**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549**

**FORM10-Q**

**(MarkOne)**
| **x**                                             | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------|------------------------------------------------------------------------------------------------|
| ** **                                        | ** **                                                                                     |
| **For the  quarterly period ended June 30, 2006** |
| ** **                                        |
| **OR**                                            |
| ** **                                        |
| **o**                                             | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                   |                                                                                                |  |

 

**Forthe transition period from            to                     **

**CommissionFile Number 0-22871**

**OMTOOL,LTD.**(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**                                              |   | **02-0447481**          |
|-----------------------------------------------------------|--------|-------------------------|
| (State or Other  Jurisdiction of                          |   | (I.R.S. Employer        |
| Incorporation or  Organization)                           |   | Identification  Number) |
|                                                      |   |                    |
| **6  Riverside Drive, Andover, MA**                       |   | **01810**               |
| (Address of  Principal Executive Offices)                 |   | (Zip Code)              |
|                                                      |   |                    |
| **(978)  327-5700**                                       |
| (Registrant’s  Telephone Number Including Area Code) |

 

Indicate by check markwhether the Registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

Yes  x  No  o

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition ofaccelerated filer and large accelerated filer in Rule 12b-2 of the ExchangeAct.

| Large Accelerated  Filer  o |   | Accelerated  Filer o |   | Non-accelerated  Filerx |
|---------------------------------------|--------|----------------------|--------|-------------------------|

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o  No  x

There were 4,017,333shares of the Company’s common stock, par value $0.01, outstanding on August 3,2006.

 

 

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**OMTOOL,LTD. AND SUBSIDIARIES**

FORM 10-QFor the Quarter Ended June 30, 2006CONTENTS

 
| Item Number                                                                                                            | ** ** | ** ** | ** ** | **Page Number** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                                                                                                                  | ** ** | ** ** | ** ** |
| PART  I:   FINANCIAL  INFORMATION                                                                                 |       |       |       |
|                                                                                                                        |       |       |       |
| Item 1.     Consolidated  Financial Statements                                                          |       | 3          |       |
| Consolidated  Balance Sheets as of June 30, 2006 (Unaudited) and December 31, 2005                                          |       | 3          |       |
| Consolidated Statements of Operations for the three  months and six months ended June 30, 2006 and 2005 (Unaudited)         |       | 4          |       |
| Consolidated Statements of Cash Flows for the six  months ended June 30, 2006 and 2005 (Unaudited)                          |       | 5          |       |
| Notes to Consolidated Financial Statements                                                                                  |       | 6          |       |
|                                                                                                                        |       |       |       |
| Item 2.     Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 11         |       |
|                                                                                                                        |       |       |       |
| Item 3.     Quantitative  and Qualitative Disclosures About Market Risk                                 |       | 25         |       |
|                                                                                                                        |       |       |       |
| Item 4.     Controls  and Procedures                                                                    |       | 25         |       |
|                                                                                                                        |       |       |       |
| PART  II:   OTHER  INFORMATION                                                                                    |       | 26         |       |
|                                                                                                                        |       |       |       |
| Item  1A.   Risk  Factors                                                                                         |       | 26         |       |
|                                                                                                                        |       |       |       |
| Item 2.     Unregistered  Sales of Equity Securities and Use of Proceeds                                |       | 26         |       |
|                                                                                                                        |       |       |       |
| Item 4.     Submission  of Matters to Vote of Security Holders                                          |       | 26         |       |
|                                                                                                                        |       |       |       |
| Item  5.     Other  Information                                                                         |       | 26         |       |
|                                                                                                                        |       |       |       |
| Item 6.     Exhibits                                                                                    |       | 27         |       |
|                                                                                                                        |       |       |       |
| Signatures                                                                                                                  |       | 28         |       |
|                                                                                                                        |       |       |       |
| Exhibit  Index                                                                                                              |       | 29         | ** ** |
|                                                                                                                        |       |       |       |
| Exhibits                                                                                                                    |       |       |       |

 

 

2

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**PART I:  FINANCIAL INFORMATION**

**Item 1.  Consolidated Financial Statements**

**OMTOOL, LTD. AND SUBSIDIARIES**

**ConsolidatedBalance Sheets**
| ** **                                                                                                                                                                                                                                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                         | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                         |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                    |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                         |       | $                       | 6,825,449  |                        | $          | 10,471,272 |   |
| Accounts receivable,  net of reserves of $32,000 at June 30, 2006 and $33,000 at  December 31, 2005                                                                                                                                                                |       | 1,935,361               |       | 1,618,799                   |       |
| Inventory                                                                                                                                                                                                                                                          |       | 147,147                 |       | 58,380                      |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                                                         |       | 453,981                 |       | 333,419                     |       |
| Total current assets                                                                                                                                                                                                                                               |       | 9,361,938               |       | 12,481,870                  |       |
| Property and equipment,  net                                                                                                                                                                                                                                       |       | 1,503,392               |       | 175,566                     |       |
| Other assets                                                                                                                                                                                                                                                       |       | 53,130                  |       | 11,562                      |       |
| Total assets                                                                                                                                                                                                                                                       |       | $                       | 10,918,460 |                        | $          | 12,668,998 |   |
|                                                                                                                                                                                                                                                               |       |                    |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                               |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                   |       | $                       | 1,267,081  |                        | $          | 905,288 |   |
| Accrued liabilities                                                                                                                                                                                                                                                |       | 1,209,657               |       | 1,170,508                   |       |
| Accrued state sales tax                                                                                                                                                                                                                                            |       | 321,976                 |       | 343,279                     |       |
| Deferred revenue,  current                                                                                                                                                                                                                                         |       | 3,599,704               |       | 3,408,002                   |       |
| Capital lease  obligations, current                                                                                                                                                                                                                                |       | 84,626                  |       | —                      |       |
| Total current  liabilities                                                                                                                                                                                                                                         |       | 6,483,044               |       | 5,827,077                   |       |
| Long term liabilities:                                                                                                                                                                                                                                             |       |                    |       |                        |       |
| Deferred revenue,  long-term                                                                                                                                                                                                                                       |       | 423,351                 |       | 410,232                     |       |
| Deferred rent                                                                                                                                                                                                                                                      |       | 309,950                 |       | —                      |       |
| Capital lease  obligations, long-term                                                                                                                                                                                                                              |       | 399,338                 |       | —                      |       |
| Total liabilities                                                                                                                                                                                                                                                  |       | 7,615,683               |       | 6,237,309                   |       |
|                                                                                                                                                                                                                                                               |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                         |       |                    |       |                        |       |
| Preferred Stock, $0.01  par value —   Authorized — 2,000,000 shares; Issued and outstanding — none                                                                                                                                                  |       | —                  |       | —                      |       |
| Common Stock, $0.01 par  value —   Authorized — 35,000,000 shares; Issued — 4,367,878 shares at June 30, 2006  and December 31, 2005; Outstanding — 4,015,147 shares at June 30, 2006 and  3,977,022 shares at December 31, 2005, respectively |       | 43,679                  |       | 43,679                      |       |
| Deferred compensation                                                                                                                                                                                                                                              |       | —                  |       | (775,865                    | )          |
| Additional paid-in  capital                                                                                                                                                                                                                                        |       | 34,624,647              |       | 35,556,639                  |       |
| Accumulated deficit                                                                                                                                                                                                                                                |       | (29,493,261             | )          | (26,327,762                 | )          |
| Treasury stock, at  cost, 352,731 shares at June 30, 2006 and 390,856 shares at  December 31, 2005                                                                                                                                                                 |       | (1,823,345              | )          | (2,005,618                  | )          |
| Accumulated other  comprehensive loss                                                                                                                                                                                                                              |       | (48,943                 | )          | (59,384                     | )          |
| Total stockholders’  equity                                                                                                                                                                                                                                   |       | 3,302,777               |       | 6,431,689                   |       |
|                                                                                                                                                                                                                                                               |       |                    |       |                        |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                    |       | $                       | 10,918,460 |                        | $          | 12,668,998 |   |

 

The accompanyingnotes are an integral part of these unaudited consolidated financialstatements.

3

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**OMTOOL, LTD. AND SUBSIDIARIES**

**Consolidated Statements of Operations**

**(Unaudited)**
| ** **                                               | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Software license                                         |       | $                                               | 925,896    |                                          | $          | 1,138,060 |   | $ | 1,957,715 |   | $ | 2,455,689 |   |
| Hardware                                                 |       | 406,667                                         |       | 721,963                                       |       | 964,067 |   | 1,559,307 |   |
| Service and  other                                       |       | 1,735,993                                       |       | 1,710,276                                     |       | 3,483,278 |   | 3,416,787 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Total revenue                                            |       | 3,068,556                                       |       | 3,570,299                                     |       | 6,405,060 |   | 7,431,783 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Cost of revenue:                                         |       |                                            |       |                                          |       |   |   |   |   |
| Software license                                         |       | 52,000                                          |       | 50,435                                        |       | 83,441 |   | 71,202 |   |
| Hardware                                                 |       | 269,604                                         |       | 483,703                                       |       | 614,682 |   | 1,027,380 |   |
| Service and  other                                       |       | 881,684                                         |       | 681,752                                       |       | 1,594,783 |   | 1,399,127 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Total cost of  revenue                                   |       | 1,203,288                                       |       | 1,215,890                                     |       | 2,292,906 |   | 2,497,709 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Gross profit                                             |       | 1,865,268                                       |       | 2,354,409                                     |       | 4,112,154 |   | 4,934,074 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Operating  expenses:                                     |       |                                            |       |                                          |       |   |   |   |   |
| Sales and  marketing                                     |       | 2,158,993                                       |       | 1,140,936                                     |       | 4,211,200 |   | 2,320,252 |   |
| Research and development                                 |       | 724,302                                         |       | 520,700                                       |       | 1,431,554 |   | 1,037,690 |   |
| General and  administrative                              |       | 818,486                                         |       | 726,137                                       |       | 1,718,428 |   | 1,501,308 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Total operating  expenses                                |       | 3,701,781                                       |       | 2,387,773                                     |       | 7,361,182 |   | 4,859,250 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Income (loss)  from operations                           |       | (1,836,513                                      | )          | (33,364                                       | )          | (3,249,028 | ) | 74,824 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Interest and  other income, net                          |       | 39,016                                          |       | 45,128                                        |       | 83,529 |   | 85,757 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Income (loss)  before income tax provision               |       | (1,797,497                                      | )          | 11,764                                        |       | (3,165,499 | ) | 160,581 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Income tax  provision                                    |       | —                                          |       | —                                        |       | — |   | 6,777 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Net income  (loss)                                       |       | $                                               | (1,797,497 | )                                             | $          | 11,764 |   | $ | (3,165,499 | ) | $ | 153,804 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Net income  (loss) per share:                            |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                    |       | $                                               | (0.45      | )                                             | $          | 0.00 |   | $ | (0.79 | ) | $ | 0.04 |   |
| Diluted                                                  |       | $                                               | (0.45      | )                                             | $          | 0.00 |   | $ | (0.79 | ) | $ | 0.04 |   |
|                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average  shares used in per share calculations: |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                    |       | 4,031,512                                       |       | 3,914,874                                     |       | 4,026,073 |   | 3,903,982 |   |
| Diluted                                                  |       | 4,031,512                                       |       | 4,047,807                                     |       | 4,026,073 |   | 4,050,652 |   |

 

The accompanyingnotes are an integral part of these unaudited consolidated financial statements*.*

4

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**OMTOOL, LTD. AND SUBSIDIARIES**

