificate of deposit secures a letter of credit required by the landlord for a rent deposit. In conjunction with the April 2001 restructuring plans, the Company decided not to occupy this leased facility. The future minimum lease payments
table referenced below does not include estimated sublease income, as there are no sublease commitments as of March 31, 2005.



In June 2004, the Company signed lease agreements for three office buildings in the Menlo Park location, under which the Company leases an aggregate of
approximately 49,000 square feet. Each of the leases has a five-year term, expiring in August 2009 without renewal options. The initial aggregate monthly cash payment for these three leases totals approximately $42,000.



The Company leases its facilities under non-cancelable operating leases with
various expiration dates through July 2012. Rent expense is recognized on a straight-line basis over the lease term for leases that have scheduled rental payment increases. Rent expense for the three months ended March 31, 2005 and 2004 was
approximately $203,000 and $532,000, respectively.



As of March
31, 2005, future minimum lease payments under these agreements, including the Companys unoccupied leased facility and lease loss portion of the restructuring charges, are as follows (in thousands):



|                                    |  |                 |       
|----------------------------------- |  | --------------- | ------
|Fiscal Year Ending December 31,     |  | OperatingLeases
|2005 (remaining 9 months)           |  | $               | 6,996 
|2006                                |  |                 | 9,282 
|2007                                |  |                 | 9,492 
|2008                                |  |                 | 9,535 
|2009                                |  |                 | 9,648 
|Thereafter                          |  |                 | 25,500
|                                    |  |                 |       
|Total future minimum lease payments |  | $               | 70,454
|                                    |  |                 |       



Employment
Agreements



In March, 2005, the Company entered into a
Change of Control and Retention Agreement (the Retention Agreement) with each of its officers, other than its Chief Executive Officer, who are subject to the reporting requirements of Section 16 of the Securities Exchange Act of 1934, as
amended (the Act) and two other officers. On December 2, 2004, the Board of Directors (the Board) of the Company authorized its Chief Executive Officer to cause the Company to enter into such agreements, with certain
specified terms, and such other terms as he may determine are appropriate, with such officers (the Section 16 Officers) and other officers of the Company he may select. Under the terms of the Retention Agreement, in the event of a
Change of Control of the Company, each officer that is a party to the agreement will be entitled, if terminated without cause or constructively terminated with good reason within 18 months after the Change of Control, (a) to receive a
cash severance payment equal to her or his annual salary and annual bonus, and (b) to have accelerated the vesting of 50% of his or her unvested options to purchase common stock of the Company, in the case of the Section 16 Officers, and 50% of such
amount, in the case of the other officers.



Legal



In April 2004, the Company was served with a civil
complaint filed by Voice Capture, Inc. in the United States District Court for the Southern District of Iowa (the Complaint). The Complaint, which names as defendants the Company, Intel Corporation and Dialogic Corporation, alleges that
certain software and services of the defendants infringe upon certain claims contained in U.S. Patent No. Re 34,587 (Interactive Computerized Communications Systems with Voice Input and Output). In January 2005, the Company settled the
case for an amount that is less than half of the projected legal fees and cost to defend the case through trial. This amount was recorded in the General and Administrative line of the condensed Consolidated Statements of Operations. As a
result of the settlement, the case has been dismissed with prejudice and the plaintiff has released all claims it may have against the Company.



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



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material impact upon the Company, as payments, if any, are expected to be made by insurance carriers, rather than by the
Company. In July 2004, the underwriters filed a motion opposing approval by the court of the settlement among the plaintiffs, issuers and insurers. In March 2005, the court granted preliminary approval of the settlement, subject to the parties
agreeing to modify the term of the settlement which limits each underwriter from seeking contribution against its issuer for damages it may be forced to pay in the action. In the event a settlement is not concluded, the Company intends to defend the
litigation vigorously. The Company believes it has meritorious defenses to the claims against the Company.



In addition, the Company is subject, from time to time, to various other legal proceedings, claims and litigation that arise in the normal course of
business. While the outcome of any 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 the Companys consolidated financial position,
results of operations or cash flows.



12. SEGMENT REPORTING



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



Revenues are generated from three primary sources: (1) new software licenses; (2) services, which include consulting services and education services; and (3) maintenance, which includes software license updates and
customer technical support. Revenues for the segments are identical to those presented on the accompanying condensed consolidated statements of operations. The Company does not track expenses or derive profit or loss based on these segments.



Sales of licenses, as well as services and maintenance,
through March 31, 2005, occurred through third-party resellers and through direct sales representatives located in the Companys headquarters in Menlo Park, California, and in other locations. These sales were supported through the Menlo Park
location. The Company does not separately report costs by region internally.



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



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|                          |  |                              |        |      |   |       
|------------------------- |  | ---------------------------- | ------ | ---- | - | ------
|                          |  | Three Months Ended March 31,
|                          |  | 2005                         |        | 2004
|License Revenue:          |  |                              |        |      |   |       
|United States             |  | $                            | 2,701  |      | $ | 4,222 
|Canada                    |  |                              | 396    |      |   | 190   
|Europe                    |  |                              | 694    |      |   | 776   
|Asia Pacific              |  |                              | 287    |      |   | 261   
|Latin America             |  |                              | 85     |      |   | 54    
|                          |  |                              |        |      |   |       
|Total license revenue     |  | $                            | 4,163  |      | $ | 5,503 
|                          |  |                              |        |      |   |       
|Service Revenue:          |  |                              |        |      |   |       
|United States             |  | $                            | 1,727  |      | $ | 1,135 
|Canada                    |  |                              | 1,366  |      |   | 1,875 
|Europe                    |  |                              | 460    |      |   | 304   
|Asia Pacific              |  |                              | 81     |      |   | 192   
|Latin America             |  |                              |       |      |   | 56    
|                          |  |                              |        |      |   |       
|Total service revenue     |  | $                            | 3,634  |      | $ | 3,562 
|                          |  |                              |        |      |   |       
|Maintenance Revenue:      |  |                              |        |      |   |       
|United States             |  | $                            | 2,527  |      | $ | 2,275 
|Canada                    |  |                              | 342    |      |   | 341   
|Europe                    |  |                              | 596    |      |   | 501   
|Asia Pacific              |  |                              | 390    |      |   | 365   
|Latin America             |  |                              | 149    |      |   | 155   
|                          |  |                              |        |      |   |       
|Total maintenance revenue |  | $                            | 4,004  |      | $ | 3,637 
|                          |  |                              |        |      |   |       
|Total revenue:            |  |                              |        |      |   |       
|United States             |  | $                            | 6,955  |      | $ | 7,632 
|Canada                    |  |                              | 2,104  |      |   | 2,406 
|Europe                    |  |                              | 1,750  |      |   | 1,581 
|Asia Pacific              |  |                              | 758    |      |   | 818   
|Latin America             |  |                              | 234    |      |   | 265   
|                          |  |                              |        |      |   |       
|Total revenue             |  | $                            | 11,801 |      | $ | 12,702
|                          |  |                              |        |      |   |       



13. RELATED PARTIES



Certain members of the Companys Board of Directors also serve as
directors for companies to which the Company sells products in the ordinary course of its business. The Company believes that the terms of its transactions with those companies are no less favorable to the Company than the terms that would have been
obtained absent those relationships.



