# **UNITED STATES**

# **SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

**(MARKONE)**

 

**ý****                          ****ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THEFISCAL YEAR ENDED SEPTEMBER 30, 2005 OR**

 

**o****                          ****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THETRANSITION PERIOD FROM                         TO**

 

**COMMISSION FILE NUMBER: 000-19960**

 

## **DATAWATCH CORPORATION**

*(Exact name of registrant as specified in itscharter)*

 

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

 

**175 CABOT STREET**

**SUITE 503**

**LOWELL, MASSACHUSETTS 01854**

(Address of principal executive office)

 

Telephone Number: **(978) 441-2200**

 

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

 

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

 

**COMMON STOCK $0.01 PAR VALUE**

(Title of Class)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes ** ****ý**     No o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.    ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).  Yes o   No  ý

 

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

 

Aggregate market value of voting stock held bynon-affiliates: $15,328,423 (based on the closing price of the registrant’sCommon Stock of $5.09 per share on March 31, 2005, the last business dayof the Company’s most recently completed second fiscal quarter, as reported bythe NASDAQ SmallCap Market).

 

Number of shares of common stock outstanding at December 1,2005:      5,464,071

 

**Documents Incorporated By Reference**

 

Registrantintends to file a definitive Proxy Statement pursuant to Regulation 14A within120 days of the end of the fiscal year ended September 30, 2005.  Portions of such Proxy Statement areincorporated by reference in Part III of this report.

 

 

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DATAWATCH CORPORATION

ANNUAL REPORT ON FORM 10-K

 

TABLE OF CONTENTS

 
| **Part I**   |                                                                                       | 3      |
|-------------------|--------------------------------------------------------------------------------------------|--------|
| Item 1.           | Business                                                                                   | 3      |
| Item 2.           | Properties                                                                                 | 7      |
| Item 3.           | Legal Proceedings                                                                          | 7      |
| Item 4.           | Submission of Matters to a  Vote of Security Holders                                       | 7      |
| **Part II**  |                                                                                       | 9      |
| Item 5.           | Market for Registrant’s  Common Equity and Related Shareholder Matters                | 9      |
| Item 6.           | Selected Consolidated  Financial Data                                                      | 9      |
| Item 7.           | Management’s Discussion and  Analysis of Financial Condition and Results of Operation | 10     |
| Item 7A.          | Quantitative and Qualitative  Disclosures about Market Risk                                | 24     |
| Item 8.           | Financial  Statements and Supplementary Data                                               | 26     |
| Item 9.           | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure      | 49     |
| Item 9A           | Controls and Procedures                                                                    | 49     |
|              |                                                                                       |   |
| **Part III** |                                                                                       | 50     |
| Item 10.          | Directors and Executive  Officers of the Registrant                                        | 50     |
| Item 11.          | Executive  Compensation                                                                    | 50     |
| Item 12.          | Security Ownership of Certain  Beneficial Owners and Management                            | 50     |
| Item 13.          | Certain Relationships and  Related Transactions                                            | 50     |
| Item 14.          | Principal Accounting Fees  and Services                                                    | 50     |
| **Part IV**  |                                                                                       | 51     |
| Item 15.          | Exhibits, Financial  Statement Schedules and Reports on Form 8-K                      | 51     |
| Signatures        |                                                                                       | 55     |

 

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**PART I**

 

**Item 1.  BUSINESS**

 

**GENERAL**

 

Datawatch Corporation (the “Company” or “Datawatch”),founded in 1985, is a leading vendor in the emerging Information Servicesmarket space. By providing solutions that build on a Service OrientedArchitecture (SOA) framework, Datawatch allows organizations to access, enhanceand deliver information from wherever it resides inside or outside theenterprise to solve business problems. The ability to maximize an organization’sinvestment in existing systems, databases, and content management archivesallows Datawatch to rapidly implement business intelligence, performancemanagement, report mining, ETL (Extract, Transform, Load) and business servicemanagement solutions with very high return on investment. Datawatch productsare used in more than 20,000 companies, institutions and government agenciesworldwide.

 

During the first quarter of fiscal 2004, the Companyintroduced a subscription sales model for the sale of its enterpriseproducts.  The Company continues to offerits enterprise products through the sale of perpetual licenses and introducedthe subscription pricing model to allows customers to begin using the Company’sproducts at a lower initial cost of software acquisition.  Subscription terms typically run 90 days or24 months and automatically renew unless terminated with 90 days notice.  During fiscal 2005, sales under thesubscription model were not significant, however, customer interest in themodel and revenues resulting from sales under the model increased during thefiscal year.

 

The Company is a Delaware corporation, with executiveoffices located at 175 Cabot Street, Lowell, Massachusetts 01854 and theCompany’s telephone number is (978) 441-2200. In September 2005, the Company entered into a new subleaseagreement and its executive offices will be relocating to 271 Mill Road, QuorumOffice Park, Chelmsford, MA 01824 on December 17, 2005.  Periodic reports are made available to thepublic, free of charge, on the Datawatch website, www.Datawatch.Com and throughthe SEC’s website, www.SEC.Gov as soon as reasonably practicable after theyhave been filed with the SEC.

 

**PRODUCTS**

 

**Monarch**- Datawatch is best known for its popular desktop report mining and businessintelligence application called Monarch. More than 450,000 copies of Monarch have been sold, with localizedversions in English, French, German and Spanish.  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’sExcel or Access.  Monarch ProfessionalEdition lets users extract and work with data in PDF and HTML files, databases,spreadsheets and ODBC sources as well as reports.  The Monarch product line representedapproximately 56% of total revenues for the fiscal year 2005.

 

**MonarchData Pump** - Monarch Data Pump (“MDP”) provides powerfulinformation delivery and data ETL capabilities in one automated solution,without programming.  Combining Datawatch’s Monarch Report Mining/DataMining engine with the Microsoft .NET framework, MDP delivers a highly scalableand easily administered enterprise solution to acquire, combine, and monitorcustomized data, and deliver that data in a wide variety of formats, on anautomatic, scheduled basis.

 

****Monarch|RMS****- Monarch|RMS (Report Mining Server) is a web-based report mining and analysissolution that integrates with any existing COLD/ERM, document or contentmanagement archiving solution.  Monarch|RMSopens up the corporate data locked in stored, static reports, enabling dynamicbusiness-driven analysis of information in users’ web browsers or favoriteproductivity tools with no programming.

 

**Datawatch**|**ES** - Datawatch|ES is a web-enabled business informationportal, providing complete report management, business intelligence and contentmanagement, and the ability to analyze data within reports, all using just aweb browser.  Datawatch|ES allowsorganizations to quickly and easily deliver business intelligence and decisionsupport, derived from existing reporting systems and other database sources,with no new programming or report writing. Datawatch|ES automatically archives report data and binary documents inan enterprise report and document warehouse and provides users a unified pointof entry to view, analyze and share information over the Internet.

 

**Datawatch**|**Researcher-** Datawatch|Researcher, acquired as part of theMergence Technologies Corporation acquisition during fiscal 2004, is a .NETbased content and data aggregation SOA technology. It finds and gathersinter-related data, documents, and communications scattered over multiple anddisparate repositories, then merges, analyzes and delivers the

 

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results for use in business processes or applications.Datawatch|Researcheris the basis for many new Datawatch|ES and Visual|QSM modulesincluding performance management, balanced scorecard, workflow, andcollaboration. Datawatch|Researcheris also being used by Datawatch partners as a SOA ready means to extend thecapabilities of their own systems for compliance, auditing, performancemanagement and more.

 

**Visual**|**QSM**  - Visual|QSM is afully internet-enabled IT support solution that can scale from a basic helpdesk system to a full business management solution that incorporates workflowand network management capabilities and provides web access to multipledatabases while enabling customers to interact via a standard browser.  Visual|QSM, a market leader in Europe, alsoprovides advanced service level management capabilities, integrated changemanagement features, business process automation tools and one of the industry’seasiest to learn and use interfaces.  TheVisual|QSM product line represented approximately 24% of total revenues forfiscal year 2005.

 

**Visual**|**Help Desk** - Visual|Help Desk (“Visual|HD”), leverages theIBM Lotus Domino platform to provide a 100% web-based help desk and call centersolution.  Cost effective and easy todeploy, Visual|HD is an enterprise-wide support solution that supports anorganization’s existing IT infrastructure. Visual|HD has the additional ability to utilize XML-based Web Servicesas well as the ability to integrate directly with IBM enterprise applications.

