UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM 10-K





ý
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2008
      OR





o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
                              
      TO





COMMISSION
FILE NUMBER: 000-19960





DATAWATCH
CORPORATION


(Exact
name of registrant as specified in its charter)





DELAWARE
            
            02-0405716(State
      or Other Jurisdiction of
              Incorporation
      or Organization)
            
            (I.R.S.
      Employer
              Identification
      No.)





271
MILL ROAD


QUORUM
OFFICE PARK


CHELMSFORD,
MASSACHUSETTS 01824


(978)
441-2200


(Address
and telephone number of principal executive office)





SECURITIES
REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:




Common
      Stock $0.01 PAR VALUE
              NASDAQ(Title
      of Class)
              (Name
      of Exchange on which
Registered)





SECURITIES
REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes o   No  ý





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes o   No  ý





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





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.    ý





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See definitions of “large accelerated filer”,
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of
the Exchange Act.




Large accelerated
      filer o
            Accelerated
      filer  o
            Non-accelerated
      filer o
              (Do not check
      if a smaller reporting company)
            Smaller reporting
      company x




Indicate
by check mark whether the registrant is a shell company (as defined in Exchange
Act Rule 12b-2).Yes o   No  ý





The
aggregate market value of voting stock held by non-affiliates of the registrant,
based on the closing price of the registrant’s common stock on March 31, 2008,
the last business day of the Company’s most recently completed second fiscal
quarter, as reported by the NASDAQ Capital Market was $15,860,548.





The
number of shares of the registrant’s common stock, $.01 par value, outstanding
as of December 22, 2008 was 5,914,358.





Documents
Incorporated By Reference





Registrant
intends to file a definitive Proxy Statement pursuant to Regulation 14A within
120 days of the end of the fiscal year ended September 30,
2008.  Portions of such Proxy Statement are incorporated by reference
in Part III of this report.











DATAWATCH
CORPORATION


ANNUAL
REPORT ON FORM 10-K





TABLE
OF CONTENTS





Page


Part IItem
      1.
            Business
            3Item
      1A.
            Risk
      Factors
            8Item
      1B.
            Unresolved
      Staff Comments
            12Item
      2.
            Properties
            12Item
      3.
            Legal
      Proceedings
            13Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            13Part IIItem
      5.
            Market
      for Registrant’s Common Equity and Related Shareholder
    Matters
            15Item
      6.
            Selected
      Consolidated Financial Data
            15Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            16Item
      7A.
            Quantitative
      and Qualitative Disclosures about Market Risk
            30Item
      8.
            Financial
      Statements and Supplementary Data
            32Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            55Item
      9A
            Controls
      and Procedures
            56Item
      9B.
            Other
      Information
            57Part IIIItem
      10.
            Directors
      and Executive Officers of the Registrant
            58Item
      11.
            Executive
      Compensation
            58Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management
            58Item
      13.
            Certain
      Relationships and Related Transactions
            58Item
      14.
            Principal
      Accounting Fees and Services
            58Part IVItem
      15.
            Exhibits
      and Financial Statement Schedules
            59





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PART I





Item
1.  BUSINESS





GENERAL





Datawatch
Corporation (the “Company” or “Datawatch”), a leader in Enterprise Information
Management (“EIM”), helps companies make better decisions and solve business
problems by simplifying access to information. Datawatch transforms the massive
amounts of data and documents generated inside or outside a company into
actionable business intelligence, without any changes needed to existing
systems. Datawatch customers benefit from the right information, in the right
context, at the right time. More than 35,000 organizations worldwide rely on
Datawatch products including its market-leading Monarch report and data mining
solutions. Founded in 1985, Datawatch is based in Chelmsford, Massachusetts with
offices in London, Sydney and Manila.





The
Company offers its enterprise products through both the sale of perpetual
licenses as well as through a subscription pricing model that allows customers
to begin using the Company’s products at a lower initial cost of software
acquisition. Subscription terms typically run 12 months or 24 months and
automatically renew unless terminated with 90 days notice following the first
year of the subscription term. The subscription arrangement includes software,
maintenance and unspecified future upgrades including major version
upgrades.





The
Company is a Delaware corporation with executive offices located at 271 Mill
Road, Quorum Office Park, Chelmsford, MA 01824 and the Company’s telephone
number is (978) 441-2200.  Periodic reports are made available to the
public, free of charge, on the Company’s website, www.datawatch.com and
through the SEC’s website, www.sec.gov as soon
as reasonably practicable after they have been filed with the SEC.





PRODUCTS





Monarch – Datawatch is best known for
its market-leading desktop report mining and business intelligence application
called Monarch. More than 450,000 copies of Monarch have been licensed, with
localized versions in English, French and German. Monarch transforms structured
text files (reports, statements, etc.) into a live database that users can sort,
filter, summarize, graph and export to other applications such as Microsoft
Corporation’s Excel or Access.  Monarch Professional Edition lets
users extract and work with data in PDF and HTML files, databases, spreadsheets
and Open Data Base Connectivity sources as well as reports.  The
Monarch product line represented approximately 51% of total revenues for the
fiscal year 2008.





Monarch Data Pump – Monarch Data Pump provides
powerful information delivery and data extract, transform and load capabilities
in one automated solution, without programming. Combining Datawatch’s Monarch
Report Mining/Data Mining engine with the Microsoft.NET framework, Monarch Data
Pump delivers a highly scalable and easily administered solution to acquire,
combine, and monitor customized data, and deliver that data in a wide variety of
formats, on an automatic, scheduled basis. Monarch Data Pump Professional
Edition adds high-volume data production, remote web administration, a web
service interface and tight integration with Microsoft SharePoint and Microsoft
SQL Server 2005 Integration Services.





Monarch BI Server – Monarch BI Server is an
out-of-the-box web-based Business Intelligence (“BI”) solution developed
specifically for small to medium size businesses and individual departments of
large businesses. By transforming reports and other business documents stored in
a central report warehouse on demand into browser-based tables, summaries and
charts or Excel spreadsheets, Monarch BI Server allows organizations to fully
leverage their investments in existing reporting output and processes. Monarch
BI Server delivers BI without data marts or programming, little or no need for
end user training and with minimal support and administration
requirements.





Monarch RMS – Monarch RMS (Report Mining
Server) is a web-based report mining and analysis solution that




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integrates
with any existing Enterprise Record Management document or content management
archiving solution including Datawatch BDS, IBM Content Manager OnDemand and
Hyland OnBase. Monarch RMS opens up the corporate data locked in stored, static
reports, enabling dynamic business-driven analysis of information in users’ web
browsers or favorite productivity tools with no programming.





Datawatch ES– Datawatch ES is an
enterprise Business Intelligence system that provides web-enabled report
management, mining and distribution as well as data analysis and MS Excel
integration, at a fraction of the complexity and cost of traditional BI
solutions. Datawatch ES allows organizations to quickly and easily deliver
business intelligence and decision support, derived from existing reporting
systems and other database sources, with no new programming or report writing.
Datawatch ES automatically stores report data in an enterprise report and
document warehouse and provides users a unified point of entry to view, analyze
and share information over the Internet. Designed to be scalable through
thousands of users, Datawatch ES offers powerful additional features including
dynamic on-line analytical process-type tools, XML forms generation,
collaboration and subscription capabilities, and live linking of report and
database information.





Datawatch BDS–Datawatch BDS (Business
Document Server) is a high speed, high volume document archive system, storing
text as wellas
images, intelligent data streams and unstructured content, complete with file
compression and encryption. Datawatch BDS is capable of enabling thousands of
end users to access and retrieve stored documents in a matter of seconds via the
network or web. Datawatch BDS also offers optional advanced business modules
including e-Notify for automatic email notification to end users of newly
archived documents, Datawatch BDS Workflow for web-enabled enterprise business
process management, Monarch RMS for web-enabled transformation of business
documents into customized data for easy analysis and Datawatch BDS Records
Management for the ability to organize and process documents and other content
within a regulatory compliant plan. The Datawatch|BDS product line represented
approximately 16% of total revenues for fiscal year 2008.





Datawatch BDSWorkflow– Datawatch BDS
Workflow is a web-enabled enterprise business process management solution. A
module for the Datawatch BDS document archive system, BDS Workflow provides
highly effective processing of document intensive business transactions and
includes the archiving of documents received from outside of the organization as
well as documents generated during and after a workflow.





Datawatch MailManager–Datawatch
MailManageris a
highly scalable email management solution that provides complete lifecycle,
compliance, and storage management for Microsoft Exchange environments. It is a
compliance solution built to scale from small and medium size organizations to
large corporate entities and is able to support even the most stringent
regulatory requirements. Datawatch MailManager automates the email management
lifecycle. It captures internal, outgoing and incoming email correspondence,
indexing it and managing its retention based on an organization’s internal
policies. In the case of audit or legal discovery, related e-mail can be
instantly and accurately retrieved for rapid response.





Visual Insight–Visual Insightis a highly customizable
performance management solution that can provide Key Performance Indicator
reporting, as well as workflow and knowledge base portals. Built on a .NET
platform, Visual Insight not only delivers performance management, but actually
facilitates performance improvement. Visual Insight is available as a web-based
business data and information management server Software Development
Kit.





Visual QSM – Visual QSM is a
Web-enabled IT service management system that scales from a basic help desk
system to a full business management solution that incorporates workflow and
network management capabilities and provides web access to multiple databases
while enabling customers to interact via a standard browser.  Visual
QSM also provides advanced service level management capabilities, integrated
change management features, business process automation tools and one of the
industry’s easiest to learn and use interfaces.  The Visual QSM
product line represented approximately 16% of total revenues for fiscal year
2008.





Visual Help Desk – Visual Help Desk
(“Visual HD”) leverages the IBM Lotus Domino platform to provide a 100%
web-based help desk and call center solution. Cost effective and easy to deploy,
Visual HD is an enterprise-




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wide
support solution that supports an organization’s existing IT infrastructure.
Visual HD has the additional ability to utilize XML-based Web Services as well
as the ability to integrate directly with IBM enterprise
applications.





VorteXML - VorteXML software
quickly and easily converts any structured text output generated from any system
into valid XML for web services and more using any DTD or XDR schema without
programming.  VorteXML dramatically speeds up and reduces the cost of
enabling current applications for web services, implementing enterprise XML
solutions, putting legacy output on the web (including bill presentment), and
more.  The VorteXML solution suite is comprised of two software
products that work together: VorteXML Designer, a desktop tool that provides
users a visual interface that allows users to extract, transform and map data
from existing text documents into XML without programming; and VorteXML
Server,a scalable,
high-volume server that automates the extraction and conversion of text
documents into XML.





The
Company also receives license royalties for its iMergence iStore product
primarily from a provider of services to the financial services industry.
iMergence iStore is a report management solution which manages
computer-generated reports, mines the data contained in them, and allows users
to interactively merge and transform them into new reports.





PRICING





The
Company’s desktop products are sold under single and multi-user licenses. A
single user license for Monarch Standard Edition is priced at $699. A single
user license for Monarch Professional Edition is priced at $849. Monarch Data
Pump is priced at $8,995 per server for the Standard Edition and $24,995 for the
Professional Edition. A single user license for VorteXML Designer is priced at
$499 and VorteXML Server is priced at $8,995 per server.





The
Company’s enterprise business intelligence, content management and business
service management products are primarily sold under server-based licenses with
named-user and concurrent-user client licenses. The base price for Monarch BI
Server is $10,995. Entry-level Datawatch ES and Datawatch BDS systems are priced
at $30,000. Entry-level Visual QSM and Visual Insight systems are priced at
approximately $20,000. An entry-level Monarch RMS system is priced at $15,000.
An entry-level Datawatch MailManager system is priced at $12,000. An entry-level
Visual HD system is priced for less than $10,000. All of the above systems with
the exception of Monarch BI Server can cost significantly more depending on the
number of software modules, software server licenses and end user licenses sold
and the amount of professional services and maintenance included.





MARKETING
AND DISTRIBUTION





Datawatch
sells its products through a variety of channels including directly to customers
through its own internal and external sales force as well as through a variety
of value-added partners, system integrators, distributors and national resellers
in order to gain broad market exposure and to satisfy the needs of its
customers.





The
Company is engaged in active sales of its products to end-users, including
repeat and add-on sales to existing customers and sales to new
customers.  Datawatch utilizes direct mail, the Internet,
telemarketing and direct personal selling to generate its sales.





Datawatch
uses a variety of marketing programs to create demand for its products. These
programs include advertising, cooperative advertising with reseller partners,
direct mail, exhibitor participation in industry shows, executive participation
in press briefings, Internet-based marketing and on-going communication with the
trade press.





The
Company offers selected distributors the ability to return obsolete versions of
its products and slow-moving products for credit. Based on its historical
experience relative to products sold to these distributors, the Company believes
that its exposure to such returns is minimal. It has provided a provision for
such estimated returns in the financial statements.





- 5
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Datawatch
warrants the physical disk media and printed documentation for its products to
be free of defects in material and workmanship for a period of 30 days from the
date of purchase depending on the product.  Datawatch also offers a 30
day money-back guarantee on certain of its products sold directly to end-users.
Under the guarantee, customers may return purchased products within the 30 day
period for a full refund if they are not completely satisfied. To date, the
Company has not experienced any significant product returns under its money-back
guarantee.





During
fiscal 2008, 2007 and 2006, one distributor, Ingram Micro Inc., represented
approximately 21%, 15% and 16%, respectively, of the Company’s total revenue.
During fiscal 2008, 2007 and 2006, another distributor, Tech Data Corporation,
represented approximately 8%, 13%, and 13%, respectively, of the Company’s total
revenue. No other customer accounted for more than 10% of the Company’s total
revenue in fiscal 2008, 2007 or 2006. Datawatch’s revenues from outside of the
U.S. are primarily the result of sales through the direct sales force of its
wholly-owned subsidiary, Datawatch International Limited and its subsidiaries
(“Datawatch International”) and through international resellers. Such
international sales (which are primarily in the UK) represented approximately
30%, 31% and 32% of the Company’s total revenue for fiscal 2008, 2007 and 2006,
respectively.  See Note 9 to the Company’s Consolidated Financial
Statements for segment information.





RESEARCH
AND DEVELOPMENT





The
Company believes that timely development of new products and enhancements to its
existing products is essential to maintain strong positions in its markets.
Datawatch intends to continue to invest significant amounts in research and
product development to ensure that its products meet the current and future
demands of its markets as well as to take advantage of evolving technology
trends.





Datawatch’s
product development efforts are conducted through in-house software development
engineers and by external developers.  External developers are
compensated through royalty payments based on product sales levels achieved or
under contracts based on services provided.  Datawatch has established
long-term relationships with several development engineering firms, providing
flexibility, stability and reliability in its development process.





Datawatch’s
product managers work closely with developers, whether independent or in-house,
to define product specifications.  The initial concept for a product
originates from this cooperative effort.  The developer is generally
responsible for coding the development project. Datawatch’s product managers
maintain close technical control over the products, giving the Company the
freedom to designate which modifications and enhancements are most important and
when they should be implemented.  The product managers and their staff
work in parallel with the developers to produce printed documentation, on-line
help files, tutorials and installation software. In some cases, Datawatch may
choose to subcontract a portion of this work on a project basis to third-party
suppliers under contracts. Datawatch personnel also perform extensive quality
assurance testing for all products and coordinate external beta test
programs.





An
existing agreement between Datawatch and Math Strategies grants the Company
exclusive worldwide rights to use and distribute certain intellectual property
owned by Math Strategies and incorporated by the Company in its Monarch, Monarch
Data Pump and certain other products. In February 2006, the Company extended its
exclusive worldwide distribution rights with Math Strategies for the technology
used in the development of Monarch products until April 30, 2015. In addition,
an amendment to the purchase option contract with Math Strategies, originally
signed on April 29, 2004, gives Datawatch the option to purchase the
intellectual property rights to the software source code and any existing
patents at any time before April 30, 2015. This option, if exercised, would
provide the Company with increased flexibility to utilize the purchased
technology in the future.





Other
Datawatch products have been developed through in-house software development or
by independent software engineers hired under contract. Datawatch maintains
source code and full product control for these products, which include Datawatch
BDS, Datawatch ES, Monarch BI Server, Visual QSM, and Visual HD




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products.
Datawatch BDS, Datawatch ES, Monarch BI Server, Visual QSM, and Visual HD are
trademarks of Datawatch Corporation. Visual Help Desk is a registered trademark
of Auxilor, Inc. (“Auxilor”), a wholly-owned subsidiary of Datawatch
Corporation.





During
fiscal 2004, the Company acquired Mergence Technologies Corporation which had a
branch software development and testing office in the Philippines. Mergence,
which was renamed Datawatch Technologies Corporation coincident with the
acquisition, developed the iMergence iStore and Visual Insight products at its
facilities in the United States and the Philippines prior to the acquisition.
The Company has integrated the Philippines development branch as an alternative
development facility for its other enterprise products.  iMergence is
a registered trademark of Datawatch Corporation.





During
fiscal 2006, the Company acquired the Integrated Document Archiving and
Retrieval Systems (“IDARS”) business from ClearStory Systems, Inc., including
Radiant Business Document Server, which was renamed Datawatch BDS, and Radiant
MailManager which was renamed Datawatch MailManager.





The
Company’s total research and development expense was $2,966,000, $2,951,000 and
$2,094,000 for fiscal years 2008, 2007 and 2006, respectively.





BACKLOG





The
Company’s software products are generally shipped within three business days of
receipt of an order.  Accordingly, the Company does not believe that
backlog for its products is a meaningful indicator of future business. The
Company does maintain a backlog of services related to its Datawatch BDS,
Datawatch ES, Visual QSM, and Visual HD business. While this services backlog
will provide future revenue to the Company, the Company believes that it is not
a meaningful indicator of future business.





COMPETITION





The
software industry is highly competitive and is characterized by rapidly changing
technology and evolving industry standards.  Datawatch competes with a
number of companies including Actuate Corporation, IBM, Microsoft Corporation,
ASG Software Solutions and others that have substantially greater financial,
marketing and technological resources than the Company. Competition in the
industry is likely to intensify as current competitors expand their product
lines and as new competitors enter the market.





PRODUCT
PROTECTION





In
addition to having certain patents pending on its software technologies,
Datawatch relies on a combination of trade secret, copyright and trademark laws,
nondisclosure and other contractual agreements, and technical measures to
protect its rights in its products.  Despite these precautions,
unauthorized parties may attempt to copy aspects of Datawatch’s products or to
obtain and use information that Datawatch regards as
proprietary.  Datawatch believes that, because of the rapid pace of
technological change in the software industry, the legal protections for its
products are less significant than the knowledge, ability and experience of its
employees and developers, the frequency of product enhancements and the
timeliness and quality of its support services.  Datawatch believes
that none of its products, trademarks, patents, and other proprietary rights
infringes on the proprietary rights of third parties, but there can be no
assurance that third parties will not assert infringement claims against it or
its developers in the future.





PRODUCTION





Production
of Datawatch’s products involves the duplication of compact disks and the
printing of user manuals, packaging and other related materials. High volume
compact disk duplication is performed by non-affiliated subcontractors, while
low volume compact disk duplication is performed in-house. Printing work is also
performed by non-affiliated subcontractors. To date, Datawatch has not
experienced any material difficulties or delays in production of its software
and related documentation and believes that, if necessary, alternative




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production
sources could be secured at a commercially reasonable cost.





EMPLOYEES





As of
December 23, 2008, Datawatch had 114 full-time and 4 contract, temporary or
part-time employees, including 32 engaged in marketing, sales, and customer
service; 35 engaged in product consulting, training and technical support; 31
engaged in product management, development and quality assurance; 18 providing
general, administrative, accounting, and IT functions; and 2 engaged in software
production and warehousing.








Item 1A.  RISK
FACTORS





The
Company does not provide forecasts of its future financial performance. However,
from time to time, information provided by the Company or statements made by its
employees may contain “forward looking” information that involves risks and
uncertainties. In particular, statements contained in this Annual Report on
Form 10-K that are not historical facts (including, but not limited to
statements contained in “Item 7.  Management’s Discussion and Analysis
of Financial Condition and Results of Operations” of Part II of this Annual
Report on Form 10-K relating to liquidity and capital resources) may
constitute forward looking statements and are made under the safe harbor
provisions of The Private Securities Litigation Reform Act of 1995. The Company
cautions readers not to place undue reliance on any such forward
looking-statements, which speak only as of the date they are made. The Company
disclaims any obligation, except as specifically required by law and the
rules of the Securities and Exchange Commission, to publicly update or
revise any such statements to reflect any change in the Company’s expectations
or in events, conditions or circumstances on which any such statements may be
based, or that may affect the likelihood that actual results will differ from
those set forth in the forward-looking statements. The Company’s actual results
of operations and financial condition have varied and may in the future vary
significantly from those stated in any forward looking
statements.  Factors that may cause such differences include, without
limitation, the risks, uncertainties and other information discussed below and
within this Annual Report on Form 10-K, as well as the accuracy of the
Company’s internal estimates of revenue and operating expense levels. The
following discussion of the Company’s risk factors should be read in conjunction
with the financial statements contained herein and related notes thereto. Such
factors, among others, may have a material adverse effect upon the Company’s
business, results of operations and financial condition.





Weakening World Wide
Economic Conditions and Softening in the Computer Software Market
May Result in Decreased Revenues or Lower Revenue Growth
Rates




The
profitability of the Company’s business depends on the overall demand for
computer software and services, particularly in the financial services markets
and other markets in which it competes. The recent deterioration of worldwide
economic conditions, including tighter credit and negative financial news may
have an adverse affect on the market for computer software and could result in
significant fluctuations in the value of foreign currencies. Because the
Company’s sales are primarily to major corporate customers, poor economic
conditions may soften the demand for computer software and services which may
result in decreased revenues, lower revenue growth rates and reduced
profitability. In addition, a weakening global economy may result in longer
sales cycles, reduced, deferred or cancelled orders, or greater than anticipated
uncollectible accounts receivables.





Furthermore,
terrorist attacks against the United States, and the United States military
response to these attacks have added to economic and political uncertainty which
may adversely affect worldwide demand for computer software and services. In a
weakened economy, the Company cannot be assured that it will be able to
effectively promote future growth in its software and services revenues or
maintain profitability.





Dependence on Principal
Products




In the
year ended September 30, 2008, Monarch, Visual QSM, Datawatch BDS and
Datawatch ES accounted for approximately 51%, 16%, 16% and 8%, respectively, of
the Company’s total revenue. The Company is primarily dependent on its Monarch,
Visual QSM, Datawatch BDS and Datawatch ES products. As a result, any




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factor
adversely affecting sales of any of these products could have a material adverse
effect on the Company. The Company’s future financial performance will depend in
part on the successful introduction of its new and enhanced versions of these
products and development of new versions of these and other products and
subsequent acceptance of such new and enhanced products. In addition,
competitive pressures or other factors may result in significant price erosion
that could have a material adverse effect on the Company’s business, financial
condition, results of operations, or cash flows.