Specifically, (1) one
member of the Companys Board of Directors is on the Board of Directors of Wells Fargo, which is a customer of the Company, and (2) one reseller, EPOS, is a wholly owned subsidiary of Tier Technologies, for which the Companys President
and CEO, Charles W. Berger, serves as a director.



The
following table summarizes the revenue generated from these two customers for the three months ended March 31, 2005 and 2004, (in thousands).



|            |  |                             |     |      |   |    
|----------- |  | --------------------------- | --- | ---- | - | ---
|            |  | Three months endedMarch 31,
|            |  | 2005                        |     | 2004
|Wells Fargo |  | $                           | 184 |      | $ | 114
|EPOS        |  |                             | 118 |      |   | 4  
|            |  |                             |     |      |   |    
|Total       |  | $                           | 302 |      | $ | 118
|            |  |                             |     |      |   |    



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The following table summarizes the accounts receivable generated from these two customers as of March 31,
2005 and December 31, 2004 (in thousands).



|            |  |                |    |                   |   |    
|----------- |  | -------------- | -- | ----------------- | - | ---
|            |  | As of         
|            |  | March 31, 2005 |    | December 31, 2004
|Wells Fargo |  | $              | 65 |                   | $ | 306
|EPOS        |  |                | 3  |                   |   | 599
|            |  |                |    |                   |   |    
|Total       |  | $              | 68 |                   | $ | 905
|            |  |                |    |                   |   |    



14. SUBSEQUENT EVENT



Merger of the Company with Scansoft, Inc.



On May 9, 2005, the Company and Scansoft, Inc. announced that the companies
had entered into a definitive agreement to merge. Under the merger agreement, which has been unanimously approved by both boards of directors, at the closing of the merger each outstanding share of Nuance common stock will be converted into a
combination of $2.20 in cash and 0.77 of a share of Scansoft common stock. In addition, at the closing of the merger, Scansoft will assume all of the Companys outstanding stock options with an exercise price below $10.01 per share. All of the
Companys other outstanding stock options will be cancelled. Completion of the merger is subject to customary closing conditions, including receipt of required approvals from the stockholders of the Company and Scansoft and receipt of required
regulatory approvals. The merger, which is expected to close in the third calendar quarter of 2005, may not be completed if any of the conditions are not satisfied.



Under terms specified in the merger agreement, the Company or Scansoft may terminate the agreement, in which case, the
terminating party may be required to pay a termination fee equal to 3% of the aggregate value of the transaction to the other party in certain circumstances.



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



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



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



OVERVIEW



We develop, market and support speech software products for automating interactions over the telephone for a range of
industries and applications. During 2004, we released a range of new products, including Nuance 8.5, a new version of our speech recognition software, an updated version of the Nuance Voice Platformand our second application, Nuance Caller Authentication. During the year and in the first quarter of 2005, we closed a number of direct sales in which customers chose the Nuance Voice
Platform to replace their incumbent Interactive Voice Response (IVR) provider and application set. Our technology leads the market in second generation IVR platforms, based on our integration with the other components of a successful
speech solution, VoiceXML compliance and readiness for Voice Over Intellectual Property (VOIP).



We seek to actively support both emerging industry standards as well as proprietary development environments. Our software is designed to support Voice
eXtensible Markup Language ( VoiceXML), the recognized industry standard language for the creation of voice-driven products and services.



We also offer a range of consulting, support and education services that enable our customers and third-party resellers to develop and maintain
voice-driven applications that use our software products. We sell our products both directly through our sales force and indirectly through third-party resellers. We sell our products to customers in the United States, Canada, Europe, and countries
in Asia and Latin America. We anticipate that markets outside of the United States will continue to represent a significant portion of total future revenue.



Overview of Operations



Our growth and anticipated profitability are heavily dependent upon general economic conditions and demand for information technology, particularly in the
call center market. Our products and services have traditionally been sold to the telecommunications and financial services industries either by our direct sales force or by other call center vendors. These industries have sustained slowdowns over
the past several years. Even though information technology spending appears to be increasing slowly, it is difficult to predict the trend in information technology spending for the foreseeable future. Also, the levels of our quarterly revenue,
particularly from license and professional service engagements, are heavily dependent on relatively large dollar transactions from a relatively small number of customers, generally in the telecommunications or financial services industry.



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



| |  |  | focusing resources on geographic and industry targets believed to have the highest potential for revenue;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | evolving our voice platform and development tools to increase the speed and ease of deployment, and reduce the total cost of ownership, of speech systems;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | developing speech applications designed to reduce deployment time and lower maintenance requirements;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | developing and strengthening a multi-channel selling model; and
| | - |  | ---------------------------------------------------------------



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| |  |  | developing advanced speech technologies that deliver customer value, support the customer experience and maintain a leading position in the speech industry.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



Some specific operating changes have already
been accomplished, such as the restructuring actions taken in 2002, 2003 and 2004, the release of two new products, NVP and NCS, in 2003, the sales execution with a multi-channel strategy, the development of a platform Value Added Reseller
(VAR) channel and the introduction of a new application, Nuance Caller Authentication, in 2004. We continue to focus on driving complete speech solutions into the large telecom and enterprise call center markets. Other operating
activities, including the introduction of new products and changes to selling and delivery channels, will continue to evolve over the next several years. We are making these strategic shifts because we believe that they will enhance our business
performance. However, some of the actions we are taking, such as the introduction of new products, present inherent risks. We believe that these new products will make speech systems faster and easier to deploy, and will create value for our
customers. The success of these products depends upon certain market factors, such as information technology spending, market acceptance of packaged software applications and industry adoption of VoiceXML and related standards.



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



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



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



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Critical accounting policies are those that are most significant to the portrayal of the Companys condition and results of operations and require difficult, subjective and complex judgments by management in order to make estimates
about the effect of matters that are inherently uncertain. As previously reported in the Companys Annual Report on Form 10-K for the year ended December 31, 2004, the Companys most critical accounting policies pertain to revenue
recognition, restructuring and impairment charges, valuation allowance for doubtful accounts, income taxes and valuation of long-lived assets. In applying such policies management must record income and expense amounts that are based upon informed
judgments and best estimates. Because of the uncertainty inherent in these estimates, actual results could differ from estimates used in applying critical accounting policies. Changes in estimates, based on more accurate future information, may
affect amounts reported in future periods. Management is not aware of any reasonably likely events or circumstances that would result in different amounts being reported that would materially affect the Companys financial condition or results
of operation.