**Consolidated Statements of Cash Flows**

**(Unaudited)**
| ** **                                                                                                | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Cash Flows from  Operating Activities:                                                                    |       |                                          |       |   |   |
| Net income  (loss)                                                                                        |       | $                                             | (3,165,499 | ) | $ | 153,804 |   |
| Adjustments to  reconcile net income (loss) to net cash (used in) provided by operating  activities— |       |                                          |       |   |   |
| Depreciation                                                                                              |       | 88,248                                        |       | 85,773 |   |
| Accounts  receivable reserves                                                                             |       | (641                                          | )          | (37,565 | ) |
| Stock-based  compensation                                                                                 |       | 166,854                                       |       | 47,656 |   |
| Changes in  assets and liabilities:                                                                       |       |                                          |       |   |   |
| Accounts  receivable                                                                                      |       | (302,883                                      | )          | 473,510 |   |
| Prepaid expenses  and other current assets                                                                |       | (115,606                                      | )          | (62,213 | ) |
| Inventory                                                                                                 |       | (88,767                                       | )          | 120,218 |   |
| Other assets                                                                                              |       | (41,568                                       | )          | — |   |
| Accounts payable                                                                                          |       | 356,361                                       |       | 22,246 |   |
| Accrued  liabilities                                                                                      |       | 32,595                                        |       | 35,083 |   |
| Accrued state  sales tax                                                                                  |       | (21,302                                       | )          | (103,926 | ) |
| Deferred revenue                                                                                          |       | 172,817                                       |       | (178,177 | ) |
| Deferred rent                                                                                             |       | 309,950                                       |       | — |   |
|                                                                                                      |       |                                          |       |   |   |
| Net cash (used  in) provided by operating activities                                                      |       | (2,609,441                                    | )          | 556,409 |   |
|                                                                                                      |       |                                          |       |   |   |
| Cash Flows from  Investing Activities:                                                                    |       |                                          |       |   |   |
| Purchases of  property and equipment                                                                      |       | (920,861                                      | )          | (63,594 | ) |
|                                                                                                      |       |                                          |       |   |   |
| Net cash used in  investing activities                                                                    |       | (920,861                                      | )          | (63,594 | ) |
|                                                                                                      |       |                                          |       |   |   |
| Cash Flows from  Financing Activities:                                                                    |       |                                          |       |   |   |
| Net proceeds  from issuance of common stock                                                               |       | 11,937                                        |       | 20,589 |   |
| Net proceeds  from issuance of restricted common stock                                                    |       | 622                                           |       | — |   |
| Purchase of  treasury stock                                                                               |       | (153,267                                      | )          | — |   |
| Repayment of  capital lease obligations                                                                   |       | (9,826                                        | )          | — |   |
|                                                                                                      |       |                                          |       |   |   |
| Net cash (used  in) provided by financing activities                                                      |       | (150,534                                      | )          | 20,589 |   |
|                                                                                                      |       |                                          |       |   |   |
| Exchange rate  effect on cash and cash equivalents                                                        |       | 35,013                                        |       | (43,508 | ) |
|                                                                                                      |       |                                          |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                                     |       | (3,645,823                                    | )          | 469,896 |   |
|                                                                                                      |       |                                          |       |   |   |
| Cash and cash  equivalents, beginning of period                                                           |       | 10,471,272                                    |       | 10,655,121 |   |
|                                                                                                      |       |                                          |       |   |   |
| Cash and cash  equivalents, end of period                                                                 |       | $                                             | 6,825,449  |   | $ | 11,125,017 |   |
|                                                                                                      |       |                                          |       |   |   |
| Supplemental  Disclosure of Noncash Investing and Financing Activities:                                   |       |                                          |       |   |   |
| Property and equipment  purchased under capital lease                                                     |       | $                                             | 493,790    |   | $ | — |   |

 

The accompanyingnotes are an integral part of these unaudited consolidated financial statements*.*

5

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**OMTOOL,LTD. AND SUBSIDIARIES**

**Notes to Consolidated FinancialStatements**

(Unaudited)

**(1)**** Basis ofPresentation**

Omtool, Ltd. (“Omtool” orthe “Company”) provides document routing solutions and services that enableorganizations to manage the capture, processing and distribution of “mixed-mode”documents (i.e., documents that contain both paper and electronic components)to electronic information systems such as enterprise content management,document management, records management, e-mail and document-archiving systems,leveraging application interfaces with which users are already familiar.  The accompanying unaudited consolidatedfinancial statements have been prepared by Omtool pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”) regarding interimfinancial reporting.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements and should be read in conjunction with theconsolidated financial statements and notes thereto for the year ended December31, 2005 as filed with the SEC as part of the Company’s Annual Report on Form10-K on March 28, 2006.  The accompanyingunaudited consolidated financial statements reflect all adjustments (consistingof normal recurring adjustments) that are, in the opinion of management,necessary for a fair presentation of results for the interim periodspresented.  The results of operations for the three and six month periodsended June 30, 2006 are not necessarily indicative of the results to beexpected for the full fiscal year.

Certain amounts in the December 31, 2005 financialstatements have been reclassified to conform to the current periodpresentation.

**(2)** **Net Income (Loss) per Common Share**

The Company reports earnings per share in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 128,*“Earnings per Share*.*”* The dilutive effect of potential common shares consisting of outstanding stockoptions and a stock warrant is determined using the treasury stock method, inaccordance with SFAS No. 128.  Diluted weighted average sharesoutstanding for the three and six month periods ended June 30, 2006, excludes408,288 of potential common shares from stock options and a stock warrantbecause to include them would have been anti-dilutive for the periods presentedas the Company reported a net loss during the periods.  For the three months and six months endedJune 30, 2005, the dilutive calculation excludes 151,824 and 151,682 shares ofcommon stock, respectively, potentially issuable upon the exercise ofoutstanding stock options that have an anti-dilutive effect since theirexercise price exceeds the market value of the Company’s common stock.  Areconciliation of basic and diluted common shares outstanding is as follows:
| ** **                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average number  of common shares outstanding           |       | 4,031,512                                       |       | 3,914,874                                     |       | 4,026,073 |   | 3,903,982 |   |
| Potential common shares  pursuant to stock options and warrant  |       | —                                          |       | 132,933                                       |       | — |   | 146,670 |   |
| Diluted weighted  average shares                                |       | 4,031,512                                       |       | 4,047,807                                     |       | 4,026,073 |   | 4,050,652 |   |
| Basic net income (loss)  per common share                       |       | $                                               | (0.45      | )                                             | $          | 0.00 |   | $ | (0.79 | ) | $ | 0.04 |   |
| Diluted net income (loss) per common and potential common share |       | $                                               | (0.45      | )                                             | $          | 0.00 |   | $ | (0.79 | ) | $ | 0.04 |   |

 

**(3)****  Income Taxes**

SFAS No. 109,**“*Accounting for Income Taxes*,”** requires a valuation allowance to be recordedagainst deferred tax assets when it is more likely than not that some or all ofthe deferred tax assets will not be realized.  As a result of cumulativelosses in recent years and continued economic uncertainty, the Company hasprovided a full valuation allowance against its net deferred tax assets andwill do so until it returns to an appropriate level of sustained taxableincome.  The ultimate realization of these deferred tax assets dependsupon the Company’s ability to generate sufficient future taxable income.  If the Company is successful in generatingsufficient future taxable income, the Company will reduce the valuationallowance through a reduction in income tax expense in the future.

During the sixmonths ended June 30, 2006, the Company did not record a tax provision due tothe net loss incurred during the period. During the six months ended June 30, 2005, the Company recorded a taxprovision of approximately $7,000 for expected tax liability in the UnitedStates.

6

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**(4)**** ComprehensiveIncome (Loss)**

The components of the Company’s comprehensive income(loss) are as follows:

 
| ** **                                | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income  (loss)                        |       | $                                               | (1,797,497 | )                                             | $          | 11,764 |   | $ | (3,165,499 | ) | $ | 153,804 |   |
| Foreign currency  translation adjustments |       | 3,256                                           |       | (14,077                                       | )          | 10,441 |   | (24,213 | ) |
| Comprehensive income  (loss)              |       | $                                               | (1,794,241 | )                                             | $          | (2,313 | ) | $ | (3,155,058 | ) | $ | 129,591 |   |

 

**(5)**** Stock BasedCompensation**

The Company’s 1996 StockOption Plan and 1997 Stock Plan, as amended, provide for the issuance of commonstock pursuant to the grant to employees of “incentive stock options” withinthe meaning of the Internal Revenue Code and the grant of nonqualified stockoptions, stock awards or opportunities to make direct purchases of stock in theCompany to employees, consultants, directors and officers of the Company.  The aggregate number of shares of commonstock that may be issued pursuant to the 1997 Stock Plan is 1,228,570.  Shares issued pursuant to these plans areissued from treasury to the extent they are available.

Prior to January1, 2006, the Company accounted for its other stock-based compensation foremployees under Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issued to Employees*” and related interpretations andfollowed the disclosure-only alternative under SFAS No. 123, “*Accounting for Stock-Based Compensation*,”as amended by SFAS No. 148, “*Accountingfor Stock-Based Compensation — Transition and Disclosure*,” for options granted using theBlack-Scholes option pricing model.

Effective January1, 2006, the Company adopted the provisions of SFAS No. 123(R), “*Share-Based Payment*”**(“SFAS No.123R”), using the modified prospective method. SFAS No. 123R requires the Company to measure the cost of employeeservices in exchange for an award of an equity instrument based on thegrant-date fair value of the award and to recognize expense over the requisiteservice period.  Under the modifiedprospective method, financial statements for periods prior to the date ofadoption are not adjusted for the change in accounting, thus, prior periodfinancial statements have not been restated. However, compensation expense is recognized for (a) all share-basedpayments granted after the effective date and (b) all awards granted toemployees prior to the effective date that remain unvested on the effectivedate.

As a result of adoptingSFAS No. 123R as of January 1, 2006, the Company incurred stock-basedcompensation expense during the three and six months ended June 30, 2006 ofapproximately $7,000 and $15,000 for stock options and shares purchased underour employee stock purchase plan, of which $1,000 and $3,000, respectively, isrecorded in cost of service and other revenue and $6,000 and $12,000,respectively, is recorded in operating expenses.

The net impact ofadopting the new accounting guidance was as follows:
| ** **                             | ** ** | **Three months ended June 30, 2006** | ** ** | **Six months ended June 30, 2006**       | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                             | ** ** | **Under Adoption of  SFAS No. 123R**      | ** ** | **If SFAS 123R   had not  been adopted** | ** ** | **Under Adoption  of SFAS  No. 123R** | ** ** | **If SFAS 123R  had not  been adopted** | ** ** |
| Loss from  operations                  |       | $                                                             | (1,836,513 | )                                                                 | $          | (1,828,922 | ) | $ | (3,249,028 | ) | $ | (3,233,768 | ) |
| Net Loss                               |       | $                                                             | (1,797,497 | )                                                                 | $          | (1,789,906 | ) | $ | (3,165,499 | ) | $ | (3,150,239 | ) |
| Cash Used in  Operating Activities     |       | $                                                             | (1,643,617 | )                                                                 | $          | (1,636,026 | ) | $ | (2,609,441 | ) | $ | (2,594,181 | ) |
| Cash Provided by  Financing Activities |       | $                                                             | 348,359    |                                                              | $          | 348,359 |   | $ | 343,256 |   | $ | 343,256 |   |
| Basic Loss per  Share                  |       | $                                                             | (0.45      | )                                                                 | $          | (0.44 | ) | $ | (0.79 | ) | $ | (0.78 | ) |
| Diluted Loss per Share                 |       | $                                                             | (0.45      | )                                                                 | $          | (0.44 | ) | $ | (0.79 | ) | $ | (0.78 | ) |

 

The following tableillustrates the effect on net income and net income per share that would havebeen reported if the fair value method had been used to account for stock-basedcompensation in 2005.  The estimated fairvalue of each option is calculated using the Black-Scholes option-pricingmodel.

7

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| ** **                                                                                                  | ** ** | **Three months  Ended  June 30,** | ** ** | **Six months  Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                    | ** ** | **2005**                                  | ** ** |
| Net income, as  reported                                                                                    |       | $                                           | 11,764     |                                      | $          | 153,804 |   |
| Add: Stock  compensation included in net income                                                             |       | 28,241                                      |       | 47,656                                    |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value method  for all awards |       | (42,562                                     | )          | (88,266                                   | )          |
| Pro forma net  income (loss)                                                                                |       | $                                           | (2,557     | )                                         | $          | 113,046 |   |
|                                                                                                        |       |                                        |       |                                      |       |
| Net income per  share:                                                                                      |       |                                        |       |                                      |       |
| Basic, as  reported                                                                                         |       | $                                           | 0.00       |                                      | $          | 0.04 |   |
| Diluted, as  reported                                                                                       |       | $                                           | 0.00       |                                      | $          | 0.04 |   |
| Basic, pro forma                                                                                            |       | $                                           | 0.00       |                                      | $          | 0.03 |   |
| Diluted, pro forma                                                                                          |       | $                                           | 0.00       |                                      | $          | 0.03 |   |

 

***Stock Options***

Under the terms ofthe Company’s 1996 Stock Option Plan and 1997 Stock Plan, options vest andbecome exercisable as determined by the Board of Directors and expire10 years after the date of grant. In 1997, the Company’s Board of Directors voted that no further optionswould be granted or issued under the Company’s 1996 Stock Option Plan. Inaccordance with the 1997 Stock Plan, stock options that are canceled or expiredare added back to the potential options available for future issuance.  Stockoption compensation expense calculated under the fair value approach isrecognized ratably over the four year vesting period.  The fair value for granted options wasestimated at the time of grant using the Black-Scholes option-pricingmodel.  Based upon historical informationand management’s estimate of future voluntary turnover rates, theCompany has calculated this expense based on an annualized estimated forfeiture rate of 10%.  The Company trues-up estimated forfeitures toactual at the end of each reporting period. The Company did not grant any stock options during the six months endedJune 30, 2006 or June 30, 2005.  Thetotal fair value of stock options vested during the three and six month periodsended June 30, 2006 was $4,000 and $8,000, respectively.

Total compensation expense related to unvested stock options was $21,000as of June 30, 2006, which amount the Company expects to recognize over aweighted average period of 1.3 years.