 

**VorteXML**- VorteXML software quickly and easily converts any structuredtext output generated from any system into valid XML for web services and moreusing any DTD or XDR schema without programming.  VorteXML dramaticallyspeeds up and reduces the cost of enabling current applications for webservices, implementing enterprise XML solutions, putting legacy output on theweb (including bill presentment), and more. The VorteXML solution suite is comprised of two powerful softwareproducts that work together:  **VorteXML Designer**, a desktop tool that provides users avisual interface that allows users to extract, transform and map data fromexisting text documents into XML without programming; and **VorteXMLServer,**a scalable, high-volume server that automates the extractionand conversion of text documents into XML.

 

TheCompany also receives license royalties for its **iMergenceiStore** product primarily from a provider of services to thefinancial services industry.  iMergenceiStore, which was acquired as part of the acquisition of Mergence TechnologiesCorporation during 2004, is a report management solution which managescomputer-generated reports, mines the data contained in them, and allows usersto interactively merge and transform them into new reports.  This product is not being actively marketedto new customers at this time.

 

**PRICING**

 

The Company’s desktop products are sold under singleand multi-user licenses.  A single userlicense for Monarch Standard Edition is priced at $659.  Multi-user licenses for Monarch StandardEdition are typically priced from $340 to $550 per user, depending upon thenumber of users.  A single user licensefor Monarch Professional Edition is priced at $799.  Multi-user licenses for Monarch ProfessionalEdition are typically priced from $450 to $685 per user, depending upon the numberof users.  Monarch Data Pump is typicallypriced at $7,999 per server.  A singleuser license for VorteXML Designer is priced at $499 and VorteXML Server istypically priced at $7,999 per server.

 

The Company’s enterprise report management and businessservice center products are primarily sold under server-based licenses withnamed-user and concurrent-user client licenses. An entry-level Monarch|RMS system is priced at $15,000, with typicalconfigurations priced in the $25,000 to $50,000 range.  Entry-level Datawatch|ES and Datawatch|Researchersystems are priced at approximately $30,000 and $40,000, respectively.  Typical configurations are priced in therange of $60,000 to $450,000.  Anentry-level Visual|QSM system is priced at approximately $20,000.  Typical configurations sell in the range of$35,000 to $200,000.  An entry-levelVisual|HD system sells for less than $10,000, with typical configurationspriced in the $10,000 to $60,000 range. Maintenance agreements, training and implementation services are soldseparately.

 

The Company also sells its Enterprise Software using asubscription model. Subscription terms typically run 90 days or 24 months andautomatically renew unless terminated with 90 days notice.  The subscription pricing does not includeprofessional services beyond the installation of the software and suchprofessional services are invoiced separately.  Prices for Datawatch|ES subscriptions typically range from approximately$1,750 to $7,000 per month.  Visual|QSMsubscriptions typically range from approximately $1,000 to $2,500 per month,and Visual|HD subscriptions typically range from $500 to $1,200 per month.

 

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**MARKETINGAND DISTRIBUTION**

 

Datawatch markets its products through a variety ofchannels in order to gain broad market exposure and to satisfy the needs of itscustomers.  Datawatch believes that somecustomers prefer to purchase products through service-oriented resellers, whileothers buy on the basis of price, purchase convenience, and/or immediatedelivery.

 

The Company is engaged in active direct sales of itsproducts to end-users, including repeat and add-on sales to existing customersand sales to new customers.  Datawatchutilizes direct mail, the Internet, telemarketing and direct personal sellingto generate its sales.

 

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

 

The Company offers certain of its resellers theability to return obsolete versions of its products and slow-moving productsfor credit.  Based on its historicalexperience relative to products sold to these distributors, the Companybelieves that its exposure to such returns is minimal.  It has provided a provision for suchestimated returns in the financial statements.

 

Datawatch warrants the physical disk media and printeddocumentation for its products to be free of defects in material andworkmanship for a period of 30 to 90 days from the date of purchase dependingon the product.  Datawatch also offers a30 day or 60 day money-back guarantee on certain of its products sold directlyto end-users.  Under the guarantee,customers may return purchased products within the 30 day or 60 day period fora full refund if they are not completely satisfied.  To date, the Company has not experienced anysignificant product returns under its money-back guarantee.

 

During fiscal 2005, 2004 and 2003, one distributor,Ingram Micro Inc., represented approximately 19%, 20% and 19%, respectively, ofthe Company’s total revenue.  No othercustomer accounted for more than 10% of the Company’s total revenue in fiscal2005, 2004 or 2003.  Datawatch’s revenuesfrom outside of the U.S. are primarily the result of sales through the directsales force of its wholly-owned subsidiary, Datawatch International Limited andits subsidiaries (“Datawatch International”) and through internationalresellers.  Such international sales(which are primarily in the UK), not including export sales from domesticoperations, represented approximately 36%, 39% and 38% of the Company’s totalrevenue for fiscal 2005, 2004 and 2003, respectively.  See Note 11 to the Consolidated FinancialStatements which appear elsewhere herein.

 

**RESEARCHAND DEVELOPMENT**

 

The Company believes that timely development of newproducts and enhancements to its existing products is essential to maintainstrong positions in its markets. Datawatch intends to continue to invest significant amounts in researchand product development to ensure that its products meet the current and futuredemands of its markets as well as to take advantage of evolving technologytrends.

 

Datawatch’s product development efforts are conductedthrough in-house software development engineers and by externaldevelopers.  External developers arecompensated either through royalty or commission payments based on productsales levels achieved or under contracts based on services provided.  Datawatch has established long-termrelationships with several development engineering firms, providingflexibility, stability and reliability in its development process.

 

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

 

An existing agreement between Datawatch and MathStrategies grants the Company exclusive worldwide rights to use and distributecertain intellectual property owned by Math Strategies and incorporated by theCompany in its Monarch, Monarch Data Pump, VorteXML and certain other products.In April 2004, the Company entered into an Option Purchase Agreement withMath Strategies giving the Company the option to purchase these intellectualproperty rights for $8,000,000. This option, if exercised, would provide theCompany with increased flexibility to utilize the purchased technology in the

 

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future.The option can be exercised by Datawatch at any time during the two yearsfollowing the effective date of the Option Purchase Agreement.

 

Other Datawatch products have been developed throughin-house software development or by independent software engineers hired undercontract.  Datawatch maintains sourcecode and full product control for these products, which include Datawatch|ES,Visual|QSM, and Visual|HD products. Datawatch|ES, Visual|QSM, and Visual|HD aretrademarks 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 MergenceTechnologies Corporation which has a branch software development and testingoffice in the Philippines.  Mergence,which was renamed Datawatch Technologies Corporation coincident with theacquisition, developed the iMergence iStore and Datawatch|Researcher productsat its facilities in the United States and the Philippines prior to theacquisition.  The Company has integrated  the Philippines development branch as analternative development facility for its other enterprise products.  iMergence is a registered trademark ofDatawatch Technologies Corporation.

 

Research and development expense was $2,031,280,$1,451,533 and $1,507,223 for fiscal years 2005, 2004 and 2003, respectively.

 

**BACKLOG**

 

The Company’s software products are generally shippedwithin three business days of receipt of an order.  Accordingly, the Company does not believethat backlog for its products is a meaningful indicator of futurebusiness.  The Company does maintain abacklog of services related to its Datawatch|ES, Visual|QSM, and Visual|HDbusiness.  While this services backlogwill provide future revenue to the Company, the Company believes that it is nota meaningful indicator of future business.

 

**COMPETITION**

 

The software industry is highly competitive and ischaracterized by rapidly changing technology and evolving industrystandards.  Datawatch competes with anumber of companies including Hyperion, Actuate Corporation, Mobius ManagementSystems, Inc. and others that have substantially greater financial,marketing and technological resources than the Company.  Competition in the industry is likely tointensify as current competitors expand their product lines and as newcompetitors enter the market.