DESCRIPTION OF OPERATING ACCOUNTS



Total Revenue. Total revenues are generated from three primary
sources: (1) new software licenses; (2) services, which include consulting services and education services; and (3) maintenance, which includes software license updates and customer technical support. License revenue consists of license fees for our
software products. Software license revenues represent all fees earned from granting customers licenses to use our technology and applications software and exclude revenue derived from software license updates, which are included in maintenance
revenue. Service revenue consists of revenue from providing consulting, education and other services. Maintenance revenue consists of fees for providing technical support and software upgrades.



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



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



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



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



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



Restructuring expense (credits). We recognize a liability for restructuring costs at fair value only when the
liability is incurred. The two main components of our restructuring plans are related to workforce reductions and the lease loss.



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



Provision for (benefit from) income taxes.Provision for (benefit from) income taxes consists of foreign taxes, tax
credits, tax assessments and penalties.



Results of Operations



We believe that period-to-period comparisons of our
historical operating results should not be relied upon as being indicative of future performance. Our prospects must be considered in light of the risks, expenses and difficulties frequently experienced by companies in early stages of development,
particularly companies in new and rapidly changing markets. We have experienced both significant revenue growth and revenue declines in the past. Furthermore, we may not achieve nor maintain profitability in the future.



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



|                               |  |                              |        |   |      |   |        |          |  |     |   
|------------------------------ |  | ---------------------------- | ------ | - | ---- | - | ------ | -------- |  | --- | --
|                               |  | Three Months Ended March 31, |       
|                               |  | 2005                         |        |   | 2004 |   |        | % change | 
|Revenue:                       |  |                              |        |   |      |   |        |          |  |     |   
|License                        |  | $                            | 4,163  |   |      | $ | 5,503  |          |  | (24 | )%
|Service                        |  |                              | 3,634  |   |      |   | 3,562  |          |  | 2   |   
|Maintenance                    |  |                              | 4,004  |   |      |   | 3,637  |          |  | 10  |   
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Total revenue                  |  |                              | 11,801 |   |      |   | 12,702 |          |  | (7  | ) 
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Cost of revenue:               |  |                              |        |   |      |   |        |          |  |     |   
|License                        |  |                              | 88     |   |      |   | 88     |          |  |    |   
|Service                        |  |                              | 3,118  |   |      |   | 2,597  |          |  | 20  |   
|Maintenance                    |  |                              | 652    |   |      |   | 708    |          |  | (8  | ) 
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Total cost of revenue          |  |                              | 3,858  |   |      |   | 3,393  |          |  | 14  |   
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Gross profit                   |  |                              | 7,943  |   |      |   | 9,309  |          |  | (15 | ) 
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Operating expenses:            |  |                              |        |   |      |   |        |          |  |     |   
|Sales and marketing            |  |                              | 6,942  |   |      |   | 6,189  |          |  | 12  |   
|Research and development       |  |                              | 3,192  |   |      |   | 4,170  |          |  | (23 | ) 
|General and administrative     |  |                              | 3,151  |   |      |   | 1,929  |          |  | 63  |   
|Restructuring credits          |  |                              | (51    | ) |      |   | (41    | )        |  | 24  |   
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Total operating expenses       |  |                              | 13,234 |   |      |   | 12,247 |          |  | 8   |   
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Loss from operations           |  |                              | (5,291 | ) |      |   | (2,938 | )        |  | 80  |   
|Interest and other income, net |  |                              | 587    |   |      |   | 234    |          |  | 151 |   
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Loss before income taxes       |  |                              | (4,704 | ) |      |   | (2,704 | )        |  | 74  |   
|Benefit from income taxes      |  |                              | (153   | ) |      |   | (97    | )        |  | 58  |   
|                               |  |                              |        |   |      |   |        |          |  |     |   
|Net loss                       |  | $                            | (4,551 | ) |      | $ | (2,607 | )        |  | 75  | % 
|                               |  |                              |        |   |      |   |        |          |  |     |   





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



|                               |  |                              |    |  |      |   
|------------------------------ |  | ---------------------------- | -- |  | ---- | --
|                               |  | Three Months Ended March 31, |   
|                               |  | 2005                         |    |  | 2004 |   
|Revenue:                       |  |                              |    |  |      |   
|License                        |  | 35                           | %  |  | 43   | % 
|Service                        |  | 31                           |    |  | 28   |   
|Maintenance                    |  | 34                           |    |  | 29   |   
|                               |  |                              |    |  |      |   
|Total revenue                  |  | 100                          |    |  | 100  |   
|Cost of revenue:               |  |                              |    |  |      |   
|License                        |  | 1                            |    |  | 1    |   
|Service                        |  | 26                           |    |  | 21   |   
|Maintenance                    |  | 6                            |    |  | 5    |   
|                               |  |                              |    |  |      |   
|Total cost of revenue          |  | 33                           |    |  | 27   |   
|                               |  |                              |    |  |      |   
|Gross profit                   |  | 67                           |    |  | 73   |   
|Operating expense:             |  |                              |    |  |      |   
|Sales and marketing            |  | 58                           |    |  | 50   |   
|Research and development       |  | 27                           |    |  | 33   |   
|General and administrative     |  | 27                           |    |  | 13   |   
|                               |  |                              |    |  |      |   
|Total operating expenses       |  | 112                          |    |  | 96   |   
|                               |  |                              |    |  |      |   
|Loss from operations           |  | (45                          | )  |  | (23  | ) 
|Interest and other income, net |  | 5                            |    |  | 1    |   
|                               |  |                              |    |  |      |   
|Loss before income taxes       |  | (40                          | )  |  | (22  | ) 
|Benefit from income taxes      |  | (1                           | )  |  | (1   | ) 
|                               |  |                              |    |  |      |   
|Net loss                       |  | (39                          | )% |  | (21  | )%
|                               |  |                              |    |  |      |   



As a percentage of
revenue:



|                                 |  |                                  |   |  |      |  
|-------------------------------- |  | -------------------------------- | - |  | ---- | -
|                                 |  | For Three Months Ended March 31, |  
|                                 |  | 2005                             |   |  | 2004 |  
|Gross profit:                    |  |                                  |   |  |      |  
|License revenue gross profit     |  | 98                               | % |  | 98   | %
|Service revenue gross profit     |  | 14                               |   |  | 26   |  
|Maintenance revenue gross profit |  | 84                               |   |  | 80   |  
|Total revenue gross profit       |  | 67                               | % |  | 73   | %



Comparison of Three Month
Periods Ended March 31, 2005 and 2004



Revenue and Cost of
Revenue



For the three months ended March 31, 2005
compared with the three months ended March 31, 2004, total revenue decreased 7%. License revenue decreased 24%, while service revenue increased 2% and maintenance revenue increased 10%.



License revenue and cost of license revenue



For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, license revenue decreased 24%. This decrease was
primarily due to lower sales in North America than the same period in the prior year.