Stock option activity for the six months ended June 30, 2006 was as follows:
| ** **                           | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life in Years** | ** ** | **Aggregate   Intrinsic  Value** | ** ** |
|--------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------|------------|
| Outstanding,  December 31, 2005 |       | 363,714                    |       | $                                          | 5.73       |                                                                   |       |                                  |       |   |
| Granted                              |       | —                     |       | —                                     |       |                                                                   |       |                                  |       |
| Exercised                            |       | (2,572                     | )          | 0.83                                       |       |                                                                   |       |                                  |       |
| Canceled and  expired                |       | (3,854                     | )          | 7.91                                       |       |                                                                   |       |                                  |       |
| Outstanding,  June 30, 2006          |       | 357,288                    |       | $                                          | 5.75       |                                                                   | 4.6        |                                  | $          | 1,212,137 |   |
| Exercisable, June 30,  2006          |       | 333,978                    |       | $                                          | 6.01       |                                                                   | 4.5        |                                  | $          | 1,181,524 |   |

 

***Employee StockPurchase Plan***

The Company’s 1997Employee Stock Purchase Plan (the “1997 Purchase Plan”) provides for theissuance of a maximum of 57,142 shares of common stock pursuant to the exerciseof nontransferable options granted to participating employees.  The exercise price for the option for eachsix-month purchase period is 85% of the lesser of the market price of thecommon stock on the first or last business day of the six-month purchaseperiod.  Employee stock purchase plan compensation expense calculated under thefair value approach is recognized ratably over the six-month purchaseperiod.  The weighted average fair valueof the shares purchased under the employee stock purchase plan was $2.79 forthe six month period ended June 30, 2006, based upon the following assumptions:

 
| ** **               | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|--------------------------|------------|---------------------------------------------------------|------------|
| Risk-free  interest rate |       | 4.4                                                     | %          |
| Volatility               |       | 95.0                                                    | %          |
| Expected  dividend yield |       | 0.0                                                     |       |
| Expected life            |       | 0.5 Years                                               |       |

 

8

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Historical Company information was the primary basis for the expectedvolatility assumptions.  The expectedlife is equal to the six-month purchase period. As of June 30, 2006, there was no unrecognized expense related toestimated purchases.

***Restricted Stock***

The Company sells sharesof restricted common stock (“restricted stock”) under the Company’s 1997 StockPlan, as amended, to its Board of Directors and certain employees of theCompany at a price per share of $0.01. The shares of restricted stock vest ratably over a four year serviceperiod.  In the event that a restrictedstockholder ceases to provide services to the Company prior to the vesting ofany of the then unvested shares held by that stockholder, the restrictedstockholder is required to sell any unvested shares of restricted stock back tothe Company at the original purchase price of $0.01 per share.

Priorto the adoption of SFAS No. 123R, the Company recorded deferred compensationbased on the intrinsic value of the shares of restricted stock at the time ofsale.  The Company then recognizeddeferred compensation as compensation expense ratably over the expected fouryear vesting period.  Due to the adoptionof SFAS No. 123R, the balance of deferred compensation of approximately$776,000, relating entirely to restricted stock grants, as of December 31,2005, has been reclassified to additional paid-in-capital in the accompanyingunaudited consolidated balance sheet as of June 30, 2006.  With respect to restricted stock, the Companyrecognized approximately $82,000 and $152,000 of stock-based compensationexpense during the three and six month periods ended June 30, 2006,respectively, and $28,000 and $47,000 during the three and six month periodsended June 30, 2005, respectively.

Restricted stockcompensation expense calculated under the fair value approach is based upon thecurrent stock price and is recognized ratably over the four year vesting period.  Based upon historical information andmanagement’s estimate of future voluntary turnover rates, the Company hascalculated this expense based on an annualized estimated forfeiture rate of6%.  The Company trues-up estimatedforfeitures to actual at the end of each reporting period.  During the six months ended June 30, 2006 andJune 30, 2005, the Company sold 62,196 and 58,683 shares of restricted stock,respectively.  The aggregate fair valueof restricted stock vested during the six month period ended June 30, 2006 was$111,000.

Total compensationexpense related to unvested shares of restricted stock was $1,038,000 as ofJune 30, 2006, which amount the Company expects to recognize over a weightedaverage period of 3.2 years.

Restricted stock activity for the six months ended June 30, 2006 was asfollows:
| ** **                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| Unvested,  December 31, 2005 |       | 114,260                    |       | $                                                       | 7.90       |   |
| Granted                           |       | 62,196                     |       | 6.84                                                    |       |
| Vested                            |       | (14,357                    | )          | 7.70                                                    |       |
| Forfeited                         |       | (1,406                     | )          | 7.70                                                    |       |
| Unvested, June 30, 2006           |       | 160,693                    |       | 7.51                                                    |       |
|                                   |            |                            |            |                                                         |            |  |

 

**(6)****           Accrued Liabilities**

Accrued liabilities consist of the following:
| ** **                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Accrued health  insurance expense  |       | $                       | 258,083    |                        | $          | 169,811 |   |
| Accrued salary  and salary-related |       | 529,818                 |       | 639,297                     |       |
| Accrued professional  fees         |       | 136,875                 |       | 128,801                     |       |
| Other accrued  expenses            |       | 284,881                 |       | 232,599                     |       |
|                               |       | $                       | 1,209,657  |                        | $          | 1,170,508 |   |

 

(7)           **Capital Lease Obligations**

The Companyentered into a capital lease agreement in the amount of $490,736 on May 1, 2006to finance the purchase of furniture and equipment for the Company’s newheadquarters located in Andover, Massachusetts. The lease has a five year term which expires on May 31, 2011 and ispayable in 60 equal monthly installments. The interest rate on the capital lease is 6.2%.  Total interest payments over the life of thelease are estimated to be $98,812.  Thelease contains a provision whereby the Company would pay the outstandingprincipal balance should the Company’s cash balance be less than $5,000,000.

9

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(8)  **Deferred Rent**

In January 2006,the Company entered into a new lease agreement for approximately 44,000 squarefeet of office space.  The Company movedto the new the new headquarters located in Andover, Massachusetts in April 2006.The lease has a ten-year term with an option to renew the lease for anadditional five-year term at the then-applicable fair market rent.  Under the terms of the lease, the Companyreceives free rent for the first six months and the landlord will provide a tenantimprovement allowance of up to $308,000. The balance of deferred rent in the accompanying balance sheet as ofJune 30, 2006, represents the accumulated amount due for the free rent periodplus the tenant improvement allowance of $247,000 received as of June 30, 2006.

** (9)         **** Segment andGeographic Information**

To date, the Company has viewed its operations andmanages its business as principally one segment, software and hardware salesand associated services. As a result, the financial information disclosedherein represents all of the material financial information related to theCompany’s principal operating segment in accordance with SFAS No. 131,**“*Disclosures About Segments of an Enterprise andRelated Information*.”

Total revenue from international sources was $512,000and $950,000 for the three months and six months ended June 30, 2006 and$807,000 and $1.3 million for the three months and six months ended June 30,2005, respectively.  The following tablerepresents amounts relating to geographic locations:
| ** **         | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **         | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total revenue  (1) | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States      |       | $                                               | 2,556,467  |                                          | $          | 2,763,512 |   | $ | 5,455,134 |   | $ | 6,169,920 |   |
| United Kingdom     |       | 164,692                                         |       | 313,610                                       |       | 336,306 |   | 495,532 |   |
| Canada             |       | 177,715                                         |       | 175,851                                       |       | 352,983 |   | 273,727 |   |
| South Africa       |       | 50,884                                          |       | 139,901                                       |       | 81,537 |   | 176,563 |   |
| Rest of World      |       | 118,798                                         |       | 177,425                                       |       | 179,100 |   | 316,041 |   |
|               |       | $                                               | 3,068,556  |                                          | $          | 3,570,299 |   | $ | 6,405,060 |   | $ | 7,431,783 |   |

 

 
| ** **             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Long-lived  assets (2) | ** ** | ** **              | ** ** | ** **                  | ** ** |
| United States          |       | $                       | 1,534,407  |                        | $          | 168,360 | ** ** |
| United Kingdom         |       | 22,115                  |       | 18,768                      | ** ** |
|                   |       | $                       | 1,556,522  |                        | $          | 187,128 | ** ** |

----

(1)             Revenue is attributedto geographic regions based on location of customer.

(2)             Long-livedassets include property and equipment and other assets.

10

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**Item 2.**

**MANAGEMENT’SDISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

Management’s Discussionand Analysis of Financial Condition and Results of Operations for the three andsix months ended June 30, 2006 should be read in conjunction with theaccompanying consolidated financial statements for the periods specified andthe associated notes.  Further reference should be made to our AnnualReport on Form 10-K for the year ended December 31, 2005, as filed with the SECon March 28, 2006.

**Overview**

In the first quarter of 2004, we introduced a new and innovative documentrouting platform for the distributed capture, process and distribution of bothpaper and electronic documents.  Thatplatform, AccuRoute® 2.0,was initially targeted at the legal vertical market.  Although AccuRoute’s features are horizontalin nature and apply to many different markets - not just the legal verticalmarket, we made a strategic decision to focus primarily on the legal verticalmarket for two reasons.  First, webelieved the characteristics of the legal vertical market were such that acompany of our size could identify, segment and, using our small direct salesforce, sell to the majority of the largest law firms.    Second, based on our enterprise fax experiencein that vertical market, we understood that large law firms had intensedocument routing requirements due to their paper-intensive businessprocesses.   These were requirementswhich we believed closely matched those of much larger enterprises and couldprovide the foundation for future market expansion.  Today, we view this strategy as having beenvery successful.  Despite the relativelysmall size of the legal vertical market, to date we have added over 140 lawfirms as AccuRoute customers, including 34 of the top 100 law firms in the U.S.

AccuRoute has received product accolades from leading industry vendorsand product analysts, which we believe underscores the product capabilities forother key vertical markets.

At this time, we expect that our leading position in the document captureand routing segment of the legal vertical market will continue to be an area ofprimary focus for us, but will not continue to provide the substantial growthopportunities we are seeking to achieve. Based on our success in the legal vertical market, the industryaccolades about AccuRoute that we continue to receive from third parties andthe fact that AccuRoute sales presently represent more than 50% of our softwarelicense revenue, we see a large market opportunity for AccuRoute in severalother vertical market segments, particularly finance and healthcare.

In April 2005, we outlined a strategic initiative to significantlyincrease our investments in sales and marketing in order to capitalize on thatlarger market opportunity.  Although oursales and marketing expenses increased gradually during the latter half of2005, we did not fill the key senior management positions in sales andmarketing until October and November of 2005 and have since continued to buildout our sales teams.  As a result, wehave not yet achieved the market success we anticipate in those segments.  Despite the relatively recent completion ofthe hiring of our management team, we believe there are many indications thatour increased investments are starting to bear fruit.  If these key business indicators continue on their current trajectories, weexpect that these investments will increasingly have a positive impact on ourfinancial results during the next few quarters.

Further, we believe that:

1.               the continued growth in AccuRoute softwarelicense and support and other revenue (a 58% increase in 2005 over 2004 with acontinuing upward trend in the first half of 2006),

2.               the stabilization of our large legacymaintenance business (support and other revenue has been flattening out overthe last four quarters after a 17% decline over the four prior quarters), and

3.               the strong increase in U.S. bookings over thelast four quarters (up 31% on the strength of AccuRoute), despite the steadyand significant declines in new fax software and hardware sales over that sameperiod,

all indicate that we are poised to take thenext step to advance our business and grow our top-line revenue.

In addition to the growth attributed to our direct sales efforts, anotherspecific area of steady growth has resulted from our significant investment inindirect sales (also referred to as channel sales).  We have seen growth in indirect bookings overthe last four quarters****andcontinue to believe that with continued focus and investment, indirect saleswill ultimately become our primary distribution method to drive widespreadmarket coverage of our products.

Clearly, we have many remaining challenges as we seek to expand ourbusiness into new vertical markets, offset declines in our legacy fax business(including the hardware revenues associated with these sales) with increasedsoftware license revenue from AccuRoute sales and improve our results outsideof the Americas.  Beyond the legal verticalmarket, we are starting to see an increasing number of opportunities in othervertical markets, but progress has been slower and more expensive than weinitially expected.  As indicated by ouroperating results for the second quarter of 2006, we continue to invest indirect and indirect sales efforts as well as marketing, ahead of anticipatedrevenues attributable to these expenses.

Sales from our European operations, which were in a steady decline forseveral years, have been relatively flat for the past four quarters and havenot yet achieved the upward trajectory of our U.S. operations.  We remain optimistic that we will see 

11

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improvements outside the Americas, but for now, wewill look primarily to our U.S. sales for our immediate future growth.  Despite these challenges, the recent stabilizationof our legacy maintenance business and the continued growth of our AccuRoutebusiness give us confidence that our continued investments are warranted, as webelieve they will produce significant improvements in our financial resultsover time.

**Productsand Services Overview**

We provide documentrouting solutions and services that enable organizations to manage the capture,processing and distribution of “mixed-mode” documents (i.e., documents thatcontain both paper and electronic components) to electronic information systemssuch as enterprise content management, document management, records management,e-mail and document-archiving systems, leveraging application interfaces withwhich users are already familiar.  Ourenterprise-class products are used by organizations that manage paper-baseddocuments as part of their standard business processes and or have stringentcompliance requirements for secure document handling, storage, integration andtracking of a variety of documents to or from corporate information systems.