 

**PRODUCTPROTECTION**

 

In addition to having certain patents pending on itssoftware 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 partiesmay attempt to copy aspects of Datawatch’s products or to obtain and useinformation that Datawatch regards as proprietary.  Datawatch believes that, because of the rapidpace of technological change in the software industry, the legal protectionsfor its products are less significant than the knowledge, ability andexperience of its employees and developers, the frequency of productenhancements and the timeliness and quality of its support services.  Datawatch believes that none of its products,trademarks, patents, and other proprietary rights infringe on the proprietaryrights of third parties, but there can be no assurance that third parties willnot assert infringement claims against it or its developers in the future.

 

**PRODUCTION**

 

Production of Datawatch’s products involves theduplication of compact and floppy disks, and the printing of user manuals,packaging and other related materials. High volume compact disk duplication is performed by non-affiliatedsubcontractors, while low volume compact disk duplication is performedin-house.  Floppy disk duplication isperformed in-house with high-capacity disk duplication equipment.  Printing work is also performed by non-affiliatedsubcontractors.  To date, Datawatch hasnot experienced any material difficulties or delays in production of itssoftware and related documentation and believes that, if necessary, alternativeproduction sources could be secured at a commercially reasonable cost.

 

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**EMPLOYEES**

 

As of December 1, 2005, Datawatch had  121 full-time and 6 contract, temporary orpart-time employees, including  48 engagedin marketing, sales, and customer service; 33 engaged in product consulting, training and technical support;  26 engaged in product management, developmentand quality assurance;  18 providinggeneral, administrative, accounting, and IT functions; and 2 engaged insoftware production and warehousing.

 

**Item 2.  PROPERTIES**

 

The Company is currently headquartered in 20,492square feet of leased office space in Lowell, Massachusetts.  The lease expires in January 2006.  The Company’s Datawatch Technologiessubsidiary is headquartered in New Jersey and leases serviced offices on anannual basis.  The Company also maintainsinternational sales and administrative offices in the United Kingdom andAustralia, sales offices in France and Germany, and a software development andtesting facility in the Philippines.

 

On September 28,2005, The Company entered into a sublease agreement as sublessee with sublessor.Under the terms of the Sublease, the Company’s US headquarters will move fromits present location at 175 Cabot Street, Lowell, Massachusetts to 271 MillRoad, Quorum Office Park, Chelmsford, Massachusetts. The new headquarters willconsist of approximately 14,683 square feet. The Sublease is for a period ofsixty-six (66) months. The aggregate rent for the term of the Sublease isapproximately $735,985. In addition to rent, the Sublease requires the Companyto pay certain taxes, insurance and operating costs related to the leasedbuilding based on the Company’s pro-rata share. The Company is also responsiblefor the costs of certain tenant improvements associated with the new facilitybut will be entitled to reimbursement for certain costs from sublessor.

 

**Item3.  LEGAL PROCEEDINGS**

 

In May 2004, the Company was served with a chargeof discrimination filed with the Massachusetts Commission AgainstDiscrimination (MCAD) by a current employee. In addition to the Company, the employee has named an executive of theCompany as well as the employee’s former supervisor as defendants.  The employee alleges that her formersupervisor engaged in sexually harassing conduct.  The employee accuses the executive ofengaging in retaliation upon learning of the employee’s complaint.  The complaint was withdrawn from the MCAD in August 2004,with the stated intent of pursuing the claim in Superior Court in the state ofMassachusetts.  To date, the Company hasnot been notified of any further filing. Given the early stage and current status of the claim, the Company isunable to predict the ultimate outcome. The Company intends to vigorously defend the claims.

 

The Company is occasionally involved in legalproceedings and other claims arising out of our operations in the normal courseof business.  The Company is not party toany other litigation that management believes will have a material adverseeffect on the Company’s consolidated financial condition, results ofoperations, or cash flows.

 

**Item4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

No matters were submitted to a vote of the Registrant’ssecurity holders during the last quarter of the fiscal year covered by thisreport.

 

**EXECUTIVEOFFICERS OF THE REGISTRANT**

 

Thenames, ages and titles of the executive officers of the Company as of December 1,2005 are as follows:

 
| Robert  W. Hagger          |   | 57 |   | President,  Chief Executive Officer and Director                                        |
|----------------------------|--------|----|--------|-----------------------------------------------------------------------------------------|
| John  H. Kitchen, III |   | 49 |   | Senior  Vice President of Desktop & Server Solutions and Secretary             |
| John  J. Hulburt           |   | 39 |   | Vice  President of Finance, Chief Financial Officer, Treasurer and Assistant  Secretary |

 

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

 

ROBERT W. HAGGER, President, Chief Executive Officerand Director.  Mr. Hagger assumedthe positions of President, Chief Executive Officer and Director on July 9,2001.  Prior thereto, and since November 1,1997, Mr. Hagger was Senior Vice President of International Operations ofthe Company.  Prior to that and since March 1997,Mr. Hagger was Managing

 

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Directorof the Company’s wholly-owned subsidiary Datawatch International Limited.  Prior to joining Datawatch, from 1993 to March 1997,Mr. Hagger was founder and Managing Director of Insight StrategyManagement Ltd.  Prior to that he wasManaging Director of Byrne Fleming Ltd.

 

JOHN H. KITCHEN, III, Senior Vice President ofDesktop & Server Solutions and Secretary.  Mr. Kitchen assumed the position ofSenior Vice President of Desktop & Server Solutions on July 9,2001.  Prior thereto, and since July 2000,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 amarketing consultant to the Company.

 

JOHN J. HULBURT, Vice President of Finance, ChiefFinancial Officer, Treasurer and Assistant Secretary.  Mr. Hulburt assumed the position of VicePresident of Finance on January 11, 2005. Prior tojoining Datawatch, Mr. Hulburt was Director of Audit and SEC Compliance atBruker Biosciences Corporation, a publicly traded medical device company, aposition he held since July 2003. Mr. Hulburt served as ChiefFinancial Officer and Treasurer of Bruker Daltonics Inc. before its merger withBruker AXS. Mr. Hulburt is a Certified Public Accountant and from 1994 to2000 he began his career withthe accounting firms Ernst & Young LLP and Arthur Andersen LLP.

 

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**PART II**

 

**Item 5.   MARKET FOR THE REGISTRANT’S COMMON EQUITYAND RELATED SHAREHOLDER MATTERS**

 

The Registrant’s common stock is listed and traded onthe Nasdaq SmallCap Market under the symbol DWCH.  The range of high and low closing pricesduring each fiscal quarter for the last two fiscal years is set forth below:

 
| **For the Year Ended**      | ** ** | **Common Stock** | ** ** |
|-----------------------------|------------|------------------|------------|
| **September 30, 2005** | ** ** | **High**         | ** ** | **Low** | ** ** |
|                        |       |             |       |   |   |
| 4th  Quarter                |       | 4.31             |       | 3.51 |   |
| 3rd  Quarter                |       | 5.12             |       | 3.53 |   |
| 2nd  Quarter                |       | 5.28             |       | 4.10 |   |
| 1st  Quarter                |       | 5.30             |       | 3.22 |   |

 
| **For the Year Ended**      | ** ** | **Common Stock** | ** ** |
|-----------------------------|------------|------------------|------------|
| **September 30, 2004** | ** ** | **High**         | ** ** | **Low** | ** ** |
|                        |       |             |       |   |   |
| 4th  Quarter                |       | 4.690            |       | 3.010 |   |
| 3rd  Quarter                |       | 6.875            |       | 3.910 |   |
| 2nd  Quarter                |       | 5.905            |       | 2.815 |   |
| 1st  Quarter                |       | 4.210            |       | 2.600 |   |

 

There are approximately 110 shareholders of record asof December 1, 2005.  The Companybelieves that the number of beneficial holders of common stock exceeds 2,000.  The last reported sale of the Company’scommon stock on December 1, 2005 was at $4.16.

 

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

 

The information set forth under the caption “EquityCompensation Plans” appearing in the Company’s definitive Proxy Statement forthe Annual Meeting of Shareholders for the fiscal year ended September 30,2005 is incorporated herein by reference.