For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, direct license revenue increased from $0.9 million to $1.6 million. Indirect license revenue, primarily our speech engine
products sold through our third-party resellers, decreased from $4.6 million to $2.6 million.



For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, the cost of license revenue and gross profit percentage from license revenue remained relatively constant.



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Service revenue and cost of service revenue



For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, service revenue increased by
2%. This revenue increase was primarily from increases in service contracts in the United States that offset by decreasing revenue from service contracts in Canada.



Cost of service revenue as a percentage of service revenue was 86% for the three months ended March 31, 2005 and 73% for the
three months ended March 31, 2004. For the three months ended March, 31, 2005 compared with the three months ended March 31, 2004, service revenue gross profit decreased from 26% to 14%, primarily due to the increase payroll cost associated with our
increase in the number of professional service employees and outside contract services.



Maintenance revenue and cost of maintenance revenue



For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, maintenance revenue increased 10%. The increased maintenance revenue was primarily due to the technical support associated with the license
revenue in 2004 and increased emphasis on getting customers to renew their technical support contracts.



For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, the cost of maintenance revenue decreased slightly. Cost of
maintenance revenue remained relatively flat due to little change in cost of maintenance headcount. Therefore, for the three months ended March 31, 2005 compared with the three months ended March 31, 2004, maintenance revenue gross profit increased
slightly from 80% to 84%.



Operating Expenses



Sales and marketing



For the three months ended March 31, 2005 compared with the three months
ended March 31, 2004, sales and marketing expense increased approximately $0.8 million. This increase was principally due to additional salary, recruiting and other compensation expenses, as our sales team added new quota bearing sales
representatives and strengthened our outbound marketing efforts.



Research and development



For the three
months ended March 31, 2005 compared with the three months ended March 31, 2004, research and development expenses decreased approximately $1.0 million. The majority of the decrease was the result of the reduction in force actions we took in the
fourth quarter of 2004, to streamline product management and engineering resources, so we can focus on increased sales and outbound marketing efforts. Headcount for research and development personnel was decreased by 24 employees, or approximately
25%, from 96 employees at March 31, 2004 to 72 employees at March 31, 2005.



General and administrative



For the
three months ended March 31, 2005 compared with the three months ended March 31, 2004, general and administrative expenses increased approximately $1.2 million. This increase was primarily attributable to increased expenses for legal expenses and,
audit and professional consultants expense for Sarbanes-Oxley compliance. Headcount for general and administrative personnel remained flat at 49 employees at March 31, 2005.



Restructuring credits



In 2001, we decided not to occupy our Pacific Shores facility. This decision resulted in a lease loss comprised of sublease loss, broker commissions and
other facility costs. To determine the sublease loss, the loss after our cost recovery efforts to sublease the building, certain assumptions were made relating to the (1) time period over which the building will remain vacant, (2) sublease terms and
(3) sublease rates. We established the reserves at the low end of the range of estimable cost against outstanding commitments, net of estimated future sublease income. These estimates were derived using the guidance provided in SAB No. 100,
Restructuring and Impairment Charges, and EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The lease
loss was increased in August 2002, September 2003 and September 2004, as described below and will continue to be adjusted in the future upon triggering events (change in estimate of time



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to sublease, actual sublease rates, or other factors as these changes become known). The restructuring balance as of
December 31, 2004 was $62.9 million. For the three months ended March 31, 2005, we incurred $79,000 as consulting expense in order to get property tax refund of $130,000, resulting in restructuring credit of $51,000.



In September 2004, with the approval of our Board of Directors, we reduced
our headcount in engineering, product management by 16 employees, to lower our overall cost structure and to allow us to reallocate resources to our sales operations and outbound marketing efforts. This resulted in a severance charge of $574,000
recorded as restructuring expense on the condensed consolidated statement of operations. For the three months ended March 31, 2005, severance in the amount of $41,932 was paid out.



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



The restructuring charges and balance are as follows (in thousands):



|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|---------------------------------------------------------- |  | --------- | ------ | - | ------------------- | - | --- | -------------- |  | ------------------ | - |  | - | ------ | -
|                                                           |  | LeaseLoss |        |   | SeveranceandRelated |   |     | AssetWriteDown |  | TotalRestructuring |  
|2001 Plan                                                  |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|                                                           |  |           |        |  
|Balance at December 31, 2004                               |  | $         | 62,827 |   |                     | $ |    |                |  | $                  |  |  | $ | 62,827 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Total charges for the quarter ended March 31, 2005         |  |           | (51    | ) |                     |   |    |                |  |                    |  |  |   | (51    | )
|Amount utilized in the quarter ended March 31, 2005        |  |           | (2,390 | ) |                     |   |    |                |  |                    |  |  |   | (2,390 | )
|Adjustment related to property tax                         |  |           | 130    |   |                     |   |    |                |  |                    |  |  |   | 130    |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at March 31, 2005                                  |  | $         | 60,516 |   |                     |   |    |                |  |                    |  |  | $ | 60,516 |  
|As of March 31, 2005:                                      |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Current restructuring accrual                              |  | $         | 10,288 |   |                     | $ |    |                |  | $                  |  |  | $ | 10,288 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Long-term restructuring accrual                            |  | $         | 50,228 |   |                     | $ |    |                |  | $                  |  |  | $ | 50,228 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Q3 2004 Plan                                               |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at December 31, 2004                               |  | $         |       |   |                     | $ | 81  |                |  | $                  |  |  | $ | 81     |  
|Total charges for the quarter ended March 31, 2005         |  |           |       |   |                     |   |    |                |  |                    |  |  |   |       |  
|Amount utilized in the quarter ended March 31, 2005        |  |           |       |   |                     |   | (42 | )              |  |                    |  |  |   | (42    | )
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Balance at March 31, 2005 - current                        |  | $         |       |   |                     | $ | 39  |                |  | $                  |  |  | $ | 39     |  
|                                                           |  |           |        |  
|Summary for balance at March 31, 2005 (two plans together) |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Restructuring accrual: Current                             |  | $         | 10,288 |   |                     | $ | 39  |                |  | $                  |  |  | $ | 10,327 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  
|Restructuring accrual: Long-term                           |  | $         | 50,228 |   |                     | $ |    |                |  | $                  |  |  | $ | 50,228 |  
|                                                           |  |           |        |   |                     |   |     |                |  |                    |   |  |   |        |  



Interest and Other Income, Net



For the three months ended March 31, 2005 compared
with the three months ended March 31, 2004, interest and other income, net increased approximately $0.4 million. This increase was mainly a result of higher interest income due to a more favorable interest rate environment and higher returns on
other marketable securities.



Benefit from Income Taxes.