We help companies achievethose levels of control by leveraging existing information technology (“IT”)infrastructures and integrating with industry-leading electronic informationsystems.  We add secure documentmanagement and routing functions, along with high-volume fax functionality, toa company’s existing communication infrastructure.  Since paper remains integral to many businessprocesses, we also provide technology that incorporates electronic delivery,distributed document capture, security and billing functionality intoindustry-leading multi-function and scanning devices.

AccuRoute, our flagshipproduct, is a software platform for the distributed capture of paper documentsand, along with existing electronic documents, provides a mechanism for theirsimplified, simultaneous and secure distribution.  Our AccuRoute product allows companies tocontrol the integration and distribution of mixed-mode documents intoever-changing corporate information systems and processes.  Similar in concept to a network router, ourAccuRoute product is the document routing hub, transforming both paper andelectronic-based documents into electronic files, dynamically converting thedocument formats to the required output format, and routing them both withinand outside an organization.

Working with majormulti-function devices (“MFDs”) and electronic information systems (enterprisecontent management, document management, records management and archivalsystems, as well as fax and e-mail systems), our AccuRoute product provides adevice-independent, personalized solution that enables users to distributedocuments from a multi-function device panel or right from their desktopcomputers using a familiar and comfortable interface.  In addition, our AccuRoute product supportsthe movement of electronic documents and information, enabling companies toincrease employee productivity by quickly capturing hardcopy documents,distributing them in electronic form and, through its security features,complying with privacy regulations related to health, financial and otherconfidential information.

We plan to continue thedevelopment of our AccuRoute product line; encapsulate the functionality of allour products into a single, configurable platform; expand our integration withcomplementary technologies (such as document and records management tools); andextend our document capture capabilities to continue to include compatibilitywith virtually all MFDs and scanners.

GenidocsTM, oursecure document-delivery application product, integrates with existing e-mailsystems and provides multiple options for content and attachment encryption,authentication, audit trail, delivery confirmation and digital signatures.  GenifaxTM, our enterprise fax product, offersa scalable, server-based feature set and shares a common Microsoft® Windows® server-based architecture with our Genidocsproduct line.

Companies can deploy oursoftware products on heterogeneous, multi-platform networks and digitalscanning and MFDs and can integrate them with both desktop and enterprisesoftware applications such as content management, e-mail and groupwaresystems.  To address customer needs, ourproducts are modular and scaleable.  As aresult, customers can add additional communication capacity through theaddition of system components and connectors to keep pace with growingdemands.  In addition, due to thisscalable, modular design, customers can add additional Omtool product serversto a configuration to provide failover redundancy, helping to ensure continuousoperation.  We license our products on acombination server/seat basis and as external hardware devices become moretechnologically advanced, we will extend a portion of our license fees to a device-basedmodel.

We resell certain hardwareproducts (such as intelligent fax boards) from third-party vendors typically inconnection with sales of our Genifax product. In most instances, hardware sales are a result of either new sales orsales to existing customers who are upgrading their IT infrastructure.  Occasionally, where our customers also wantfax capabilities, we sell hardware products with our AccuRoute product.  We undertake these hardware sales as a convenienceto our customers, who alternatively can opt to obtain hardware directly from athird-party vendor.  The fax boards andfax modems that we resell are not functional without our product software andwe are not generally in the business of selling fax boards and modems.  We purchase these hardware products as neededto ship to our customers and we typically maintain a minimal inventory of thesehardware products.

12

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Serviceand other revenue has historically consisted primarily of the sale of supportcontracts to complement software products we license to our customers.  We generate a smaller portion of our serviceand other revenue from consulting, training and installation services.

Thefollowing table is a presentation of our total revenue:
| ** **                                    | ** ** | **Total Revenue** | ** ** | **Net Income (Loss)** | ** ** | **Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|---------------------------------|------------|------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                      | 3,068,556  |                            | $          | (1,797,497                         | )          | $ | 925,896 |   |
| Three months  ended June 30, 2005             |       | $                      | 3,570,299  |                            | $          | 11,764                             |       | $ | 1,138,060 |   |
| Change over same  period of prior fiscal year |       | $                      | (501,743   | )                               | $          | (1,809,261                         | )          | $ | (212,164 | ) |
|                                          |       | or (14.1               | )%         | or (15,379.6                    | )%         | or (18.6                           | )%         |
|                                          |       |                   |       |                            |       |                               |       |
| Six months ended  June 30, 2006               |       | $                      | 6,405,060  |                            | $          | (3,165,499                         | )          | $ | 1,957,715 |   |
| Six months ended  June 30, 2005               |       | $                      | 7,431,783  |                            | $          | 153,804                            |       | $ | 2,455,689 |   |
| Change over same period  of prior fiscal year |       | $                      | (1,026,723 | )                               | $          | (3,319,303                         | )          | $ | (497,974 | ) |
|                                          |       | or (13.8               | )%         | or (2,158.1                     | )%         | or (20.3                           | )%         |

 

We experienced a decreasein our revenue due in part to an increase in orders for which we hold contractsbut had to defer recognition of revenue because the associated sales did notyet meet all of the criteria for revenue recognition.  The balance of those orders was $573,000 asof June 30, 2006 and $98,000 as of June 30, 2005.  These amounts are included in our deferredrevenue balance for each respective date.  Of the $573,000 deferred ordersas of June 30, 2006 we expect to be able to recognize approximately $199,000 insoftware license revenue and $122,000 in hardware revenue during the thirdquarter of 2006 and the remaining $252,000 over the next twelve months asprimarily support and service revenue. Furthermore, during the first six months of 2006, we experienced adecline in our software license and hardware revenue primarily as a result of adecrease in sales for our legacy fax product. This decrease was partially offset by an increase in our AccuRoutesoftware license revenue.  Our serviceand other revenue increased during the six month period ended June 30, 2006 ascompared to the same period in 2005 as a result of an 86% increase in AccuRouterelated support services revenue..  Thisincrease in service and other revenue was offset in part by a decline in ourfax related maintenance support revenue. Any decrease in demand for ourproducts would likely result in decreased revenue, which would, in turn, have asignificant negative impact on our financial results because a significantportion of our operating costs such as personnel, rent and depreciation arefixed in advance of a particular quarter. As a result, our costs for sales and marketing, research and developmentand general and administrative could continue to increase as a percentage ofrevenue, thereby negatively affecting our operating results.

Our future revenue andoperating results may fluctuate from quarter to quarter based on the number andsize of sales transactions we enter into with customers, the adequacy ofprovisions for losses, general economic conditions and other factors.  In addition, revenue from one or more largeorders may constitute a significant portion of our total revenue in aparticular quarter, further exacerbating fluctuations in quarterly results.

We have historicallyderived a majority of our total revenue from sales within the UnitedStates.  Revenue from our Europeanoperations decreased during the six months ended June 30, 2006, as compared tothe same period in 2005, due to a decrease in support and hardware revenue fromour European customers.  We will continueto leverage our AccuRoute base in Europe, as well as our indirect channelrelationships in Europe, to focus sales resources on the legal and financialservices vertical markets.  There can be,however, no assurance that we will be able to increase international sales ofour products and the failure to do so may have a material adverse effect onbusiness, financial condition and results of operations.

The following is apresentation of our domestic and international revenue:
|                                               | ** ** | **Total Revenue** | ** ** | **United States Revenue** | ** ** | **Non-United States Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-------------------------------------|------------|-----------------------------------------|------------|
|  Three months ended June 30,  2006       |       | $                      | 3,068,556  |                                | $          | 2,556,467                               |       | $ | 512,089 |   |
|                                               |       |                   |       | or 83.3% of Total  Revenue          |       | or 16.7% of Total  Revenue              |       |
| Three months  ended June 30, 2005             |       | $                      | 3,570,299  |                                | $          | 2,763,512                               |       | $ | 806,787 |   |
|                                          |       |                   |       | or 77.4% of Total  Revenue          |       | or 22.6% of Total  Revenue              |       |
| Change from same period of  prior fiscal year |       | $                      | (501,743   | )                                   | $          | (207,045                                | )          | $ | (294,698 | ) |
|                                               |       | or (14.1               | )%         | or (7.5                             | )%         | or (36.5                                | )%         |
|                                          |       |                   |       |                                |       |                                    |       |
| Six months ended June 30,  2006               |       | $                      | 6,405,060  |                                | $          | 5,455,134                               |       | $ | 949,926 |   |
|                                               |       |                   |       | or 85.2% of Total  Revenue          |       | or 14.8% of Total  Revenue              |       |
| Six months ended  June 30, 2005               |       | $                      | 7,431,783  |                                | $          | 6,169,920                               |       | $ | 1,261,863 |   |
|                                          |       |                   |       | or 83.0% of Total  Revenue          |       | or 17.0% of Total  Revenue              |       |
| Change from same period of  prior fiscal year |       | $                      | (1,026,723 | )                                   | $          | (714,786                                | )          | $ | (311,937 | ) |
|                                               |       | or (13.8               | )%         | or (11.6)% of Total Revenue         |       | or (24.7)% of Total Revenue             |       |

 

13

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Our United Kingdomsubsidiary, Omtool Europe Limited, transacts business primarily in its localcurrency.  We then translate resultsgenerated by that entity into United States dollars and consolidate them withour domestic results for reporting purposes. As we make sales to customers in a variety of countries, significantcurrency exchange rate fluctuations could have a material impact on our resultsof operations.  We manage our foreigncurrency exchange exposure by monitoring our net monetary position usingnatural hedges of our assets and liabilities denominated in localcurrencies.  There can be no assurancethat this policy will eliminate all foreign currency exchange exposure.  Foreign currency exposure has not beenmaterial to our financial position or results of operations to date.  If the volume of our business denominated inforeign currencies increases, we may be required to use derivatives to hedgeforeign currency exposure.

We will continueto leverage our existing distribution channels, where appropriate, to broadenour reach to our target vertical markets and further penetrate our installedbase.  We are pursuing salesopportunities via our solution/reseller channels, as well as focusing salesefforts on specific market segments, in order to facilitate acceptance of ourproducts.   However, we currently havemore of our sales resources focused on the direct model and have consequentlyderived a significant portion of our year-to-date revenue from direct sales.

 
| ** **                                    | ** ** | **Total Software  License and  Hardware  Revenue** | ** ** | **Software License and  Hardware Revenue from  Indirect Distribution  Channel Sales** | ** ** | **Software License  and Hardware  Revenue From  Indirect Distribution  Channel Sales as a  Percentage of Total  Software License  and Hardware Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                                            | 1,332,563  |                                                                                                                | $          | 719,313                                                                                                                                                                                                              |       | 54.0 | % |
| Three months  ended June 30, 2005             |       | $                                                            | 1,860,023  |                                                                                                                | $          | 810,139                                                                                                                                                                                                              |       | 43.6 | % |
| Change from same  period of prior fiscal year |       | $                                                            | (527,460   | )                                                                                                                   | $          | (90,826                                                                                                                                                                                                              | )          | 10.4 | % |
|                                          |       | or (28.4                                                     | )%         | or (11.2                                                                                                            | )%         |                                                                                                                                                                                                                 |       |
|                                          |       |                                                         |       |                                                                                                                |       |                                                                                                                                                                                                                 |       |
| Six months ended  June 30, 2006               |       | $                                                            | 2,921,782  |                                                                                                                | $          | 1,290,594                                                                                                                                                                                                            |       | 44.2 | % |
| Six months ended  June 30, 2005               |       | $                                                            | 4,014,996  |                                                                                                                | $          | 1,439,853                                                                                                                                                                                                            |       | 35.9 | % |
| Change from same period  of prior fiscal year |       | $                                                            | (1,093,214 | )                                                                                                                   | $          | (149,259                                                                                                                                                                                                             | )          | 8.3 | % |
|                                          |       | or (27.2                                                     | )%         | or (10.4                                                                                                            | )%         |                                                                                                                                                                                                                 |       |

 

*Recent events*

InJanuary 2006, we entered into a new lease agreement for approximately44,000 square feet of office space.  Wemoved our headquarters to this facility in Andover, Massachusetts at the end ofApril 2006.  The lease has aten-year term and we have an option to renew the lease for an additionalfive-year term at the then-applicable fair market rent.  Under the terms of the lease, the landlordwill provide us with a tenant improvement allowance of up to $308,000, of whichwe have received $247,000 as of June 30, 2006. Additionally, we have a one-time right to terminate the lease, upontwelve months’ written notice, after the sixth year of the lease term.  If we decide to terminate the lease, we mustpay a penalty of six months’ rent and the unamortized portion of the tenantimprovement allowance.  We believe thenew facility will be suitable and sufficient for our needs for the foreseeablefuture.

**CriticalAccounting Policies and Estimates**

We have identified thepolicies and estimates below as critical to our business operations and theunderstanding of our results of operations. The impact and any associated risks related to these policies on ourreported and expected financial results and business operations are discussedin appropriate sections throughout Management’s Discussion and Analysis ofFinancial Condition and Results of Operations. Our preparation of this Form 10-Q required us to makeestimates and assumptions that affect the reported amount of assets andliabilities, the disclosure of contingent assets and liabilities as of the dateof the financial statements included herein and the reported amounts of revenueand expenses during the period covered by this report.  There can be no assurance that actual resultswill not differ materially from those estimates.