Fluctuations in Quarterly
Operating Results




The
Company’s future operating results could vary substantially from
quarter-to-quarter because of uncertainties and/or risks associated with such
things as current economic conditions, technological change, competition, delays
in the introduction of products or product enhancements and general market
trends. Historically, the Company has operated with minimal backlog of orders
because its software products are generally shipped as orders are received. As a
result, net sales in any quarter are substantially dependent on orders booked
and shipped in that quarter. Further, any increases in sales under the Company’s
subscription sales model could result in decreased revenues over the short term.
Because the Company’s staffing and operating expenses are based on anticipated
revenue levels and a high percentage of the Company’s costs are fixed in the
short-term, small variations in the timing of revenues can cause significant
variations in operating results from quarter-to-quarter. Because of these
factors, the Company believes that period-to-period comparisons of its results
of operations are not necessarily meaningful and should not be relied upon as
indications of future performance. The Company can give no assurance that it
will not experience such variations in operating results in the future or that
such variations will not have a material adverse effect on its business,
financial condition or results of operations.





Dependence on New
Introductions; New Product Delays




Growth in
the Company’s business depends in substantial part on the continuing
introduction of new products. The length of product life cycles depends in part
on end-user demand for new or additional functionality in the Company’s products
and its ability to update its products to meet such demands. If the Company
fails to accurately anticipate the demand for, or encounters any significant
delays in developing or introducing, new products or additional functionality on
its products, there could be a material adverse effect on the Company’s
business. Product life cycles can also be affected by suppliers of operating
systems introducing comparable functionality within their products. The failure
of the Company to anticipate the introduction of additional functionality in
products developed by such suppliers could have a material adverse effect on the
Company’s business. In addition, the Company’s competitors may introduce
products with more features and lower prices than the Company’s products. Such
increase in competition could adversely affect the life cycles of the Company’s
products, which in turn could have a material adverse effect on the Company’s
business.





Software
products may contain undetected errors or failures when first introduced or as
new versions are released.  There can be no assurance that, despite
testing by the Company and by current and potential end-users, errors will not
be found in new products after commencement of commercial shipments, resulting
in loss of or delay in market acceptance. Any failure by the Company to
anticipate or respond adequately to changes in technology and customer
preferences, or any significant delays in product development or introduction,
could have a material adverse effect on the Company’s business.





Volatility of Stock
Price




As seen
recently with the turmoil in the financial markets, and is frequently the case
with the stocks of high technology companies, the market price of the Company’s
common stock has been, and may continue to be, volatile. Factors such as
quarterly fluctuations in results of operations, increased competition, the
introduction of new products by the Company or its competitors, expenses or
other difficulties associated with assimilating companies acquired by the
Company, changes in the mix of sales channels, the timing of significant
customer orders, and macroeconomic conditions generally, may have a significant
impact on the market price of the stock of the Company. Any shortfall in revenue
or earnings from the levels anticipated by securities analysts could have an
immediate and significant adverse effect on the market price of the Company’s
common stock in any given period. In addition, the stock market has from time to
time experienced extreme price and volume fluctuations,




- 9
-


which
have particularly affected the market price for many high technology companies
and which, on occasion, have appeared to be unrelated to the operating
performance of such companies. Finally, to maintain its stock listing with
Nasdaq, the Company must be in compliance with Nasdaq Marketplace Rules,
including but not limited to, minimum bid price requirements. If it is not able
to maintain compliance with these rules, and if the Company’s common stock does
not qualify for, or is subsequently delisted from the Nasdaq Capital Market,
investors may have difficulty converting their investment into cash
efficiently. The price of the Company’s common stock and the ability of
holders to sell such stock would be adversely affected.





Goodwill Impairment
Charges




The
Company reviews goodwill for impairment annually or more frequently if events
and circumstances indicate that the asset may be impaired and that the carrying
value may not be recoverable. Factors the Company considers important that could
trigger an impairment review include, but are not limited to, significant
underperformance relative to historical or projected future operating results,
significant changes in the manner of use of the acquired assets or the strategy
for the Company’s overall business, significant negative industry or economic
trends, a significant decline in the Company’s stock price for a sustained
period, and decreases in its market capitalization below the recorded amount of
its net assets for a sustained period. The Company’s stock price is highly
volatile and has experienced significant declines since September 30, 2008. If
its stock price does not improve prior to the end of the first quarter or if
other factors indicate that it is more likely than not that an impairment may
exist, the Company could determine that an interim impairment test is required,
which could result in a non-cash impairment charge. The balanceofgoodwillis$6,116,000 as of September 30, 2008.
There can be no assurance that future goodwill impairments will not
occur.





International
Sales




In the
years ended September 30, 2008, 2007 and 2006, international sales
accounted for approximately 30%, 31% and 32%, respectively, of the Company’s
total revenue. The Company anticipates that international sales will continue to
account for a significant percentage of its total revenue. A significant portion
of the Company’s total revenue will therefore be subject to risks associated
with international sales, including further deterioration of international
economic conditions, unexpected changes in legal and regulatory requirements,
changes in tariffs, currency exchange rates and other barriers, political and
economic instability, possible effects of war and acts of terrorism,
difficulties in account receivable collection, difficulties in managing
distributors or representatives, difficulties in staffing and managing
international operations, difficulties in protecting the Company’s intellectual
property overseas, seasonality of sales and potentially adverse foreign tax
consequences.





Acquisition
Strategy




The
Company continues to address the need to develop new products, in part, through
the acquisition of other companies including its May 2006 acquisition of the
IDARS business from ClearStory Systems, Inc., its August 2004 acquisition
of Mergence Technologies Corporation and its October 2002 acquisition of
Auxilor Inc. Acquisitions involve numerous risks including difficulties in the
assimilation of the operations, technologies and products of the acquired
companies, the diversion of management’s attention from other business concerns,
risks of entering markets in which the Company has no or limited direct prior
experience and where competitors in such markets have stronger market positions,
and the potential loss of key employees of the acquired
company.  Achieving and maintaining the anticipated benefits of an
acquisition will depend in part upon whether the integration of the companies’
business is accomplished in an efficient and effective manner, and there can be
no assurance that this will occur. The successful combination of companies in
the high technology industry may be more difficult to accomplish than in other
industries.





Limitations on Effectiveness
of Controls




The
Company’s management, including the Chief Executive Officer and President and
the Chief Financial Officer, does not expect that its internal controls will
prevent all errors and intentional misrepresentations. A control system, no
matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met. Further,
the design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their
costs. Because of




- 10
-


the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues, if any, within the Company
have been detected. These inherent limitations include the realities that
judgments in decision-making can be faulty and that breakdowns can occur because
of simple error or mistake. Additionally, controls can be circumvented by the
individual acts of some persons, by collusion of two or more people, or by
management override of the control. The design of any system of controls also is
based in part upon certain assumptions about the likelihood of future events,
and no assurance can be given that any design will succeed in achieving its
stated goals under all potential future conditions; over time, controls may
become inadequate because of changes in conditions, or the degree of compliance
with the policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control system, misstatements due to error or
intentional conduct may occur and not be detected.





Rapid Technological
Change




The
markets in which the Company competes have undergone, and can be expected to
continue to undergo, rapid and significant technological change. The ability of
the Company to grow will depend on its ability to successfully update and
improve its existing products and market and license new products to meet the
changing demands of the marketplace and that can compete successfully with the
existing and new products of the Company’s competitors.  There can be
no assurance that the Company will be able to successfully anticipate and
satisfy the changing demands of the personal computer software marketplace, that
the Company will be able to continue to enhance its product offerings, or that
technological changes in hardware platforms or software operating systems, or
the introduction of a new product by a competitor, will not render the Company’s
products obsolete.





Competition in the Software
Industry




The
software market for personal computers is highly competitive and characterized
by continual change and improvement in technology. Several of the Company’s
existing and potential competitors, including Actuate Corporation, IBM,
Microsoft Corporation, ASG Software Solutions and others, have substantially
greater financial, marketing and technological resources than the
Company.  No assurance can be given that the Company will have the
resources required to compete successfully in the future.





Dependence on Proprietary
Software Technology




The
Company’s success is dependent upon proprietary software technology. Although
the Company does not own all patents on any such technology, it does hold
exclusive licenses to such technology and relies principally on a combination of
trade secret, copyright and trademark laws, nondisclosure and other contractual
agreements and technical measures to protect its rights to such proprietary
technology. Despite such precautions, there can be no assurance that such steps
will be adequate to deter misappropriation of such technology.





Reliance on Software License
Agreements




A
majority of the Company’s products incorporate third-party proprietary
technology which is generally licensed to the Company on an exclusive, worldwide
basis. Failure by such third-parties to continue to develop technology for the
Company and license such technology to the Company could have a material adverse
effect on the Company’s business and results of operations.





Dependence on the Ability to
Hire and Retain Skilled Personnel




Qualified
personnel are in great demand throughout the software industry. The Company’s
success depends, in large part, upon its ability to attract, train, motivate and
retain highly skilled employees, particularly, technical personnel and product
development and professional services personnel, sales and marketing personnel
and other senior personnel. The Company’s failure to attract and retain the
highly trained technical personnel that are integral to the Company’s product
development, professional services and direct sales teams may limit the rate at
which the Company can generate sales and develop new products or product
enhancements. A change in key management could result in transition and
attrition in the affected department. This could have a material adverse effect
on the Company’s business, operating results and financial
condition.





- 11
-


Evolving Regulation of
Corporate Governance and Public Disclosure May Result in Additional Expenses and
Continuing Uncertainty




Changing
laws, regulations and standards relating to corporate governance and public
disclosure, including the Sarbanes-Oxley Act of 2002 and related SEC regulations
as well as the listing standards of the NASDAQ Stock Market, are creating
uncertainty for public companies. The Company continually evaluates and monitors
developments with respect to new and proposed rules and cannot predict or
estimate the amount of the additional costs incurred or the timing of such
costs. These new or changed laws, regulations and standards are subject to
varying interpretations, in many cases due to their lack of specificity, and as
a result, their application in practice may evolve over time as new guidance is
provided by regulatory and governing bodies. This could result in continuing
uncertainty regarding compliance matters and higher costs necessitated by
ongoing revisions to disclosure and governance practices. The Company is
committed to maintaining high standards of corporate governance and public
disclosure. As a result, the Company has invested resources to comply with
evolving laws, regulations and standards. This investment may result in
increased general and administrative expenses and a diversion of management time
and attention from revenue-generating activities to compliance activities. If
the Company’s efforts to comply with new or changed laws, regulations and
standards differ from the activities intended by regulatory or governing bodies
due to ambiguities related to practice, regulatory authorities may initiate
legal proceedings against the Company and it may be harmed.





Indirect Distribution
Channels




The
Company sells a significant portion of its products through distributors and
resellers, none of which are under the direct control of the Company. The loss
of major distributors or resellers of the Company’s products, or a significant
decline in their sales, could have a material adverse effect on the Company’s
operating results. There can be no assurance that the Company will be able to
attract or retain additional qualified distributors or resellers or that any
such distributors or resellers will be able to effectively sell the Company’s
products. The Company seeks to select and retain distributors and resellers on
the basis of their business credentials and their ability to add value through
expertise in specific vertical markets or application programming expertise. In
addition, the Company may rely on resellers to provide post-sales service and
support, and any deficiencies in such service and support could adversely affect
the Company’s business.





Subscription Sales Model
Risk




The
Company sells its enterprise products through the sale of perpetual licenses and
through a subscription pricing model. The subscription pricing model allows
customers to begin using the Company’s products at a lower initial cost of
software acquisition when compared to the more traditional perpetual license
sale. Although the subscription sales model is designed to increase the number
of enterprise solutions sold and also reduce dependency on short-term sales by
building a recurring revenue stream, it introduces increased risks for the
Company primarily associated with the timing of revenue recognition and reduced
cash flows. The subscription model delays revenue recognition when compared to
the typical perpetual license sale and also, as the Company allows termination
of certain subscriptions with 90 days notice, could result in decreased revenue
for solutions sold under the model if the Company experiences a high percentage
of subscription cancellations following the first 12 months of the
subscription.  Further, as amounts due from customers are invoiced
over the life of the subscription, there are delayed cash flows from
subscription sales when compared to perpetual license sales.








Item
1B.  UNRESOLVED STAFF COMMENTS





Not
applicable.








Item
2.  PROPERTIES





The
Company is currently headquartered in 14,683 square feet of leased office space
in Chelmsford,




- 12
-


Massachusetts
pursuant to a sublease agreement executed on September 28, 2005. The sublease
expires in June 2011. The sublease contains annual rent escalations for each
year of the sublease as well as an abatement of rent during the first twelve
months of the sublease term. The aggregate rent for the remaining term of the
sublease is approximately $467,000. In addition to rent, the sublease requires
the Company to pay certain taxes, insurance and operating costs related to the
leased facility based on the Company’s pro-rata share of such costs. The Company
is also responsible for the costs of certain tenant improvements associated with
the new facility but will be entitled to reimbursement for certain of such costs
from the sublessor.





The
Company also maintains international sales and administrative offices in the
United Kingdom and Australia. In addition, the Company maintains a software
development and testing facility in the Philippines.








Item 3.  LEGAL
PROCEEDINGS





The
Company is occasionally involved in legal proceedings and other claims arising
out of our operations in the normal course of business. The Company is not party
to any litigation that management believes will have a material adverse effect
on the Company’s consolidated financial condition, results of operations, or
cash flows.








Item
4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS





No
matters were submitted to a vote of the Registrant’s security holders during the
last quarter of the fiscal year covered by this report.





Executive
Officers of the Registrant





The
names, ages and titles of the executive officers of the Company as of November
26, 2008 are as follows:





Kenneth
      P. Bero
            
            54
            
            President,
      Chief Executive Officer and DirectorJohn
      H. Kitchen, III
            
            53
            
            Chief
      Marketing Officer, Senior Vice President and SecretaryMurray
      P. Fish
            
            57
            
            Chief
      Financial Officer, Vice President of Finance, Treasurer andAssistant
      SecretaryHarvey
      Gross
            
            59
            
            Vice
      President, Product Management and DevelopmentRobert
      Clemens
            
            51
            
            Vice
      President, Worldwide SalesDaniel
      F. Incropera
            
            44
            
            Corporate
      Controller & Vice President





Officers
are elected by, and serve at the discretion of, the Board of
Directors.





KENNETH P. BERO, President, Chief
Executive Officer and Director. Mr. Bero was appointed President and
Chief Executive Officer of the Company effective January 1, 2008. Prior thereto,
and since April 1, 2007, Mr. Bero held the position of Chief Operating Officer
& Senior Vice President of Sales. Previously, Mr. Bero had been Senior Vice
President of Enterprise Solutions. In April 2006, Mr. Bero joined the Company as
Vice President of Enterprise Sales for North America. Prior to joining
Datawatch, Mr. Bero served as Vice President, North American Channel Sales at
Business Objects S.A., an international provider of business intelligence
software and services. Previous roles include the position of Chief Operating
Officer and Executive Vice President of Sales and Marketing at NAVIDEC, as
Nasdaq listed software development and services company. Mr. Bero was also
appointed a Director of the Company effective October 19, 2007.





JOHN H. KITCHEN, III, Chief
Marketing Officer, Senior Vice President and Secretary. Mr. Kitchen
was appointed Chief Marketing Officer & Senior Vice President effective
April 1, 2007. Prior thereto, and since July 2001, Mr. Kitchen held the position
of Senior Vice President of Desktop & Server Solutions. From July 2000
until July 2001, Mr. Kitchen was the Company’s Vice President of Marketing.
Prior to July 2000, and since March 1998, Mr. Kitchen was the
Company’s Director of Marketing. Prior to that, Mr. Kitchen was a marketing
consultant to the Company.





- 13
-


MURRAY P. FISH, Chief Financial
Officer, Vice President of Finance, Treasurer and Assistant
Secretary.  Mr. Fish was appointed Chief Financial
Officer, Vice President of Finance, Treasurer and Assistant Secretary on March
26, 2007. Prior to joining Datawatch, Mr. Fish served as Chief Financial
Officer of Cymfony, Inc., a marketing business intelligence company owned by
TNS-MI.  From 2003 until 2005, Mr. Fish was the principal consultant
at M.P. Fish Associates, where he provided financial consulting services to
large public and private organizations.  From 1998 until 2003, Mr.
Fish was the Chief Financial Officer and a Director at Network-1 Security
Solutions, Inc., a publicly held company.





HARVEY GROSS, Vice President,
Product Management and Development. Mr. Gross was appointed Vice
President, Product Management and Development on October 1, 2008. Mr. Gross
joined the Company in February 2007. Prior to joining Datawatch, Mr. Gross was
the principal consultant at HG & Associates, a content management consulting
company serving a variety of companies in business, technology and the federal
government, and was a principal consultant at eVisory, a leading industry
consulting group. Other roles included Chief Technology Officer for Lason, Inc.,
an international business process outsourcing firm, Senior Vice President at
Virtual Image Technologies, Inc., a regional document management service
company, and Senior Vice President of Product Development at 360Services,
Inc.





ROBERT CLEMENS, Vice President,
Worldwide Sales. Mr. Clemens was appointed Vice President of Worldwide
Sales on January 1, 2008. Mr. Clemens served as Vice President of North American
sales from April 2007 until December 2007. Prior to joining Datawatch, Mr.
Clemens was the Director of Sales at Zantaz, Vice President, Worldwide Sales at
GaleForce Solutions and Director of North American Channel Sales at Business
Objects. Mr. Clemens also served in a variety of executive and senior level
sales positions at companies such as NeTpower, Ashton-Tate/Borland and
more.





DANIEL F. INCROPERA, Corporate
Controller & Vice President.  Mr. Incropera was appointed
Corporate Controller & Vice President on September 7, 2007.  Mr.
Incropera has served as the Company’s Controller since October 2006. From 2003
until joining the Company, Mr. Incropera served as Controller of Pennichuck
Corporation, a publicly traded company that operates several water utility and
real estate investment subsidiaries.  From 2002 until 2003, Mr.
Incropera was the Assistant Controller at Concord Communications, Inc. which was
a publicly traded software company providing network service management
solutions.








- 14
-


PART II





Item
5.   MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS





The
Registrant’s common stock is listed and traded on the Nasdaq Capital Market
(formerly the Nasdaq SmallCap Market) under the symbol DWCH.  The
range of high and low closing prices during each fiscal quarter for the last two
fiscal years is set forth below:





For
      the Year Ended
            
            Common
      StockSeptember 30,
      2008
            
            High
      ($)
            
            Low
      ($)4th
      Quarter
            
            2.62
            
            1.323rd
      Quarter
            
            4.35
            
            2.342nd
      Quarter
            
            7.22
            
            3.101st
      Quarter
            
            7.68
            
            4.57





For
      the Year Ended
            
            Common
      StockSeptember 30,
      2007
            
            High
      ($)
            
            Low
      ($)4th
      Quarter
            
            6.20
            
            4.213rd
      Quarter
            
            6.07
            
            2.852nd
      Quarter
            
            3.10
            
            2.451st
      Quarter
            
            2.93
            
            1.89





There are
approximately 100 shareholders of record as of December 10,
2008.  The Company believes that the number of beneficial holders of
common stock is approximately 1,800.  The last reported sale of the
Company’s common stock on December 22,2008 was at $1.18.





The
Company has not paid any cash dividends and it is anticipated that none will be
declared in the foreseeable future. The Company intends to retain future
earnings, if any, to provide funds for the operation, development and expansion
of its business.





The
information set forth under the caption “Equity Compensation Plans” appearing in
the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders
for the fiscal year ended September 30, 2008 is incorporated herein by
reference.








Item
6.   SELECTED CONSOLIDATED FINANCIAL DATA





The
following table sets forth selected consolidated financial data of the Company
for the periods indicated.  The selected consolidated financial data
for and as of the end of the years in the five-year period ended
September 30, 2008 are derived from the Consolidated Financial Statements
of the Company.  The information set forth below should be read in
conjunction with “Management’s Discussion and Analysis of Financial Condition
and Results of Operations” and the Consolidated Financial Statements and notes
which appear elsewhere in this Annual Report on Form 10-K.




- 15
-


Statements
      of Operations Data:Years
      Ended September 30,
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(In
      thousands, except per share data)Revenue
              
              $
              23,030
              
              
              $
              25,259
              
              
              $
              20,811
              
              
              $
              21,511
              
              
              $
              19,335Costs
      and Expenses
              
              
              22,531
              
              
              
              23,524
              
              
              
              21,345
              
              
              
              20,823
              
              
              
              18,410Income
      (loss) from Operations
              
              
              499
              
              
              
              1,735
              
              
              
              (534
              )
              
              
              688
              
              
              
              925Net
      Income (Loss)
              
              $
              717
              
              
              $
              1,669
              
              
              $
              (555
              )
              
              $
              800
              
              
              $
              1,085Earnings
      (Loss) per Common Share:Basic
              
              $
              0.12
              
              
              $
              0.30
              
              
              $
              (0.10
              )
              
              $
              0.15
              
              
              $
              0.21Diluted
              
              $
              0.12
              
              
              $
              0.29
              
              
              $
              (0.10
              )
              
              $
              0.14
              
              
              $
              0.19Balance
      Sheet Data:September 30,
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(In
      thousands)Total
      Assets
              
              $
              18,169
              
              
              $
              18,337
              
              
              $
              16,025
              
              
              $
              13,412
              
              
              $
              12,629Working
      Capital (Deficiency)
              
              
              1,130
              
              
              
              (279
              )
              
              
              (2,465
              )
              
              
              3,487
              
              
              
              2,548Long-Term
      Obligations
              
              
              627
              
              
              
              448
              
              
              
              266
              
              
              
              —
              
              
              
              125Shareholders’
      Equity
              
              
              10,082
              
              
              
              9,020
              
              
              
              6,956
              
              
              
              7,306
              
              
              
              6,436





Item
7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS





The
following discussion and analysis is qualified by reference to, and should be
read in conjunction with, the Consolidated Financial Statements of Datawatch and
its subsidiaries which appear elsewhere in this Annual Report on
Form 10-K.





GENERAL





Introduction





Datawatch
is engaged in the design, development, manufacture, marketing, and support of
business computer software primarily for the Enterprise Information Management
market which incorporates business intelligence, enterprise content management
and business service management and workflow solutions to allow organizations to
access and analyze information in a more meaningful fashion.