 

**Item6.   SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following table sets forth selected consolidatedfinancial data of the Company for the periods indicated.  The selected consolidated financial data forand as of the end of the years in the five-year period ended September 30,2005 are derived from the Consolidated Financial Statements of theCompany.  The information set forth belowshould be read in conjunction with “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and the Consolidated FinancialStatements and notes which appears elsewhere in this Annual Report on Form 10-K.

 
| **Statements of Operations Data**                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Years Ended September 30,**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|                                                                  |       |       |       |       |       |       |       |       |       |       |       |
| Revenue                                                               |       | $          | 21,511,595 |       | $          | 19,335,146 |       | $          | 17,712,206 |       | $          | 19,440,743 |   | $ | 18,321,251 |   |
| Costs and Expenses                                                    |       | 20,823,225 |       | 18,410,460 |       | 16,886,018 |       | 18,499,009 |       | 23,638,923 |       |
| Income (Loss) from Operations                                         |       | 688,370    |       | 924,686    |       | 826,188    |       | 941,734    |       | (5,317,672 | )          |
| Income (Loss) from Continuing Operations                              |       | 800,414    |       | 1,084,776  |       | 846,545    |       | 846,379    |       | (5,385,051 | )          |
| Discontinued Operations Income (Loss) from Guildsoft  operations, net |       | —     |       | —     |       | —     |       | —     |       | (143,856   | )          |
| Gain on sale of Guildsoft                                             |       | —     |       | —     |       | —     |       | 17,096     |       | 413,013    |       |
| Income from Discontinued Operations                                   |       | —     |       | —     |       | —     |       | 17,096     |       | 269,157    |       |
| Net Income (Loss)                                                     |       | $          | 800,414    |       | $          | 1,084,776  |       | $          | 846,545    |       | $          | 863,475 |   | $ | (5,115,894 | ) |
|                                                                  |       |       |       |       |       |       |       |       |       |       |       |
| Net Income (Loss) from Continuing Operations per  Common Share:       |       |       |       |       |       |       |       |       |       |       |       |
| Basic                                                                 |       | $          | 0.15       |       | $          | 0.21       |       | $          | 0.16       |       | $          | 0.17 |   | $ | (1.12 | ) |
| Diluted                                                               |       | $          | 0.14       |       | $          | 0.19       |       | $          | 0.16       |       | $          | 0.16 |   | $ | (1.12 | ) |
|                                                                  |       |       |       |       |       |       |       |       |       |       |       |   |   |   |   |   |
| Net Income (Loss) per Common Share:                                   |       |       |       |       |       |       |       |       |       |       |       |
| Basic                                                                 |       | $          | 0.15       |       | $          | 0.21       |       | $          | 0.16       |       | $          | 0.17 |   | $ | (1.07 | ) |
| Diluted                                                               |       | $          | 0.14       |       | $          | 0.19       |       | $          | 0.16       |       | $          | 0.16 |   | $ | (1.07 | ) |

 

9

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| **Balance  Sheet Data  September 30,** | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**   | ** ** | **2002**  | ** ** | **2001**  | ** ** |
|---------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|-----------|------------|-----------|------------|
|                                        |       |      |       |      |       |       |       |      |       |      |       |
| Total Assets                                |       | $         | 13,412,256 |      | $          | 12,628,794 |       | $         | 10,503,942 |      | $          | 9,454,466 |   | $ | 9,423,894 |   |
| Working Capital                             |       | 3,487,484 |       | 2,547,879 |       | 3,407,639  |       | 2,022,702 |       | 596,136   |       |
| Long-Term Obligations                       |       | —    |       | 125,373   |       | 3,115      |       | 12,795    |       | 126,121   |       |
| Shareholders’ Equity                   |       | 7,305,764 |       | 6,435,929 |       | 5,138,115  |       | 4,060,212 |       | 2,985,289 |       |
|                                             |            |           |            |           |            |            |            |           |            |           |            |  |  |  |  |  |

 

During the first quarter of fiscal 2003, the Companyapproved and completed a restructuring undertaken to reduce costs related toits international operations. In accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 146, “*Accountingfor Costs Associated with Exit or Disposal Activities,*” the Companyrecorded a restructuring charge of approximately $181,000 for severancebenefits for five terminated employees and costs resulting from thecancellation of leases and the disposal of fixed assets related to a relocationto smaller facilities.  The charges forthis restructuring were fully paid in February 2003.  At September 30, 2004 there was anadditional accrued severance amount of approximately $1,000, which was notrelated to restructuring activities.  At September 30,2005 the restructuring reserve was $0.

 

The following tablesummarizes the restructuring activity related to the Company’s restructurings:

 
| Restructuring  Reserve as of September 30, 2002 |   | $        | 169,000 |   |
|------------------------------------------------------|--------|----------|---------|--------|
| Fiscal 2003  Restructuring Charge                    |   | 181,000  |    |
| Cash Payments -  Fiscal 2003                         |   | (334,000 | )       |
| Restructuring  Reserve as of September 30, 2003 |   | 16,000   |    |
| Cash Payments -  Fiscal 2004                         |   | (12,000  | )       |
| Restructuring  Reserve as of September 30, 2004 |   | 4,000    |    |
| Cash Payments -  Fiscal 2005                         |   | (4,000   | )       |
| Restructuring  Reserve as of September 30, 2005 |   | $        | —  |   |

 

**Item7.   MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

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

 

**GENERAL**

 

Datawatch is engaged in the design, development,manufacture, marketing, and support of business computer software primarily forthe Windows-based market.  Its productsaddress the enterprise content management and reporting, business intelligence,data replication, business service management and help desk markets.

 

10

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Datawatch’s principal products are:  Monarch, a desktop report mining and businessintelligence application that lets users extract and manipulate data from ASCIIreport files, PDF files or HTML files produced on any mainframe, midrange,client/server or PC system; Monarch Data Pump, a data replication and migrationtool that offers a shortcut for populating and refreshing data marts and datawarehouses, for migrating legacy data into new applications and for providingautomated delivery of reports in a variety of formats via email; Monarch|RMS, aweb-based report mining and analysis solution that integrates with any existingCOLD/ERM, document or content management archiving solution; Datawatch|ES, aweb-enabled business information portal, providing complete report management,business intelligence and content management, and the ability to analyze datawithin reports derived from existing reporting systems with no new programmingor report writing; Datawatch|Researcher, a .NET based content and data aggregation solutionthat searches inter-related data, documents, and communications scattered overmultiple and disparate repositories, then merges and analyzes the results into comprehensiveactionable case records; Visual|QSM, a fully internet-enabled IT supportsolution that incorporates workflow and network management capabilities andprovides web access to multiple databases via a standard browser; Visual|HelpDesk or Visual|HD, a web-based help desk and call center solution operating onthe IBM Lotus Domino platform; and VorteXML, a data transformation product forthe emerging XML market that easily and quickly converts structured text outputfrom any system into valid XML for web services and more using any DTD or XDRschema without programming.

 

On August 11, 2004, Datawatch acquired 100% ofthe shares of Mergence Technologies Corporation, which subsequently changed itsname to Datawatch Technologies, in exchange for $2,500,000 in cash and $96,691in direct costs.  The purchase agreementalso included a provision for quarterly cash payments to the former Mergenceshareholders equal to 10% of revenue, as defined, of the Datawatch|Researcherproduct for a period of six years, not all Mergence products are subject toroyalties.  The activities of Mergencefrom August 11, 2004 are included in the Company’s consolidated financialstatements.  See Note 2 to theconsolidated financial statements which appear elsewhere herein for moredetailed financial information on the acquisition of Mergence.

 

During the first quarter of fiscal 2004, the Companyintroduced a subscription sales model for the sale of its enterpriseproducts.  The Company continues to offerits enterprise products through the sale of perpetual licenses and introducedthe subscription pricing model to allow customers to begin using the Company’sproducts at a lower initial cost of software acquisition.  Subscriptions automatically renew unlessterminated with 90 days notice.  Duringfiscal 2004 and fiscal 2005, revenues under the subscription model were notsignificant, however, customer interest in the model and sales under the modelhave been increasing.

 

**CRITICALACCOUNTING POLICIES**

 

In thepreparation of financial statements and other financial data, managementapplies certain accounting policies to transactions that, depending on choicesmade by management, can result in different outcomes. In order for a reader tounderstand the following information regarding the financial performance andcondition of the Company, an understanding of those accounting policies isimportant. The policies that the Company believes are most important for areader’s understanding of the financial information provided in this report aredescribed below.