*Revenue Recognition andAccounts Receivable Reserves.**  *We derive our revenue primarilyfrom two sources: (i) product revenue, which includes software license andhardware revenue, and (ii) service and support revenue, which includessoftware maintenance and support, installation, training and consulting revenue.  We license our software products on aperpetual basis.  We generate revenuefrom licensing the rights to use our software products and sales of hardwaredirectly to end-users and indirectly through resellers.  Our resellers order products from us based onpurchase orders received from end-users and do not order stock.  We 

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generally sell our products to resellers and directlyto end-users without any specifically stated rights of return.  Occasionally, however, in our solediscretion, we will accept a product return if the end-user finds that theproduct does not fit its needs.  We alsosell hardware products, which are provided by a third-party, at cost plus anadditional mark-up, to end-users and indirectly through resellers.  The hardware products that we resell are notfunctional without our software.  Tosupport our software products, we sell software maintenance, support,installation, training and consulting services to end-users and indirectlythrough resellers.

We apply the provisionsof Statement of Position (“SOP”) 97-2,**“*Software Revenue Recognition*,” as amended by SOP 98-9,Modification of SOP 97-2,**“*SoftwareRevenue Recognition with Respect to Certain Transactions*,” toall transactions involving the sale of multiple elements including software,hardware and service revenue.  We applythe provisions of Statement of Financial Accounting Standards (“SFAS”)No. 48,**“*RevenueRecognition When Right of Return Exists*,” with respect toproviding for potential future product returns. As described below, we must make and use significant judgments andestimates in connection with the revenue recognized in any accountingperiod.  Material differences may haveresulted in the amount and timing of our revenue if we had made differentjudgments or utilized different estimates.

We recognize revenue fromthe sale of software products and hardware to both end-users and resellers whenpersuasive evidence of an arrangement exists, the products have been delivered,the fee is fixed or determinable, collection of the resulting receivable isreasonably assured and there are no uncertainties regarding customeracceptance.  We maintain a reserve forpotential product returns.  We recognizesoftware maintenance and support revenue over the term of the related maintenanceperiod, which is typically a one-year period. On those occasions when we sell multiple-year maintenance contracts, werecognize the associated revenue over the multiple-year term of the maintenancecontract.  We recognize other servicerevenue as we perform the services.  Ifan arrangement includes an acceptance provision and acceptance is uncertain,then we will defer all revenue until the customer accepts the productspurchased.  Acceptance in these instancesgenerally occurs upon the earlier of receipt of a written customer acceptanceor expiration of the acceptance period. If an arrangement includes an acceptance provision tied to determinationthat our product meets published specifications and there are no uncertaintieswith regard to the customer’s acceptance, then we will recognize revenue at thetime of sale, provided that all other revenue recognition criteria previouslymentioned have been met and the acceptance period is of short duration.

Our transactionsfrequently involve the sale of software, hardware and related services undermultiple element arrangements.  Revenueunder multiple element arrangements is allocated to each element under theresidual method, in accordance with SOP 98-9, Modification of SOP 97-2,**“*Software Revenue Recognition with Respect to CertainTransactions*.”  Underthis method, revenue is allocated first to all undelivered elements, such asservices, based on the fair value of those elements, which is calculated to bethe price charged when these elements are sold separately and unaccompanied byother elements.  Our services generallyare not essential to the functionality of the software, as these services donot alter the capabilities of the software and do not carry a significantdegree of risk to perform.  The amountallocated to the delivered elements, such as software license and hardwarerevenue, is the difference between the total arrangement value and the amountallocated to the undelivered elements. If the delivered elements include both software and hardware, the amountallocated to hardware revenue is based on the price charged to us by the thirdparty vendor plus an additional mark up, with the remainder allocated tosoftware revenue.  To the extent that adiscount is offered in the arrangement, the entire discount is allocated to thedelivered element or elements.  If thedelivered elements include hardware and software, the discount is allocated tothe hardware and software based on their respective list prices.

For all sales, we use abinding purchase order, a signed contract or a credit card authorization asevidence of an arrangement.  Salesthrough our resellers are evidenced by a master agreement governing therelationship, together with binding purchase orders issued on atransaction-by-transaction basis.

At the time of atransaction, we assess whether the fee associated with the transaction is fixedor determinable and whether or not collection is reasonably assured.  If a significant portion of a fee is duebeyond our normal payment terms, which are thirty to sixty days from invoicedate, we account for the fee as not being fixed or determinable.  In these cases, we recognize revenue as thefees become due.  We assess collectionbased on a number of factors, including past transaction history with the customerand the credit-worthiness of the customer. We review Dunn & Bradstreet credit reports for our resellersand adjust our credit limits with those resellers accordingly.  If a particular reseller does not have afavorable report or if we do not have enough credit information to determine ifthe reseller is creditworthy then we predominantly sell to those resellers oncash on delivery terms.  We do notrequest collateral from our customers. If we determine that collection of a fee is not reasonably assured, thefee is deferred and revenue is recognized at the time collection becomesreasonably assured, which is generally upon receipt of payment.

We maintain reserves forpotential product returns and make adjustments to these reserves as neededbased on historical product return rates. We also consider the impact of new product introductions, changes incustomer demand and acceptance of our products on the adequacy of thesereserves.  Our calculation of theestimated return reserve is based upon (1) an account specific review ofpotential returns, where a return probability is known and (2) an estimatebased upon past historical returns as a percentage of revenue.  We must make and use significant judgments andestimates in connection with establishing the product returns reserve in anyaccounting period.  Material differencesmay have resulted in the amount and timing of revenue for this or any priorperiod if we made different judgments or utilized different estimates.

As with the productreturn reserve, we must make estimates of our ability to collect on ouraccounts receivable.  We record tradeaccounts receivable at the invoiced amount and these accounts do not bearinterest.  We specifically analyzeaccounts receivable, historical bad debts, customer credit-worthiness, currenteconomic trends and changes in customer payment patterns when evaluating 

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the adequacy of our allowance for doubtfulaccounts.  We review our allowance fordoubtful accounts on a monthly basis. Our calculation of the estimated accounts receivable reserve is alsobased upon (1) an account specific review of potential uncollectibleaccounts, where a bad debt probability is known, and (2) an estimate basedupon past historical bad debts as a percentage of accounts receivable.  We do not have any off-balance-sheet creditexposure to our customers.

Our combined accountsreceivable and product returns reserve was $32,000 and $33,000 at June 30, 2006and December 31, 2005, respectively. Both components of calculating the estimated reserve — specificidentification and historic experience — are material judgments that wemake.  We base these judgments onhistoric trends, taking into consideration current business and economicconditions, which could change materially, thus changing the required reservelevel materially.  The potential changeto the size of our required reserve could be positive, in the event the reserveestimate proves unnecessary, or negative, if the reserve proves inadequate.

Our deferred revenue iscomprised mainly of revenue that is deferred for software maintenance andsupport contracts.  The other componentsof deferred revenue are amounts from sales transactions that were deferredbecause they did not meet all of the provisions of our revenue recognitionpolicy.

*Software DevelopmentCosts.**  *We consider software development costs forcapitalization when technological feasibility is established in accordance withSFAS No. 86,**“*Accountingfor the Costs of Computer Software To Be Sold, Leased or Otherwise Marketed*.”  We sell software in a market that is subjectto rapid technological change, new product introductions and changing customerneeds.  Accordingly, we have determinedthat we cannot ascertain technological feasibility until the development stateof the product is nearly complete.  The timeperiod during which cost could be capitalized from the point of reachingtechnological feasibility until the time of general product release is veryshort and, consequently, the amounts that might be capitalized are not materialto our consolidated financial position or results of operations.  Therefore, we charge all software developmentcosts to operations in the period incurred.

*Taxes*.   Weare required to estimate our income and state sales taxes.  This process involves estimating our actualcurrent tax obligations, while also assessing differences resulting from thedifferent treatment of items for tax and accounting purposes that result indeferred income tax assets and liabilities and accrued state sales taxliabilities.  We include deferred income taxassets and liabilities and accrued state sales tax liabilities in our balancesheet.

We assess our deferredtax assets for each reporting period to determine whether it is more likelythan not that we will recover from future taxable income.  In making this assessment, we includeassumptions regarding ongoing tax planning strategies.  We establish a valuation allowance for assetswhen their recovery is not certain.  Weinclude changes to the valuation allowance as an expense or benefit within thetax provision in our statement of operations.

We provide a fullvaluation allowance against all of our net deferred tax assets and willcontinue to do so until we return to an appropriate level of sustained taxableincome.  The ultimate realization ofthese deferred tax assets depends upon our ability to generate sufficientfuture taxable income.  If we aresuccessful in generating sufficient future taxable income, we will reduce thevaluation allowance through a reduction in income tax expense in the future.

We estimate accrued statesales taxes for each reporting period based on tax rates in effect for thereporting periods in each of the states where we have a potential nexus and forthe time period during which we have that nexus.  The assumptions and estimates used todetermine this liability are subject to change as they are difficult to measureor value.  In the event that actualresults differ from these estimates, our state sales taxes expense could bematerially impacted.

**NewAccounting Pronouncements**

In June 2006, the FASB issued FASB Interpretation No. 48, *“Accounting for Uncertaininty in Income Taxes, an Interpretation ofFASB Statement No. 109” (“FIN 48”),* which clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with SFAS 109.  FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  FIN 48 becomeseffective for fiscal years beginning after December 15, 2006.  We do not currently expect to elect earlyadoption of this statement.  We do notexpect FIN 48 to have a material impact on our financial position and resultsof operations.

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**Resultsof Operations**

The followingtable sets forth certain financial data as a percentage of total revenue:
| ** **                      | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                        |       |                                            |       |                                          |       |   |   |   |   |
| Software license                |       | 30.2                                            | %          | 31.9                                          | %          | 30.6 | % | 33.0 | % |
| Hardware                        |       | 13.2                                            |       | 20.2                                          |       | 15.0 |   | 21.0 |   |
| Service and  other              |       | 56.6                                            |       | 47.9                                          |       | 54.4 |   | 46.0 |   |
| Total revenue                   |       | 100.0                                           |       | 100.0                                         |       | 100.0 |   | 100.0 |   |
| Cost of revenue:                |       |                                            |       |                                          |       |   |   |   |   |
| Software license                |       | 1.7                                             |       | 1.4                                           |       | 1.3 |   | 1.0 |   |
| Hardware                        |       | 8.8                                             |       | 13.5                                          |       | 9.6 |   | 13.8 |   |
| Service and  other              |       | 28.7                                            |       | 19.2                                          |       | 24.9 |   | 18.8 |   |
| Total cost of  revenue          |       | 39.2                                            |       | 34.1                                          |       | 35.8 |   | 33.6 |   |
| Gross profit                    |       | 60.8                                            |       | 65.9                                          |       | 64.2 |   | 66.4 |   |
| Operating  expenses:            |       |                                            |       |                                          |       |   |   |   |   |
| Sales and  marketing            |       | 70.4                                            |       | 32.0                                          |       | 65.7 |   | 31.2 |   |
| Research and  development       |       | 23.6                                            |       | 14.6                                          |       | 22.4 |   | 14.0 |   |
| General and  administrative     |       | 26.6                                            |       | 20.3                                          |       | 26.8 |   | 20.2 |   |
| Total operating  expenses       |       | 120.6                                           |       | 66.9                                          |       | 114.9 |   | 65.4 |   |
| Income (loss)  from operations  |       | (59.8                                           | )          | (1.0                                          | )          | (50.7 | ) | 1.0 |   |
| Interest and  other income, net |       | 1.2                                             |       | 1.3                                           |       | 1.3 |   | 1.2 |   |
| Income tax  provision           |       | 0.0                                             |       | 0.0                                           |       | 0.0 |   | 0.1 |   |
|                            |       |                                            |       |                                          |       |   |   |   |   |
| Net income  (loss)              |       | (58.6                                           | )%         | 0.3                                           | %          | (49.4 | )% | 2.1 | % |
|                            |       |                                            |       |                                          |       |   |   |   |   |
| Gross profit:                   |       |                                            |       |                                          |       |   |   |   |   |
| Software license                |       | 94.4                                            | %          | 95.6                                          | %          | 95.7 | % | 97.1 | % |
| Hardware                        |       | 33.7                                            |       | 33.0                                          |       | 36.2 |   | 34.1 |   |
| Service and other               |       | 49.2                                            |       | 60.1                                          |       | 54.2 |   | 59.1 |   |

 

**ThreeMonths Ended June 30, 2006 and 2005**

*Revenue*

*SoftwareLicense*.  Our softwarelicense revenue decreased by approximately 19% to $926,000 in the three monthsended June 30, 2006, compared to $1.1 million in the same period in 2005, as aresult of a decline in software license revenue for our legacy fax products aswell as an increase in orders for which we hold contracts but had to deferrecognition of revenue because the associated sales did not yet meet all of thecriteria for revenue recognition. The amount of these orders is included in ourdeferred revenue balance.  We expect to be able to recognize the licenserevenue for these orders (approximately $199,000) during the third quarter of2006.