The
Company’s principal products are Business Intelligence Solutions (including
Monarch, Monarch Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Visual
Insight, iMergence and VorteXML), Content Management Solutions (including
Datawatch BDS, Datawatch BDS Workflow and Datawatch MailManager) and Business
Service Management and Workflow Solutions (including Visual QSM and Visual HD).
Included in the above categories are: Monarch, a desktop report mining and
business intelligence application that lets users extract and manipulate data
from ASCII report files, PDF files or HTML files produced on any mainframe,
midrange, client/server or PC system; Monarch Data Pump, a data replication and
migration tool that offers a shortcut for populating and refreshing data marts
and data warehouses, for migrating legacy data into new applications and for
providing automated delivery of reports in a variety of formats via email;
Monarch RMS, a web-based report mining and analysis solution that integrates
with any existing Enterprise Report Management  document or content
management archiving solution; Monarch BI Server, an out-of-the-box web-based
Business Intelligence solution developed specifically for small to medium size
businesses and departments;  Datawatch ES, an enterprise business
intelligence system that provides web-enabled report management, mining and
distribution as well as data analysis and MS Excel integration; Visual Insight,
a performance management solution that provides web-based knowledge management
and Key Performance Indicator reporting; iMergence, an enterprise report mining
system; VorteXML, a data transformation product for the emerging XML market that
easily and




- 16
-


quickly
converts structured text output from any system into valid XML for web services
and more using any DTD or XDR schema without programming; Datawatch BDS, a
system for high-volume document capture, archiving, and online presentation;
Datawatch BDS Workflow, a web-enabled enterprise business process management
solution that provides highly effective processing of document intensive
business transactions; Datawatch MailManager, a highly scalable email management
solution that provides complete lifecycle, compliance and storage management for
Microsoft Exchange environments; Visual QSM, a fully internet-enabled IT service
management solution that incorporates workflow and network management
capabilities and provides web access to multiple databases via a standard
browser; and Visual Help Desk or Visual HD, a web-based help desk and call
center solution operating on the IBM Lotus Domino platform.





On May 3,
2006, the Company acquired certain assets of ClearStory Systems, Inc’s
Integrated Document Archiving and Retrieval Systems (“IDARS”) business in
exchange for $4,349,000 in cash and incurred $441,000 in direct costs. In
accordance with the purchase and sale agreement, payments equal to 30% of
revenue for a period of eighteen months from the closing date (May 3, 2006) of
the Datawatch BDS product, excluding the first $337,500 of revenue, net of any
claims, commenced during the Company’s third and fourth quarters of fiscal year
2007 and the final payments were made in the first quarter of fiscal year 2008.
These amounts were recorded as goodwill as additional purchase price, as
incurred or accrued. At September 30, 2007, the Company had accrued
approximately $329,000 related to future earn out payments. The final earn-out
payments were made in the first quarter of fiscal 2008 and, accordingly, no
amounts are accrued at September 30, 2008. Since the acquisition date, the
Company made payments of approximately $1.1 million related to the IDARS
earn-out arrangement. The activities of the IDARS business from May 3, 2006 are
included in the Company’s consolidated financial statements. See Note 2 to the
Consolidated Financial Statements for more detailed financial information on the
acquisition of the IDARS business.





The
Company offers its enterprise products through perpetual licenses and
subscription pricing models. Subscriptions automatically renew unless terminated
with 90 days notice following the first year of the subscription term. The
subscription arrangement includes software, maintenance and unspecified future
upgrades including major version upgrades. The subscription renewal rate is the
same as the initial subscription rate. During fiscal years 2008, 2007 and 2006,
subscription revenues were approximately $600,000, $649,000 and $615,000,
respectively.





CRITICAL
ACCOUNTING POLICIES





In the
preparation of financial statements and other financial data, management applies
certain accounting policies to transactions that, depending on choices made by
management, can result in different outcomes. In order for a reader to
understand the following information regarding the financial performance and
condition of the Company, an understanding of those accounting policies is
important. Certain of those policies are comparatively more important to the
Company’s financial results and condition than others. The policies that the
Company believes are most important for a reader’s understanding of the
financial information provided in this report are described below.





Revenue Recognition,
Allowance for Bad Debts and Returns Reserve





The
Company has two types of software product offerings: Enterprise Software and
Desktop and Server Software. Enterprise Software products are generally sold
directly to end-users and through the use of value added resellers. The Company
sells its Desktop and Server Software products directly to end-users and through
distributors and resellers. Sales to distributors and resellers accounted for
approximately 41%, 39% and 40%, of total sales for fiscal years 2008, 2007 and
2006, respectively. Revenue from the license of all software products is
generally recognized at the time of shipment, provided there are no
uncertainties surrounding product acceptance, the fee is fixed and determinable,
collection is considered probable, persuasive evidence of the arrangement exists
and there are no significant obligations remaining. Both types of the Company’s
software product offerings are “off-the-shelf” as such term is defined by
Statement of Position No. 97-2, “Software Revenue
Recognition.” The Company’s software products can be installed and used
by customers on their own with little or no customization required. Multi-user
licenses marketed by the Company are sold as a right to use the number of
licenses and




- 17
-


license
fee revenue is recognized upon delivery of all software required to satisfy the
number of licenses sold. Upon delivery, the licensing fee is payable without
further delivery obligations of the Company.





Desktop
and Server Software products are generally not sold in multiple element
arrangements. Enterprise Software sales are generally multiple element
arrangements which include software license deliverables, professional services
and post-contract customer support, which primarily consists of maintenance. In
such multiple element arrangements, the Company applies the residual method in
determining revenue to be allocated to a software license. In applying the
residual method, the Company deducts from the sale proceeds the vendor specific
objective evidence (“VSOE”) of fair value of the services and post-contract
customer support in determining the residual fair value of the software license.
The VSOE of fair value of the services and post-contract customer support is
based on the amounts charged for these elements when sold separately.
Professional services include implementation, integration, training and
consulting services with revenue recognized as the services are performed. These
services are generally delivered on a time and materials basis, are billed on a
current basis as the work is performed, and do not involve modification or
customization of the software or any other unusual acceptance clauses or terms.
Post-contract customer support is typically provided under a maintenance
agreement which provides technical support and rights to unspecified software
maintenance updates and bug fixes on a when-and-if available basis. Revenue from
post-contract customer support services is deferred and recognized ratably over
the contract period (generally one year). Such deferred amounts are recorded as
part of deferred revenue in the Company’s Consolidated Balance Sheets included
herein.





The
Company also sells its Enterprise Software using a subscription model. At the
time a customer enters into a binding agreement to purchase a subscription, the
customer is invoiced for an initial 90 day service period and an account
receivable and deferred revenue are recorded. Beginning on the date the software
is installed at the customer site and available for use by the customer, and
provided that all other criteria for revenue recognition are met, the deferred
revenue amount is recognized ratably over the period the service is provided.
The customer is then invoiced every 90 days and, in accordance with SOP 97-2,
revenue is recognized ratably over the period the service is provided. The
subscription arrangement includes software, maintenance and unspecified future
upgrades including major version upgrades. The subscription renewal rate is the
same as the initial subscription rate. Subscriptions can be cancelled by the
customer at any time by providing 90 days written notice following the first
year of the subscription term.





The
Company’s software products are sold under warranty against certain defects in
material and workmanship for a period of 30 days from the date of purchase.
Certain software products, including desktop versions of Monarch, Monarch Data
Pump, and VorteXML licensed directly to end-users, include a guarantee under
which such customers may return products within 30 days for a full refund.
Additionally, the Company provides its distributors with stock-balancing rights
and applies the guidance found in Statement of Financial Accounting Standards
No. 48, “Revenue Recognition
when Right of Return Exists.” Revenue from the license of software
products to distributors and resellers is recognized at the time of shipment
providing all other criteria for revenue recognition as stated above are met and
(i) the distributor or reseller is unconditionally obligated to pay for the
products, including no contingency as to product resale, (ii) the
distributor or reseller has independent economic substance apart from the
Company, (iii) the Company is not obligated for future performance to bring
about product resale, and (iv) the amount of future returns can be
reasonably estimated. The Company’s experience and history with its distributors
and resellers allows for reasonable estimates of future returns. Among other
things, estimates of potential future returns are made based on the inventory
levels at the various distributors and resellers, which the Company monitors
frequently. Once the estimates of potential future returns from all sources are
made, the Company determines if it has adequate returns reserves to cover
anticipated returns and the returns reserve is adjusted as required. Adjustments
are recorded as increases or decreases in revenue in the period of adjustment.
Actual returns have historically been within the range estimated by the Company.
The Company’s returns reserves were $65,000 and $80,000 as of September 30,
2008 and 2007, respectively.





The
Company maintains allowances for doubtful accounts for estimated losses
resulting from the inability of customers to make required payments. The Company
analyzes accounts receivable and the composition of the accounts receivable
aging, historical bad debts, customer creditworthiness, current economic trends,
foreign currency exchange rate fluctuations and changes in customer payment
terms when evaluating the adequacy of the




- 18
-


allowance
for doubtful accounts. Based upon the analysis and estimates of the
collectibility of its accounts receivable, the Company records an increase in
the allowance for doubtful accounts when the prospect of collecting a specific
account receivable becomes doubtful. Actual results could differ from the
allowances for doubtful accounts recorded, and this difference may have a
material effect on the Company’s financial position and results of operations.
The Company’s allowance for doubtful accounts was $171,000 and $223,000 as of
September 30, 2008 and 2007, respectively.





Income
Taxes





The
Company has deferred tax assets related to net operating loss carryforwards and
tax credits that expire at different times through and until 2028. At September
30, 2008, the Company had U.S. federal tax loss carryforwards of approximately
$7.3 million, expiring at various dates through 2028, including $210,000
resulting from the Mergence acquisition undertaken during 2004 which are subject
to additional annual limitations as a result of the changes in Mergence’s
ownership, and had approximately $1.7 million in state tax loss carryforwards,
which also expire at various dates through 2028. An alternative minimum tax
credit of approximately $157,000 is available to offset future regular federal
taxes. Research and development credits of approximately $397,000 expire
beginning in 2011. In addition, the Company has the following foreign net
operating loss carryforwards: United Kingdom losses of $9.0 million with no
expiration date and Australian losses of $3.3 million with no expiration
date.





Significant judgment is required in
determining the Company’s provision for income taxes, the carrying value of
deferred tax assets and liabilities and the valuation allowance recorded against
net deferred tax assets.  Factors such as future reversals of deferred
tax assets and liabilities, projected future taxable income, changes in enacted
tax rates and the period over which the Company’s deferred tax assets will be
recoverable are considered in making these determinations. Management does not
believe the deferred tax assets are more likely than not to be realized and a
full valuation allowance, previously provided against the deferred tax assets,
continues to be provided. Management evaluates the realizability of the deferred
tax assets quarterly and, if current economic conditions change or future
results of operations are better than expected, future assessments may result in
the Company concluding that it is more likely than not that all or a portion of
the deferred tax assets are realizable. If this conclusion were reached, the
valuation allowance against deferred tax assets would be reduced resulting in a
tax benefit being recorded for financial reporting purposes. Total net deferred
tax assets subject to the full valuation allowance were approximately $4.4
million as of September 30, 2008. In relation to the Company’s asset
purchase of the IDARS business, the applicable goodwill associated with this
purchase has an indefinite life for US GAAP purposes but is deductible over a 15
year life for tax reporting purposes. Accordingly, for each reporting period,
the Company will record deferred tax expense and an offsetting deferred tax
liability on this difference in tax amortization of intangibles with indefinite
lives based on the Company’s effective tax rate for the period. Deferred tax
expense recorded for the fiscal years ended September 30, 2008, 2007 and 2006
was approximately $115,000, $111,000 and $36,000,
respectively.





The
Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes — An Interpretation of FASB Statement No. 109”
(“FIN 48”) on October 1, 2007. FIN 48 provides a comprehensive model
for the financial statement recognition, measurement, presentation and
disclosure of uncertain tax positions taken or expected to be taken in income
tax returns.





Under
FIN 48, the Company first determines whether a tax authority would “more
likely than not” sustain its tax position if it were to audit the position with
full knowledge of all the relevant facts and other information. For those tax
positions that meet this threshold, the Company measures the amount of tax
benefit based on the largest amount of tax benefit that the Company has a
greater than 50% chance of realizing in a final settlement with the relevant
authority. Those tax positions failing to qualify for initial recognition are
recognized in the first interim period in which they meet the more likely than
not standard, or are resolved through negotiation or litigation with the taxing
authority, or upon expiration of the statute of limitations. The Company
maintains a cumulative risk portfolio relating to all of its uncertainties in
income taxes in order to perform this analysis, but the evaluation of the
Company’s tax position in connection with FIN 48 requires significant
judgment and estimation in part because, in certain cases, tax law is subject to
varied interpretation, and whether a tax position will ultimately be
  - 19
-
 sustained
may be uncertain. The actual outcome of the Company’s tax positions, if
significantly different from its estimates, could materially impact the
financial statements.





Upon
adoption of FIN 48, the Company recorded a reduction of the Company’s deferred
tax asset in the amount of $690,000 and a corresponding reduction to the tax
asset valuation reserve of $690,000 for all identified uncertain tax positions,
for any years open under the statute of limitations. The Company recorded a
$75,000 tax liability fully related to foreign tax exposure. This amount was
recorded as an increase to other long-term liabilities and an increase in
the accumulated deficit on the Company’s Consolidated Balance
Sheets.





Capitalized Software
Development Costs





The
Company capitalizes certain software development costs as well as purchased
software upon achieving technological feasibility of the related products.
Software development costs incurred and software purchased prior to achieving
technological feasibility are charged to research and development expense as
incurred.  Commencing upon initial product release, capitalized costs
are amortized to the cost of software licenses using the straight-line method
over the estimated life of the product (which approximates the ratio that
current gross revenues for a product bear to the total of current and
anticipated future gross revenues for that product) which is generally 24 to 36
months. The Company’s acquired and capitalized software was $664,000 and
$395,000 at September 30, 2008 and 2007, respectively. During fiscal 2008,
the Company capitalized approximately $411,000 of software development costs
related to new products in development.





Goodwill, Other Intangible
Assets and Other Long-Lived Assets





The
Company performs an evaluation of whether goodwill is impaired annually or when
events occur or circumstances change that would more likely than not reduce the
fair value of the applicable reporting unit below its carrying amount. The
annual impairment analysis is performed on May 31st of each
applicable fiscal year. Fair value is determined using market comparables for
similar businesses, current market valuations of the Company’s common stock, or
forecasts of discounted future cash flows. At September 30, 2008, a valuation of
the Company was performed in accordance with SFAS No. 142, “Goodwill and Other Intangible
Assets.” The results of the valuation analysis indicated that there was
no impairment of the Company’s goodwill at September 30, 2008. Factors the
Company considers important that could trigger an impairment review include, but
are not limited to, significant underperformance relative to historical or
projected future operating results, significant changes in the manner of use of
the acquired assets or the strategy for the Company’s overall business,
significant negative industry or economic trends, a significant decline in the
Company’s stock price for a sustained period, and decreases in our market
capitalization below the recorded amount of our net assets for a sustained
period. The Company’s stock price is highly volatile and has experienced
significant declines since September 30, 2008. If the Company’s stock price does
not improve prior to the end of the first quarter of fiscal 2009 or if other
factors indicate that it is more likely than not that an impairment may exist,
the Company could determine that an interim impairment test is required, which
could result in a non-cash impairment charge.The balance of goodwill is
$6,116,000 as of September 30, 2008.





The
Company also reviews other intangible assets and other long-lived assets when an
indication of potential impairment exists, such as a significant reduction in
cash flows associated with the assets. Should the fair value of the Company’s
long-lived assets decline because of reduced operating performance, market
declines, or other indicators of impairment, a charge to operations for
impairment may be necessary. In fiscal 2007, the Company concluded there was a
partial impairment of its iMergence trademark resulting in a $39,000 impairment
charge to operations. This charge was reflected in general and administrative
costs in the Company’s Consolidated Statements of Operations for the year ended
September 30, 2007. No impairment charges were taken during fiscal year
2008.





Accounting for Stock-Based
Compensation





The
Company recognizes stock-based compensation expense in accordance with Statement
of Financial Accounting Standards No. 123 (revised 2004) (“SFAS No. 123(R)”),
“Share-Based Payment.”SFAS 123(R)




- 20
-


requires
all share-based awards, including grants of employee stock options, to be
recognized in the financial statements based on their fair value.





Under the
provisions of SFAS No. 123(R), the Company recognizes the fair value of
share-based awards over the requisite service period of the individual awards,
which generally equals the vesting period. For the fiscal year ended September
30, 2008, the Company recorded stock-based compensation expense of approximately
$225,000. In order to determine the fair value of stock options on the date of
grant, the Company applies the Black-Scholes option-pricing model. Inherent in
this model are assumptions related to expected stock-price volatility, option
life, risk-free interest rate and dividend yield. While the risk-free interest
rate and dividend yield are less subjective assumptions, typically based on
factual data derived from public sources, the expected stock-price volatility
and option life assumptions require a greater level of judgment which makes them
critical accounting estimates.





The
Company uses an expected stock-price volatility assumption that represents
historical volatilities of the underlying stock which are obtained from public
data sources. The Company believes this approach results in a reasonable
estimate of volatility. For stock option grants issued during the fiscal year
ended September 30, 2008, the Company used an expected stock-price volatility of
73% based upon the historical volatility at the time of issuance.





With
regard to the weighted-average option life assumption, the Company considers the
exercise behavior of past grants and models the pattern of aggregate historical
exercises. Patterns are determined on specific criteria of the aggregate pool of
optionees including the reaction to vesting, realizable value and
short-time-to-maturity effect. For stock option grants issued during the year
ended September 30, 2008, the Company used an expected option life assumption of
5 years.





With
regard to the forfeiture rate assumption, the Company reviews historical
voluntary turnover rates. For stock option grants issued during the fiscal year
ended September 30, 2008, the Company used an annual estimated forfeiture rate
of 10%. Additional expense will be recorded if the actual forfeiture rate is
lower than estimated, and a recovery of prior expense will be recorded if the
actual forfeiture rate is higher than estimated.








RESULTS
OF OPERATIONS





The
following table sets forth certain statements of operations data as a percentage
of total revenues for the periods indicated. The data has been derived from the
Company’s consolidated financial statements. The operating results for any
period should not be considered indicative of the results expected for any
future period.




- 21
-


Year
      Ended September 30,2008
              
              
              2007
              
              
              2006REVENUE:Software
      licenses and subscriptions
              
              
              54.0
              %
              
              
              58.8
              %
              
              
              63.2
              %Maintenance
      and services
              
              
              46.0
              
              
              
              41.2
              
              
              
              36.8Total
      Revenue
              
              
              100.0
              
              
              
              100.0
              
              
              
              100.0COSTS
      AND EXPENSES:Cost
      of software licenses and subscriptions
              
              
              9.6
              
              
              
              9.8
              
              
              
              10.9Cost
      of maintenance and services
              
              
              18.5
              
              
              
              15.6
              
              
              
              19.0Sales
      and marketing
              
              
              35.4
              
              
              
              36.8
              
              
              
              43.9Engineering
      and product development
              
              
              12.9
              
              
              
              11.7
              
              
              
              10.1General
      and administrative
              
              
              21.4
              
              
              
              19.3
              
              
              
              18.7Total
      costs and expenses
              
              
              97.8
              
              
              
              93.2
              
              
              
              102.6INCOME
      (LOSS) FROM OPERATIONS
              
              
              2.2
              
              
              
              6.8
              
              
              
              (2.6
              )Interest
      expense
              
              
              —
              
              
              
              (0.1
              )
              
              
              (0.1
              )Interest
      income and other income, net
              
              
              1.6
              
              
              
              0.4
              
              
              
              0.2INCOME
      (LOSS) BEFORE INCOME TAXES
              
              
              3.8
              
              
              
              7.1
              
              
              
              (2.5
              )Provision
      for income taxes
              
              
              (0.7
              )
              
              
              (0.5
              )
              
              
              (0.2
              )NET
      INCOME (LOSS)
              
              
              3.1
              
              
              
              6.6
              
              
              
              (2.7
              )




Fiscal Year Ended
September 30, 2008 as Compared to


Fiscal Year Ended
September 30, 2007





Total
Revenues





The
following table presents total revenue, total revenue increase (decrease) and
percentage change in total revenue for the years ended September 30, 2008
and 2007:




Year
      Ended September 30,
              
              
              Increase
              
              
              Percentage2008
              
              
              2007
              
              
              (Decrease)
              
              
              Change(In
      thousands)Software
      licenses and subscriptions
              
              $
              12,435
              
              
              $
              14,852
              
              
              $
              (2,417
              )
              
              
              -16.3
              %Maintenance
      and services
              
              
              10,595
              
              
              
              10,407
              
              
              
              188
              
              
              
              1.8
              %Total
      revenue
              
              $
              23,030
              
              
              $
              25,259
              
              
              $
              (2,229
              )
              
              
              -8.8
              %





Revenue
for the fiscal year ended September 30, 2008 was $23,030,000, which
represents a decrease of $2,229,000 or approximately 9% from revenue of
$25,259,000 for the fiscal year ended September 30, 2007. For fiscal 2008,
Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch
RMS, Monarch BI Server, Datawatch ES, Visual Insight, iMergence and VorteXML),
Content Management Solutions (including Datawatch BDS and Datawatch MailManager)
and Business Service Management and Workflow Solutions (including Visual QSM and
Visual HD) revenue accounted for 67%, 16%, and 17% of total revenue,
respectively, as compared to 67%, 14%, and 19%, respectively, for fiscal
2007.





Software
license and subscription revenue for the fiscal year ended September 30,
2008 was $12,435,000 or approximately 54% of total revenue, as compared to
$14,852,000 or approximately 59% of total revenue for the fiscal year ended
September 30, 2007. This represents a decrease of $2,417,000 or
approximately 16% from fiscal 2007. The overall decrease in software license and
subscription revenue consists of a $1,858,000 decrease in Business Intelligence
Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Datawatch BI
Server, Datawatch ES, Visual Insight, iMergence and VorteXML products), a
$144,000 decrease in Content Management Solutions (including Datawatch BDS and
Datawatch MailManager products) and a $415,000 decrease in Business Service
Management and Workflow Solutions (including Visual QSM and Visual HD products).
The decrease in Business Intelligence Solutions is primarily due to decreased
Monarch license sales as




- 22
-


compared
to fiscal 2007. Sales from the Company’s Monarch product were significantly
higher during fiscal 2007 following the release of upgrade version 9.0 in
February 2007.





Maintenance
and services revenue for the fiscal year ended September 30, 2008 was
$10,595,000 or approximately 46% of total revenue, as compared to $10,407,000 or
approximately 41% of total revenue for the fiscal year ended September 30,
2007. This represents an increase of $188,000 or approximately 2% from fiscal
2007. The increase in maintenance and services revenue consists of a $554,000
increase in Business Intelligence Solutions (including Monarch, Monarch Data
Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Visual Insight, iMergence
and VorteXML products) and a $191,000 increase in Content Management Solutions
(including Datawatch BDS and Datawatch MailManager products) which were
partially offset by a $557,000 decrease in Business Service Management and
Workflow Solutions (including Visual QSM and Visual HD products). The Company
attributes the overall increases in maintenance and services revenue to
continued customer loyalty, which has resulted in high renewal rates for annual
maintenance service contracts and an increased demand for professional services
from existing customers, which also includes upgrades and additional training.
The decrease in maintenance revenue for the Business Service Management and
Workflow Solutions product line was the result of lower renewal rates of annual
maintenance contracts from existing customers. The decrease in Business Service
Management and Workflow Solutions revenue was also the result of less demand for
professional services work related to this product line. No significant product
upgrades were introduced within the Visual QSM or Visual Help Desk product lines
during fiscal year 2008.