 

Revenue Recognition,Allowance for Bad Debts and Returns Reserve

 

TheCompany has two types of software product offerings: Enterprise Software andDesktop and Server Software. Enterprise Software products are generally solddirectly to end-users. The Company sells its Desktop and Server Softwareproducts directly to end-users and through distributors and resellers.  Sales to distributors and resellers accountedfor approximately 31%, 29% and 29%, of total sales for fiscal years 2005, 2004and 2003, respectively.  Revenue from thesale of all software products is generally recognized at the time of shipment,provided there are no uncertainties surrounding product acceptance, the fee isfixed or determinable, collection is considered probable, persuasive evidenceof the arrangement exists and there are no significant obligationsremaining.  Both types of the Company’ssoftware product offerings are “off-the-shelf” as such term is defined byStatement of Position No. 97-2, “*Software Revenue Recognition*.”  The Company’s software products can beinstalled and used by customers on their own with little or no customizationrequired.  Multi-user licenses marketedby the Company are sold as a right to use the number of licenses and licensefee revenue is recognized upon delivery of all software required to satisfy thenumber of licenses sold.  Upon delivery,the licensing fee is payable without further delivery obligations of theCompany.

 

Desktopand Server Software products are generally not sold in multiple elementarrangements.  Accordingly, the pricepaid by the customer is considered the vendor specific objective evidence (“VSOE”)of fair value for those products.

 

11

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EnterpriseSoftware sales are generally multiple element arrangements which includesoftware license deliverables, professional services and post-contract customersupport.  In such multiple elementarrangements, the Company applies the residual method in determining revenue tobe allocated to a software license.  Inapplying the residual method, the Company deducts from the sale proceeds theVSOE of fair value of the services and post-contract customer support indetermining the residual fair value of the software license.  The VSOE of fair value of the services andpost-contract customer support is based on the amounts charged for theseelements when sold separately. Professional services include implementation,integration, training and consulting services with revenue recognized as theservices are performed. These services are generally delivered on a time andmaterials basis, are billed on a current basis as the work is performed, and donot involve modification or customization of the software or any other unusualacceptance clauses or terms. Post-contract customer support is typically provided under a maintenanceagreement which provides technical support and rights to unspecified softwaremaintenance updates and bug fixes on a when-and-if available basis.  Revenue from post-contract customer supportservices is deferred and recognized ratably over the contract period (generallyone year).  Such deferred amounts arerecorded as part of deferred revenue in the Company’s Consolidated BalanceSheets included elsewhere herein.

 

TheCompany also sells its Enterprise Software using a subscription model.  At the time a customer enters into a bindingagreement to purchase a subscription, the customer is invoiced for an initial90 day service period and an account receivable and deferred revenue arerecorded.  Beginning on the date thesoftware is installed at the customer site and available for use by thecustomer, and provided that all other criteria for revenue recognition are met,the deferred revenue amount is recognized ratably over the period the serviceis provided.  The customer is theninvoiced every 90 days and revenue is recognized ratably over the period theservice is provided.  Subscriptions canbe cancelled by the customer at any time by providing 90 days written notice.

 

TheCompany’s software products are sold under warranty against certain defects inmaterial and workmanship for a period of 30 to 90 days from the date ofpurchase. Certain software products, including desktop versions of Monarch,Monarch Data Pump, and VorteXML sold directly to end-users, include a guaranteeunder which such customers may return products within 30 to 60 days for a fullrefund. Additionally, the Company provides its distributors withstock-balancing rights and applies the guidance found in SFAS No. 48, “*Revenue Recognition when Right of Return Exists*.”  Revenue from the sale of software products todistributors and resellers is recognized at the time of shipment providing allother criteria for revenue recognition as stated above are met and (i) thedistributor or reseller is unconditionally obligated to pay for the products,including no contingency as to product resale, (ii) the distributor orreseller has independent economic substance apart from the Company, (iii) theCompany 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 itsdistributors and resellers allows for reasonable estimates of future returns.Among other things, estimates of potential future returns are made based on theinventory levels at the various distributors and resellers, which the Companymonitors frequently.  Once the estimatesof potential future returns from all sources are made, the Company determinesif it has adequate returns reserves to cover anticipated returns and thereturns reserve is adjusted as required. Adjustments are recorded as increasesor decreases in revenue in the period of adjustment. Actual returns havehistorically been within the range estimated by the Company.  The Company’s returns reserve was $123,315and $186,277 for the period ended as of September 30, 2005 and 2004,respectively.

 

TheCompany maintains allowances for doubtful accounts for estimated lossesresulting from the inability of customers to make required payments. TheCompany analyzes accounts receivable and the composition of the accountsreceivable aging, historical bad debts, customer creditworthiness, currenteconomic trends, foreign currency exchange rate fluctuations and changes incustomer payment terms when evaluating the adequacy of the allowance fordoubtful accounts.  Based upon theanalysis and estimates of the uncollectibility of its accounts receivable, theCompany records an increase in the allowance for doubtful accounts when theprospect of collecting a specific account receivable becomes doubtful. Actualresults could differ from the allowances for doubtful accounts recorded, andthis difference may have a material effect on the Company’s financial positionand results of operations. The Company’s allowance for doubtful accounts was $293,943and $230,034 for the period ended as of September 30, 2005 and 2004,respectively.

 

Deferred Tax Assets

 

The Company has deferred tax assets related to net operatingloss carryforwards and tax credits that expire at different times through anduntil 2020, as well as book and tax temporary differences.  Significant judgment is required indetermining the Company’s provision for income taxes, the carrying value ofdeferred tax assets and liabilities and the valuation allowance recordedagainst net deferred tax assets.  Factorssuch as future reversals of deferred tax assets and liabilities, projectedfuture taxable income, changes in enacted tax rates and the period over whichthe Company’s deferred tax assets will be recoverable are considered in makingthese determinations.  The Company’sdomestic operations have been profitable during the past three years whileinternational operations have continued to generate operating losses.  During fiscal 2004, the Company

 

12

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increasedsales and marketing expense by approximately 24% and introduced a subscriptionsales model, both of which could have an adverse effect on profitability.  Accordingly, management does not believe thedeferred tax assets are more likely than not to be realized and a fullvaluation allowance continues to be provided against these net deferred taxassets.    Management evaluates the realizability of thedeferred tax assets quarterly and, if current economic conditions change orfuture results of operations are better than expected, future assessments mayresult in the Company concluding that it is more likely than not that all or aportion of the deferred tax assets are realizable. If this conclusion werereached, the valuation allowance against deferred tax assets would be reducedresulting in a tax benefit being recorded for financial reportingpurposes.  Total net deferred tax assetssubject to a valuation allowance was approximately $4.7 million as of September 30,2005.

 

Capitalized Software Development Costs

 

The Company capitalizes certain software developmentcosts as well as purchased software upon achieving technological feasibility ofthe related products.  Softwaredevelopment costs incurred and software purchased prior to achievingtechnological feasibility are charged to research and development expense asincurred.  Commencing upon initialproduct release, capitalized costs are amortized to the cost of softwarelicenses using the straight-line method over the estimated life (whichapproximates the ratio that current gross revenues for a product bear to thetotal of current and anticipated future gross revenues for that product),generally 24 to 72 months.  The Company’scapitalized software was $583,158 and $936,522 for the period ended as of September 30,2005 and 2004, respectively.

 

Goodwill,Other Intangible Assets and Other Long-Lived Assets

 

TheCompany performs an evaluation of whether goodwill and indefinite livedintangible assets are impaired annually or when events occur or circumstanceschange that would more likely than not reduce the fair value of a reportingunit below its carrying amount. Our annual impairment analysis is performedeach May of the applicable fiscal year. Fair value is determined using market comparables for similar businessesor forecasts of discounted future cash flows. The Company also reviews otherintangible assets and other long-lived assets when an indication of potentialimpairment exists, such as a significant reduction in cash flows associatedwith the assets. Should the fair value of the Company’s long-lived assetsdecline because of reduced operating performance, market declines, or otherindicators of impairment, a charge to operations for impairment may benecessary.  No impairment charges weretaken during fiscal 2005.

 

Accountingfor stock-based compensation

 

TheCompany accounts for stock-based compensation using the intrinsic value methodprescribed in Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issued to Employees*”.The Company’s policy is to grant options with an exercise price equal to theestimated fair value of the Company’s stock on the grant date.  The Company provides additional pro formadisclosures as required under Statement of Financial Accounting Standard No. 123(“SFAS 123”), “*Accounting for Stock-Based Compensation*”,as amended by SFAS No 148, “*Accounting forstock-based compensation, transition and disclosure”*.