During the threemonths ended June 30, 2006, our revenue by product category (excluding freightand allowances for returns), as compared to the same period in the prior fiscalyear was as follows:
| ** **                                    | ** ** | **Total  Revenue** | ** ** | **Software License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax   License  Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|------------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                  | 3,068,556  |                               | $          | 925,896                         |       | $                                           | 600,474    |   | $ | 323,261 |   |
| Three months  ended June 30, 2005             |       | $                  | 3,570,299  |                               | $          | 1,138,060                       |       | $                                           | 563,761    |   | $ | 529,140 |   |
| Change from same  period of prior fiscal year |       | $                  | (501,743   | )                                  | $          | (212,164                        | )          | $                                           | 36,713     |   | $ | (205,879 | ) |
|                                          |       | or (14.1           | )%         | or (18.6                           | )%         | or 6.5                          | %          | or (38.9                                    | )%         |

 

During the three monthsended June 30, 2006, our software license revenue represented a decreasedpercentage of our total revenue, due to a decrease in software license revenueas a result of a decrease in our legacy fax product revenues as well as thecontracts which we had to defer recognition of revenue, as discussed above, forthe three months ended June 30, 2006 when compared to the same period in 2005.
| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | 30.2                                                                                              | %          |
| Three months  ended June 30, 2005             |       | 31.9                                                                                              | %          |
| Change from same period  of prior fiscal year |       | (1.7                                                                                              | )%         |

 

17

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The results for the threemonths ended June 30, 2006 and 2005 demonstrate that our license revenue hasshifted towards our AccuRoute product, as displayed in the table below, whichsummarizes revenue from our two major product lines (excluding freight and allowancesfor returns) as a percentage of our total software license revenue:
| ** **                                   | ** ** | **AccuRoute License Revenue as  a Percentage of Software  License Revenue** | ** ** | **Legacy Fax License  Revenue as  Percentage of  Software License Revenue** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| Three months ended June  30, 2006            |       | 64.9                                                                                                           | %          | 34.9                                                                                                                | %          |
| Three months ended June  30, 2005            |       | 49.5                                                                                                           | %          | 46.5                                                                                                                | %          |
| Change from same period of prior fiscal year |       | 15.4                                                                                                           | %          | (11.6                                                                                                               | )%         |

 

Although we cannotaccurately predict the exact mix of products that we will sell in the future,we expect that software license revenue will constitute a larger percentage ofour total revenue in the future if demand for our AccuRoute product, whichgenerally does not require the purchase of additional hardware, continues togrow and if our AccuRoute product gains additional market acceptance.

*Hardware.*  Hardware revenue decreased during the threemonth period ended June 30, 2006 as compared to the three month period endedJune 30, 2005, due to an increase in orders for which we hold contracts but hadto defer recognition of revenue because the associated sales did not yet meetall of the criteria for revenue recognition. The amount of these orders isincluded in our deferred revenue balance.  We expect to be able torecognize the hardware revenue for these orders (approximately $122,000),during the third quarter of 2006.  In addition, hardware revenue decreased due to a decrease in our legacyfax product, which sales are the main driver for our hardware revenue.
| ** **                                    | ** ** | **Hardware Revenue** | ** **         | **Hardware Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------|--------------------|--------------------------------------------------------------------------------------|------------|
| Three months ended June  30, 2006             |       | $                         | 406,667            |                                                                                 | 13.2       | % |
| Three months ended June  30, 2005             |       | $                         | 721,963            |                                                                                 | 20.2       | % |
| Change from same period  of prior fiscal year |       | $                         | (315,296  or (43.7 | )  )%                                                                                | (7.0       | )% |

 

We expect market demandfor AccuRoute, which generally does not require our customers to purchaseadditional hardware, to increase and, if it does, we anticipate hardwarerevenue will constitute a smaller percentage of our total revenue.

*Serviceand Other.*  Service andother revenue, which consists primarily of the sale of support contracts tocomplement software products sold to customers and, to a lesser extent,consulting, training and installation services, increased in the three monthsended June 30, 2006, as compared to the same period in the prior fiscal year. This increase was due primarily to an increase in sales of AccuRoute-relatedsupport services, which increased by 72% from the same period in 2005.  This increase was offset in part by adecrease in support related to our legacy fax product line.
| ** **                                   | ** ** | **Service and Other Revenue** | ** **     | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|----------------|---------------------------------------------------------------------------------------------------------|------------|
| Three months ended June  30, 2006            |       | $                                            | 1,735,993      |                                                                                                    | 56.6       | % |
| Three months ended June  30, 2005            |       | $                                            | 1,710,276      |                                                                                                    | 47.9       | % |
| Change from same period of prior fiscal year |       | $                                            | 25,717  or 1.5 | %                                                                                                       | 8.7        | % |

 

                We are focused onimproving the renewal rate of software maintenance contracts with our existingcustomer base in both our United States and European operations and continue tofocus our attention on generating additional service and other revenue infuture quarters.

*Costof Revenue*

*SoftwareLicense.*  Cost ofsoftware license revenue consists primarily of the costs we incur insublicensing third-party software products, product media and productduplication.  Cost of software licenserevenue for the three months ended June 30, 2006 increased by 3% as compared tothe corresponding period in 2005.  Theincrease is due primarily to increased royalty payments associated withadditional third-party software that we incorporated into our products during thethird quarter of 2005.  We may licenseadditional third-party software components in the future and, therefore, weexpect that our software license cost as a percentage of software licenserevenue may increase slightly.

18

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As a result of theincrease in the cost of software license revenue that we incurred during thesecond quarter of 2006, we incurred a decrease in our software license grossmargin percentage as set forth in the following table:

 
| ** **                                    | ** ** | **Cost of Software License Revenue** | ** **    | **Software License Gross Margin** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|---------------|--------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                                        | 52,000        |                                             | 94.4       | % |
| Three months  ended June 30, 2005             |       | $                                                        | 50,435        |                                             | 95.6       | % |
| Change from same  period of prior fiscal year |       | $                                                        | 1,565  or 3.1 | %                                                | (1.2       | )% |

 

*Hardware.*  Cost of hardware revenue consists primarilyof the cost we incur in purchasing third-party hardware products. Cost ofhardware represented 66% and 67% of hardware revenue for the three months endedJune 30, 2006 and June 30, 2005, respectively. The decrease in dollar amount for the cost of hardware revenue was dueprimarily to the decrease in hardware unit sales.  The gross margin percentage for hardwaresales increased due to a change in the mix of particular hardware productssold.  We do not expect significantchanges in unit prices for the remainder of 2006.
| ** **                                    | ** ** | **Cost of Hardware Revenue** | ** **         | **Hardware Gross Margin** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|--------------------|-------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                           | 269,604            |                                | 33.7       | % |
| Three months  ended June 30, 2005             |       | $                                           | 483,703            |                                | 33.0       | % |
| Change from same  period of prior fiscal year |       | $                                           | (214,099  or (44.3 | )  )%                               | 0.7        | % |

 

*Serviceand Other.*  Cost ofservice and other revenue consists primarily of the costs we incur in providingtelephone support as well as other miscellaneous customer service-relatedexpenses.  Cost of service and otherrevenue represented 51% and 40% of service and other revenue for the threemonth period ended June 30, 2006 and June 30, 2005, respectively.  The gross margin percentage for service andother revenue decreased during the three months ended June 30, 2006, ascompared to the same period in 2005. This decrease in gross margin is primarily due to an increase inoverhead expenses including predominantly an increase in healthcare costs andto a lesser extent to an increase in recruiting and wages expense as a resultof hiring additional employees in the service department during theperiod.  We do not expect any significantvariances in our service and other revenue gross margin for the remainder offiscal year 2006.
| ** **                                    | ** ** | **Cost of Service and Other  Revenue** | ** **       | **Gross Margin for Service  and Other Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------------|--------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                                          | 881,684          |                                                                     | 49.2       | % |
| Three months  ended June 30, 2005             |       | $                                                          | 681,752          |                                                                     | 60.1       | % |
| Change from same  period of prior fiscal year |       | $                                                          | 199,932  or 29.3 | %                                                                        | (10.9      | )% |

 

*OperatingExpenses*

*Salesand Marketing.*  Sales and marketing expenses consist primarily ofemployee salaries, benefits, commissions, and associated overhead costs, andthe cost of marketing programs such as direct mailings, public relations, tradeshows, seminars and related communication costs.  Sales and marketing expenses increased in thesecond quarter of 2006 as compared to the second quarter of 2005 due to anincreased number of employees in our sales and marketing departments and theassociated costs of supporting those employees, as well as an increasein overhead expenses, including an increase in health care costs.

Additionally,we increased our marketing program expenditures, including lead generationprograms, trade shows and public relations during the second quarter of 2006 ascompared to the second quarter of 2005. These expense increases reflect our initiative to further penetrate thelegal vertical market with our AccuRoute product, as well as our initiative totarget new vertical markets, including the financial and healthcare verticalmarkets.  Building on the successof the current version of our AccuRoute product within the legal verticalmarket since its introduction in 2004, we intend to continue broadening ourcurrent sales and marketing strategy, which we began in the second quarter of2005, to encompass the financial services and healthcare vertical markets.  During the remainder of 2006, our investmentin sales and marketing and business development will remain at the currentlevel and we expect to start seeing the impact of these investments in growingour business during the remainder of 2006.
| ** **                                    | ** ** | **Sales and Marketing Expenses** | ** **         | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|--------------------|------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                               | 2,158,993          |                                                                                                       | 70.4       | % |
| Three months  ended June 30, 2005             |       | $                                               | 1,140,936          |                                                                                                       | 32.0       | % |
| Change from same  period of prior fiscal year |       | $                                               | 1,018,057  or 89.2 | %                                                                                                          | 38.4       | % |

 

*Researchand Development.* Research and development expenses includeexpenses associated with the development of new products, enhancements ofexisting products and quality assurance activities. These expenses consistprimarily of employee salaries, 

19

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benefits, associated overhead costs, consultingexpenses and the cost of software development tools. Research and developmentexpenses increased during the three months ended June 30, 2006 compared to thesame period in 2005, due to increases in overhead expenses, including anincrease in health care costs.  To alesser extent, research and development expenses increased due to higherconsulting expenses and salary expenses as compared with the same period in2005.  We expect research and developmentexpenses to remain consistent in absolute dollars for the remainder of 2006, aswe believe we currently have a sufficient amount of engineers and third partyconsultants to support our expansion of our AccuRoute product into othervertical markets.
| ** **                                    | ** ** | **Research and Development  Expenses** | ** **       | **Research and Development  Expenses as a Percentage of  Total Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------------|-------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                                | 724,302          |                                                                                                        | 23.6       | % |
| Three months  ended June 30, 2005             |       | $                                                | 520,700          |                                                                                                        | 14.6       | % |
| Change from same  period of prior fiscal year |       | $                                                | 203,602  or 39.1 | %                                                                                                           | 9.0        | % |

 

*Generaland Administrative.* General and administrative expenses consist primarily of employeesalaries, benefits for administrative, executive and finance personnel andassociated corporate general and administrative expenses. In the most recentlycompleted fiscal quarter, our general and administrative expenses increased ascompared to the same period in the prior fiscal year.  The increase in general and administrativeexpenses, both in dollar amount and as a percentage of total revenue, is due toan increase in overhead expenses, including an increase in health carecosts.  In addition, general andadministrative expenses increased due to higher salary expense and to higheraccounting and legal expenses as a result of increased expenses related tosales tax compliance and patent related work. We did not incur any significant professional fees related to thecompliance with Section 404 of the Sarbanes-Oxley Act of 2002 during the secondquarter of 2006.  The deadline forcompliance with Section 404 had been delayed to the first fiscal yearending on or after July 15, 2007 for companies like us with a public floatof less than $75 million.
| ** **                                    | ** ** | **General and Administrative  Expenses** | ** **      | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|-----------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006             |       | $                                                  | 818,486         |                                                                                                              | 26.7       | % |
| Three months  ended June 30, 2005             |       | $                                                  | 726,137         |                                                                                                              | 20.3       | % |
| Change from same  period of prior fiscal year |       | $                                                  | 92,349  or 12.7 | %                                                                                                                 | 6.4        | % |

 

*Interestand Other Income, net.*  Interest and other income, net consistsprincipally of interest income earned on cash and cash equivalent balances,offset by interest expense associated with a capital lease that we entered intoto finance the furnishing of our new office facility and a new phone system.  Interest and other income, net decreased as aresult of a lower cash balance during the three months ended June 30, 2006 ascompared to the three months ended June 30, 2005 and also as a result of thenew finance charges related to the capital lease discussed above.  We expect that interest and other income willbe relatively stable quarter over quarter for the remainder of fiscal year2006.
| ** **                                      | ** ** | **Interest and Other Income** | ** **       | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------------|---------------------------------------------------------------------------------------------------------|------------|
| Three months  ended June 30, 2006               |       | $                                            | 39,016           |                                                                                                    | 1.2        | % |
| Three months  ended June 30, 2005               |       | $                                            | 45,128           |                                                                                                    | 1.3        | % |
| Increase from  same period of prior fiscal year |       | $                                            | (6,112  or (13.5 | )  )%                                                                                                   | (0.1       | )% |

 

*Provision for Income Taxes.*  Duringthe three months ended June 30, 2006, and June 30, 2005 we did not record a taxprovision.