Costs
and Operating Expenses





The
following table presents costs and operating expenses, increase/(decrease) in
costs and operating expenses and percentage changes in costs and operating
expenses for the years ended September 30, 2008 and 2007:




Year
      Ended September 30,
              
              
              Increase
      /
              
              
              Percentage2008
              
              
              2007
              
              
              (Decrease)
              
              
              Change(in
      thousands)Cost
      of software licenses and subscriptions
              
              $
              2,218
              
              
              $
              2,468
              
              
              $
              (250
              )
              
              
              -10.1
              %Cost
      of maintenance and services
              
              
              4,271
              
              
              
              3,943
              
              
              
              328
              
              
              
              8.3
              %Sales
      and marketing expenses
              
              
              8,153
              
              
              
              9,290
              
              
              
              (1,137
              )
              
              
              -12.2
              %Engineering
      and product development expenses
              
              
              2,966
              
              
              
              2,951
              
              
              
              15
              
              
              
              0.5
              %General
      and administrative expenses
              
              
              4,923
              
              
              
              4,872
              
              
              
              51
              
              
              
              1.0
              %Total
      costs and operating expenses
              
              $
              22,531
              
              
              $
              23,524
              
              
              $
              (993
              )
              
              
              -4.2
              %




Cost of
software licenses and subscriptions for the fiscal year ended September 30,
2008 was $2,218,000 or approximately 18% of software license and subscription
revenues, as compared to $2,468,000 or approximately 17% of software license and
subscription revenues for the fiscal year ended September 30, 2007. Cost of
software licenses and subscriptions as a percentage of software licenses and
subscription revenue have remained relatively consistent year over year. The
dollar decrease in cost of software licenses and subscriptions is primarily due
to lower royalty costs associated with lower sales of Monarch during fiscal
2008. As previously described, sales of the Company’s Monarch product were
significantly higher during fiscal 2007 due to the release of version 9.0 in
February 2007.





Cost of
maintenance and services for the fiscal year ended September 30, 2008 was
$4,271,000 or approximately 40% of maintenance and service revenue, as compared
to $3,943,000 or approximately 38% of maintenance and service revenue for the
fiscal year ended September 30, 2007. The increase in total cost of
maintenance and services is primarily due to higher employee-related costs due
to increased headcount and higher incentive compensation costs as compared to
fiscal 2007.





Sales and
marketing expenses for the fiscal year ended September 30, 2008 were $8,153,000,
or 35% of total revenue as compared to $9,290,000, or approximately 37% of total
revenue for fiscal 2007.  The decrease in sales




- 23
-


and
marketing expenses of $1,137,000, or approximately 12%, is primarily
attributable to cost savings resulting from the Company’s restructuring plan
which was initiated and completed during the first quarter of fiscal year 2007
and resulted in lower headcount. Additionally, the Company incurred fewer
consulting and travel-related expenses during the fiscal year ended September
30, 2008 as compared to fiscal 2007.





Engineering
and product development expenses were $2,966,000, or 13% of total revenue for
the fiscal year ended September 30, 2008 as compared to $2,951,000, or 12%
of total revenue in fiscal 2007. The slight increase in engineering and product
development expenses of $15,000, or approximately 1%, is primarily attributable
to the increased use of external development consultants and employee-related
costs, net of capitalized software.





General
and administrative expenses were $4,923,000, or 21% of total revenue for the
fiscal year ended September 30, 2008 as compared to $4,872,000, or 19% of
total revenue in fiscal 2007. The increase in general and administrative
expenses of $51,000, or approximately 1%, is primarily attributable to higher
accounting and auditing fees and compliance costs associated with the Section
404 of the Sarbanes-Oxley Act.





Interest
expense for the fiscal year ended September 30, 2007 was $33,000 which resulted
from the Company’s $1 million borrowing under its line of credit in the third
quarter of fiscal 2006. There was no interest expense for the fiscal year ended
September 30, 2008 as the Company elected to repay its outstanding balance under
its line of credit in the second quarter of fiscal 2007.





Interest
income and other income (expense) includes primarily the following two
components: interest income; and a gain on the dissolution of the Company’s
French and German subsidiaries (Datawatch France SARL and Datawatch GmbH).
Interest income for the fiscal year ended September 30, 2008 was $130,000 as
compared to $40,000 for fiscal 2007. The increase in interest income was the
result of higher cash balances held in interest-bearing accounts. Additionally,
during fiscal 2008, there was a gain of $147,000 recorded upon the dissolution
of two of the Company’s foreign subsidiaries: Datawatch France SARL and
Datawatch GmbH. This amount represents the cumulative effect of translation
adjustments related to the consolidation of these subsidiaries which were
previously accumulated and reported in the shareholders’ equity section of the
Company’s consolidated balance sheets.





Gain
(loss) on foreign currency transactions for the fiscal year ended September 30,
2008 was a gain of $79,000 as compared to a loss of $7,000 for the fiscal year
ended September 30, 2007.





Income
tax expense for the year ended September 30, 2008 was $153,000 as compared to
$133,000 for the year ended September 30, 2007. Income tax expense for both
periods includes additional deferred tax expense related to the tax-deductible
goodwill generated by the Company’s acquisition of the business assets of IDARS.
The goodwill resulting from this transaction is deductible for tax purposes and
a deferred tax expense is recognized for financial reporting purposes equal to
the tax rate on the excess of tax amortization over the amortization for
financial reporting purposes, which is zero unless there is an impairment. The
increase in income taxes of $20,000 is a result of additional deferred tax
expense related to the earn-out provisions of the IDARS acquisition and
uncertain tax positions relative to foreign taxes.





Net
income for the year ended September 30, 2008 was $717,000 as compared to
net income of $1,669,000 for the year ended September 30,
2007.








Fiscal Year Ended
September 30, 2007 as Compared to


Fiscal Year Ended
September 30, 2006





Total
Revenues





The
following table presents total revenue, total revenue increase (decrease) and
percentage change in total revenue for the years ended September 30, 2007
and 2006:




- 24
-


Year
      Ended September 30,
              
              
              Increase
              
              
              Percentage2007
              
              
              2006
              
              
              (Decrease)
              
              
              Change(In
      thousands)Software
      licenses and subscriptions
              
              $
              14,852
              
              
              $
              13,145
              
              
              $
              1,707
              
              
              
              13.0
              %Maintenance
      and services
              
              
              10,407
              
              
              
              7,666
              
              
              
              2,741
              
              
              
              35.8
              %Total
      revenue
              
              $
              25,259
              
              
              $
              20,811
              
              
              $
              4,448
              
              
              
              21.4
              %


Revenue
for the fiscal year ended September 30, 2007 was $25,259,000, which
represents an increase of $4,448,000 or approximately 21% from revenue of
$20,811,000 for the fiscal year ended September 30, 2006. For fiscal 2007,
Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch
RMS, Datawatch ES, Visual Insight, iMergence and VorteXML), Content Management
Solutions (including Datawatch BDS and Datawatch MailManager) and Business
Service Management and Workflow Solutions (including Visual QSM and Visual HD)
revenue accounted for 67%, 14%, and 19% of total revenue, respectively, as
compared to 73%, 5%, and 22%, respectively, for fiscal 2006. The increase in
software license revenue can be attributed primarily to the Monarch Version 9
upgrade that was released in February 2007.





Software
license and subscription revenue for the fiscal year ended September 30,
2007 was $14,852,000 or approximately 59% of total revenue, as compared to
$13,145,000 or approximately 63% of total revenue for the fiscal year ended
September 30, 2006. This represents an increase of $1,707,000 or
approximately 13% from fiscal 2006. The overall increase in software license and
subscription revenue during fiscal 2007 includes a $1,391,000 increase in
Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch
RMS, Datawatch ES, Datawatch Researcher, Visual Insight, iMergence and VorteXML
products), a $230,000 increase in Content Management Solutions (including
Datawatch BDS and Datawatch MailManager products) and an $85,000 increase in
Business Service Management and Workflow Solutions (including Visual QSM and
Visual HD products). Datawatch BDS license revenues increased $230,000 which is
attributable to a full year of BDS sales in fiscal 2007. The BDS product was
acquired in connection with the Company’s acquisition of the Integrated Document
Archiving and Retrieval Systems (“IDARS”) business from ClearStory Systems, Inc.
in May 2006. Monarch revenues increased $1,499,000 in fiscal 2007 which is
attributed to the release of version 9 during fiscal 2007.





Maintenance
and services revenue for the fiscal year ended September 30, 2007 was
$10,407,000 or approximately 41% of total revenue, as compared to $7,666,000 or
approximately 37% of total revenue for the fiscal year ended September 30,
2006. This represents an increase of $2,741,000 or approximately 36% from fiscal
2006. The increase in maintenance and services revenue includes a $2,343,000
increase in Content Management Solutions (including Datawatch BDS and Datawatch
MailManager products), a $225,000 increase in Business Intelligence Solutions
(including Monarch, Monarch Data Pump, Monarch RMS, Datawatch ES, Datawatch
Researcher, Visual Insight, iMergence and VorteXML products) and a $173,000
increase in Business Service Management and Workflow Solutions (including Visual
QSM and Visual HD products). Datawatch BDS services and maintenance revenues
increased $2,343,000 which is attributable to a full year of revenues associated
with the Company’s acquisition of the IDARS business in May 2006. Maintenance
and services revenue for the Business Service Management and Workflow Solutions
product line increased due to higher professional services which were offset by
lower renewal rates of annual maintenance contracts from existing customers.
Visual QSM had a product upgrade release and new products were integrated with
it during 2007. There was no new upgrade introduced for the Visual|Help Desk
product line during fiscal year 2007. The Company attributes the overall
increases in maintenance and services revenue to continued customer loyalty,
which has resulted in high renewal rates for annual maintenance service
contracts and an increased demand for professional services from existing
customers, which also includes upgrades and additional training.





Costs
and Operating Expenses





The
following table presents costs and operating expenses, increase/(decrease) in
costs and operating




- 25
-


expenses
and percentage changes in costs and operating expenses for the years ended
September 30, 2007 and 2006:




Year
      Ended September 30,
              
              
              Increase
      /
              
              
              Percentage2007
              
              
              2006
              
              
              (Decrease)
              
              
              Change(in
      thousands)Costs
      of software licenses and subscriptions
              
              $
              2,468
              
              
              $
              2,268
              
              
              $
              200
              
              
              
              8.8
              %Costs
      of maintenance and services
              
              
              3,943
              
              
              
              3,949
              
              
              
              (6
              )
              
              
              -0.2
              %Sales
      and marketing expenses
              
              
              9,290
              
              
              
              9,136
              
              
              
              154
              
              
              
              1.7
              %Engineering
      and product development expenses
              
              
              2,951
              
              
              
              2,094
              
              
              
              857
              
              
              
              40.9
              %General
      and administrative expenses
              
              
              4,872
              
              
              
              3,898
              
              
              
              974
              
              
              
              25.0
              %Total
      costs and operating expenses
              
              $
              23,524
              
              
              $
              21,345
              
              
              $
              2,179
              
              
              
              10.2
              %




Cost of
software licenses and subscriptions for the fiscal year ended September 30,
2007 was $2,468,000 or approximately 17% of software license and subscription
revenues, as compared to $2,268,000 or approximately 17% of software license
revenues for the fiscal year ended September 30, 2006. Costs of software
licenses and subscriptions as a percentage of software licenses and subscription
revenue have remained consistent year over year.





Cost of
maintenance and services for the fiscal year ended September 30, 2007 was
$3,943,000 or approximately 38% of maintenance and service revenues, as compared
to $3,949,000 or approximately 52% of maintenance and service revenues, for the
fiscal year ended September 30, 2006. The slight decrease in total cost of
maintenance and services was attributable to the net effect of (i) savings
generated from the Company’s restructuring plan which was initiated and
completed during the first quarter of fiscal 2007 and additional headcount
attrition offset by (ii) increased costs attributable to additional headcount
brought on from the acquisition of IDARS in the third quarter of fiscal
2006.





Sales and
marketing expenses were $9,290,000 for the fiscal year ended September 30,
2007, which represents an increase of $154,000 or approximately 2%, from
$9,136,000 for the fiscal year ended September 30, 2006. This increase is
primarily attributable to an increase in amortization expense for a full year in
2007 related to the customer lists acquired in the IDARS acquisition in May 2006
as well as an increase in costs associated with the 2007 user conference (net of
sales).  These increases were partially offset by cost savings
resulting from the Company’s restructuring plan which was initiated and
completed during the first quarter of fiscal year 2007.





During
the first quarter of fiscal 2007, the Company initiated and completed a
restructuring plan in an effort to reduce costs and focus on key areas of the
business. The restructuring plan was limited to one of the Company’s wholly
owned subsidiaries, Datawatch International Limited and resulted in charges for
severance benefits and related costs for nine terminated employees of
approximately $128,000.  All of these costs were charged in the first
quarter of fiscal 2007 and none were accrued or incurred in fiscal 2006. The
Company anticipates annual sales and marketing expense savings from this
restructuring to approximate $1.2 million.





Engineering
and product development expenses were $2,951,000 for the fiscal year ended
September 30, 2007, which represents an increase of $857,000 or
approximately 41% from $2,094,000 for the fiscal year ended September 30,
2006. This increase is primarily attributable to the additional headcount
resulting from the IDARS acquisition and increases in outsourced development
activities. The Company will continue to use third-party development activities
in conjunction with in-house development for the foreseeable
future.





General
and administrative expenses were $4,872,000 for the fiscal year ended
September 30, 2007, which represents an increase of $974,000 or
approximately 25% from $3,898,000 for the fiscal year ended September 30,
2006. This increase is primarily attributable to accruals related to the
Company’s executive bonus




- 26
-


plan,
administrative costs related to personnel hired for revenue recognition
expertise and increased consulting, audit and legal professional
fees.





Net
income for the year ended September 30, 2007 was $1,669,000, which compares
to net loss of $555,000 for the year ended September 30, 2006. Net income
for fiscal year 2007 includes a tax provision of approximately $133,000 while
net loss for fiscal year 2006 includes a tax provision of $36,000.




OFF
BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES
AND COMMITMENTS





The
Company leases various facilities and equipment in the U.S. and overseas under
noncancelable operating leases that expire through 2011. The lease agreements
generally provide for the payment of minimum annual rentals, pro rata share of
taxes, and maintenance expenses. Rental expense for all operating leases was
approximately $440,000, $511,000 and $632,000 for fiscal years 2008, 2007 and
2006, respectively.





As of
September 30, 2008, contractual obligations include minimum rental
commitments under noncancelable operating leases and long-term liabilities
related to potential tax exposures pursuant to FASB Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes - An Interpretation of FASB
Statement No. 109” (“FIN 48”) as follows (in
thousands):




Less
      than 1
              
              
              
              
              
              
              
              
              More
      thanContractual
      Obligations:
              
              Total
              
              
              Year
              
              
              1-3
      Years
              
              
              3-5
      Years
              
              
              5
      YearsOperating
      LeaseObligations
              
              $
              681
              
              
              $
              346
              
              
              $
              335
              
              
              $
              —
              
              
              $
              —Other
      Liabilities
              
              $
              100
              
              
              $
              —
              
              
              $
              —
              
              
              $
              —
              
              
              $
              100







The
Company is also obligated to pay royalties ranging from 7% to 50% on revenue
generated by the sale of certain licensed software products. Royalty expense
included in cost of software licenses was approximately $1,779,000, $1,865,000
and $1,602,000 respectively, for the years ended September 30, 2008, 2007
and 2006.  The Company is not obligated to pay any minimum amounts for
royalties.





On August
11, 2004, the Company acquired 100% of the shares of Mergence Technologies
Corporation. The purchase agreement includes a provision for quarterly cash
payments to the former Mergence shareholders equal to 10% of revenue, as
defined, of the Datawatch Researcher product until September 30, 2010. The
Company expensed approximately $4,000, $17,000 and $5,000 for the fiscal years
ended September 30, 2008, 2007 and 2006, respectively, for royalty payments to
Mergence.





The
Company’s software products are sold under warranty against certain defects in
material and workmanship for a period of 30 days from the date of purchase. If
necessary, the Company would provide for the estimated cost of warranties based
on specific warranty claims and claim history. However, the Company has never
incurred significant expense under its product or service warranties. As a
result, the Company believes the estimated fair value of these warranty
agreements is minimal and there are no liabilities recorded for warranty claims
as of September 30, 2008.





The
Company is required by the sublease agreement related to its Chelmsford,
Massachusetts facility to provide a letter of credit in the amount of
approximately $125,000 as a security deposit to the landlord of amounts due
under the lease. Cash on deposit providing security in the amount of this letter
of credit is classified as restricted cash in the Company’s consolidated balance
sheets as of September 30, 2008 and 2007.





The
Company enters into indemnification agreements in the ordinary course of
business. Pursuant to these agreements, the Company generally agrees to
indemnify, hold harmless, and reimburse the indemnified party for losses
suffered or incurred by the indemnified party, generally its customers, in
connection with any patent, copyright or other intellectual property
infringement claim by any third party with respect to the Company’s products.
The term of these indemnification agreements is generally perpetual. The maximum
potential amount of future payments the Company could be required to make under
these indemnification agreements is generally




- 27
-


unlimited.
The Company has never incurred costs to defend lawsuits or settle claims related
to these indemnification agreements. As a result, the Company believes the
estimated fair value of these agreements is minimal. Accordingly, the Company
has no liabilities recorded for these agreements as of September 30,
2008.





Certain
of the Company’s agreements also provide for the performance of services at
customer sites. These agreements may contain indemnification clauses, whereby
the Company will indemnify the customer from any and all damages, losses,
judgments, costs and expenses for acts of its employees or subcontractors
resulting in, among other things, bodily injury or property damage. The maximum
potential amount of future payments the Company could be required to make under
these indemnification agreements is generally unlimited; however, the Company
has general and umbrella insurance policies that would enable it to recover a
portion of any amounts paid. The Company has never incurred costs to defend
lawsuits or settle claims related to these indemnification agreements. As a
result, the Company believes the estimated fair value of these agreements is
minimal. Accordingly,the Company has no liabilities recorded for these agreements as of
September 30, 2008.





As
permitted under Delaware law, the Company has agreements with its directors
whereby the Company will indemnify them for certain events or occurrences while
the director is, or was, serving at the Company’s request in such capacity. The
term of the director indemnification period is for the later of ten years after
the date that the director ceases to serve in such capacity or the final
termination of proceedings against the director as outlined in the
indemnification agreement. The maximum potential amount of future payments the
Company could be required to make under these indemnification agreements is
unlimited; however, the Company’s director and officer insurance policy would
enable it to recover a portion of any future amounts paid. As a result of its
insurance policy coverage for directors, the Company believes the estimated fair
value of these indemnification agreements is minimal. The Company has no
liabilities recorded for these agreements as of September 30,
2008.





LIQUIDITY
AND CAPITAL RESOURCES





Management
believes that its current cash balances and cash generated from operations will
be sufficient to meet the Company’s cash needs for working capital and
anticipated capital expenditures for at least the next twelve months. At
September 30, 2008, the Company had $4,885,000 of cash and equivalents, an
increase of $1,044,000 from September 30, 2007.





At
September 30, 2008, the Company had working capital of $1,130,000 as compared to
a working capital deficit of $279,000 as of September 30, 2007. The Company
expects cash flows from operations to remain positive as it anticipates
continued profitability in the future. However, if the Company’s cash flow from
operations were to decline significantly, it may need to consider further
reductions to its operating expenses. The Company does not anticipate additional
cash requirements to fund significant growth or the acquisition of complementary
technology or businesses. However, if in the future, such expenditures are
anticipated or required, the Company may need to seek additional financing by
issuing equity or obtaining credit facilities to fund such requirements. There
can be no assurance that the Company will be able to issue additional equity or
obtain a new credit facility at attractive prices or rates, or at
all.





The
Company had net income of approximately $717,000 for the year ended September
30, 2008 as compared to a net income of approximately $1,669,000 for the year
ended September 30, 2007 and net loss of approximately $555,000 for the
year ended September 30, 2006. During the years ended September 30, 2008
and 2007, approximately $1,838,000 and $3,521,000, respectively, of cash was
provided by the Company’s operations. During fiscal year 2008, the main source
of cash from operations was net income adjusted for depreciation and
amortization as well as a decrease in accounts receivable.





Net cash
used in investing activities for the year ended September 30, 2008 of
$1,030,000 is primarily related to earn-out payments associated with the
Company’s IDARS acquisition, capitalized software development costs and the
purchase of property and equipment.





Net cash
provided by financing activities for the year ended September 30, 2008 of
$515,000 is related to the proceeds from the exercise of stock
options.





- 28
-


On May 3,
2006, the Company acquired certain assets of ClearStory Systems, Inc’s.
Integrated Document Archiving and Retrieval Systems (“IDARS”) business. The
acquisition of IDARS was consummated pursuant to an asset purchase agreement
dated as of March 10, 2006 among the Company and Clearstory Systems, Inc. The
purchase agreement includes a provision for payments over an 18 month period
equal to 30% of net revenues from the IDARS business, excluding the first
$337,500 of revenues, net of any claims. The earn-out payments are considered
additional purchase price and were recorded as additional goodwill as incurred.
At September 30, 2007, the Company had accrued approximately $329,000 related to
such earn-out payments. In accordance with the asset purchase agreement,
payments commenced during the Company’s third and fourth quarters of fiscal year
2007 and the final payments were made in the first quarter of fiscal year 2008.
Accordingly, no amounts are accrued as of September 30, 2008.





The
Mergence purchase agreement dated August 11, 2004 includes a provision for
quarterly cash payments to the former Mergence shareholders equal to 10% of
revenue, as defined, of the Datawatch Researcher product for a period of six
years. As the cash payments are based on recognized revenue and no minimum
payments are required, they are not expected to have a significant impact on the
Company’s liquidity or cash flows. See the section titled “Off Balance
Sheet Arrangements, Contractual Obligations and Contingent Liabilities and
Commitments” included elsewhere herein for a more complete disclosure of the
Company’s commitments and contingent liabilities.