 

UnderAPB Opinion No. 25, compensation expense is based on the difference, ifany, on the date of the grant, between the estimated fair value of the Company’sstock and the exercise price. SFAS No. 123 defines a “fair value” basedmethod of accounting for an employee stock option or similar equity instrument.

 

TheCompany accounts for equity instruments issued to non-employees in accordancewith the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18,“*Accounting for Equity Instruments That AreIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods or Services”* which requires that such equity instruments arerecorded at their fair value on the measurement date. The measurement ofstock-based compensation is subject to periodic adjustment as the underlyingequity instruments vest.

 

13

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**RESULTS OF OPERATIONS**

 

The following table sets forth certain statements ofoperations data as a percentage of total revenues for the periods indicated.The data has been derived from our consolidated financial statements.  The operating results for any period shouldnot be considered indicative of the results expected for any future period.

 
| ** **                                  | ** ** | **Year Ended September 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------|------------|
| ** **                                  | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| REVENUE:                                    | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software licenses and subscriptions         |       | 66.2                              | %          | 64.3 | % | 68.9 | % |
| Maintenance and services                    |       | 33.8                              | %          | 35.7 | % | 31.1 | % |
| Total Revenue                               |       | 100.0                             | %          | 100.0 | % | 100.0 | % |
|                                        |       |                              |       |   |   |   |   |
| COSTS AND  EXPENSES:                        |       |                              |       |   |   |   |   |
| Cost of software licenses and subscriptions |       | 11.7                              | %          | 13.4 | % | 14.5 | % |
| Cost of maintenance and services            |       | 16.0                              | %          | 14.0 | % | 13.4 | % |
| Sales and marketing                         |       | 40.4                              | %          | 39.5 | % | 34.6 | % |
| Engineering and product development         |       | 9.4                               | %          | 7.5 | % | 8.5 | % |
| General and administrative                  |       | 19.3                              | %          | 20.9 | % | 23.4 | % |
| Restructuring  costs                        |       | 0.0                               | %          | 0.0 | % | 1.0 | % |
| Total costs and expenses                    |       | 96.8                              | %          | 95.3 | % | 95.4 | % |
| INCOME FROM  OPERATIONS                     |       | 3.2                               | %          | 4.7 | % | 4.6 | % |
| Interest expense                            |       | 0.0                               | %          | 0.0 | % | 0.0 | % |
| Interest income  and other income, net      |       | 0.4                               | %          | 0.2 | % | 0.2 | % |
| INCOME BEFORE  INCOME TAXES                 |       | 3.6                               | %          | 4.9 | % | 4.8 | % |
| Provision  (benefit) for income taxes       |       | (0.1                              | )%         | (0.7 | )% | 0.0 | % |
| NET INCOME                                  |       | 3.7                               | %          | 5.6 | % | 4.8 | % |

 

*Fiscal Year Ended September 30, 2005 asCompared to*

*Fiscal Year Ended September 30, 2004*

 

***Total Revenues***

 

The following table presents total revenue, change intotal revenue and total revenue growth for the year ended September 30,2005 and 2004:

 
| ** **                           | ** ** | **Year Ended September 30,** | ** ** | ** ** | ** ** | **Percentage** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|------------|------------|----------------|------------|
| ** **                           | ** ** | **2005**                          | ** ** | **2004**   | ** ** | **Increase**   | ** ** | **Increase** | ** ** |
| Software  licenses and subscriptions |       | $                                 | 14,232,946 |       | $          | 12,441,667     |       | 1,791,279 |   | 14.4 | % |
| Maintenance and  services            |       | 7,278,649                         |       | 6,893,479  |       | 385,170        |       | 5.6 | % |
|                                 |       |                              |       |       |       |           |       |   |   |
| Total revenue                        |       | $                                 | 21,511,595 |       | $          | 19,335,146     |       | $ | 2,176,449 |   | 11.3 | % |
|                                      |            |                                   |            |            |            |                |            |  |  |  |  |  |

 

Revenue for the fiscal year ended September 30,2005 was $21,511,595, which represents an increase of $2,176,449 orapproximately 11% from revenue of $19,335,146 for the fiscal year ended September 30,2004.   For fiscal 2005 Monarch(including Monarch Data Pump and VorteXML and Redwing), Datawatch|ES (includingMonarch|RMS, Datawatch|Researcher and iMergence iStore) and Visual|QSM andVisual|HD sales accounted for 59%, 15% and 26% of total revenue, respectively,as compared to 56%, 14% and 30%, respectively, for fiscal 2004.

 

Software license and subscription revenue for the fiscalyear ended September 30, 2005 was $14,232,946 or approximately 66% oftotal revenue, as compared to $12,441,667 or approximately 64% of total revenuefor the fiscal year ended September 30, 2004.  This represents an increase of $1,791,279 orapproximately 14% from fiscal 2004 to fiscal 2005.

 

14

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Theoverall increase in license revenue during fiscal 2005 consists of a $1,421,000increase in Monarch license revenue (which also includes the Monarch Data Pumpand VorteXML products), a $324,000 increase in the Report Management licenseand subscription revenue, and a $46,000 increase in Business Service Managementlicense and subscription revenue.  The$324,000 net increase in the Report Management license and subscription revenueincludes an increase of $532,000 from the Researcher and iMergence iStoreproducts, which were new products from the Mergence acquisition.  This increase offsets a $208,000 decrease inrevenues from Datawatch|ES.  The $46,000net increase in Business Service Management license and subscription revenueconsists of a $113,000 increase in Visual|QSM revenue, which offset a $67,000decrease in Visual|HD revenue.  TheCompany attributes the increase in Monarch software license revenue to therelease of a new version of Monarch V8 in March 2005, and also tocustomers who increased their capital spending as a result of a an improveddomestic economic outlook.  The Companyattributes the decrease in Visual|HD software license and subscription revenueto intensified competitive pressure to reduce pricing for a product in a maturemarket.

 

Maintenance and services revenue for the fiscal yearended September 30, 2005 was $7,278,649 or approximately 34% of total revenue,as compared to $6,893,479 or approximately 36% of total revenue for the fiscal yearended September 30, 2004.  This representsan increase of $385,170 or approximately 6% from fiscal 2004 to fiscal 2005. Theoverall increase in maintenance and service revenue consists of a $401,000increase in Monarch revenue, and a $303,000 increase in Report Managementrevenue (which includes maintenance for Datawatch|ES, Monarch|RMS, Datawatch|Researcherand iMergence iStore).  These increaseswere partially offset by decreases in Business Service Management maintenanceand services revenues of $319,000.  The$303,000 net increase in Report Management revenue includes both a $409,000increase related to Researcher and iMergence iStore products, which were newproducts from the Mergence acquisition, offset by a $106,000 decrease inDatawatch|ES revenue.  The Companyattributes the overall increases in maintenance and services revenue tocontinued customer loyalty, which has resulted in high renewal rates for annualmaintenance service contracts and an increased demand for professional servicesfrom existing customers, which also includes upgrades and additionaltraining.   The decrease in maintenancerevenue for the Business Service Management product line was the result oflower renewal rates of annual maintenance contracts from existing customers duea mature market for the product.  Thedecrease in Business Service Management maintenance and services also resultedin less demand for professional services work related to this product line.  No significant product upgrades were introducedwithin the Visual product lines during fiscal year 2005.