For the three months ended March 31, 2005 and 2004,
we recorded a tax provision of $235,000 and $40,000, respectively, mainly related to our international subsidiaries. These were offset by credits of approximately $396,000 and $133,000, respectively, due to the recognition of research and
development tax credits from our Canadian operations, as well as the state tax provision of $8,000 for the three months ended March 31, 2005 and deferred tax credits of 4,000 for the three months ended March 31, 2004



Liquidity and Capital Resources



Overall



As of March 31, 2005, we had cash and cash equivalents of $69.5 million and short-term investments of approximately $18.0
million. We believe that our current cash, cash equivalents, short-term investment and other financing capabilities will be sufficient to satisfy our working capital, capital expenditure and other liquidity needs through at least the next 12 months.



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We have incurred losses since our inception, including a net loss of approximately $4.6 million for the
three months ended March 31, 2005. As of March 31, 2005, we had an accumulated deficit of approximately $288.9 million.



Cash, cash equivalents and short-term investments



Cash and cash equivalents consist of highly liquid investments in time deposits held at major banks, commercial paper, United States government agency
notes and bonds, money market mutual funds and other money market securities with original maturities of 90 days or less. Short-term investments include similar highly liquid investments that mature by March 31, 2006. Our investment policy allows
maturities of investments not in excess of fourteen months.



|                                          |  |                            |        |   |      |   |       |  
|----------------------------------------- |  | -------------------------- | ------ | - | ---- | - | ----- | -
|                                          |  | Three Months EndedMarch 31 |       
|                                          |  | 2005                       |        |   | 2004 |  
|Net cash used in operating activities     |  | $                          | (3,093 | ) |      | $ | (250  | )
|Net cash provided by investing activities |  |                            | 19,029 |   |      |   | 6,169 |  
|Net cash provided by financing activities |  |                            | 145    |   |      |   | 303   |  
|Increase in cash and cash equivalents     |  |                            | 15,964 |   |      |   | 6,219 |  



Net cash used in operating
activities



Our operating activities used cash of $3.1
million and $0.3 million during the three months ended March 31, 2005 and 2004, respectively. For the three months ended March 31, 2005, we generated cash of $5.1 million from accounts receivable which was $0.7 million higher than $4.4 million for
the three months ended March 31, 2004. This was mainly due to improved collection cycles. The restructuring accrual used cash of $2.4 equally for the three months ended March 31, 2005 and 2004, primarily due to Pacific Shore lease payments and cash
paid out for the severance resulting from the restructuring actions taken in 2001, 2002 and 2003. Other accruals used cash of 0.2 million for the three months ended March 31, 2005 and generated cash of $0.4 million for the three months ended March
31, 2004. This was primarily due to the increased payment of accruals for marketing, consulting, commissions and bonuses in the most recent period. Deferred revenue generated cash of $0.2 million for the three months ended March 31, 2004 and used
cash of $0.8 million for the three months ended March 31, 2005. This change was primarily due to the prepayments from December 2004 for professional service projects being worked into the professional service revenue in the first quarter of 2005 as
we recognized the prepayment amounts into revenue.



Net cash provided by
investing activities



Our investing activities provided
cash of $19.0 million and $6.2 million for the three months ended March 31, 2005 and 2004, respectively. The cash provided from investing activities was primarily the proceeds from maturities of investments, offset by the purchase of certain
investments, property and equipment. Our investments in property and equipment decreased slightly from $0.9 million for the three months ended March 31, 2004 to $0.4 million for the three months ended March 31, 2005, primarily resulting from an
internal software upgrade of our financial reporting system for the three months ended March 31, 2004 and no such action incurred again for the three months ended March 31, 2005.



Net cash provided by financing activities



Our financing activities generated cash of $0.1 million and $0.3 million for the three months ended March 31, 2005 and 2004, respectively. This cash
was provided solely from the proceeds from the exercise of stock options and purchases of our stock under the employee stock purchase plan.



Contractual commitments



In May 2000, we entered into a lease for our Pacific Shore facility. The lease has an eleven-year term, which began in August 2001. A $10.9 million
certificate of deposit secures a letter of credit required by the landlord for a rent deposit. In conjunction with the April 2001 restructuring plans, we decided not to occupy this leased facility. The future minimum lease payments table referenced
below does not include estimated sublease income, as there are no sublease commitments as of March 31, 2005.



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In June 2004, we signed lease agreements for three office buildings in the Menlo Park location, under
which we lease an aggregate of approximately 49,000 square feet. Each of the leases has a five-year term, expiring in August 2009 without renewal options. The initial aggregate monthly cash payment for these three leases totals approximately
$42,000.



We have contractual commitments for non-cancelable
operating real estate leases. We provide letters of credit as guarantees on these leases. The letters of credit underlying amounts are presented as restricted cash on the March 31, 2005 condensed consolidated balance sheets. As of March
31, 2005, our restricted cash balance was $11.1 million, consisting of a $10.9 million certificate of deposit required by the landlord as a rent deposit for our Pacific Shores lease and $201,000 related for our Montreal lease. These deposits
comprise our only material guarantees or commitments.



Off Balance Sheet
Arrangements



In the normal course of business, we
enter into contractual commitments to purchase goods and services from suppliers and vendors. These non-cancelable purchase obligations for goods and services were not material as of March 31, 2005.



Capital Expenditures



Our capital requirements depend on numerous factors. We do not plan to spend
more than $2.7 million on capital expenditures in the remaining nine months of 2005.



We may continue to report significant quarterly operating losses, resulting in future negative operating cash flows. However, we believe that our cash, cash equivalents and short-term investments will be sufficient to
fund our operating activities and existing contractual commitments for at least the next 12 months. Thereafter, we may need to raise additional amounts in order to: fund expansion, including increases in employees and office facilities; to develop
new or enhance existing products or services; or to respond to competitive pressures; In addition, we may, from time to time, evaluate potential acquisitions of other businesses, products and technologies, the acquisition of which could require
substantial cash expenditures. We may consider additional equity or debt financing to cover these obligations, which financing could be dilutive to existing investors. Furthermore, such funding may not be available on favorable terms or at all.



Code of Business Conduct and Ethics



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



RISK FACTORS



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



Our ability
to accurately forecast our quarterly sales is limited, most of our short term costs are relatively fixed, certain of our costs are difficult to predict, and we expect our business to be affected by seasonality. As a result, our quarterly operating
results are likely to fluctuate.



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



| |  |  | changes or projected changes in United States or international economic and political conditions;
| | - |  | -------------------------------------------------------------------------------------------------



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



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



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



| |  |  | delays in recognition of revenue for sales transactions completed but not earned, as required by applicable accounting principles;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | our ability to manage product transitions;
| | - |  | ------------------------------------------



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



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



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



| |  |  | delays in the negotiation and documentation of orders, particularly large orders and orders from large companies;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | expenses incurred in defending and settling litigation, which is difficult to predict and manage;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | changes in the amount, and the timing of our expenses;
| | - |  | ------------------------------------------------------



| |  |  | expenses incurred in responding to new corporate governance requirements, particularly those relating to the testing of internal controls; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



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



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



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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 are likely to lead to fluctuations in our quarterly operating results. Nevertheless, it is difficult for us to evaluate the degree to which this seasonality may affect our business.