An
existing agreement between Datawatch and Math Strategies grants the Company
exclusive worldwide rights to use and distribute certain intellectual property
owned by Math Strategies and incorporated by the Company in its Monarch, Monarch
Data Pump, VorteXML and certain other products. On April 29, 2004, the
Company entered into a two year Option Purchase Agreement with Math Strategies
giving the Company the option to purchase these intellectual property rights for
$8 million (“Option Purchase Agreement”). In February 2006, the Company entered
into an amendment to the original license agreement with Math Strategies dated
January 19, 1989. Pursuant to the amendment, the term of the license agreement
was extended to April 30, 2015. Contemporaneous with the license amendment, the
Company also entered into an amendment to the Option Purchase Agreement. After
amending this agreement, the option has been extended to April 30, 2015. The
option purchase amendment changes the purchase price for the option to a formula
price based on a multiple of the aggregate royalties paid to Math Strategies by
the Company for the four fiscal quarters preceding the exercise of the option.
This option, if exercised, would provide the Company with increased flexibility
to utilize the purchased technology in the future.





Management
believes that the Company’s current operations have not been materially impacted
by the effects of inflation.





RECENT
ACCOUNTING PRONOUNCEMENTS





In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
157, “FairValueMeasurements” (“SFAS
157”), which establishes a framework for measuring fair value and expands
disclosures about the use of fair value measurements and liabilities in interim
and annual reporting periods subsequent to initial recognition.  Prior to
SFAS 157, which emphasizes that fair value is a market-based measurement and not
an entity-specific measurement, there were different definitions of fair value
and limited guidance for applying those definitions in generally accepted
accounting principles. SFAS 157 is effective for the Company on a
prospective basis for the reporting period beginning October 1, 2008.  In
February 2008, the FASB delayed the effective date of SFAS 157 for all
nonrecurring fair value measurements of nonfinancial assets and nonfinancial
liabilities until fiscal years beginning after November 15, 2008. The Company
does not expect that the adoption of this Statement will have a material impact
on its financial position or results of operations.





In
February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 expands
opportunities to use fair value measurements in financial




- 29
-


reporting
and permits entities to choose to measure many financial instruments and certain
other items at fair value. This Statement is effective for the Company beginning
October 1, 2008. The Company has not elected to measure eligible financial
assets and liabilities at fair value and therefore adoption of this Statement
did not have an impact on the Company’s consolidated financial
statements.





In
December 2007, the FASB issued Statement No. 141(R), “Business Combinations”(“SFAS 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) establishes
principles and requirements for how an acquirer recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
any non-controlling interest in the acquiree and the goodwill acquired as well
as the treatment of acquisition-related costs. This Statement also establishes
disclosure requirements which will enable users to evaluate the nature and
financial effects of the business combination. SFAS 141(R) is effective for
fiscal years beginning after December 15, 2008. The adoption of SFAS 141(R) will
have an impact on accounting for business combinations once adopted, but the
effect is dependent upon acquisitions after that time.





In
December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in
Consolidated Financial Statements – an amendment of Accounting Research Bulletin
No. 51”(“SFAS 160”), which establishes accounting and reporting
standards for ownership interests in subsidiaries held by parties other than the
parent, the amount of consolidated net income attributable to the parent and to
the noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained non-controlling equity investments when a subsidiary is
deconsolidated. The Statement also establishes reporting requirements that
provide sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the non-controlling owners. SFAS
160 is effective for fiscal years or interim periods beginning after December
15, 2008. The Company does not believe this Statement will have any impact on
its consolidated financial statements upon adoption.





In March
2008, the FASB issued Statement No. 161, “Disclosures About Derivative
Instruments and Hedging Activities – an amendment of FASB Statement No.
133” (“SFAS 161”).  SFAS 161 amends and expands the disclosure
requirements of SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities.”  SFAS 161 requires
qualitative disclosures about objectives and strategies for using derivatives,
quantitative disclosures about fair value amounts of gains and losses on
derivative instruments and disclosures about credit-risk-related contingent
features in derivative agreements. SFAS 161 also amends SFAS No. 107, “Disclosures About Fair Value of
Financial Instruments” (“SFAS 107”), to clarify that derivative
instruments are subject to SFAS 107’s concentration-of-credit risk disclosures.
SFAS 161 is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008.  Early adoption is
permitted, and entities are encouraged, but not required, to provide comparative
disclosures for earlier periods. The adoption of SFAS 161 will not affect the
Company’s consolidated financial statements or financial condition, but may
require additional disclosures if the Company enters into derivative and hedging
activities.








Item
7(A).  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK







Derivative Financial
Instruments, Other Financial Instruments, and Derivative Commodity
Instruments




At
September 30, 2008, the Company did not participate in or hold any
derivative financial instruments or commodity instruments.  The
Company holds no investment securities that possess significant market
risk.





Primary Market Risk
Exposures




The
Company’s primary market risk exposure is foreign currency exchange rate risk.
International revenues and expenses are generally transacted by the Company’s
foreign subsidiaries and are denominated in local currency. Approximately 30%,
31% and 32% of the Company’s revenues for 2008, 2007 and 2006, respectively,
were from foreign subsidiaries. In addition, approximately 31%, 34% and 36% of
the Company’s operating expenses for fiscal 2008, 2007 and 2006, respectively,
were from foreign subsidiaries.





The
Company’s exposure to currency exchange rate fluctuations has been and is
expected to continue to be




- 30
-


modest
due to the fact that the operations of its international subsidiaries are almost
exclusively conducted in their respective local currencies, and dollar advances
to the Company’s international subsidiaries, if any, are considered to be of a
long-term investment nature. Therefore, the majority of currency movements are
reflected in the Company’s other comprehensive income (loss). There are,
however, certain situations where the Company will invoice customers in
currencies other than its own. Such gains or losses from operating activity,
whether realized or unrealized, are reflected in other income (expense), net in
the consolidated statements of operations. These have not been material in the
past nor does management believe that they will be material in the future.
Currently, the Company does not engage in foreign currency hedging
activities.










































































- 31
-


Item
8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA





The
following consolidated financial statements and the related notes thereto of
Datawatch Corporation and the Report of Independent Registered Public Accounting
Firm thereon are filed as part of this Annual Report on Form 10-K.














REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
            33CONSOLIDATED
      FINANCIAL STATEMENTS AS OF SEPTEMBER 30, 2008 AND 2007 AND FOR EACH OF THE
      THREE YEARS IN THE PERIOD ENDED SEPTEMBER 30, 2008:Consolidated
      Balance Sheets
            34Consolidated
      Statements of Operations
            35Consolidated
      Statements of Shareholders’ Equity and Comprehensive Income
      (Loss)
            36Consolidated
      Statements of Cash Flows
            37Notes
      to Consolidated Financial Statements
            38



















- 32
-


REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM








To the
Board of Directors and Shareholders of Datawatch Corporation


Chelmsford,
Massachusetts





We have
audited the accompanying consolidated balance sheets of Datawatch Corporation
and subsidiaries (the “Company”) as of September 30, 2008 and 2007, and the
related consolidated statements of operations, shareholders’ equity and
comprehensive income (loss), and cash flows for each of the three years in the
period ended September 30, 2008.  These financial statements are the
responsibility of the Company’s management. Our responsibility is to
express an opinion on these financial statements based on our
audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting.  Our audits included consideration
of internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company’s internal control
over financial reporting.  Accordingly, we express no such opinion. 
An audit also includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe that
our audits provide a reasonable basis for our opinion.





In our
opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of Datawatch Corporation and subsidiaries as of
September 30, 2008 and 2007, and the results of their operations and their cash
flows for each of the three years in the period ended September 30, 2008, in
conformity with accounting principles generally accepted in the United States of
America.





As
discussed in Note 6 to the consolidated financial statements, on October 1,
2007, the Company adopted Financial Accounting Standards Board Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB
Statement No. 109”.





/s/
DELOITTE & TOUCHE LLP





Boston,
Massachusetts


December
23, 2008








- 33
-


DATAWATCH
CORPORATION


CONSOLIDATED
BALANCE SHEETS


(In
thousands, except share and per share amounts)




September
      30,
              
              
              September
      30,2008
              
              
              2007ASSETSCURRENT
      ASSETS:Cash
      and equivalents
              
              $
              4,885
              
              
              $
              3,841Accounts receivable,
      less allowance for doubtful accounts and sales returns of
      $236,000 in 2008 and $303,000 in 2007
              
              
              3,287
              
              
              
              4,174Inventories
              
              
              57
              
              
              
              48Prepaid
      expenses
              
              
              361
              
              
              
              527Total
      current assets
              
              
              8,590
              
              
              
              8,590Property
      and equipment:Office
      furniture and equipment
              
              
              2,046
              
              
              
              2,090Engineering
      equipment
              
              
              180
              
              
              
              2882,226
              
              
              
              2,378Less
      accumulated depreciation and amortization
              
              
              (1,489
              )
              
              
              (1,522
              )Net
      property and equipment
              
              
              737
              
              
              
              856Goodwill
              
              
              6,116
              
              
              
              6,020Other
      intangible assets, net
              
              
              2,577
              
              
              
              2,676Restricted
      cash
              
              
              125
              
              
              
              125Other
      long-term assets
              
              
              24
              
              
              
              70$
              18,169
              
              
              $
              18,337LIABILITIES
      AND SHAREHOLDERS’ EQUITYCURRENT
      LIABILITIES:Accounts
      payable
              
              $
              1,028
              
              
              $
              1,215Accrued
      expenses
              
              
              2,385
              
              
              
              2,839Deferred
      revenue
              
              
              4,047
              
              
              
              4,486Accrued
      cost of acquisition
              
              
              —
              
              
              
              329Total
      current liabilities
              
              
              7,460
              
              
              
              8,869LONG-TERM
      LIABILITIES:Deferred
      rent
              
              
              120
              
              
              
              179Deferred
      revenue - long-term
              
              
              145
              
              
              
              122Deferred
      tax liability
              
              
              262
              
              
              
              147Other
      liabilities
              
              
              100
              
              
              
              —Total
      long-term liabilities
              
              
              627
              
              
              
              448COMMITMENTS
      AND CONTINGENCIESSHAREHOLDERS’
      EQUITY:Common
      stock, par value $.01; 20,000,000 shares authorized; issued, 5,928,604
      shares and 5,647,666 shares, respectively; outstanding, 5,914,358 shares
      and 5,633,420 shares, respectively
              
              
              59
              
              
              
              56Additional
      paid-in capital
              
              
              23,421
              
              
              
              22,684Accumulated
      deficit
              
              
              (12,430
              )
              
              
              (13,072
              )Accumulated
      other comprehensive loss
              
              
              (828
              )
              
              
              (508
              )10,222
              
              
              
              9,160Less
      treasury stock, at cost, 14,246 shares
              
              
              (140
              )
              
              
              (140
              )Total
      shareholders’ equity
              
              
              10,082
              
              
              
              9,020$
              18,169
              
              
              $
              18,337




See
notes to consolidated financial statements.




- 34
-


DATAWATCH
CORPORATION


CONSOLIDATED STATEMENTS OF
OPERATIONS


(In
thousands, except per share amounts)








Year
      Ended September 30,2008
              
              
              2007
              
              
              2006REVENUE:Software
      licenses and subscriptions
              
              $
              12,435
              
              
              $
              14,852
              
              
              $
              13,145Maintenance
      and services
              
              
              10,595
              
              
              
              10,407
              
              
              
              7,666Total
      revenue
              
              
              23,030
              
              
              
              25,259
              
              
              
              20,811COSTS
      AND EXPENSES:Cost
      of software licenses and subscriptions
              
              
              2,218
              
              
              
              2,468
              
              
              
              2,268Cost
      of maintenance and services
              
              
              4,271
              
              
              
              3,943
              
              
              
              3,949Sales
      and marketing
              
              
              8,153
              
              
              
              9,290
              
              
              
              9,136Engineering
      and product development
              
              
              2,966
              
              
              
              2,951
              
              
              
              2,094General
      and administrative
              
              
              4,923
              
              
              
              4,872
              
              
              
              3,898Total
      costs and expenses
              
              
              22,531
              
              
              
              23,524
              
              
              
              21,345INCOME
      (LOSS) FROM OPERATIONS
              
              
              499
              
              
              
              1,735
              
              
              
              (534
              )Interest
      expense
              
              
              —
              
              
              
              (33
              )
              
              
              (18
              )Interest
      income and other income (expense), net
              
              
              292
              
              
              
              107
              
              
              
              40Foreign
      currency transaction gains (losses)
              
              
              79
              
              
              
              (7
              )
              
              
              (7
              )INCOME
      (LOSS) FROM OPERATIONS BEFOREINCOME
      TAXES
              
              
              870
              
              
              
              1,802
              
              
              
              (519
              )Provision
      for income taxes
              
              
              (153
              )
              
              
              (133
              )
              
              
              (36
              )NET
      INCOME (LOSS)
              
              $
              717
              
              
              $
              1,669
              
              
              $
              (555
              )Net
      income (loss) per share - Basic:
              
              $
              0.12
              
              
              $
              0.30
              
              
              $
              (0.10
              )Net
      income (loss) per share - Diluted:
              
              $
              0.12
              
              
              $
              0.29
              
              
              $
              (0.10
              )Weighted-Average
      Shares Outstanding - Basic
              
              
              5,835
              
              
              
              5,558
              
              
              
              5,481Weighted-Average
      Shares Outstanding - Diluted
              
              
              6,035
              
              
              
              5,855
              
              
              
              5,481
















See
notes to consolidated financial statements.





- 35
-


DATAWATCH
CORPORATION


CONSOLIDATED STATEMENTS OF
SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)





Years
Ended September 30, 2008, 2007 and 2006


(In
thousands, except share amounts)





AccumulatedAdditional
              
              
              
              
              
              Other
              
              
              Comprehensive
              
              
              
              
              
              
              
              
              TotalCommon
      Stock
              
              
              
              
              
              Paid-In
              
              
              Accumulated
              
              
              Comprehensive
              
              
              Income/
              
              
              Treasury
      Stock
              
              
              Shareholders’Shares
              
              
              Amount
              
              
              Capital
              
              
              Deficit
              
              
              Loss
              
              
              (Loss)
              
              
              Shares
              
              
              Amount
              
              
              EquityBALANCE,OCTOBER 1, 2005
              
              
              5,383,084
              
              
              $
              54
              
              
              $
              21,957
              
              
              $
              (14,186
              )
              
              $
              (378
              )
              
              
              
              
              
              (14,246
              )
              
              $
              (140
              )
              
              $
              7,307Stock
      options exercised
              
              
              143,401
              
              
              
              1
              
              
              
              180
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              181Stock-based
      compensationexpense
              
              
              
              
              
              
              
              
              
              
              67
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              67Comprehensive
      income (loss):Translation
      adjustments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (44
              )
              
              $
              (44
              )
              
              
              
              
              
              
              
              
              
              
              (44
              )Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (555
              )
              
              
              
              
              
              
              (555
              )
              
              
              
              
              
              
              
              
              
              
              (555
              )Total
      comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              (599
              )BALANCE,SEPTEMBER 30, 2006
              
              
              5,526,485
              
              
              
              55
              
              
              
              22,204
              
              
              
              (14,741
              )
              
              
              (422
              )
              
              
              
              
              
              
              (14,246
              )
              
              
              (140
              )
              
              
              6,956Stock
      options exercised
              
              
              121,181
              
              
              
              1
              
              
              
              348
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              349Stock-based
      compensationexpense
              
              
              
              
              
              
              
              
              
              
              132
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              132Comprehensive
      income (loss):Translation
      adjustments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (86
              )
              
              
              (86
              )
              
              
              
              
              
              
              
              
              
              
              (86
              )Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,669
              
              
              
              
              
              
              
              1,669
              
              
              
              
              
              
              
              
              
              
              
              1,669Total
      comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              1,583BALANCE,SEPTEMBER 30, 2007
              
              
              5,647,666
              
              
              
              56
              
              
              
              22,684
              
              
              
              (13,072
              )
              
              
              (508
              )
              
              
              
              
              
              
              (14,246
              )
              
              
              (140
              )
              
              
              9,020Adjustment
      to accumulateddeficit upon adoptionof FIN
      48
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (75
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (75
              )Stock
      options exercised
              
              
              280,938
              
              
              
              3
              
              
              
              512
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              515Stock-based
      compensationexpense
              
              
              
              
              
              
              
              
              
              
              225
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              225Comprehensive
      income (loss):Translation
      adjustments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (320
              )
              
              
              (320
              )
              
              
              
              
              
              
              
              
              
              
              (320
              )Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              717
              
              
              
              
              
              
              
              717
              
              
              
              
              
              
              
              
              
              
              
              717Total
      comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              397BALANCE,SEPTEMBER 30, 2008
              
              
              5,928,604
              
              
              $
              59
              
              
              $
              23,421
              
              
              $
              (12,430
              )
              
              $
              (828
              )
              
              
              
              
              
              
              (14,246
              )
              
              $
              (140
              )
              
              $
              10,082







See
notes to consolidated financial statements.





- 36
-


DATAWATCH
CORPORATION


CONSOLIDATED STATEMENTS OF CASH
FLOWS


(In
thousands)


Year
      Ended September 30,2008
              
              
              2007
              
              
              2006CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income (loss)
              
              $
              717
              
              
              $
              1,669
              
              
              $
              (555
              )Adjustments
      to reconcile net income (loss) to cash provided by operating
      activities:Depreciation
      and amortization
              
              
              861
              
              
              
              928
              
              
              
              832Impairment
      of trademark
              
              
              —
              
              
              
              39
              
              
              
              —Provision
      for doubtful accounts and sales returns
              
              
              (67
              )
              
              
              25
              
              
              
              (149
              )Loss
      on disposal of equipment
              
              
              (1
              )
              
              
              —
              
              
              
              8Gain
      on disolution of foreign subsidiaries
              
              
              (147
              )
              
              
              —
              
              
              
              —Stock-based
      compensation
              
              
              225
              
              
              
              132
              
              
              
              67Deferred
      income taxes
              
              
              115
              
              
              
              111
              
              
              
              36Changes
      in current assets and liabilities, net of effects of the acquisition of
      IDARS:Accounts
      receivable
              
              
              819
              
              
              
              (320
              )
              
              
              569Inventories
              
              
              (9
              )
              
              
              (10
              )
              
              
              22Prepaid
      expenses and other assets
              
              
              164
              
              
              
              146
              
              
              
              95Accounts
      payable, accrued expenses and other liabilities
              
              
              (590
              )
              
              
              797
              
              
              
              (197
              )Deferred
      revenue
              
              
              (249
              )
              
              
              4
              
              
              
              247Cash
      provided by operating activities
              
              
              1,838
              
              
              
              3,521
              
              
              
              975CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of equipment and fixtures
              
              
              (237
              )
              
              
              (136
              )
              
              
              (912
              )Proceeds
      from sale of equipment
              
              
              2
              
              
              
              8
              
              
              
              2Purchase
      of IDARS business, net of cash acquired
              
              
              (424
              )
              
              
              (671
              )
              
              
              (4,575
              )Capitalized
      software development costs
              
              
              (411
              )
              
              
              (81
              )
              
              
              —Decrease
      in restricted cash
              
              
              —
              
              
              
              —
              
              
              
              268Other
      assets
              
              
              40
              
              
              
              (25
              )
              
              
              (9
              )Cash
      used in investing activities
              
              
              (1,030
              )
              
              
              (905
              )
              
              
              (5,226
              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from exercise of stock options
              
              
              515
              
              
              
              349
              
              
              
              181(Repayments)
      borrowings on line of credit
              
              
              —
              
              
              
              (1,000
              )
              
              
              1,000Cash
      provided by (used in) financing activities
              
              
              515
              
              
              
              (651
              )
              
              
              1,181EFFECT
      OF EXCHANGE RATE CHANGES ON CASH ANDEQUIVALENTS
              
              
              (279
              )
              
              
              14
              
              
              
              31INCREASE
      (DECREASE) IN CASH AND EQUIVALENTS
              
              
              1,044
              
              
              
              1,979
              
              
              
              (3,039
              )CASH
      AND EQUIVALENTS, BEGINNING OF YEAR
              
              
              3,841
              
              
              
              1,862
              
              
              
              4,901CASH
      AND EQUIVALENTS, END OF YEAR
              
              $
              4,885
              
              
              $
              3,841
              
              
              $
              1,862SUPPLEMENTAL
      CASH FLOW INFORMATION:Interest
      paid
              
              $
              —
              
              
              $
              42
              
              
              $
              31Income
      taxes paid
              
              $
              23
              
              
              $
              4
              
              
              $
              6





See
notes to consolidated financial statements.





- 37
-


DATAWATCH
CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS








1.   NATURE
OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Nature
of Business





Datawatch
Corporation (the “Company” or “Datawatch”) designs, develops, markets and
distributes business computer software products. The Company also provides a
wide range of consulting services, including implementation and support of its
software products, as well as training on their use and administration. The
Company is subject to a number of risks including dependence on key individuals,
competition from substitute products and larger companies and the need for
successful ongoing development and marketing of products.





Summary of Significant
Accounting Policies





Principles of
Consolidation




These
consolidated financial statements include the accounts of Datawatch and its
wholly-owned subsidiaries. All intercompany accounts and transactions have been
eliminated in consolidation.





Accounting
Estimates




The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and judgments, which are evaluated on an on-going basis, that affect
the amounts and disclosures reported in the Company’s consolidated financial
statements and accompanying notes. Management bases its estimates on historical
experience and on various other assumptions that it believes are reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results could differ from those
estimates and judgments. In particular, significant estimates and judgments
include those related to revenue recognition, allowance for doubtful accounts,
sales returns reserve, useful lives of property and equipment, valuation of net
deferred tax assets, business combinations, valuation of goodwill and other
intangible assets and valuation of share-based awards.





Revenue
Recognition




The
Company follows the guidance as defined by the American Institute of Certified
Public Accountants (“AICPA”) Statement of Position 97-2, “Software Revenue Recognition”
(“SOP 97-2”), as amended by Statement of Position 98-9, “Modification of SOP 97-2, Software
Revenue Recognition, With Respect to Certain Transactions” (“SOP 98-9”)
in recognizing revenue on software transactions. SOP 97-2 requires that revenue
allocated to software products, specified upgrades and enhancements be
recognized upon delivery of the related product, upgrades or enhancements.
Revenue is allocated by vendor specific objective evidence (“VSOE”) of fair
value to post-contract customer support (primarily maintenance) and is
recognized ratably over the term of the support, and revenue allocated by VSOE
to service elements (primarily training and consulting) is recognized as the
services are performed. The residual method of revenue recognition is used for
multi-element arrangements when the VSOE of the fair value does not exist for
one of the delivered elements. Under the residual method, the arrangement fee is
recognized as follows: (1) the total fair value of the undelivered elements, as
supported by VSOE, is deferred and subsequently recognized in accordance with
relevant sections of SOP 97-2 and (2) the difference between the total
arrangement fee and the amount deferred for the undelivered elements is
recognized as revenue related to the delivered elements.