 

***Costs and Operating Expenses***

 

The following table presents costs and operatingexpenses, changes in costs and operating expenses and costs and operating expensesgrowth for the year ended September 30, 2005 and 2004:

 
| ** **                                    | ** ** | **Year Ended September 30,** | ** ** | **Increase /** | ** ** | **Percentage  Increase /** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|----------------|------------|----------------------------|------------|
| ** **                                    | ** ** | **2005**                          | ** ** | **2004**       | ** ** | **(Decrease)**             | ** ** | **(Decrease)** | ** ** |
| Costs of  software licenses and subscriptions |       | $                                 | 2,515,060  |           | $          | 2,582,627                  |       | (67,567 | ) | (2.6 | )% |
| Costs of  maintenance and services            |       | 3,438,319                         |       | 2,710,562      |       | 727,757                    |       | 26.8 | % |
| Sales and  marketing expenses                 |       | 8,686,672                         |       | 7,629,058      |       | 1,057,614                  |       | 13.9 | % |
| Engineering and  product development expenses |       | 2,031,280                         |       | 1,451,533      |       | 579,747                    |       | 39.9 | % |
| General and  administrative expenses          |       | 4,151,894                         |       | 4,036,680      |       | 115,214                    |       | 2.9 | % |
|                                          |       |                              |       |           |       |                       |       |   |   |
| Total costs and  operating expenses           |       | $                                 | 20,823,225 |           | $          | 18,410,460                 |       | $ | 2,412,765 |   | 13.1 | % |
|                                               |            |                                   |            |                |            |                            |            |  |  |  |  |  |

 

Cost of software licenses and subscriptions for thefiscal year ended September 30, 2005 was $2,515,060 or approximately 18%of software license and subscription revenues, as compared to $2,582,627 orapproximately 21% of software license revenues for the fiscal year ended September 30,2004.  The decrease in costs of softwarelicenses and subscriptions as a percentage of software licenses andsubscription revenue is due to the decreasing amortization expense ofcapitalized software costs and the increased sales of internally-developed  products, which do not have any associatedroyalty expenses.

 

Cost of maintenance and services for the fiscal yearended September 30, 2005 was $3,438,319 or approximately 47% ofmaintenance and service revenues, as compared to $2,710,562 or approximately 39%of maintenance and service revenues, for the fiscal year ended September 30,2004.  During fiscal 2005, gross marginson maintenance and services decreased and

 

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overallcosts increased  primarily due to the useof third-party consultants to supplement the Company’s internal consulting and trainingstaff in revenue-generating activities and due to increased salaries for technicalsupport staff.  During fiscal year 2005,the Company hired additional consulting staff and training the new staffresulted in lower utilization rates per person as compared to fiscal year 2004.

 

Sales and marketing expenses were $8,686,672 for thefiscal year ended September 30, 2005, which represents an increase of $1,057,614or approximately 14%, from $7,629,058 for the fiscal year ended September 30,2004.  This increase is primarilyattributable to increased sales staff personnel, increased salaries and other relatedexpenses, increased marketing expenses for lead generation, and trade showexpense.  Mid-way through fiscal year 2004the Company made a strategic decision for additional investments within thesales and marketing programs to improve upon the Company’s top-line revenuegrowth initiatives.  This additionalinvestment focus was continued throughout the entire 2005 fiscal  year.

 

Engineeringand product development expenses were $2,031,280 for the fiscal year ended September 30,2005, which represents an increase of $579,747 or approximately 40% from$1,451,533 for the fiscal year ended September 30, 2004.  This increase is primarily attributable to anincrease of approximately $600,000 in product development expenses resultingfrom the acquisition of the Datawatch Technologies subsidiary.  The Company continues to transition someexisting outsourced development activities in-house, but currently expects tocontinue to use third-party development activities, as well as in-housedevelopment, in the foreseeable future.

 

Generaland administrative expenses were $4,151,894 for the fiscal year ended September 30,2005, which represents an increase of $115,214 or approximately 3% from$4,036,680 for the fiscal year ended September 30, 2004.  This increase is primarily attributable to overallgrowth in the business and certain costs incurred during the year in relationto the Company preparing for its Sarbanes-Oxley 404 Internal Controldocumentation and preparation (“SOX 404”) and acceleration of un-vested stockoptions.  The Company’s external SOX 404costs were approximately $35,000.  In September 2005the Company accelerated all un-vested stock options and incurred a charge ofapproximately $47,000.  See Note 9 to theconsolidated financial statements which appear elsewhere herein for moredetailed information on the stock option acceleration.

 

Netincome for the year ended September 30, 2005 was $800,414, which comparesto net income of $1,084,776 for the year ended September 30, 2004.  Net income for fiscal year 2005 and fiscalyear 2004 include a tax benefit of $22,000 and $126,650, respectively.

 

*Fiscal Year Ended September 30, 2004 asCompared to*

*Fiscal Year Ended September 30, 2003*

 

***Total Revenues***

 

The following table presents total revenue, change intotal revenue and total revenue growth for the year ended September 30,2004 and 2003:

 
| ** **                           | ** ** | **Year Ended September 30,** | ** ** | ** ** | ** ** | **Percentage** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|------------|------------|----------------|------------|
| ** **                           | ** ** | **2004**                          | ** ** | **2003**   | ** ** | **Increase**   | ** ** | **Increase** | ** ** |
| Software  licenses and subscriptions |       | $                                 | 12,441,667 |       | $          | 12,209,857     |       | 231,810 |   | 1.9 | % |
| Maintenance and  services            |       | 6,893,479                         |       | 5,502,349  |       | 1,391,130      |       | 25.3 | % |
|                                 |       |                              |       |       |       |           |       |   |   |
| Total revenue                        |       | $                                 | 19,335,146 |       | $          | 17,712,206     |       | $ | 1,622,940 |   | 9.2 | % |
|                                      |            |                                   |            |            |            |                |            |  |  |  |  |  |

 

Revenue from continuing operations for the fiscal yearended September 30, 2004 was $19,335,146, which represents an increase of$1,622,940 or approximately 9% from revenue of $17,712,206 for the fiscal yearended September 30, 2003.   Forfiscal 2004 Monarch (including Monarch Data Pump and VorteXMLand Redwing),Visual|QSM and Visual|HD, and Datawatch|ES (including Monarch|RMS and iMergenceiStore) sales accounted for 56%, 30% and 14% of total revenue, respectively, ascompared to 59%, 29% and 12%, respectively, for fiscal 2003.

 

Software license and subscription revenue for thefiscal year ended September 30, 2004 was $12,441,667 or approximately 64%of total revenue, as compared to $12,209,857 or approximately 69% of totalrevenue for the fiscal year

 

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ended September 30,2003.  This represents an increase of$231,810 or approximately 2% from fiscal 2003 to fiscal 2004.  In fiscal 2004, Datawatch|ES license andsubscription revenue increased by $276,000 ($58,000 was iMergence iStorerevenue resulting from the Mergence acquisition for the period August 11,2004 through September 30, 2004) and Monarch license revenue (includingMonarch Data Pump and VorteXML) increased by $241,000, when compared to fiscal2003.  These increases were partiallyoffset by a decrease in Visual|QSM and Visual|HD license revenue of $285,000(Visual|QSM license and subscription revenue decreased by $276,000 and Visual|HDlicense and subscription revenue decreased by $9,000). The Company attributes theincreases in Datawatch|ES and Monarch software license and subscription revenueto increased capital spending in fiscal 2004 resulting from an improveddomestic economic outlook and the decrease in Visual|QSM and Visual|HD softwarelicense and subscription revenue to increased competitive pressure to reduceproduct pricing for products in that mature market.

 

Maintenance and services revenue for the fiscal yearended September 30, 2004 was $6,893,479 or approximately 36% of total revenue,as compared to $5,502,349 or approximately 31% of total revenue for the fiscalyear ended September 30, 2003.  Thisrepresents an increase of $1,391,130 or approximately 25% from fiscal 2003 tofiscal 2004. This increase is primarily attributable to increases in Visual|QSMand Visual|HD maintenance and services revenue of $1,012,000, Datawatch|ES(including Monarch|RMS and iMergence iStore) maintenance and services revenueof $320,000 and Monarch maintenance and services revenue of $58,000.  The increase in Visual|QSM and Visual|HDmaintenance and services revenue is the result of increases in bothprofessional services (increase of $843,000) and maintenance (increase of$169,000) revenues. The increase in Datawatch|ES maintenance and servicesrevenue is also the result of increases in both professional services (increaseof $215,000) and maintenance (increase of $105,000) revenues.  The Company attributes the increases inmaintenance and services revenue to continued customer loyalty resulting inincreased demand for professional services due to upgrades and expanded use ofthe Company’s products and a high percentage of maintenance renewals.  Additionally, the Datawatch|ES revenueincludes iMergence iStore services revenue of $116,000 resulting from theMergence acquisition (professional services revenue of $110,000 and maintenancerevenue of $6,000) for the period from August 11, 2004 to September 30,2004.