We depend on a limited number of orders for a substantial portion of our revenue during
any given quarter. The loss or delay of a significant order could substantially reduce our revenue in any given period and harm our business.



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



Historically we have depended upon third-party resellers for a significant portion of our sales. The loss of key third-party resellers, or a decline in third-party
resellers resale of our products and services, could limit our ability to sustain and grow our revenue.



The percentage of our revenue obtained through indirect sales was 50% for the three months ended March 31, 2005. Although this percentage may decrease in
the future, we intend to continue to rely on third-party resellers for a significant portion of our future sales. As a result, our revenues are dependent upon the viability and financial stability of our third-party resellers, as well as upon their
continued interest and success in selling our products. In addition, some of our third-party resellers are thinly capitalized or otherwise experiencing financial difficulties. The loss of a significant third-party reseller or our failure to develop
new and viable third-party reseller relationships could limit our ability to sustain and grow our revenue. Furthermore, expansion or changes in the focus of our internal sales force, in an effort to increase third-party reseller sales or replace the
loss of a significant third-party reseller, could require increased management attention and higher expenditures.



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



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Speech software products and services generally, and our products and services in particular, may not achieve
widespread acceptance, which could require us to modify our sales and marketing efforts and could limit our ability to successfully grow our business.



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



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



| |  |  | acceptance by businesses of the benefits of speech technology;
| | - |  | --------------------------------------------------------------



| |  |  | widespread and successful deployment of speech software applications;
| | - |  | ---------------------------------------------------------------------



| |  |  | end-user demand for services and solutions having a voice user interface;
| | - |  | -------------------------------------------------------------------------



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



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



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



Our products and services can have a long sales and implementation cycle and, as a result,
our quarterly revenues and operating results may fluctuate.



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



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



After purchase by a
customer, it may take time and resources to complete any services we are providing and to integrate our software with the customers existing systems. If we are performing services that are essential to



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the functionality of the software, in connection with its implementation, we recognize license and service revenues based
on the percentage of services completed, using contract accounting. In cases where the contract specifies milestones or acceptance criteria, we may not be able to recognize either license or service revenue until these conditions are met. We have in
the past experienced, and may in the future experience, such delays in recognizing revenue. Consequently, the length of our sales and implementation cycles, the deployment process for our products, and the terms and conditions of our license and
service arrangements often make it difficult to predict the quarter in which revenue recognition may occur and may cause license and service revenue and our operating results to vary significantly from quarter to quarter.



Our current and potential competitors, some of whom have greater resources and experience
than we have, may market or develop products, services or technologies that may cause demand for, and the prices of, our products to decline.



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



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



Use of our products may infringe the intellectual property rights of others. Intellectual
property infringement claims against our customers or us could be costly to us. Such claims could also slow our sales cycle or market adoption of our products.



The software industry in general, and the field of speech and voice technologies in particular, is characterized by the
existence of a significant number of patents. Litigation and threats of litigation based on allegations of patent infringement and the violation of intellectual property rights are common in software markets and appear to be increasing. Although we
attempt to avoid infringing known proprietary rights of third parties, we do not engage in affirmative efforts to attempt to familiarize ourselves with such third-party rights, principally due to the costs that would be involved in such activities.
We may be subject to claims and legal proceedings for alleged infringement, either by us or our customers, of third-party proprietary rights, such as patents, trade secrets, trademarks or copyrights. In addition, former employers of our employees
may assert that these employees have improperly disclosed confidential or proprietary information to us.



We typically indemnify our customers against claims by third parties that our products infringe their intellectual property rights. Any claims relating to
the infringement of third-party proprietary rights, even if not successful or meritorious, could result in costly litigation, divert managements attention from our business and require us and our customers to enter into royalty or license
agreements that are costly and otherwise disadvantageous to us. Any such claims could also require us to defend our customer against the claim and



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indemnify our customer for its damages resulting from such claim. Any of these effects could have a material adverse
effect on our business and results of operations. Further, parties making these claims may be able to obtain injunctions, preventing us from selling our products. These types of claims could also slow our sales cycle and/or market adoption generally
with respect to the affected product, which could harm our business. We have recently been sued for patent infringement, the defense of which will be costly. See Part II: Other Information, Item 1. Legal Proceedings. We may be
increasingly subject to infringement claims as the number and features of our products grow, we extend our speech application business and the speech market grows.



We understand that holders of a substantial number of patents have alleged that certain of their patents cover a wide range
of automated services in the call center and computer telephony areas. We believe that one of such patent holders has sent letters to many providers of such automated services, including some of our customers, suggesting that a license under its
portfolio is required in order to provide such automated services. This holder has also sued a number of such entities, alleging patent infringement. A number of the entities against which this holder has made such claims have entered into license
agreements with respect to the holders patents. Recently, one of our customers notified us that one of such holders has claimed that the customers call center operations, which utilize our products, infringe one or more claims of the
holders patents, and has made a related indemnity claim against us. It is possible that one or more of our other customers, in response to an infringement claim by any of such patent holders, might assert indemnity rights against us, whether
or not meritorious. It is also possible that one or more of such patent holders might make a claim against us directly, whether or not meritorious. The costs associated with resolving any such disputes, regardless of the legal outcome, could be
substantial and could materially and adversely affect our operating results.



We have a history of losses. We expect to continue to incur losses in the near term, and we may not achieve or maintain profitability.



We have incurred losses aggregating in excess of $288.9 million since our inception, including a net loss of approximately $4.6 million for the three
months ended March 31, 2005. We expect to continue to spend significant amounts to develop and enhance our products, services and technologies and to enhance our delivery capabilities. As a result, we will need to generate increasing revenue to
achieve profitability. No assurance can be given that we will be able to grow our revenue. Even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. No assurances can be given that we
will be profitable or have positive cash flow at any time in the future.



Sales to customers outside the united states have historically accounted for a significant portion of our revenue, exposing us to risks inherent in international operations.



International sales represented approximately 41% of our total revenue for
the three months ended March 31, 2005. We anticipate that revenue from markets outside the United States will continue to represent a significant portion of our total revenue for the foreseeable future. We are subject to a variety of risks
associated with conducting business internationally, any of which could harm our business. These risks include the following:



| |  |  | difficulties and costs of staffing and managing foreign operations;
| | - |  | -------------------------------------------------------------------



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



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



| |  |  | longer sales and payment cycles than we experience in the United States;
| | - |  | ------------------------------------------------------------------------



| |  |  | political and economic instability outside the United States;
| | - |  | -------------------------------------------------------------



| |  |  | import or export licensing and product certification requirements;
| | - |  | ------------------------------------------------------------------



| |  |  | tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by the United States or foreign countries;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | potential adverse tax consequences, including higher marginal rates and withholding taxes;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | the impact of foreign exchange translations on the expense of our foreign operations; and
| | - |  | -----------------------------------------------------------------------------------------



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



We are exposed to general economic conditions, which may continue to harm our business.