The
Company has two types of software product offerings: (1) Enterprise Software and
(2) Desktop and Server Software. Enterprise Software products are sold directly
to end-users and through value added resellers. The Company sells its Desktop
and Server Software products directly to end-users and through distributors and
resellers. Sales to distributors and resellers accounted for approximately 41%,
39% and 40%, of total sales for the years ended September 30, 2008, 2007 and
2006, respectively. Revenue from the sale of all software products




- 38
-


(when
separately sold) is generally recognized at the time of shipment, provided there
are no uncertainties surrounding product acceptance, the fee is fixed or
determinable, collection is considered probable, persuasive evidence of the
arrangement exists and there are no significant obligations remaining. Both
types of the Company’s software product offerings are “off-the-shelf” as such
term is defined by SOP 97-2.  The Company’s software products can be
installed and used by customers on their own with little or no customization
required. Multi-user licenses marketed by the Company are sold as a right to use
the number of licenses and license fee revenue is recognized upon delivery of
all software required to satisfy the number of licenses sold. Upon delivery, the
licensing fee is payable without further delivery obligations to the
Company.





Desktop
and Server Software products are generally not sold in multiple element
arrangements. Enterprise Software sales are generally multiple element
arrangements which may include software licenses, professional services and
post-contract customer support. In such multiple element arrangements, the
Company applies the residual method in determining revenue to be allocated to
the software license. In applying the residual method, the Company deducts from
the sale proceeds the VSOE of fair value of the professional services and
post-contract customer support in determining the residual fair value of the
software license. The VSOE of fair value of the services and post-contract
customer support is based on the amounts charged for these elements when sold
separately. Professional services include implementation, integration, training
and consulting services with revenue recognized as the services are performed.
These services are generally delivered on a time and materials basis, are billed
on a current basis as the work is performed, and do not involve modification or
customization of the software or any unusual acceptance clauses or terms.
Post-contract customer support is typically provided under a maintenance
agreement which provides technical support and rights to unspecified software
maintenance updates and bug fixes on a when-and-if available basis. Revenue from
post-contract customer support services is deferred and recognized ratably over
the period of support (generally one year). Such deferred amounts are recorded
as part of deferred revenue in the Company’s consolidated balance
sheets.





The
Company also sells its Enterprise Software using a subscription model. At the
time a customer enters into a binding agreement to purchase a subscription, the
customer is invoiced for an initial 90 day service period and an account
receivable and deferred revenue are recorded. Beginning on the date the software
is installed at the customer site and available for use by the customer, and
provided that all other criteria for revenue recognition are met, the deferred
revenue amount is recognized ratably over the period of the subscription. The
customer is then invoiced every 90 days and revenue is recognized ratably over
the period of the subscription. The subscription arrangement includes software,
maintenance and unspecified future upgrades including major version upgrades.
The subscription renewal rate is the same as the initial subscription rate.
Subscriptions can be cancelled by the customer at any time by providing 90 days
prior written notice following the first year of the subscription
term.





The
Company’s software products are sold under warranty against certain defects in
material and workmanship for a period of 30 days from the date of purchase.
Certain software products, including desktop versions of Monarch, Monarch Data
Pump, BI Server and VorteXML sold directly to end-users, include a guarantee
under which such customers may return products within 30 days for a full refund.
Additionally, the Company provides its distributors with stock-balancing rights
and applies the guidance found in Statement of Financial Accounting Standards
(“SFAS”) No. 48, “Revenue
Recognition when Right of Return Exists.” Revenue from the sale of
software products to distributors and resellers is recognized at the time of
shipment providing all other criteria for revenue recognition are met and (i)
the distributor or reseller is unconditionally obligated to pay for the
products, including no contingency as to product resale, (ii) the distributor or
reseller has independent economic substance apart from the Company, (iii) the
Company is not obligated for future performance to bring about product resale,
and (iv) the amount of future returns can be reasonably estimated. The Company’s
experience and history with its distributors and resellers allow for reasonable
estimates of future returns. Among other things, estimates of potential future
returns are made based on the inventory levels at the various distributors and
resellers, which the Company monitors frequently.





Allowance for
Doubtful Accounts




The
Company maintains allowances for doubtful accounts for estimated losses
resulting from the inability of customers to make required payments. The Company
analyzes accounts receivable and the composition of




- 39
-


the
accounts receivable aging, historical bad debts, customer creditworthiness,
current economic trends and changes in customer payment terms when evaluating
the adequacy of the allowance for doubtful accounts. Actual results could differ
from the allowances recorded, and this difference could have a material effect
on the Company’s financial position and results of operations.





For the
fiscal years ended September 30, 2008, 2007 and 2006, changes to and ending
balances of the allowance for doubtful accounts were approximately as
follows:




2008
              
              
              2007
              
              
              2006(in
      thousands)Allowance
      for doubtful accounts balance - beginning of year
              
              $
              223
              
              
              $
              193
              
              
              $
              294Additions
      to the allowance for doubtful accounts
              
              
              62
              
              
              
              57
              
              
              
              11Deductions
      against the allowance for doubtful accounts
              
              
              (114
              )
              
              
              (27
              )
              
              
              (112
              )Allowance
      for doubtful accounts balance - end of year
              
              $
              171
              
              
              $
              223
              
              
              $
              193




Sales
Returns Reserve




The
Company maintains reserves for potential future product returns.  The
Company estimates future product returns based on its experience and history
with the Company’s various distributors and resellers as well as by monitoring
inventory levels at such companies. Adjustments are recorded as increases or
decreases in revenue in the period of adjustment.  Actual returns have
historically been within the range estimated by management. Actual results could
differ from the reserve for sales returns recorded, and this difference could
have a material effect on the Company’s financial position and results of
operations.





For the
fiscal years ended September 30, 2008, 2007 and 2006, changes to and ending
balances of the sales returns reserve were approximately as
follows:




2008
              
              
              2007
              
              
              2006(in
      thousands)Sales
      returns reserve balance - beginning of year
              
              $
              80
              
              
              $
              79
              
              
              $
              123Additions
      to the sales returns reserve
              
              
              93
              
              
              
              131
              
              
              
              82Deductions
      against the sales returns reserve
              
              
              (108
              )
              
              
              (130
              )
              
              
              (126
              )Sales
      returns reserve balance - end of year
              
              $
              65
              
              
              $
              80
              
              
              $
              79




Capitalized
Software Development Costs




The
Company capitalizes certain software development costs as well as purchased
software upon achieving technological feasibility of the related products.
Software development costs incurred and software purchased prior to achieving
technological feasibility are charged to research and development expense as
incurred. Commencing upon initial product release, capitalized costs are
amortized to cost of software licenses using the straight-line method over the
estimated life of the product (which approximates the ratio that current gross
revenues for a product bear to the total of current and anticipated future gross
revenues for that product), which is generally 24 to 36 months.





For the
fiscal years ended September 30, 2008, 2007 and 2006, amounts related to
capitalized and purchased software development costs and purchased software were
approximately as follows:




- 40
-


2008
              
              
              2007
              
              
              2006(in
      thousands)Capitalized
      and purchased software balance - beginning of year
              
              $
              395
              
              
              $
              473
              
              
              $
              583Capitalized
      software development costs
              
              
              411
              
              
              
              81
              
              
              
              —Capitalized
      purchased software
              
              
              —
              
              
              
              —
              
              
              
              180Amortization
      of capitalized software development costs andpurchased
      software
              
              
              (142
              )
              
              
              (159
              )
              
              
              (290
              )Capitalized
      and purchased software balance - end of year
              
              $
              664
              
              
              $
              395
              
              
              $
              473
  Cash
and Equivalents




Cash and
equivalents include cash on hand, cash deposited with banks and highly liquid
securities including money market investments and short-term treasury deposits
with maturities of 90 days or less when purchased.





Concentration
of Credit Risks and Major Customers




The
Company sells its products and services to U.S. and non-U.S. dealers and other
software distributors, as well as to end users, under customary credit terms.
One customer, Ingram Micro Inc., individually accounted for 21%, 15% and 16% of
total revenue in 2008, 2007 and 2006, respectively. Ingram Micro Inc. accounted
for 26% and 15% of outstanding gross trade receivables as of September 30, 2008
and 2007, respectively. One other customer, Tech Data Product Management,
individually accounted for approximately 8%, 13% and 13% of total revenue in
2008, 2007 and 2006, respectively. Tech Data Product Management accounted for 4%
and 20% of outstanding gross trade receivables as of September 30, 2008 and
2007, respectively. The Company sells to Ingram Micro Inc. and Tech Data Product
Management under distribution agreements, which automatically renew for
successive one-year terms unless terminated. Other than these two customers, no
other customer constitutes a significant portion (more than 10%) of sales or
accounts receivable. The Company performs ongoing credit evaluations of its
customers and generally does not require collateral.





Deferred
Revenue




Deferred
revenue consisted of the following at September 30:




2008
              
              
              2007(in
      thousands)Maintenance
              
              $
              3,763
              
              
              $
              4,012Other
              
              
              429
              
              
              
              596Total
              
              
              4,192
              
              
              
              4,608Less:
      Long-term portion of deferred maintenance
              
              
              (145
              )
              
              
              (122
              )Current
      portion of deferred revenue
              
              $
              4,047
              
              
              $
              4,486




Maintenance
deferred revenue consists of the unearned portion of post-contract customer
support services provided by the Company to customers who purchased maintenance
agreements for the Company’s products. Maintenance revenues are recognized on a
straight-line basis over the term of the maintenance period, generally 12
months.





Other
deferred revenue consists of deferred license, subscription and professional
services revenue generated from arrangements that are invoiced in accordance
with the terms and conditions of the arrangement but do not meet all the
criteria for revenue recognition, and are, therefore, deferred until all revenue
recognition criteria are met.





Inventories




Inventories
consist of software components, primarily software manuals, compact disks and
retail packaging




- 41
-


materials.
Inventories are valued at the lower of cost (first-in, first-out method) or
market.





Property
and Equipment




Property
and equipment consists of office equipment, furniture and fixtures, software and
leasehold improvements, all of which are recorded at cost. Depreciation and
amortization are provided using the straight-line method over the estimated
useful lives of the related assets or over the terms, if shorter, of the related
leases. Useful lives and lease terms range from one to seven years. Depreciation
and amortization expense related to property and equipment was $352,000,
$407,000 and $363,000, respectively, for the years ended September 30, 2008,
2007 and 2006.





Long-Lived
Assets




The
Company periodically evaluates whether events or circumstances have occurred
that indicate that the estimated remaining useful lives of long-lived assets and
certain identifiable intangibles may warrant revision or that the carrying value
of these assets may be impaired. To determine whether assets have been impaired,
the estimated undiscounted future cash flows for the estimated remaining useful
life of the respective assets are compared to the carrying value. To the extent
that the undiscounted future cash flows are less than the carrying value, the
fair value of the asset is determined and an impairment is recognized. If such
fair value is less than the current carrying value, the asset is written down to
its estimated fair value. No such impairments were recorded during the year
ended September 30, 2008. An impairment of $39,000 related to one of the
Company’s trademarks was recorded in the year ended September 30,
2007.





Goodwill
and Other Intangible Assets




Other
intangible assets consist of internally developed software costs, acquired
technology, patents, customer lists, trademarks and non-compete agreements
acquired through business combinations. The values allocated to the majority of
these intangible assetsare amortized using the
straight-line method over the estimated useful life of the related asset and are
recorded in cost of software licenses and subscriptions. The values allocated to
customer relationships and non-compete agreements are amortized using the
straight-line method over the estimated useful life of the related asset and are
recorded in sales and marketing expenses. Intangible assets are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable and an impairment loss is
recognized when it is probable that the estimated cash flows are less than the
carrying amount of the asset.





Goodwill
and certain trademarks are not subject to amortization and are tested annually,
on May 31st, for
impairment or more frequently if events and circumstances indicate that the
asset might be impaired. Goodwill is tested for impairment using a two-step
approach. The first step is to compare the fair value of the reporting unit to
its carrying amount, including goodwill. If the fair value of the reporting unit
is greater than its carrying amount, goodwill is not considered impaired, but if
the fair value of the reporting unit is less than its carrying amount, the
amount of the impairment loss, if any, must be measured. An impairment loss is
recognized to the extent that the carrying amount exceeds the asset’s fair
value. Factors the Company considers important that could trigger an impairment
review include, but are not limited to, significant underperformance relative to
historical or projected future operating results, significant changes in the
manner of use of the acquired assets or the strategy for the Company’s overall
business, significant negative industry or economic trends, a significant
decline in the Company’s stock price for a sustained period, and decreases in
our market capitalization below the recorded amount of our net assets for a
sustained period. The Company’s stock price is highly volatile and has
experienced significant declines since September 30, 2008. If the Company’s
stock price does not improve prior to the end of the first quarter of fiscal
2009 or if other factors indicate that it is more likely than not that an
impairment may exist, the Company could determine that an interim impairment
test is required, which could result in a non-cash impairment
charge.





Changes
in the carrying amounts of goodwill for the years ended September 30, 2008 and
2007 are as follows (in thousands):





- 42
-


2008
            
            
            2007Balance
      at beginning of year
            
            $
            6,020
            
            
            $
            5,236Acquisition
      of IDARS business
            
            
            96
            
            
            
            784Balance
      at end of year
            
            $
            6,116
            
            
            $
            6,020





The
Company has the following other intangible assets as of September 30, 2008 and
2007:




Weighted
              
              
              September
      30, 2008
              
              
              September
      30, 2007Average
              
              
              Gross
              
              
              
              
              
              
              
              
              GrossIdentified
      Intangible
              
              Useful
      Life
              
              
              Carrying
              
              
              Accumulated
              
              
              Net
      Carrying
              
              
              Carrying
              
              
              Accumulated
              
              
              Net
      CarryingAsset
              
              in
      Years
              
              
              Amount
              
              
              Amortization
              
              
              Amount
              
              
              Amount
              
              
              Amortization
              
              
              Amount(in
      thousands)Capitalized
      software
              
              2
              
              
              $
              1,828
              
              
              $
              1,384
              
              
              $
              444
              
              
              $
              1,747
              
              
              $
              1,671
              
              
              $
              76Purchased
      software
              
              5
              
              
              
              700
              
              
              
              480
              
              
              
              220
              
              
              
              700
              
              
              
              381
              
              
              
              319Patents
              
              20
              
              
              
              160
              
              
              
              33
              
              
              
              127
              
              
              
              160
              
              
              
              24
              
              
              
              136Customer
      lists
              
              10
              
              
              
              1,790
              
              
              
              531
              
              
              
              1,259
              
              
              
              1,790
              
              
              
              337
              
              
              
              1,453Non-compete
      agreements
              
              4
              
              
              
              640
              
              
              
              409
              
              
              
              231
              
              
              
              640
              
              
              
              254
              
              
              
              386Trademark
              
              2
              
              
              
              21
              
              
              
              10
              
              
              
              11
              
              
              
              21
              
              
              
              —
              
              
              
              21Trademark
              
              indefinite
              
              
              
              285
              
              
              
              —
              
              
              
              285
              
              
              
              285
              
              
              
              —
              
              
              
              285Total
              
              
              
              
              
              $
              5,424
              
              
              $
              2,847
              
              
              $
              2,577
              
              
              $
              5,343
              
              
              $
              2,667
              
              
              $
              2,676





During
fiscal 2007, the Company determined that a trademark with a carrying value of
$60,000 no longer had an indefinite useful life and was impaired by
$39,000.  The remaining balance of $21,000 is being amortized over the
remaining estimated useful life of two years.





During
fiscal 2008, the Company wrote-off approximately $329,000 of fully-amortized
capitalized software costs for technology no longer in use.





The
intangible asset amounts amortized to cost of software licenses and
subscriptions totaled $160,000, $167,000 and $300,000 for fiscal 2008, 2007 and
2006, respectively. Intangible asset amounts amortized to sales and marketing
expense totaled $349,000, $354,000 and $178,000, respectively.





As of
September 30, 2008, the estimated future amortization expense related to
amortizing intangible assets was as follows (in thousands):




Years
      Ending September 30,2009
              
              $
              6782010
              
              
              5552011
              
              
              1952012
              
              
              1742013
              
              
              174Thereafter
              
              
              516Total
      estimated future amortization expense
              
              $
              2,292





Restricted
Cash




At
September 30, 2008 and 2007, restricted cash consisted of a $125,000 security
deposit in the form of an irrevocable letter of credit held in escrow for the
landlord of the Company’s Chelmsford, MA corporate offices.





Financial
Instruments




The
Company’s financial instruments consist primarily of cash and equivalents,
accounts receivable and




- 43
-


accounts
payable and their carrying values approximate fair value because of their
short-term nature.





Income
Taxes




Deferred
income taxes are provided for the tax effects of temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes and operating loss carryforwards
and credits. Valuation allowances are recorded to reduce the net deferred tax
assets to amounts the Company believes are more likely than not to be
realized.





Net Income (Loss)
Per Share




Basic net
income (loss) per common share is computed by dividing net income (loss) by the
weighted-average number of common shares outstanding during the
period.  Diluted net income per share reflects the impact, when
dilutive, of the exercise of options using the treasury-stock
method.





The
following table presents the options that were not included in the computation
of diluted net income per share, because the exercise price of the options was
greater than the average market price of the common stock for the years ended
September 30, 2008, 2007 and 2006:





2008
            
            
            2007
            
            
            2006Quantity
      of option shares not included
            
            
            227,751
            
            
            
            190,042
            
            
            
            255,753Weighted-average
      exercise price
            
            $
            5.00
            
            
            $
            4.90
            
            
            $
            4.76





Foreign Currency
Translations and Transactions




Assets
and liabilities of foreign subsidiaries are translated into U.S. dollars at
rates in effect at each balance sheet date. Revenues, expenses and cash flows
are translated into U.S. dollars at average rates prevailing when transactions
occur. The related translation adjustments are reported as a separate component
of shareholders’ equity under the heading “Accumulated Other Comprehensive
Loss.” Gains and losses resulting from transactions that are denominated in
currencies other than the applicable unit’s functional currency are included in
the operating results of the Company and were $79,000 for the year ended
September 30, 2008.  Foreign currency gains and losses were not
material in the years ended September 30, 2007 or 2006.





Advertising and
Promotional Materials




Advertising
costs are expensed as incurred and amounted to $281,000, $311,000 and $325,000
in 2008, 2007 and 2006, respectively. Direct mail/direct response costs are
expensed as the associated revenue is recognized. The amortization period is
based on historical results of previous mailers (generally three to six months
from the date of the mailing). Direct mail expense was $54,000, $164,000 and
$33,000 in 2008, 2007 and 2006, respectively. At September 30, 2007, deferred
direct mail/direct response costs were $4,000. These costs were included under
the caption “prepaid expenses” in the accompanying consolidated balance sheets.
There were no deferred direct mail/direct response costs at September 30,
2008.





Stock-Based
Compensation




The
Company recognizes stock-based compensation expense in accordance with SFAS No.
123 (revised 2004) (“SFAS 123(R)”), “Share-Based Payment.”SFAS
123(R) requires all share-based payments, including grants of employee stock
options, to be recognized in the financial statements based on their fair
values.





Under the
provisions of SFAS No. 123(R), the Company recognizes the fair value of
share-based awards over the requisite service period of the individual awards,
which generally equals the vesting period. All of the Company’s share-based
awards are accounted for initially as equity instruments. See additional
Stock-Based Compensation disclosure in Note 7 to the Company’s consolidated
financial statements.





Comprehensive Income (Loss)




The only
item other than net income (loss) that is included in comprehensive income
(loss) is foreign




- 44
-


currency
translation adjustments. Foreign currency translation losses arising during
2008, 2007 and 2006 were $320,000, $86,000, and $44,000, respectively. In fiscal
2008, the Company recognized a $147,000 gain primarily consisting of cumulative
translation adjustments as a result of the liquidation of two of its foreign
subsidiaries: Datawatch France SARL and Datawatch GmbH, which is included in
interest income and other income (expense), net in the consolidated statements
of operations for the year ended September 30, 2008.





Segment
Information




The
Company has determined that it has only one operating segment meeting the
criteria established under SFAS No. 131, “Disclosures about Segments of an
Enterprise and Related Information.” The Company’s chief operating
decision maker, (determined to be the Chief Executive Officer), does not manage
any part of the Company separately, and the allocation of resources and
assessment of performance is based on the Company’s consolidated operating
results. See Note 9 for information about the Company’s revenue by product lines
and geographic operations.





Guarantees and
Indemnifications




The
Company’s software products are sold under warranty against certain defects in
material and workmanship for a period of 30 days from the date of purchase. The
Company has never incurred significant expense under its product or service
warranties. As a result, the Company believes the estimated fair value of these
warranty agreements is minimal. Accordingly, there are no liabilities recorded
for warranty claims as of September 30, 2008 and 2007.





The
Company is required by the lease related to its Chelmsford, Massachusetts
facility to provide a letter of credit in the amount of $125,000 as a security
deposit to provide credit support for payment to the landlord of amounts due
under the lease.  As previously disclosed, cash on deposit providing
security in the amount of this letter of credit is classified as part of
restricted cash in the Company’s consolidated balance sheets at September 30,
2008. See Note 5 for disclosure of minimum rental commitments under
non-cancelable operating leases.





In August
2004, the Company entered into a Stock Purchase Agreement for the acquisition of
Mergence in which the Company made certain warranties regarding, among other
things, its legal authority to enter into the agreement consummating the
acquisition and its ability to continue in its business.  The Company
further agreed to indemnify the sellers of Mergence and hold them harmless for
any damages incurred or suffered arising out of any misrepresentation or breach
of such warranties made by the Company in the agreement. The Company believes
that no such misrepresentations or breaches of warranty exist, or are likely to
exist in the future, and, accordingly, has recorded no liabilities related to
such indemnification as of September 30, 2008 and 2007.





The
Company enters into indemnification agreements in the ordinary course of
business.  Pursuant to these agreements, the Company agrees to
indemnify, hold harmless, and to reimburse the indemnified party for losses
suffered or incurred by the indemnified party, generally its customers, in
connection with any patent, copyright or other intellectual property
infringement claim by any third party with respect to the Company’s products.
The term of these indemnification agreements is generally perpetual and the
maximum potential amount of future payments the Company could be required to
make under these indemnification agreements is unlimited. The Company has never
incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, the Company believes the estimated fair
value of these agreements is minimal. Accordingly, the Company has no
liabilities recorded for these agreements as of September 30, 2008 and
2007.





Certain
of the Company’s agreements also provide for the performance of services at
customer sites. These agreements may contain indemnification clauses, whereby
the Company will indemnify the customer from any and all damages, losses,
judgments, costs and expenses for acts of its employees or subcontractors
resulting in bodily injury or property damage. The maximum potential amount of
future payments the Company could be required to make under these
indemnification agreements is unlimited; however, the Company has general and
umbrella insurance policies that would enable it to recover a portion of any
amounts paid. The Company has never incurred costs to defend lawsuits or settle
claims related to these indemnification agreements. As a result, the Company
believes the estimated fair value of these agreements is minimal. Accordingly,
the Company has no




- 45
-


liabilities
recorded for these agreements as of September 30, 2008and
2007.