**SixMonths Ended June 30, 2006 and 2005**

*Revenue*

*SoftwareLicense*.  Our softwarelicense revenue decreased by approximately 20% to $2.0 million in the sixmonths ended June 30, 2006, compared to $2.5 million in the same period in2005, as a result of a decline in software license revenue for our legacy faxproduct and an increase in orders for which we hold contracts but had to deferrecognition of revenue because the associated sales did not yet meet all of thecriteria for revenue recognition. The amount of these orders is included in ourdeferred revenue balance.  We expect to be able to recognize the licenserevenue for these orders (approximately $199,000) during the third quarter of2006.  We did not have any sales of our other software products during thesix month period ended June 30, 2006, which reflects our continued focus on thedevelopment and sale of our AccuRoute product.

During the sixmonths ended June 30, 2006, our revenue by product category (excluding freightand allowances for returns), as compared to the same period in the prior fiscalyear was as follows:

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|                                               | ** ** | **Total  Revenue** | ** ** | **Software License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax   License  Revenue** | ** ** | **Other Software  License  Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|------------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| Six months ended June 30,  2006               |       | $                  | 6,405,060  |                               | $          | 1,957,715                       |       | $                                           | 1,122,363  |                                      | $          | 822,241 |   | $ | 0 |   |
| Six months ended  June 30, 2005               |       | $                  | 7,431,783  |                               | $          | 2,455,689                       |       | $                                           | 1,168,216  |                                      | $          | 1,219,729 |   | $ | 4,845 |   |
| Change from same period of  prior fiscal year |       | $                  | (1,026,723 | )                                  | $          | (497,974                        | )          | $                                           | (45,853    | )                                         | $          | (397,488 | ) | $ | (4,845 | ) |
|                                               |       | or (13.8           | )%         | or (20.3                           | )%         | or (3.9                         | )%         | or (32.6                                    | )%         | or (100.0                                 | )%         |

 

During the six monthsended June 30, 2006, our software license revenue represented a decreasedpercentage of our total revenue, primarily because of a decrease in softwarelicense sales for the six months ended June 30, 2006 when compared to the sameperiod in 2005.
| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | 30.6                                                                                              | %          |
| Six months ended  June 30, 2005               |       | 33.0                                                                                              | %          |
| Change from same period  of prior fiscal year |       | (2.4                                                                                              | )%         |

 

The results for the sixmonths ended June 30, 2006 and 2005 demonstrate that our license revenue hasshifted towards our AccuRoute product, as displayed in the table below, whichsummarizes revenue from each of our major product lines and other components ofrevenue (excluding freight and allowances for returns) as a percentage of ourtotal software license revenue:
| ** **                                    | ** ** | **AccuRoute License Revenue as  a Percentage of Software  License Revenue** | ** ** | **Legacy Fax License  Revenue as  Percentage of  Software License Revenue** | ** ** | **Other Software License  Revenue as a Percentage of  Software License Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | 57.3                                                                                                           | %          | 42.0                                                                                                                | %          | 0.0                                                                                                                      | %          |
| Six months ended  June 30, 2005               |       | 47.6                                                                                                           | %          | 49.7                                                                                                                | %          | 0.2                                                                                                                      | %          |
| Change from same period  of prior fiscal year |       | 9.7                                                                                                            | %          | (7.7                                                                                                                | )%         | (0.2                                                                                                                     | )%         |

 

Included insoftware license revenue for the six months ended June 30, 2006 and 2005 is anet reduction of $7,000 and $21,000, respectively, in the sales returns andallowance reserve relating primarily to specific accounts where we havedetermined that the risk of a return is no longer present.  Although we cannot accurately predict theexact mix of products that we will sell in the future, we expect that softwarelicense revenue will constitute a larger percentage of our total revenue in thefuture if demand for our AccuRoute product, which generally does not requirethe purchase of additional hardware, continues to grow and if our AccuRouteproduct gains additional market acceptance.

*Hardware.*  Hardware revenue decreased during the sixmonth period ended June 30, 2006 as compared to the six month period ended June30, 2005 due primarily to a decrease in sales of our legacy fax product, whichsales are the main driver for our hardware revenue.  Furthermore, at June 30, 2006, we experiencedan increase in orders for which we hold contracts but had to defer recognitionof revenue because the associated sales did not yet meet all of the criteriafor revenue recognition. The amount of these orders is included in our deferredrevenue balance.  We expect to be able to recognize the hardware revenuefor these orders (approximately $122,000) during the third quarter of 2006.
| ** **                                    | ** ** | **Hardware Revenue** | ** **         | **Hardware Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------|--------------------|--------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                         | 964,067            |                                                                                 | 15.0       | % |
| Six months ended  June 30, 2005               |       | $                         | 1,559,307          |                                                                                 | 21.0       | % |
| Change from same  period of prior fiscal year |       | $                         | (595,240  or (38.2 | )  )%                                                                                | (6.0       | )% |

 

We expect market demandfor AccuRoute, which generally does not require our customers to purchaseadditional hardware, to increase and, if it does, we anticipate hardwarerevenue will constitute a smaller percentage of our total revenue.

*Serviceand Other.*  Service andother revenue, which consists primarily of the sale of support contracts tocomplement software products sold to customers and, to a lesser extent,consulting, training and installation services, increased in the six monthsended June 30, 2006, as compared to the same period in the prior fiscalyear.  This increase was due primarily to an increase in AccuRoute-relatedsupport services, which increased by 86% from the same period in 2005.  This increase was offset in part by adecrease in support related to our legacy fax product line.

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| ** **                                    | ** ** | **Service and Other Revenue** | ** **     | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|----------------|---------------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                            | 3,483,278      |                                                                                                    | 54.4       | % |
| Six months ended  June 30, 2005               |       | $                                            | 3,416,787      |                                                                                                    | 46.0       | % |
| Change from same period  of prior fiscal year |       | $                                            | 66,491  or 1.9 | %                                                                                                       | 8.4        | % |

 

*Costof Revenue*

*SoftwareLicense.*  Cost ofsoftware license revenue consists primarily of the costs we incur insublicensing third-party software products, product media and productduplication.  Cost of software licenserevenue for the six months ended June 30, 2006 increased by 17% as compared tothe same period in 2005.  The increase isdue primarily to increased royalty payments associated with additionalthird-party software we incorporated into our products during the third quarterof 2005.

As a result of theincrease in the cost of software license revenue that we incurred during thefirst six months of 2006, we incurred a decrease in our software license grossmargin percentage as set forth in the following table:
| ** **                                    | ** ** | **Cost of Software License Revenue** | ** **      | **Software License Gross Margin** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|-----------------|--------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                                        | 83,411          |                                             | 95.7       | % |
| Six months ended  June 30, 2005               |       | $                                                        | 71,202          |                                             | 97.1       | % |
| Change from same  period of prior fiscal year |       | $                                                        | 12,209  or 17.1 | %                                                | (1.4       | )% |

 

*Hardware.*  Cost of hardware revenue consists primarilyof the cost we incur in purchasing third-party hardware products. Cost ofhardware represented 64% and 66% of hardware revenue for the six months endedJune 30, 2006 and June 30, 2005, respectively. The decrease in dollar amount for the cost of hardware revenue was dueprimarily to the decrease in hardware unit sales.  The gross margin percentage for hardwaresales increased due to a change in the mix of particular hardware productssold.  We do not expect significantchanges in unit prices for the remainder of 2006.
| ** **                                    | ** ** | **Cost of Hardware Revenue** | ** **         | **Hardware Gross Margin** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|--------------------|-------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                           | 614,682            |                                | 36.2       | % |
| Six months ended  June 30, 2005               |       | $                                           | 1,027,380          |                                | 34.1       | % |
| Change from same  period of prior fiscal year |       | $                                           | (412,698  or (40.2 | )  )%                               | 2.1        | % |

 

*Serviceand Other.*  Cost ofservice and other revenue consists primarily of the costs we incur in providingtelephone support as well as other miscellaneous customer service-relatedexpenses.  Cost of service and otherrevenue represented 46% and 41% of service and other revenue for the six monthperiods ended June 30, 2006 and June 30, 2005, respectively.  The gross margin percentage for service andother revenue decreased during the six months ended June 30, 2006 compared tothe same period in 2005.  This decreasein gross margin is primarily due to an increase in overhead expenses, includingan increase in healthcare costs.  We do notexpect any significant variances in our service and other gross margins for theremainder of fiscal year 2006.
| ** **                                    | ** ** | **Cost of Service and Other  Revenue** | ** **       | **Gross Margin for Service  and Other Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------------|--------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                                          | 1,594,783        |                                                                     | 54.2       | % |
| Six months ended  June 30, 2005               |       | $                                                          | 1,399,127        |                                                                     | 59.1       | % |
| Change from same  period of prior fiscal year |       | $                                                          | 195,656  or 14.0 | %                                                                        | (4.9       | )% |

 

*Operating Expenses*

*Salesand Marketing.*  Sales and marketing expenses consist primarily ofemployee salaries, benefits, commissions, and associated overhead costs, andthe cost of marketing programs such as direct mailings, public relations, tradeshows, seminars and related communication costs.  Sales and marketing expenses increased duringthe first six months of 2006 as compared to the same period in 2005 due to anincreased number of employees in our sales and marketing departments and theassociated costs of supporting those employees.

Additionally,we increased our marketing program expenditures, including lead generationprograms, trade shows and public relations during the first six months of 2006as compared to the first six months of 2005. These increased expenditures reflect our initiative to further penetratethe legal vertical market with our AccuRoute product, as well as our initiativeto target new vertical markets, including the healthcare and financial verticalmarkets.  Building on the successof the current version of our AccuRoute product within the legal verticalmarket since its introduction in 2004, we intend to continue broadening ourcurrent sales and marketing strategy, which we began in the second quarter of2005, to encompass the financial services and healthcare vertical markets.  During the remainder of 2006, our investmentin sales and marketing and business development will remain at the current leveland we expect to start seeing the impact of these investments in growing ourbusiness during the remainder of 2006.

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| ** **                                    | ** ** | **Sales and Marketing Expenses** | ** **         | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|--------------------|------------------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                               | 4,211,200          |                                                                                                       | 65.7       | % |
| Six months ended  June 30, 2005               |       | $                                               | 2,320,252          |                                                                                                       | 31.2       | % |
| Change from same  period of prior fiscal year |       | $                                               | 1,890,948  or 81.5 | %                                                                                                          | 34.5       | % |

 

*Researchand Development.* Research and development expenses includeexpenses associated with the development of new products, enhancements ofexisting products and quality assurance activities. These expenses consistprimarily of employee salaries, benefits, associated overhead costs, consultingexpenses and the cost of software development tools. Research and developmentincreased during the six month period ended June 30, 2006 compared to the sameperiod in the prior fiscal year due to an increase in consulting expenses andoverhead costs including predominantly an increase in health care costs.  To a lesser extent, research and developmentexpenses increased due to an increase in the resources allocated to thedepartment resulting in increased wages expense.  We expect research and development expensesto remain consistent in absolute dollars for the remainder of 2006, as webelieve we currently have a sufficient amount of engineers and third partyconsultants to support our expansion of our AccuRoute product into othervertical markets.
| ** **                                    | ** ** | **Research and Development  Expenses** | ** **       | **Research and Development  Expenses as a Percentage of  Total Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------------|-------------------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                                | 1,431,554        |                                                                                                        | 22.4       | % |
| Six months ended  June 30, 2005               |       | $                                                | 1,037,690        |                                                                                                        | 14.0       | % |
| Change from same  period of prior fiscal year |       | $                                                | 393,864  or 38.0 | %                                                                                                           | 8.4        | % |

 

*Generaland Administrative.* General and administrative expenses consist primarily of employeesalaries, benefits for administrative, executive and finance personnel andassociated corporate general and administrative expenses.  During the six months ended June 30, 2006,our general and administrative expenses increased as compared to the sameperiod in 2005.  The increase in generaland administrative expenses, both in dollar amount and as a percentage of totalrevenue, is due in part to an increase in accounting and legal expenses as aresult of increased expenses related to sales tax compliance as well as hiringa Managing Director for our United Kingdom subsidiary.  To a lesser extent, our general andadministrative expenses increased due to an increase in health care costs,expenses incurred in connection with the relocation to our new headquarters andan increase in resources allocated to the general and administrativedepartment, which resulted in increased wages and stock-based compensationexpenses.  These increases were offset inpart by a decrease in professional fees related to the compliance with Section404 of the Sarbanes-Oxley Act of 2002 during the first six months of 2006.  The deadline for compliance withSection 404 has been delayed to the first fiscal year ending on or afterJuly 15, 2007 for companies like us that have a public float of less than$75 million.
| ** **                                    | ** ** | **General and Administrative  Expenses** | ** **       | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006               |       | $                                                  | 1,718,428        |                                                                                                              | 26.8       | % |
| Six months ended  June 30, 2005               |       | $                                                  | 1,501,308        |                                                                                                              | 20.2       | % |
| Change from same  period of prior fiscal year |       | $                                                  | 217,120  or 14.5 | %                                                                                                                 | 6.6        | % |

 

*Interestand Other Income.*  Interest and other income, net consistsprincipally of interest income earned on cash and cash equivalent balancesoffset by interest expense associated with a capital lease that we entered intoto finance the furnishing of our new headquarters and a new phone system.  The decrease in interest income, net is aresult of a lower average cash balance during the six month period ended June30, 2006 as compared to the six month period ended June 30, 2005 together withthe finance charges for the capital lease discussed above.  We expect that interest and other income willbe relatively stable quarter over quarter for fiscal year 2006.
| ** **                                      | ** ** | **Interest and Other Income** | ** **      | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|-----------------|---------------------------------------------------------------------------------------------------------|------------|
| Six months ended  June 30, 2006                 |       | $                                            | 83,529          |                                                                                                    | 1.3        | % |
| Six months ended  June 30, 2005                 |       | $                                            | 85,757          |                                                                                                    | 1.2        | % |
| Increase from  same period of prior fiscal year |       | $                                            | (2,228  or (2.6 | )  )%                                                                                                   | 0.1        | % |

 

*Provision for Income Taxes.*  Duringthe six months ended June 30, 2006, we did not record a tax provision due tothe net loss incurred during the period. During the six months ended June 30, 2005, the Company recorded anet tax provision of $6,777 for expected tax liability in the United States.