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



Our stock price may be volatile due to many factors, some of which are outside of our
control.



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



| |  |  | actual or anticipated variations in operating results;
| | - |  | ------------------------------------------------------



| |  |  | announcements of operating results and business conditions by our customers, suppliers or competitors;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | announcements by our competitors relating to new customers, technological innovations or new products or services;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | announcements by us of new products and/or shifts in business focus or sales and distribution models;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | material increases in our capital expenditures, including for infrastructure and information technology;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | economic developments in our industry as a whole;
| | - |  | -------------------------------------------------



| |  |  | general market and economic conditions; and
| | - |  | -------------------------------------------



| |  |  | general decline and other changes in information technology and capital spending plans.
| | - |  | ---------------------------------------------------------------------------------------



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



Any defects in, or other problems with, our products could harm our business and result in claims against us.



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



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If we are unable to effectively manage our operations and resources in accordance with market and economic conditions,
our business could be harmed.



Our operations have changed
significantly over time, due in part to volatility in our business, and may continue to change in the future. We have experienced significant growth in personnel in the past. However, between April 2001 and September 2004, in five separate
restructuring actions, we reduced our workforce by approximately 42%. We may be required to expand or contract our business operations in the future to adapt to the market environment, and as a result may need to expand or contract our management,
operational, sales, marketing, financial, engineering or other human resources, as well as management information systems and controls, to align with and support any such growth or contraction. Our failure to successfully manage these types of
changes would place a substantial burden on our business, our operations and our management team, and could negatively impact sales, customer relationships and other aspects of our business.



We could be adversely impacted by the need for an increase in our restructuring accrual
for our Pacific Shores facility.



Our restructuring
accrual is represented by a lease loss created by our decision not to occupy our leased Pacific Shores facility. We added $19.2 million to that restructuring accrual in the third quarter of 2004. The accrual assumptions for such loss are based upon
estimates of real estate market conditions and values. These market conditions are subject to wide fluctuations, and market values may not improve or may decline further, which could require an additional restructuring accrual. We have attempted to
sublease the Pacific Shores facility, but, to date, have not been successful in those efforts. There can be no assurances that we will be able to sublease the facility at a lease rate approximating our estimate of its lease value, or at all. If we
are unable to sublease the facility, we will have to record an additional restructuring charge of up to $22 million, which represents the sublease income we have estimated we may receive over the remaining life of the lease of approximately eight
years.



We rely on the services of our key personnel, whose knowledge of our
business and technical expertise would be difficult to replace.



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



Our failure to successfully respond to and manage rapid change in the market for speech software could cause us to lose revenue and harm our business. It is essential that we continue to develop new products that
achieve commercial acceptance.



The speech software
industry remains immature and is rapidly changing. Our future success will depend substantially upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and features that meet
changing third-party reseller and end-user requirements and incorporate technological advancements, such as products that speed deployment and accelerate customers return on investment, as well as achieve commercial acceptance. Commercial
acceptance of new products and technologies we may introduce will depend on, among other things, the ability of our services, products and technologies to meet and adapt to the needs of our target markets; the performance and price of our products
and services and our competitors products and services; and our ability to deliver speech solutions, customer service and professional services directly and through our third-party resellers. If we are unable to develop or deploy new products
and enhance functionalities or technologies to adapt to these changes, we may be unable to retain



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existing customers or attract new customers, which could materially harm our business. In addition, as we develop new
products, sales of existing products may decrease. If we are unable to offset a decline in revenue from existing products with sales of new products, our business would be adversely affected.



Speech products are not 100% accurate, and we could be subject to claims related to the
performance of our products. Any claims, whether successful or unsuccessful, could result in significant costs and could damage our reputation.



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



We may incur a variety of costs to engage in future acquisitions of companies, products or technologies, and the anticipated benefits of those acquisitions may never
be realized.



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



| |  |  | difficulties in assimilating the operations, personnel and technologies of acquired companies;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | diversion of our managements attention from ongoing business concerns;
| | - |  | -----------------------------------------------------------------------



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



| |  |  | additional expense associated with impairments of acquired assets, such as goodwill or acquired workforce;
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | increases in the risk of claims against us, related to the intellectual property or other activities of the businesses we acquire;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | maintenance of uniform standards, controls, procedures and policies; and
| | - |  | ------------------------------------------------------------------------



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



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



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We are exposed to the liquidity problems of our customers. We may have difficulty collecting amounts owed to us.



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



Due to changed requirements relating to accounting treatment for employee stock options, we may be forced to change our business practices.



We currently account for the issuance of stock options under APB No. 25,
Accounting for Stock Issued to Employees. The Financial Accounting Standards Board now requires companies to include, effective for the first quarter of fiscal 2006, a compensation expense in their statement of operations relating to the
issuance of employee stock options. As a result, we could decide to decrease the number of employee stock options that we would grant. This could affect our ability to retain existing employees or to attract qualified candidates for open positions,
and we may have to increase the cash compensation we would have to pay to them. Issuing a number of stock options comparable to the number we have issued in the past to new or existing employees would adversely impact our results of operations under
the new accounting requirements, once they take effect.



International sales
opportunities may require us to develop localized versions of our products. If we are unable to do so timely, our ability to grow our international revenue and execute our international business strategy will be adversely affected.



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



If the industry standards we support are not adopted as the standards for speech software,
customers may not use our speech software products.



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



Our applications, Nuance Application environment and our Nuance Voice
Platform software are each designed to work, in all material respects, with the recently adopted VoiceXML standard. There are currently other, similar standards in development, some of which may become more widely adopted than VoiceXML. If VoiceXML
is not widely accepted by our target customers or if another competing standard were to become widely adopted, then sales of our products could decline and our business would be materially harmed. In that



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case, we may find it necessary to redesign our existing products or design new products that are compatible with
alternative standards that are widely adopted or that replace VoiceXML. This design or redesign could be costly and time-consuming. If a third-party proprietary technology were to become a standard, we might be precluded from developing products to
conform to that standard unless we are able to enter into agreements to license the rights to develop such products. Any such license could require us to pay substantial royalties, whether upfront or based on sales of such products, which could
materially adversely affect our margins for such products and, as a result, our results of operations.



Our 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 through reliance
upon a combination of patent, copyright, trademark and trade secret laws, as well as with our confidentiality procedures and contractual provisions. These legal protections afford only limited protection, and may be time-consuming and expensive to
obtain, maintain or enforce. Further, despite our efforts, we may be unable to prevent third parties from infringing or misappropriating our intellectual property or to recover adequate compensation from any such infringers.