As
permitted under Delaware law, the Company has agreements with its directors
whereby the Company will indemnify them for certain events or occurrences while
the director is, or was, serving at the Company’s request in such capacity. The
term of the director indemnification period is for the later of ten years after
the date that the director ceases to serve in such capacity or the final
termination of proceedings against the director as outlined in the
indemnification agreement. The maximum potential amount of future payments the
Company could be required to make under these indemnification agreements is
unlimited; however, the Company’s director and officer insurance policy limits
the Company’s exposure and enables it to recover a portion of any future amounts
paid. As a result of its insurance policy coverage for directors, the Company
believes the estimated fair value of these indemnification agreements is
minimal. The Company has no liabilities recorded for these agreements as of
September 30, 2008 and 2007.





Recent
Accounting Pronouncements




In
September 2006, the Financial Accounting Standards Board issued Statement No.
157, “FairValueMeasurements” (“SFAS
157”), which establishes a framework for measuring fair value and expands
disclosures about the use of fair value measurements and liabilities in interim
and annual reporting periods subsequent to initial recognition.  Prior to
SFAS 157, which emphasizes that fair value is a market-based measurement and not
an entity-specific measurement, there were different definitions of fair value
and limited guidance for applying those definitions in generally accepted
accounting principles. SFAS 157 is effective for the Company on a
prospective basis for the reporting period beginning October 1, 2008. In
February 2008, the FASB delayed the effective date of SFAS 157 for all
nonrecurring fair value measurements of nonfinancial assets and nonfinancial
liabilities until fiscal years beginning after November 15, 2008. The Company
does not expect that the adoption of this Statement will have a material impact
on its financial position or results of operations.





In
February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 expands
opportunities to use fair value measurement in financial reporting and permits
entities to choose to measure many financial instruments and certain other items
at fair value. This Statement is effective for the Company beginning October 1,
2008. The Company has not elected to measure eligible financial assets and
liabilities at fair value and therefore adoption of this Statement did not have
an impact on the Company’s consolidated financial statements.





In
December 2007, the FASB issued Statement No. 141(R), “Business Combinations”(“SFAS 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) establishes
principles and requirements for how an acquirer recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
any non-controlling interest in the acquiree and the goodwill acquired, as well
as the treatment of acquisition-related costs. The Statement also establishes
disclosure requirements which will enable users to evaluate the nature and
financial effects of the business combination. SFAS 141(R) is effective for
fiscal years beginning after December 15, 2008. The adoption of SFAS 141(R) will
have an impact on accounting for business combinations once adopted, but the
effect is dependent upon acquisitions after that time.





In
December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in
Consolidated Financial Statements – an amendment of Accounting Research Bulletin
No. 51”(“SFAS 160”), which establishes accounting and reporting
standards for ownership interests in subsidiaries held by parties other than the
parent, the amount of consolidated net income attributable to the parent and to
the noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained non-controlling equity investments when a subsidiary is
deconsolidated. The Statement also establishes reporting requirements that
provide sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the non-controlling owners. SFAS
160 is effective for fiscal years beginning after December 15, 2008. The Company
does not believe this Statement will have any impact on its consolidated
financial statements upon adoption.





In March
2008, the FASB issued Statement No. 161, “Disclosures About Derivative
Instruments and Hedging Activities – an amendment of FASB Statement No.
133” (“SFAS 161”).  SFAS 161 amends and expands




- 46
-


the
disclosure requirements of SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities.”  SFAS 161 requires
qualitative disclosures about objectives and strategies for using derivatives,
quantitative disclosures about fair value amounts of gains and losses on
derivative instruments and disclosures about credit-risk-related contingent
features in derivative agreements. SFAS 161 also amends SFAS No. 107, “Disclosures About Fair Value of
Financial Instruments” (“SFAS 107”), to clarify that derivative
instruments are subject to SFAS 107’s concentration-of-credit risk disclosures.
SFAS 161 is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008.  Early adoption is
permitted, and entities are encouraged, but not required, to provide comparative
disclosures for earlier periods. The adoption of SFAS 161 will not affect the
Company’s consolidated financial statements or financial condition, but may
require additional disclosures if the Company enters into derivative and hedging
activities.





2.  ACQUISITION





On May 3,
2006, the Company acquired certain assets and assumed certain liabilities of
ClearStory Systems, Inc.’s Integrated Document Archiving and Retrieval Systems
(“IDARS”) business. The acquisition of IDARS was consummated pursuant to an
asset purchase agreement dated March 10, 2006 among the Company and ClearStory
Systems, Inc. The acquisition was accounted for as a purchase, and accordingly,
the purchase price was allocated to the assets purchased and liabilities assumed
based on their estimated fair values. The operating results of IDARS for the
period beginning May 3, 2006 are included in the consolidated financial
statements. The acquisition cost for IDARS was approximately $4,790,000,
consisting of $4,349,000 in cash and direct acquisition costs of approximately
$441,000. Additional acquisition costs included an 18-month earn-out payment
equal to 30% of net revenues from the IDARS business excluding the first
$337,500 of revenues, net of any claims. The earn-out payments were considered
additional purchase price and were recorded as additional goodwill when
incurred. At September 30, 2007, the Company accrued approximately $329,000
related to such earn-out payments. In accordance with the asset purchase
agreement, payments commenced during the third and fourth quarters of fiscal
2007 and the final payments were made in the first quarter of fiscal year 2008.
Accordingly, no amounts are accrued at September 30, 2008. Since the acquisition
date, the Company made payments totaling approximately $1.1 million related to
the IDARS earn-out arrangement. The goodwill associated with this acquisition is
deductible for tax purposes and has a 15 year amortization period for tax
purposes.





3.
            INVENTORIES





Inventories
consisted of the following at September 30:




2008
              
              
              2007(in
      thousands)Raw
      materials
              
              $
              44
              
              
              $
              32Finished
      goods
              
              
              13
              
              
              
              16Total
              
              $
              57
              
              
              $
              48





4.
            ACCRUED
      EXPENSES





Accrued
expenses consisted of the following at September 30:




2008
              
              
              2007(in
      thousands)Accrued
      salaries and benefits
              
              $
              412
              
              
              $
              357Accrued
      royalties and commissions
              
              
              1,092
              
              
              
              1,542Accrued
      professional fees
              
              
              375
              
              
              
              421Other
              
              
              506
              
              
              
              519Total
              
              $
              2,385
              
              
              $
              2,839





- 47
-


5.        COMMITMENTS
AND CONTINGENCIES





Leases




The
Company leases various facilities and equipment in the U.S. and overseas under
non-cancelable operating leases which expire through 2011. The lease agreements
generally provide for the payment of minimum annual rentals, pro-rata share of
taxes, and maintenance expenses. Rental expense for all operating leases was
$440,000, $511,000 and $632,000 for the years ended September 30, 2008, 2007 and
2006, respectively.  Certain of the Company’s facility leases include
options to renew.





As of
September 30, 2008, minimum rental commitments under noncancelable operating
leases are as follows (in thousands):




Years Ending September
      30,2009
              
              
              3462010
              
              
              1962011
              
              
              139Total
      future minimum lease payments
              
              $
              681





Royalties




The
Company is committed to pay royalties ranging from 7% to 50% on revenue
generated by the sale of certain licensed software products. Royalty expense
included in cost of software licenses and subscriptions was $1,779,000,
$1,865,000 and $1,602,000 for the years ended September 30, 2008, 2007 and
2006, respectively. The Company is not obligated to pay minimum royalty
amounts.





On August
11, 2004, the Company acquired 100% of the shares of Mergence Technologies
Corporation.  The purchase agreement includes a provision for
quarterly cash payments to the former Mergence shareholders equal to 10% of
revenue, as defined, of the Datawatch Researcher product until September 30,
2010. The Company expensed approximately $4,000, $17,000 and $5,000,
respectively, for the years ended September 30, 2008, 2007 and
2006.





Contingencies




From time
to time, the Company is subject to other claims and may be party to other
actions that arise in the normal course of business. The Company is not party to
any litigation that management believes will have a material adverse effect on
the Company’s consolidated financial condition, results of operations or cash
flows.





6.
            INCOME
      TAXES





Income
(loss) from operations before income taxes consists of the following for the
years ended September 30:




2008
              
              
              2007
              
              
              2006(in
      thousands)Domestic
              
              $
              (2
              )
              
              $
              2,078
              
              
              $
              1,551Foreign
              
              
              872
              
              
              
              (276
              )
              
              
              (2,070
              )Total
              
              $
              870
              
              
              $
              1,802
              
              
              $
              (519
              )





The
provision for income taxes consisted of the following for the years ended
September 30:




- 48
-


2008
              
              
              2007
              
              
              2006(in
      thousands)Current:Federal
              
              $
              —
              
              
              $
              12
              
              
              $
              —State
              
              
              13
              
              
              
              9
              
              
              
              —Foreign
              
              
              25
              
              
              
              1
              
              
              
              —38
              
              
              
              22
              
              
              
              —Deferred:Federal
              
              
              295
              
              
              
              138
              
              
              
              (26
              )State
              
              
              8
              
              
              
              52
              
              
              
              10Foreign
              
              
              —
              
              
              
              —
              
              
              
              (32
              )Change
      in valuation allowance
              
              
              (188
              )
              
              
              (79
              )
              
              
              84115
              
              
              
              111
              
              
              
              36Total
      provision
              
              $
              153
              
              
              $
              133
              
              
              $
              36





At
September 30, 2008, the Company had U.S. federal tax loss carryforwards of
approximately $7.3 million, expiring at various dates through 2028, including
$210,000 resulting from the Mergence acquisition during 2004 which are subject
to additional annual limitations as a result of the changes in Mergence’s
ownership, and had approximately $1.7 million in state tax loss carryforwards,
which also expire at various dates through 2028. An alternative minimum tax
credit of approximately $157,000 is available to offset future regular federal
taxes. Research and development credits of approximately $397,000 expire
beginning in 2011. In addition, the Company has the following net operating loss
carryforwards: United Kingdom losses of $9.0 million with no expiration date and
Australia losses of $3.3 million with no expiration date.





The
components of the Company’s net deferred tax assets are as follows at September
30:




2008
              
              
              2007
              
              
              2006(in
      thousands)Deferred
      tax liabilities:Goodwill
      amortization
              
              $
              (262
              )
              
              $
              (147
              )
              
              $
              (36
              )Prepaid
      expenses
              
              
              (27
              )
              
              
              (71
              )
              
              
              (58
              )Acquired
      intangibles
              
              
              (84
              )
              
              
              (152
              )
              
              
              (356
              )(373
              )
              
              
              (370
              )
              
              
              (450
              )Deferred
      tax assets:Net
      operating loss carryforwards
              
              
              3,563
              
              
              
              3,931
              
              
              
              4,147Research
      and development credits
              
              
              397
              
              
              
              499
              
              
              
              418Accounts
      and notes receivable reserves
              
              
              69
              
              
              
              84
              
              
              
              144Alternative
      minimum tax credits
              
              
              157
              
              
              
              157
              
              
              
              148Depreciation
      and amortization
              
              
              349
              
              
              
              734
              
              
              
              182Deferred
      rent
              
              
              71
              
              
              
              92
              
              
              
              95Other
              
              
              184
              
              
              
              311
              
              
              
              544,790
              
              
              
              5,808
              
              
              
              5,188Total
              
              
              4,417
              
              
              
              5,438
              
              
              
              4,738Valuation
      allowance
              
              
              (4,679
              )
              
              
              (5,585
              )
              
              
              (4,774
              )Deferred
      tax liability, net
              
              $
              (262
              )
              
              $
              (147
              )
              
              $
              (36
              )





For
financial reporting purposes, the Company had profitable income from domestic
operations in 2007 and 2006 but incurred a loss from domestic operations in
2008. The Company had operating losses from its significant international
subsidiaries during the years ended September 30, 2007 and 2006. The Company had
domestic taxable losses in 2008 and 2006 and had marginal domestic taxable
income in 2007 as the Company’s subsidiaries in the




- 49
-


United
Kingdom are treated as branches on the domestic tax returns and, accordingly,
any losses at such subsidiaries are recorded on the domestic income tax returns.
Prior to the results of the last three years, the Company experienced
significant losses from operations, both domestically and internationally, over
several prior years. The Company has also had a history of certain state net
operating loss carryforwards expiring. Approximately $6.8 million of state net
operating loss carryforwards expired in fiscal 2008. Accordingly, management
does not believe the deferred tax assets are more likely than not to be realized
and a full valuation allowance has been provided.





SFAS No.
109, “Accounting for Income
Taxes,” requires recognition of deferred tax liabilities and deferred tax
assets (and related valuation allowances, if necessary) for the excess of
tax-deductible goodwill over goodwill for financial reporting purposes. The tax
benefit for the excess tax-deductible goodwill is recognized when realized on
the tax return. During fiscal year 2006, Datawatch acquired the business assets
of IDARS that resulted in tax-deductible amortization being recognized as a
deferred tax expense in 2008, 2007 and 2006. As the goodwill is deducted for tax
purposes, a deferred tax expense will be recognized each year with a
corresponding deferred tax liability equal to the excess of tax amortization
over the amortization for financial reporting purposes. During the fiscal years
ended September 30, 2008, 2007 and 2006, the Company recorded deferred tax
expense of approximately $115,000, $111,000 and $36,000,
respectively.





The
following table reconciles the Company’s tax provision based on its effective
tax rate to its tax provision based on the federal statutory rate of 34% for the
years ended September 30, 2008, 2007 and 2006 (in thousands):





2008
            
            
            2007
            
            
            2006Provision
      at federal statutory rate
            
            $
            296
            
            
            $
            613
            
            
            $
            (176
            )State,
      net of federal impact
            
            
            13
            
            
            
            21
            
            
            
            6Foreign
      income taxes
            
            
            25
            
            
            
            (473
            )
            
            
            (76
            )Valuation
      allowance (decrease) increase
            
            
            (188
            )
            
            
            (79
            )
            
            
            350Extra-territorial
      income exclusion
            
            
            —
            
            
            
            —
            
            
            
            (72
            )Other
            
            
            (7
            )
            
            
            51
            
            
            
            4Provision
      for income taxes
            
            $
            153
            
            
            $
            133
            
            
            $
            36





FASB Interpretation
No. 48


The
Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes — An Interpretation of FASB Statement No. 109”
(“FIN 48”) on October 1, 2007. FIN 48 provides a comprehensive model
for the financial statement recognition, measurement, presentation and
disclosure of uncertain tax positions taken or expected to be taken in income
tax returns.





Under
FIN 48, the Company first determines whether it would “more likely than
not” sustain its tax position if it were analyzed with full knowledge of all the
relevant facts and other information. For those tax positions that meet this
threshold, the Company measures the amount of tax benefit based on the largest
amount of tax benefit that the Company has a greater than 50% chance of
realizing in a final settlement with the relevant authority. Those tax positions
failing to qualify for initial recognition are recognized in the first interim
period in which they meet the more likely than not standard, or are resolved
through negotiation or litigation with the taxing authority, or upon expiration
of the statute of limitations.




Upon
adoption of FIN 48, the Company recorded a reduction of the Company’s deferred
tax asset in the amount of $646,000 and a corresponding reduction to the
valuation allowance of $646,000. The Company recorded a $75,000 tax
liability related to tax exposures that could result in cash payments. This
amount was recorded as an increase to other long-term liabilities and
an increase in the accumulated deficit on the Company’s consolidated
balance sheets. The Company also increased this liability by $25,000 during
fiscal 2008. It does not expect this liability to change significantly during
the next twelve months. The Company has not accrued any interest and penalties
associated with this liability as they are immaterial. Also, in fiscal 2008, the
Company recorded additional uncertain tax positions of approximately $13,000
which were recorded as a reduction of the Company’s deferred tax asset and a
corresponding reduction to its valuation allowance. The Company’s policy is to
recognize
  - 50
-
 interest
and penalties related to uncertain tax positions as a component of income tax
expense in its consolidated statements of operations.





As of
October 1, 2007, the Company had approximately $721,000 of total gross
unrecognized tax benefits (before consideration of any valuation allowance).
These unrecognized tax benefits represent differences between tax positions
taken by the Company in its various consolidated and separate worldwide tax
returns and the benefits recognized and measured pursuant to FIN 48. This amount
also represents the amount of unrecognized tax benefits that, if recognized,
would favorably affect the effective income tax rate in any future periods. The
change in the unrecognized tax benefits in fiscal 2008 was as
follows:





Balance
      at October 1, 2007
            
            $
            721Additions
      for prior year tax positions
            
            38Balance
      at September 30, 2008
            
            $
            759





In the
normal course of business, the Company is subject to examination by taxing
authorities throughout the world, including such jurisdictions as the United
Kingdom, Australia, and the United States, and as a result, files numerous
consolidated and separate income tax returns in the U.S. federal jurisdiction
and various state and foreign jurisdictions. The fiscal years ended September
30, 2005 through September 30, 2007 are generally still open to examination in
the jurisdictions listed above.





7.
            SHAREHOLDERS’
      EQUITY





Stock
Option Plans




The
Company provides its employees, officers, consultants, and directors stock
options, restricted shares and other stock rights to purchase common stock of
the Company on a discretionary basis pursuant to three stock compensation plans
described more fully below. All option grants are subject to the terms and
conditions determined by the Compensation and Stock Committee of the Board of
Directors, and generally vest over a three-year period beginning three months
from date of grant and expire either seven or ten years from the date of grant
depending on the plan. Generally, options, restricted shares and other stock
rights are granted at exercise prices not less than the fair market value at the
date of grant.





On
October 4, 1996, the Company established the 1996 International Employee
Non-Qualified Stock Option Plan. Pursuant to this plan, nonqualified options
were available to be granted to any employee or consultant of any of the
Company’s foreign subsidiaries through October 4, 2006. This plan expired on
October 4, 2006.





On
December 10, 1996, the Company established the Datawatch Corporation 1996 Stock
Plan, which provides for the granting of both incentive stock options and
nonqualified options, the award of Company common stock, and opportunities to
make direct purchases of Company common stock (collectively, “Stock Rights”), as
determined by a committee appointed by the Board of Directors. Options pursuant
to this plan were available to be granted through December 9, 2006 and shall
vest as specified by this committee. This plan expired on December 9,
2006.





On
January 20, 2006, the Company established the Datawatch Corporation 2006 Equity
Compensation and Incentive Plan (the “2006 Plan”) which provides for the
granting of both incentive stock options and non-qualified options, the award of
Company common stock and opportunities to make direct purchase of Company common
stock (collectively, “Stock Rights”), as determined by a committee appointed by
the Board of Directors.  Options pursuant to this plan may be granted
through March 10, 2016 and shall vest as specified by the
committee.





The
Company recognizes stock-based compensation expense in accordance with SFAS No.
123(R) which requires all share-based awards, including grants of employee stock
options, to be recognized in the financial statements based on their fair
values.





- 51
-


Under the
provisions of SFAS No. 123(R), the Company recognizes the fair value of
share-based awards over the requisite service period of the individual awards,
which generally equals the vesting period. All of the Company’s stock
compensation awards are accounted for as equity instruments and there have been
no liability awards granted.





Stock-based
compensation expense for the fiscal years ended September 30, 2008, 2007 and
2006 was $225,000, $132,000 and $67,000, respectively, which was included in the
following expense categories (in thousands):





Years
      Ended September 30,2008
            
            
            2007
            
            
            2006Sales
      and marketing
            
            $
            68
            
            
            $
            51
            
            
            $
            25Engineering
      and product development
            
            
            16
            
            
            
            11
            
            
            
            7General
      and administrative
            
            
            141
            
            
            
            70
            
            
            
            35$
            225
            
            
            $
            132
            
            
            $
            67





The
Company uses the Black-Scholes option-pricing model to calculate the fair value
of options. The key assumptions for this valuation method include the expected
life of the option, stock price volatility, risk-free interest rate and dividend
yield. The weighted-average fair values of the options granted under the stock
options plans were $3.11, $1.54 and $3.10 for the years ended September 30,
2008, 2007 and 2006, respectively. The total intrinsic value of options
exercised during the years ended September 30, 2008, 2007 and 2006 was
approximately $1,156,000, $190,000 and $184,000, respectively. Total cash
received from option exercises during the years ended September 30, 2008, 2007
and 2006 was $515,000, $349,000 and $181,000, respectively. The tax benefit
realized from stock options exercised was $697,000, $187,000 and $463,000,
respectively. As of September 30, 2008, there was $315,000 of total unrecognized
compensation cost related to nonvested stock option arrangements, which is
expected to be recognized over a weighted-average period of 1.97
years.





The table
below indicates the key assumptions used in the option valuation calculations
for options granted for the years ended September 30, 2008 and
2007:




2008
              2007Expected
      life
              5
      years
              5
      yearsExpected
      volatility
              70.11%
      - 73.26%
              75.88%
      - 83.34%Weighted-average
      volatility
              72.56%
              77.63%Risk-free
      interest rate
              2.87%
      - 4.03%
              4.48%
      - 4.99%Dividend
      yield
              0.0%
              0.0%





The
dividend yield of zero is based on the fact that the Company has never paid cash
dividends and has no present intention to pay cash dividends. The Company uses
an expected stock-price volatility assumption that is based on historical
volatilities of the Company’s stock which are obtained from public data sources.
The risk-free interest rate is equal to the historical U.S. Treasury zero-coupon
bond rate with a remaining term equal to the expected life of the option. The
expected life is based on historical trends and data. With regard to the
weighted-average option life assumption, the Company considers the exercise
behavior of past grants and models the pattern of aggregate exercises. Patterns
are determined on specific criteria of the aggregate pool of optionees including
the reaction to vesting, realizable value and short-time-to-maturity effect.
Based on the Company’s historical voluntary turnover rates, an annualized
estimated forfeiture rate of 10% has been used in calculating the estimated
cost. Additional expense will be recorded if the actual forfeiture rate is lower
than estimated, and a recovery of prior expense will be recorded if the actual
forfeiture is higher than estimated.





At
September 30, 2008, 600,000 shares were authorized and 379,500 shares were
available for future issuance under the 2006 Plan.