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**Inflation**

During the fiscalyears ended December 31, 2005, 2004 and 2003 and the first and second fiscalquarters of 2006, neither inflation nor changing prices have had a materialimpact on our net sales, revenue or income from continuing operations.

**Liquidityand Capital Resources**

Since 1996, we have financed our operations primarilythrough cash flow from operations, private sales of preferred stock and commonstock and our initial public offering of common stock completed inAugust 1997. As of June 30, 2006, we had cash and cash equivalents of $6.8million and working capital of $2.9 million. We believe that our existing cash and cash equivalents will besufficient to meet our working capital, capital expenditures and otherliquidity requirements for at least the next twelve months.
|                                               | ** ** | **Cash Provided (Used)** | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **Operating  Activities**          | ** ** | **Investing Activities** | ** ** | **Financing Activities** | ** ** |
| Six months ended June 30,  2006               |       | $                                  | (2,609,441 | ) | $ | (920,861 | ) | $ | (150,534 | ) |
| Six months ended June  30, 2005               |       | $                                  | 556,409    |   | $ | (63,594 | ) | $ | 20,589 |   |
| Change from same period of  prior fiscal year |       | $                                  | (3,165,850 | ) | $ | (857,267 | ) | $ | (171,123 | ) |
|                                               |       | or (569.0)                         | %          | or (1,348.0) | % | or (831.1) | % |

 

Our operatingactivities used cash of $2.6 million during the six months ended June 30, 2006and provided $556,000 of cash during the six months ended June 30, 2005.  We believethat the additional resources being allocated to improve the success of ourAccuRoute product in the legal vertical market and its expansion into thefinancial services and healthcare vertical markets will continue to putpressure on our earnings and operating cash flow during the remainder of 2006,but that our existing cash is sufficient for at least the next twelve months.

Net cash usedduring the six months ended June 30, 2006 consisted primarily of a net lossfrom operations and an increase in accounts receivable, prepaids and othercurrent assets and inventory, offset in part by a increase in accounts payable,deferred rent and deferred revenue as well as the non-cash effects ofstock-based compensation and depreciation.

The increase inaccounts receivable is due to the fact that much of our sales order processingoccurred at the end of the quarter.  Inaddition, the increase in prepaid expenses and other current assets is due tothe payment of third party royalty agreements for software licenses.  The increase in accounts payable is due tothe timing of vendor payments.  Theincrease in deferred rent is a result of cash received from a tenantimprovement allowance related to our new headquarters.  The increase in deferred revenue andinventory is due to an increase in orders for which we hold contracts but hadto defer recognition of revenue because the associated sales did not yet meetall of the criteria for revenue recognition. Cash provided by operating activities during the six months ended June30, 2005 consisted primarily of net income from operations and the non-casheffects of depreciation and stock-based compensation, decreases to accountsreceivable and inventory offset by decreases to the accounts receivable reserveand deferred revenue and an increase to prepaid expenses and other currentassets.

Investingactivities used cash of $921,000 and $64,000 during the six months ended June30, 2006 and 2005, respectively.  The primary use of cash for investingactivities during the first six months of 2006 was the purchase of furnitureand equipment for our new headquarters. We expect that we will reduce our investments in computer-relatedsoftware and hardware products for the remainder of 2006 since we have alreadyimproved our IT infrastructure and facilities during the first half of fiscalyear 2006 as part of our relocation of our office. The sole use of cash forinvesting activities during the first six months of 2005 consisted of hardwareand software purchases.

Financingactivities used cash of $150,534 for the six months ended June 30, 2006primarily for the purchase of stock from an unaffiliated stockholder.  Financing activities provided $21,000 of cashfor the six months ended June 30, 2005 due to the net proceeds from theissuance of common stock from our employee stock purchase program.

Based on our performance for the first six months of2006 and current expectations for the remainder of the fiscal year, we believethat our current cash and cash equivalents balance, as well as the cashexpected to be generated from operations for the remainder of the year, will besufficient to satisfy our working capital needs, capital expenditures and otherliquidity requirements associated with our operations through at least the nexttwelve months.  We expect that principal uses of cash will be foroperations, working capital, payment of sales taxes and purchases of propertyand equipment.  There can be no assurance that any necessary additionalfinancing will be available to us on commercially reasonable terms, or at all.

24

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The following table represents the approximate amountsof payments due under specified contractual obligations as of June 30, 2006:
| **Contractual Obligations** | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  Three years** | ** ** | **Three to  five years** | ** ** | **More than  Five years** | ** ** |
|----------------------------------|------------|-----------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
|                             |       |      |       |                              |       |                              |       |                               |       |                                |       |
| Capital lease  obligations       |       | $         | 579,722    |                              | $          | 117,910                           |       | $                                  | 235,819    |                                | $          | 225,993 |   | $ | — |   |
| Operating lease  obligations     |       | $         | 4,172,688  |                              | $          | 319,957                           |       | $                                  | 761,296    |                                | $          | 809,015 |   | $ | 2,282,420 |   |
| Total contractual  obligations   |       | $         | 4,752,410  |                              | $          | 437,867                           |       | $                                  | 997,115    |                                | $          | 1,035,008 |   | $ | 2,282,420 |   |

 

Capital lease obligations consist of a capital leasewith a five-year term related to the purchase of furniture and equipment forour new headquarters.  Operating leaseobligations consist of lease payments for our offices in Andover, Massachusettsand London, England, United Kingdom. As of June 30, 2006, we did not have anymaterial commitments for capital expenditures or other long-term liabilitiesfor which payments are required.

**Off-BalanceSheet Arrangements**

We do not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, that would have beenestablished for the purpose of facilitating off-balance sheet arrangements (asthat term is defined in Item 303(a)(4)(ii) of Regulation S-K) or othercontractually narrow or limited purposes.  As such, we are not exposed toany financing, liquidity, market or credit risk that could arise if we hadengaged in those types of relationships.

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

*Derivative Financial Instruments, Other FinancialInstruments, and Derivative Commodity Instruments.*** ** As of June 30, 2006, the Company didnot participate in any derivative financial instruments or other financial andcommodity instruments for which fair value disclosure would be required underSFAS No. 133,**“*Accountingfor Derivative Instruments and Hedging Activities*.” All ofthe Company’s investments consist of money market funds and commercial paperthat are carried on the Company’s books at amortized cost, which approximatesfair market value. Accordingly, the Company has no quantitative informationconcerning the market risk of participating in such investments.

*PrimaryMarket Risk Exposure*s.* *The Company’s primary market risk exposures are in the areas of interest raterisk and foreign currency exchange rate risk. The Company’s investmentportfolio of cash equivalents is subject to interest rate fluctuations, but theCompany believes this risk is immaterial due to the short-term nature of theseinvestments. The Company’s exposure to currency exchange rate fluctuations hasbeen and is expected to continue to be modest due to the fact that theoperations of its United Kingdom subsidiary are almost exclusively conducted inits local currency. The United Kingdom subsidiary’s operating results aretranslated into U.S. dollars and consolidated for reporting purposes. Theimpact of currency exchange rate movements on intercompany transactions wasimmaterial for the quarter ended June 30, 2006. The Company manages its foreigncurrency exchange risk by monitoring its net monetary position using naturalhedges of its assets and liabilities denominated in local currencies. There can be no assurance that this approach will eliminate all foreigncurrency exchange rate exposure. Currently, the Company does not engage inforeign currency hedging activities.

**Item4. Controls and Procedures**

(a)           Evaluation of disclosure controls andprocedures.

As of June 30, 2006 (the “Evaluation Date”), theCompany, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of the Company’s disclosure controls andprocedures pursuant to Rule 13a-15(b) promulgated under the Securities ExchangeAct of 1934, as amended (the “Exchange Act”).  Based upon that evaluation,the Company’s Chief Executive Officer and Chief Financial Officer concludedthat, as of the Evaluation Date, the Company’s disclosure controls andprocedures were effective in ensuring that information relating to the Company(including its consolidated subsidiaries) required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, including ensuringthat such information is accumulated and communicated to the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, as appropriate to allow timely decisions regarding requireddisclosure.

(b)           Changes in internal control overfinancial reporting

There was nochange in the Company’s internal control over financial reporting during theCompany’s fiscal quarter ended June 30, 2006 or in other factors that hasmaterially affected, or is reasonably likely to materially affect, the Company’sinternal control over financial reporting.

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**PARTII:  OTHER INFORMATION**

**Item1A.  Risk Factors**

There are nomaterial changes from risk factors as previously disclosed in **Item 1A, “Risk Factors,”of our 2005 Form 10-K.**

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**
| **ISSUER PURCHASES OF EQUITY SECURITIES** | ** ** |
|---------------------------------------------------------------|------------|
| **Period**                                                    | ** ** | **(a) Total Number  of Shares  Purchased** | ** ** | **(b) Average Price  Paid per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares  that May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|                                                          |       |   |   |   |   |   |   |   |   |
| April 1, 2006 — April  30, 2006                          |       | — |   | — |   | — |   | — |   |
| May 1, 2006 — May 31,  2006                              |       | — |   | — |   | — |   | — |   |
| June 1, 2006 — June 30, 2006                             |       | 25,000 |   | $ | 5.51 |   | — |   | — |   |
|                                                               |            |  |  |  |  |  |  |  |  |  |

 

(1)  On June 1, 2006, the Company, in anopen-market transaction, repurchased 25,000 shares of its Common Stock from anon-affiliated stockholder.  The Companyeffected the share repurchase at a purchase price of $5.51 per share.

**Item4.  Submission of Matters to a Vote ofSecurity Holders**.

We held our AnnualMeeting of Stockholders on Tuesday, May 23, 2006 at our offices at 6 RiversideDrive, Andover, Massachusetts.  The onlymatters voted upon were the elections of Martin A. Schultz and Robert L. Voelkas Class III directors of the Company. The tabulation with respect to each nominee is as set forth below:

 
| **Nominee**       | ** ** | **Number of  Votes For** | ** ** | **Number of  Votes Withheld** | ** ** | **Number of  Abstentions** | ** ** | **Number of  Broker non-votes** | ** ** |
|-------------------|------------|------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|-------------------------------------------|------------|
| Martin A. Schultz |       | 3,239,438                          |       | 3,976                              |       | N/A                             |       | 0                                         |       |
| Robert L. Voelk   |       | 3,236,582                          |       | 6,832                              |       | N/A                             |       | 0                                         |       |

 

The terms ofoffice of Richard D. Cramer, Arnold E. Ditri, Andrew E. Lietz, William J.Drummey and James P. O’Halloran continued after the meeting.

**Item5.  Other Information**

There have been nochanges to the procedures by which security holders may recommend nominees tothe Company’s Board of Directors during the time period covered by thisQuarterly Report on Form 10-Q.

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** **

**Item6.  Exhibits**
| 31.1   |   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 31.2   |   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                               |
|   |   |                                                                                                                                                 |
| 32.1   |   | Certification of 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 Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

 

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**Signatures**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|           | OMTOOL, LTD. |
|----------------|--------------|
|           |         |
|           |         |
| August 7, 2006 | By:          | /s/ Daniel A. Coccoluto |   |
|           |         | Daniel A. Coccoluto |
|           |         | Chief Financial Officer, Secretary and Treasurer |
|           |         | (Duly authorized officer and principal financial  officer) |

 

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**Exhibit Index**
| 31.1   |   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 31.2   |   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                               |
|   |   |                                                                                                                                                 |
| 32.1   |   | Certification of 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 Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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