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



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



Our charter and bylaws and Delaware law contain provisions which may delay or prevent a
change of control of Nuance.



Our Shareholder Rights Plan,
as well as provisions of our charter and bylaws, may make it more difficult for a third-party to acquire, or may discourage a third-party from attempting to acquire, control of Nuance. The plan and 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 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.



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We are subject to the anti-takeover provisions of the Delaware General Corporation Law, including Section
203, which may deter potential acquisition bids for our company. Under Delaware law, a corporation may opt out of Section 203. We do not presently intend to opt out of the provisions of Section 203.



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



We rely on a continuous power supply to conduct our operations, and an energy crisis could disrupt our operations and increase our expenses.



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



Information that we may provide to investors from time to time is accurate only as of the date we disseminate it and we undertake no obligation to update the
information.



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



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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



The following section describes our exposure to market risk related to changes in foreign currency exchange rates and interest rates. This section
contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors, including those set forth in the risk factors section of this Report on Form 10-Q. We believe
there have been no significant changes in our market risk exposures during the three months ended March 31, 2005 as compared to what was previously disclosed in our annual report on Form 10-K for the year ended December 31, 2004.



Foreign Currency Exchange Rate Risk



The majority of our revenues have been denominated in U.S. dollars, thus
limiting our exposure to foreign currency exchange risk. We currently do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative
purposes. We expect, however, that future product license and services revenues derived from international markets may be denominated in the currency of the applicable market. Also, we currently have substantial research and development and sales
personnel outside the United States. Costs and expenses for these employees and related expenses are in the local currency. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of
certain currencies in relation to the U.S. dollar. Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less
competitive in international markets. Although we will continue to monitor our exposure to currency fluctuations and, when appropriate, may use financial hedging techniques to minimize the effect of these fluctuations, we can give no assurances you
that exchange rate fluctuations will not adversely affect our financial results in the future.



Interest Rate Risk



As
of March 31, 2005, we had cash, cash equivalents and short-term investments of $87.6 million. Any decline in interest rates over time would reduce our interest income from our short-term and long-term investments. Based upon our balance of cash and
cash equivalents and short-term investments, an absolute reduction in interest rates of 0.5% would cause a corresponding decrease in our annual interest income by approximately $0.4 million.



ITEM 4. CONTROLS AND PROCEDURES



Based on their evaluation as of March 31, 2005, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934, as amended) were sufficiently effective to ensure that the information required to be disclosed by us in this quarterly report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the
SECs rules and Form 10-Q.



There were no changes in our
internal controls over financial reporting during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.



Our management, including our Chief Executive Officer and Chief Financial
Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance
that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Nuance have been detected.



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PART II: OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



In
April 2004, we were served with a civil complaint filed by Voice Capture, Inc. in the United States District Court for the Southern District of Iowa (the Complaint). The Complaint, which names as defendants Nuance, Intel Corporation and
Dialogic Corporation, alleges that certain software and services of the defendants infringe upon certain claims contained in U.S. Patent No. Re 34,587 (Interactive Computerized Communications Systems with Voice Input and Output). In
January 2005, we settled the case for an amount that is less than half of the projected legal fees and cost to defend the case through trial. This amount was recorded in the General and Administrative line of the condensed Consolidated
Statements of Operations. As a result of the settlement, the case has been dismissed with prejudice and the plaintiff has released all claims it may have against us.



In August 2001, the first of a number of complaints was filed, in the United States District Court for the Southern District
of New York, on behalf of a purported class of persons who purchased our stock between April 12, 2000, and December 6, 2000. Those complaints have been consolidated into one action. The complaint generally alleges that various investment bank
underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities. The complaint makes claims for violation of several provisions of the federal securities laws against those
underwriters, and also against us and some of our directors and officers. Similar lawsuits, concerning more than 250 other companies initial public offerings, were filed in 2001. In February 2003, the Court denied a motion to dismiss with
respect to the claims against us. In the third quarter of 2003, a proposed settlement in principle was reached among the plaintiffs, issuer defendants (including us) and the issuers insurance carriers. The settlement calls for the dismissal
and release of claims against the issuer defendants, including us, in exchange for a contingent payment to be paid, if necessary, by the issuer defendants insurance carriers and an assignment of certain claims. The timing of the conclusion of
the settlement remains unclear, and the settlement is subject to a number of conditions, including approval of the Court. The settlement is not expected to have any material impact upon us, as payments, if any, are expected to be made by insurance
carriers, rather than by us. In July 2004, the underwriters filed a motion opposing approval by the court of the settlement among the plaintiffs, issuers and insurers. In March 2005, the court granted preliminary approval of the settlement, subject
to the parties agreeing to modify the term of the settlement which limits each underwriter from seeking contribution against its issuer for damages it may be forced to pay in the action. In the event a settlement is not concluded, we intend to
defend the litigation vigorously. We believe that we have meritorious defenses to the claims against us.



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



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | (a) | Exhibits
| | --- | --------



Exhibit Index



|              |  |                                                                                                                                                         
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibitnumber |  | Description                                                                                                                                             
|3.1*          |  | Restated Certificate of Incorporation of the Company, as currently in effect.                                                                           
|              | 
|3.2**         |  | Bylaws of the Company, as amended, as currently in effect.                                                                                              
|              | 
|10.21         |  | Form of Change of Control and Retention Agreement with each of the Registrants executive officers, other than its Chief Executive Officer.             
|              | 
|31.1          |  | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
|              | 
|31.2          |  | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
|              | 
|32.1          |  | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  
|              | 
|32.2          |  | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002   

---

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



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



(b) Reports on Form 8-K



|                     |  |                     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-------------------- |  | ------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Date Furnished       |  | Item No.            |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                           
|February 14, 2005*** |  | Items 2.02 and 9.01 |  | On February 14, 2005, the Company furnished a report on Form 8-K to report under Item 2.02 its financial results for the quarter and fiscal year ended December 31, 2004, and to list under
Item 9.01 a press release furnished with the filing. The Companys statement of operations and balance sheet for the quarter and fiscal year ended December 31, 2004 were included with the press release that is an exhibit to the
report
|                     |  |                    
|March 23, 2005       |  | Items 1.01          |  | On March 23, 2005, the Company furnished a report from 8-K to report under Item 1.01 that the Company had entered into a Change of Control and Retention Agreement with each of its officers,
other than its Chief Executive Officer.                                                                                                                                                                                                 



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



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SIGNATURES



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



|                   |  |                             |  |                                           
|------------------ |  | --------------------------- |  | ------------------------------------------
|                   |  | NUANCE COMMUNICATIONS, INC.
|                   |  | (Registrant)               
|                   |  |                            
|Date: May 10, 2005 |  | By:                         |  | /S/    KAREN
BLASING                      
|                   |  |                             |  | Karen Blasing                             
|                   |  |                             |  | Vice President and Chief Financial Officer



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