The
following table is a summary of combined activity for all of the Company’s stock
option plans:





- 52
-


Weighted-
            
            
            Weighted
      - AverageNumber
      of
            
            
            Average
            
            
            Remaining
            
            
            AggregateOptions
            
            
            Exercise
            
            
            Contractual
            
            
            IntrinsicOutstanding
            
            
            Price
            
            
            Term
            
            
            Value
      $(000)Outstanding,
      October 1, 2005
            
            
            912,042
            
            
            $
            2.39Granted
            
            
            100,000
            
            
            
            4.14Canceled
            
            
            (16,325
            )
            
            
            6.89Exercised
            
            
            (143,401
            )
            
            
            1.26Outstanding,
      September 30, 2006
            
            
            852,316
            
            
            
            2.65Granted
            
            
            110,000
            
            
            
            2.67Canceled
            
            
            (31,592
            )
            
            
            4.38Exercised
            
            
            (121,181
            )
            
            
            2.88Outstanding,
      September 30, 2007
            
            
            809,543
            
            
            
            2.55Granted
            
            
            98,000
            
            
            
            4.99Canceled
            
            
            (49,753
            )
            
            
            4.63Exercised
            
            
            (275,934
            )
            
            
            1.87


Outstanding,
      September 30, 2008
            
            
            581,856
            
            
            $
            3.10
            
            
            
            4.92
            
            
            $
            103Vested
      or expected to vest, September 30, 2008
            
            
            568,788
            
            
            $
            3.08
            
            
            
            4.77
            
            
            $
            103Exercisable,
      September 30, 2008
            
            
            451,174
            
            
            $
            2.80
            
            
            
            4.62
            
            
            $
            103Exercisable,
      September 30, 2007
            
            
            685,828
            
            
            $
            2.43





The
following table presents weighted-average price and life information regarding
options outstanding and exercisable at September 30, 2008:





Outstanding
            
            ExercisableWeighted-Average
            
            Weighted-
            
            
            
            Weighted-Remaining
            
            Average
            
            
            
            AverageExercise
            
            Number
      of
            
            Contractual
            
            Exercise
            
            
            
            ExercisePrices
            
            Shares
            
            Life
      (Years)
            
            Price
            
            Shares
            
            Price$
      0.74 – $3.10
            
            314,961
            
            4.04
            
            $
            1.75
            
            273,325
            
            $
            1.66$3.11
      – $5.76
            
            243,113
            
            6.18
            
            4.44
            
            162,399
            
            4.27$5.77
      – $7.59
            
            23,782
            
            3.60
            
            7.44
            
            15,450
            
            7.55581,856
            
            4.92
            
            $
            3.10
            
            451,174
            
            $
            2.80





Restricted
Stock Units




The
Company periodically grants awards of restricted stock units (“RSU”) to each of
its non-employee Directors on a discretionary basis pursuant to its 2006 Plan.
Each RSU entitles the holder to receive, at the end of each vesting period, a
specified number of shares of the Company’s common stock. The total number of
RSUs unvested at September 30, 2008 was 27,496. Each RSU vests at the rate of
33.33% on each of the first through third anniversaries of the grant date with
final vesting of the most recent grants scheduled to occur in March 2011. The
fair value related to the RSUs was calculated based on the average stock price
of the Company’s common stock on the date of the grant and is being amortized
evenly on a pro-rata basis over the vesting period to general and administrative
expense. The fair value of the RSUs granted in fiscal years 2008 and 2007,
respectively, was approximately $62,000 (or $3.53 fair value per share) and
$52,000 (or $3.49 weighted average fair value per share). There were no RSUs
granted in fiscal year 2006. The Company recorded compensation related to the
RSUs of $29,000 and $8,000 during the years ended September 30, 2008 and 2007,
respectively, which is included in the total stock-based compensation expense
disclosed above. As of September 30, 2008, there was $77,000 of total
unrecognized compensation cost related to RSUs, which is expected to be
recognized over a weighted average period of 2.1 years.





The
following table presents RSU information for the fiscal year ended September 30,
2008:





- 53
-


Number
      ofRSUsOutstandingOutstanding,
      October 1, 2007
            
            
            15,000Granted
            
            
            17,500Vested
            
            
            (5,004
            )Outstanding,
      September 30, 2008
            
            
            27,496





8.
            RETIREMENT
      SAVINGS PLAN





The
Company has a 401(k) retirement savings plan covering substantially all of the
Company’s full-time domestic employees. Under the provisions of the plan,
employees may contribute a portion of their compensation within certain
limitations. The Company, at the discretion of the Board of Directors, may make
contributions on behalf of its employees under this plan. Such contributions, if
any, become fully vested after five years of continuous service. The Company did
not make any contributions to the 401(k) retirement savings plan in fiscal 2008,
2007 or 2006.





9.       SEGMENT
INFORMATION





The
following table presents information about the Company’s revenues by product
line for the years ended September 30:




2008
              
              
              2007
              
              
              2006Business
      Intelligence Solutions (including Monarch, Monarch
      Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Visual Insight
      and VorteXML)
              
              
              67
              %
              
              
              67
              %
              
              
              73
              %Content
      Management Solutions (including  Datawatch
      BDS, Datawatch MailManager and Datawatch
Researcher)
              
              
              16
              %
              
              
              14
              %
              
              
              5
              %Business
      Service Management and Workflow Solutions (including Visual QSM and
      Visual HD)
              
              
              17
              %
              
              
              19
              %
              
              
              22
              %100
              %
              
              
              100
              %
              
              
              100
              %




The
Company conducts operations in the U.S. and internationally (principally in the
United Kingdom).  The following table presents information about the
Company’s geographic operations:




- 54
-


International(PrincipallyDomestic
              
              
              U.K.)
              
              
              Eliminations
              
              
              Total(In
      thousands)Year
      Ended September 30, 2008Total
      revenue
              
              $
              17,476
              
              
              $
              6,875
              
              
              $
              (1,321
              )
              
              $
              23,030Operating
      income (loss)
              
              
              530
              
              
              
              (31
              )
              
              
              —
              
              
              
              499Long-lived
      assets
              
              
              9,515
              
              
              
              64
              
              
              
              —
              
              
              
              9,579Year
      Ended September 30, 2007Total
      revenue
              
              $
              18,521
              
              
              $
              7,800
              
              
              $
              (1,062
              )
              
              $
              25,259Operating
      income (loss)
              
              
              2,091
              
              
              
              (356
              )
              
              
              —
              
              
              
              1,735Long-lived
      assets
              
              
              9,632
              
              
              
              115
              
              
              
              —
              
              
              
              9,747Year
      Ended September 30, 2006Total
      revenue
              
              $
              15,110
              
              
              $
              6,676
              
              
              $
              (975
              )
              
              $
              20,811Operating
      income (loss)
              
              
              565
              
              
              
              (1,099
              )
              
              
              —
              
              
              
              (534
              )Long-lived
      assets
              
              
              8,806
              
              
              
              881
              
              
              
              —
              
              
              
              9,687


10.           QUARTERLY
RESULTS (UNAUDITED)





Supplementary
Information:




First
              
              
              Second
              
              
              Third
              
              
              Fourth(in
      thousands, except per share amounts)Year
      Ended September 30, 2008:Software
      license and subscription revenue
              
              $
              3,333
              
              
              $
              3,155
              
              
              $
              3,116
              
              
              $
              2,831Maintenance
      and service revenue
              
              
              2,734
              
              
              
              2,718
              
              
              
              2,659
              
              
              
              2,484Cost
      of software licenses and subscriptions
              
              
              572
              
              
              
              550
              
              
              
              556
              
              
              
              540Cost
      of maintenance and services
              
              
              1,120
              
              
              
              1,177
              
              
              
              1,031
              
              
              
              943Expenses
              
              
              4,175
              
              
              
              4,077
              
              
              
              4,170
              
              
              
              3,620Income
      from operations
              
              
              200
              
              
              
              69
              
              
              
              18
              
              
              
              212Net
      income
              
              
              247
              
              
              
              83
              
              
              
              91
              
              
              
              296Net
      income per share - basic
              
              $
              0.04
              
              
              $
              0.01
              
              
              $
              0.02
              
              
              $
              0.05Net
      income per share - diluted
              
              $
              0.04
              
              
              $
              0.01
              
              
              $
              0.02
              
              
              $
              0.05Year
      Ended September 30, 2007:Software
      license and subscription revenue
              
              $
              3,438
              
              
              $
              3,257
              
              
              $
              4,091
              
              
              $
              4,066Maintenance
      and service revenue
              
              
              2,338
              
              
              
              2,892
              
              
              
              2,392
              
              
              
              2,785Cost
      of software licenses and subscriptions
              
              
              537
              
              
              
              560
              
              
              
              691
              
              
              
              680Cost
      of maintenance and services
              
              
              1,032
              
              
              
              983
              
              
              
              922
              
              
              
              1,006Expenses
              
              
              4,117
              
              
              
              4,138
              
              
              
              4,470
              
              
              
              4,388Income
      from operations
              
              
              90
              
              
              
              468
              
              
              
              400
              
              
              
              777Net
      income
              
              
              34
              
              
              
              424
              
              
              
              382
              
              
              
              829Net
      income per share - basic
              
              $
              0.01
              
              
              $
              0.08
              
              
              $
              0.07
              
              
              $
              0.15Net
      income per share - diluted
              
              $
              0.01
              
              
              $
              0.07
              
              
              $
              0.06
              
              
              $
              0.14




Item 9.  CHANGES
IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE





Not
Applicable.





- 55
-


Item 9A. CONTROLS AND
PROCEDURES





(a)
            Evaluation
      of Disclosure Controls and
Procedures





The
principal executive officer and principal financial officer, with the
participation of the Company’s management, evaluated the effectiveness of the
Company’s disclosure controls and procedures as of the end of the period covered
by this Annual Report on Form 10-K.  The term “disclosure controls and
procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act,
means controls and other procedures of a company that are designed to ensure
that information required to be disclosed by a company in the reports that it
files or submits under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the SEC’s rules and forms.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed by a
company in the reports that it files or submits under the Exchange Act is
accumulated and communicated to the company’s management, including its
principal executive and principal financial officers, as appropriate to allow
timely decisions regarding required disclosure. Management recognizes that any
system of controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving their objectives. Based upon that
evaluation, the Company’s principal executive officer and principal financial
officer concluded that the Company’s disclosure controls and procedures are
effective in enabling the Company to record, process, summarize and report
information required to be included in the Company’s periodic SEC filings within
the required time period.





(b)
            Changes
      in Internal Controls





No
changes in our internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter
ended September 30, 2008 that have materially affected, or are reasonably likely
to materially affect, our internal control over financial
reporting.





(c)
            Management’s
      Report on Internal Control over Financial
  Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Rule 13a-15(f) and 15d-15(f)
under the Exchange Act. Internal control over financial reporting is designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles (“GAAP”). Internal control over
financial reporting includes those policies and procedures that: 1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the Company; 2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with GAAP, and that
receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the Company; and 3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of the Company’s assets that could have a
material effect on the financial statements.





Because
of its inherent limitations, a system of internal control over financial
reporting can provide only reasonable assurance and may not prevent or detect
misstatements. Projections of any evaluation of effectiveness to future periods
are subject to the risk that controls may become inadequate because of changes
in conditions, or that the degree of compliance with the policies or procedures
may deteriorate.





Our
management assessed the effectiveness of our internal control over financial
reporting as of September 30, 2008. In making its assessment, management used
the criteria set forth in “Internal Control–Integrated
Framework” issued by the Committee of Sponsoring Organizations (“COSO”)
of the Treadway Commission. Based on this assessment, our management concluded
that our internal control over financial reporting is effective as of September
30, 2008.





This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by the




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Company’s
registered public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit the Company to provide only management’s
report in this annual report.








Item 9B. OTHER
INFORMATION





None.











































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PART III








Item
10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT





Information
with respect to Directors may be found under the caption “Election of Directors”
appearing in the Company’s definitive Proxy Statement for the Annual Meeting of
Shareholders for the fiscal year ended September 30, 2008. Such information is
incorporated herein by reference. Information with respect to the Company’s
executive officers may be found under the caption “Executive Officers of the
Registrant” appearing in Part I of this Annual Report on Form 10-K.








Item
11.  EXECUTIVE COMPENSATION





The
information set forth under the captions “Compensation and Other Information
Concerning Directors and Officers” appearing in the Company’s definitive Proxy
Statement for the Annual Meeting of Shareholders for the fiscal year ended
September 30, 2008 is incorporated herein by reference.








Item 12.  SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT





The
information set forth under the caption “Principal Holders of Voting Securities”
and “Equity Compensation Plans” appearing in the Company’s definitive Proxy
Statement for the Annual Meeting of Shareholders for the fiscal year ended
September 30, 2008 is incorporated herein by reference.








Item 13.  CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS





The
information set forth under the caption “Certain Transactions” appearing in the
Company’s definitive Proxy Statement for the Annual Meeting of Shareholders for
the fiscal year ended September 30, 2008 is incorporated herein by
reference.








Item
14.  PRINCIPAL ACCOUNTING FEES AND SERVICES





The
information set forth under the caption “Principal Accountant Fees and Services”
appearing in the Company’s definitive Proxy Statement for the Annual Meeting of
Shareholders for the fiscal year ended September 30, 2008 is incorporated herein
by reference.




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PART
IV




Item
15.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
8-K





The
following documents are filed as part of this report:





(a)
            1.  Consolidated
      Financial Statements





Report of
Independent Registered Public Accounting Firm


Consolidated
Balance Sheets as of September 30, 2008 and 2007


Consolidated
Statements of Operations for the Years Ended September 30, 2008, 2007 and
2006


Consolidated
Statements of Shareholders’ Equity and Comprehensive Income (Loss) for the Years
Ended September 30, 2008, 2007 and 2006


Consolidated
Statements of Cash Flows for the Years Ended September 30, 2008, 2007 and
2006


Notes to
Consolidated Financial Statements





2.  Financial
Statement Schedules





All
schedules are omitted as the required information is not applicable or is
included in the financial statements or related notes.





3.  List
of Exhibits





Ex.
No.                                                             Description





(1)
            
            3.1
            
            Restated
      Certificate of Incorporation of the Registrant (Exhibit
    3.2)(6)
            
            3.2
            
            Certificate
      of Amendment of Restated Certificate of Incorporation of the Registrant
      (Exhibit 3.2)(1)
            
            3.3
            
            By-Laws,
      as amended, of the Registrant (Exhibit 3.3)(1)
            
            4.1
            
            Specimen
      certificate representing the Common Stock (Exhibit 4.4)(4)
            
            4.2
            
            Warrant
      to Purchase Stock issued to Silicon Valley Bank, dated January 17, 2001
      (Exhibit 4.1)(11)
            
            10.2*
            
            Form
      of Incentive Stock Option Agreement of the Registrant (Exhibit
      10.2)(11)
            
            10.3*
            
            Form
      of Nonqualified Stock Option Agreement of the Registrant (Exhibit
      10.3)(1)
            
            10.4
            
            Software
      Development and Marketing Agreement by and between Personics Corporation
      and Raymond Huger, dated January 19, 1989 (Exhibit
  10.12)(9)
            
            10.5
            
            Option
      Purchase Agreement by and among Datawatch Corporation, Personics
      Corporation and Raymond J. Huger dated April 29, 2005. (Exhibit
      10.1)(8)
            
            10.6
            
            Distribution
      Agreement, dated December 10, 1992, by and between Datawatch Corporation
      and Ingram Micro Inc. (Exhibit 10.2)(2)
            
            10.7*
            
            1996
      Non-Employee Director Stock Option Plan, as amended on December 10, 1996
      (Exhibit 10.30)(2)
            
            10.8*
            
            1996
      International Employee Non-Qualified Stock Option Plan (Exhibit
      10.31)(8)
            
            10.9*
            
            1996
      Stock Plan as amended as of March 7, 2003 (Exhibit
10.1)(3)
            
            10.10
            
            Indemnification
      Agreement between Datawatch Corporation and James Wood, dated January 12,
      2001 (Exhibit 10.1)(3)
            
            10.11
            
            Indemnification
      Agreement between Datawatch Corporation and Richard de J. Osborne, dated
      January 12, 2001 (Exhibit 10.2)(5)
            
            10.12
            
            Form
      of Indemnification Agreement between Datawatch Corporation and each of its
      Non-Employee Directors (Exhibit 10.1)(5)
            
            10.13*
            
            Advisory
      Agreement, dated April 5, 2001, by and between Datawatch Corporation and
      Richard de J. Osborne (Exhibit 10.2)(7)
            
            10.14*
            
            Executive
      Agreement, dated April 25, 2002, by and between Datawatch Corporation and
      John Kitchen (Exhibit 10.2)(10)
            
            10.15
            
            Stock
      Purchase Agreement among Datawatch Corporation, Mergence Technologies
      Corporation and the Management Sellers, dated as of August 11, 2005
      (Exhibit 2.1).(10)
            
            10.16
            
            Form
      of Stock Purchase Agreement among Datawatch Corporation, Mergence
      Technologies Corporation and the Non-Management Sellers, dated as of
      August 11, 2005 (Exhibit 2.2)(12)
            
            10.17*
            
            Form
      of Lock-up Agreement between Datawatch Corporation and each Executive
      Officer of Datawatch Corporation, dated September 26, 2005 (Exhibit
      99.1)




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(12)
            
            10.18
            
            Sublease
      Agreement, dated September 28, 2005, between Tellabs Operations, Inc., and
      Datawatch Corporation (Exhibit 99.2)(14)
            
            10.19
            
            February
      2006 Amendment to Software Development and Marketing Agreement, dated
      February 21, 2006 by and among the Company, Personics Corporation, Raymond
      J. Huger and Math Strategies (Exhibit 10.1)(14)
            
            10.20
            
            Amendment
      to Option Purchase Agreement, dated February 21, 2006 by and among the
      Company, Personics Corporation, Raymond J. Huger and Math Strategies
      (Exhibit 10.2)(15)
            
            10.21*
            
            2006
      Equity Compensation and Incentive Plan(20)
            
            10.22*
            
            Form
      of 2006 Non-Qualified Stock Option Agreement for Directors (Exhibit
      10.26)(20)
            
            10.23*
            
            Form
      of 2006 Non-Qualified Stock Option Agreement for Officers (Exhibit
      10.27)(20)
            
            10.24*
            
            Form
      of 2006 Incentive Stock Option Agreement for Officers (Exhibit
      10.28)(16)
            
            10.25
            
            Asset
      Purchase Agreement dated as of March 10, 2006 between Datawatch
      Corporation and ClearStory Systems, Inc. (Exhibit 10.1)(21)
            
            10.26*
            
            Executive
      Agreement, dated March 26, 2007, between Datawatch Corporation and Murray
      Fish (Exhibit 10.1)(22)
            
            10.27*
            
            Form
      of Restricted Stock Unit Agreement for Directors (Exhibit
      10.1)(23)
            
            10.28*
            
            Management
      Consulting Agreement dated October 22, 2007 by and between Robert W.
      Hagger and Datawatch Corporation (Exhibit 10.1)21.1
            
            Subsidiaries
      of the Registrant (filed herewith)23.1
            
            Consent
      of Independent Registered Pubic Accounting Firm (filed
      herewith)31.1
            
            Certification
      of the Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002. (filed herewith)31.2
            
            Certification
      of the Chief Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002. (filed herewith)32.1
            
            Certification
      of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
      (furnished herewith)32.2
            
            Certification
      of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
      (furnished herewith)





*
            
            Indicates
      a management contract or compensatory plan or
  contract.





Note:  The
      number given in parenthesis next to each item listed above indicates the
      corresponding exhibit in each filing listed below.(1)
            
            Previously
      filed as an exhibit to Registration Statement 33-46290 on Form S-1 and
      incorporated herein by reference.(2)
            
            Previously
      filed as an exhibit to Registrant’s Annual Report on Form 10-K for the
      fiscal year ended September 30, 1996 and incorporated herein by
      reference.(3)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      February 2, 2001 and incorporated herein by reference.(4)
            
            Previously
      filed as an exhibit to Registrant’s Quarterly Report on Form 10-Q for the
      quarter ended December 31, 2000 and incorporated herein by
      reference.(5)
            
            Previously
      filed as an exhibit to Registrant’s Quarterly Report on Form 10-Q for the
      quarter ended March 31, 2001 and incorporated herein by
      reference.(6)
            
            Previously
      filed as an exhibit to Registrant’s Annual Report on Form 10-K for the
      fiscal year ended September 30, 2001 and incorporated herein by
      reference.(7)
            
            Previously
      filed as an exhibit to Registrant’s Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2002 and incorporated herein by
      reference.(8)
            
            Previously
      filed as an exhibit to Registrant’s Quarterly Report on Form 10-Q for the
      quarter ended March 31, 2003 and incorporated herein by
      reference.(9)
            
            Previously
      filed as an exhibit to Registrant’s Quarterly Report on Form 10-Q for the
      quarter ended March 31, 2004 and incorporated herein by
      reference.(10)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      August 20, 2004 and incorporated herein by reference.(11)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      November 2, 2004 and incorporated herein by reference.(12)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      September 26, 2005 and incorporated herein by
  reference.




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(13)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      February 21, 2006 and incorporated herein by reference.(14)
            
            Previously
      filed as Appendix A to Registrant’s Definitive Proxy Statement dated
      January 30, 2006 and incorporated herein by reference.(15)
            
            Previously
      filed as an exhibit to Registrant’s Annual Report on Form 10-K for the
      fiscal year ended September 30, 2006 and incorporated herein by
      reference.(16)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated March
      10, 2006 and incorporated herein by reference.(17)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated March
      26, 2007 and incorporated herein by reference.(18)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      August 2, 2007 and incorporated herein by reference.(19)
            
            Previously
      filed as an exhibit to Registrant’s Current Report on Form 8-K dated
      October 23, 2007 and incorporated herein by
  reference.








(b)  Exhibits





The
Company hereby files as exhibits to this Annual Report on Form 10-K those
exhibits listed in Item 15(a)3 above.








(c)  Financial
Statement Schedules





Not
applicable.





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SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





Datawatch
      CorporationDate:
            December
      24, 2008
            By:
            /s/ Kenneth P. BeroKenneth
      P. BeroPresident,
      Chief Executive Officer
              and
      Director





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.





SIGNATURE
            
            TITLE
            
            DATE/s/
      Kenneth P. Bero
            
            President,
      Chief Executive Officer and Director
            
            December
      24, 2008Kenneth
      P. Bero
            
            (Principal
      Executive Officer)/s/
      Murray P. Fish
            
            Vice
      President of Finance, Chief Financial Officer,
            
            December
      24, 2008Murray
      P. Fish
            
            Treasurer
      and Assistant Secretary(Principal
      Financial and Accounting Officer)/s/
      Richard de J. Osborne
            
            Chairman
      of the Board
            
            December
      24, 2008Richard
      de J. Osborne/s/
      Robert W. Hagger
            
            Director
            
            December
      24, 2008Robert
      W. Hagger/s/
      Thomas H. Kelly
            
            Director
            
            December
      24, 2008Thomas
      H. Kelly/s/
      Terry W. Potter
            
            Director
            
            December
      24, 2008Terry
      W. Potter/s/
      David T. Riddiford
            
            Director
            
            December
      24, 2008David
      T. Riddiford/s/
      William B. Simmons, Jr.
            
            Director
            
            December
      24, 2008William
      B. Simmons, Jr./s/
      James Wood
            
            Director
            
            December
      24, 2008James
      Wood





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