 

***Costs and Operating Expenses***

 

The following table presents costs and operatingexpenses, changes in costs and operating expenses and costs and operatingexpenses growth for the year ended September 30, 2004 and 2003:

 
| ** **                                    | ** ** | **Year Ended September 30,** | ** ** | **Increase /** | ** ** | **Percentage  Increase /** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|----------------|------------|----------------------------|------------|
| ** **                                    | ** ** | **2004**                          | ** ** | **2003**       | ** ** | **(Decrease)**             | ** ** | **(Decrease)** | ** ** |
| Costs of  software licenses and subscriptions |       | $                                 | 2,582,627  |           | $          | 2,563,400                  |       | 19,227 |   | 0.8 | % |
| Costs of  maintenance and services            |       | 2,710,562                         |       | 2,368,556      |       | 342,006                    |       | 14.4 | % |
| Sales and  marketing expenses                 |       | 7,629,058                         |       | 6,128,640      |       | 1,500,418                  |       | 24.5 | % |
| Engineering and  product development expenses |       | 1,451,533                         |       | 1,507,223      |       | (55,690                    | )          | (3.7 | )% |
| General and  administrative expenses          |       | 4,036,680                         |       | 4,136,740      |       | (100,060                   | )          | (2.4 | )% |
| Restructuring  and centralization costs       |       | —                            |       | 181,459        |       | (181,459                   | )          | (100.0 | )% |
|                                          |       |                              |       |           |       |                       |       |   |   |
| Total costs and  operating expenses           |       | $                                 | 18,410,460 |           | $          | 16,886,018                 |       | $ | 1,524,442 |   | 9.0 | % |
|                                               |            |                                   |            |                |            |                            |            |  |  |  |  |  |

 

Cost of software licenses and subscriptions for thefiscal year ended September 30, 2004 was $2,582,627 or approximately 21%of software license and subscription revenues, as compared to $2,563,400 orapproximately 21% of software license revenues for the fiscal year ended September 30,2003.

 

Cost of maintenance and services for the fiscal yearended September 30, 2004 was $2,710,562 or approximately 39% ofmaintenance and service revenues, as compared to $2,368,556 or approximately43% of maintenance and service revenues, for the fiscal year ended September 30,2003.  While gross margins on maintenanceand services improved in fiscal 2004 when compared to fiscal 2003, overallcosts increased primarily due to the use of third-party consultants tosupplement the Company’s internal consulting and training staff inrevenue-generating activities (increase of $217,000) and increased technicalsupport staff salaries and related expenses (increase of $133,000).

 

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Sales and marketing expenses were $7,629,058 for thefiscal year ended September 30, 2004, which represents an increase of$1,500,418, or approximately 24%, from $6,128,640 for the fiscal year ended September 30,2003.  This increase is primarilyattributable to increased sales staff salaries and related expenses (increaseof $1,409,000) and increased marketing expenses for lead generation (increaseof $168,000), trade show expense (increase of $49,000) and web site development(increase of $44,000), partially offset by a decrease in advertising expenses(decrease of $166,000).

 

Engineering and product development expenses were$1,451,533 for the fiscal year ended September 30, 2004, which representsa decrease of $(55,690) or approximately 4% from $1,507,223 for the fiscal yearended September 30, 2003.  Thisdecrease is attributable to reduced engineering and development expensesrelated to the Visual|HD product (decrease of $128,000) and decreased costs foremployee severance payments (decrease of $90,000), partially offset byincreased development costs outsourced to third party developers (increase of$172,000).  During fiscal 2004, theCompany capitalized $191,000 in software development costs.  This compares to $109,000 capitalized duringfiscal 2003.  This increase incapitalized costs is primarily due to increased capitalized costs associatedwith development projects to increase the functionality and improve theperformance of the Company’s enterprise products.

 

General and administrative expenses were $4,036,680for the fiscal year ended September 30, 2004, which represents a decreaseof $(100,060) or approximately 2% from $4,136,740 for the fiscal year ended September 30,2003.  This decrease is primarilyattributable to reductions in international general and administrative expenses(decrease of $118,000).

 

As a result of the foregoing, income before incometaxes for the year ended September 30, 2004 was $958,000, which comparesto income before taxes of $852,000 for the year ended September 30,2003.  In 2004, the Company recorded abenefit for income taxes of approximately $126,650 which included therecognition of a $148,000 reduction in the valuation allowance as a result ofrealizing the tax benefit of certain of the Company’s deferred tax assets dueto deferred tax liabilities associated with the Mergence acquisition, partiallyoffset by the recording of a provision for income taxes primarily due to anestimated federal tax liability for alternative minimum tax due.  In fiscal 2003, the Company recorded aprovision for income taxes of $5,500, primarily due to an estimated federal taxliability for alternative minimum tax due. No tax benefits or provisions were recorded in either fiscal 2004 orfiscal 2003 in any other jurisdiction due to the Company’s current estimatethat it will not be in a significant taxable position in any other jurisdictionowing primarily to the availability of loss carryforwards for which valuationallowances had previously been provided. At September 30, 2004, the Company had federal tax losscarryforwards available to offset future taxable income of approximately $5million (plus approximately $2 million in state tax loss carryforwards and $6million in tax loss carryforwards in foreign jurisdictions); a full valuationreserve has been established against these assets as uncertainty continues toexist regarding the Company’s ability to generate sufficient future taxableincome for the utilization of these losses and the Company has determined thatit is not more likely than not that future taxable income will be sufficient torealize a tax benefit from its loss carryforwards.

 

Net income for the year ended September 30, 2004was $1,084,776, which compares to net income of $846,545 for the year ended September 30,2003.

 

**OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUALOBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS**

 

The Company leases various facilities, equipment andautomobiles in the U.S. and overseas under noncancelable operating leases thatexpire through 2011.  The leaseagreements generally provide for the payment of minimum annual rentals, prorata share of taxes, and maintenance expenses. Rental expense for all operating leases was approximately $663,664, $678,677and $766,416 for Fiscal 2005, 2004 and 2003, respectively.  The current U.S. facilities lease is due toexpire in January 2006.

 

On September 28,2005, The Company entered into a sublease agreement (the “Sublease”). Under theterms of the Sublease, the Company’s U.S. headquarters will move from itspresent location at 175 Cabot Street, Lowell, Massachusetts to 271 Mill Road,Chelmsford, Massachusetts. The new headquarters will consist of approximately14,683 square feet. The Sublease is for a period of sixty-six (66) months.The aggregate rent for the term of the Sublease is approximately $735,985. Inaddition to rent, the Sublease requires the Company to pay certain taxes,insurance and operating costs related to the leased building based on theCompany’s pro-rata share. The Company is also responsible for the costs ofcertain tenant improvements associated with the new facility but will beentitled to reimbursement for certain costs from sublessor.

 

As of September 30,2005, minimum rental commitments under noncancelable operating leases are asfollows:

 

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| **Contractual Obligations:** | ** ** | **Total** | ** ** | **Less than 1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than 5 Years** | ** ** |
|------------------------------|------------|-----------|------------|----------------------|------------|---------------|------------|---------------|------------|-----------------------|------------|
| Operating Lease Obligations  |       | $         | 1,033,539  |                 | 253,587    |          | 309,012    |          | 337,875    |                  | 133,065    |   |
|                              |            |           |            |                      |            |               |            |               |            |                       |            |  |

 

The Company is also obligated to pay royalties rangingfrom 7% to 50% on revenue generated by the sale of certain licensed softwareproducts. Royalty expense included in cost of software licenses wasapproximately $1,659,308, $1,677,231 and $1,583,921, respectively, for the yearended September 30, 2005, 2004 and 2003. The Company is not obligated to pay any minimum amounts for royalties.

 

On August 11, 2004, the Company acquired 100% ofthe shares of Mergence Technologies Corporation. The purchase agreementincludes a provision for quarterly cash payments to the former Mergenceshareholders equal to 10% of revenue, as defined, of the Datawatch|Researcherproduct until September 30, 2010, not all Mergence products are subject toroyalties.  The Company expensedapproximately $10,400 for the year ended September 30, 2005.    See Note 2 to the Consolidated FinancialStatements which appear elsewhere herein for more detailed financialinformation on the acquisition of Mergence.

 

The Company’s software products are sold underwarranty against certain defects in material and workmanship for a period of 30to 90 days from the date of purchase. If necessary, the Company would providefor the estimated cost of warranties based on specific warranty claims andclaim history. However, the Company has never incurred significant expenseunder its product or service warranties. As a result, the Company believes theestimated fair value of these warranty agreements is minimal. Accordingly,there are no liabilities recorded for warranty claims as of September 30,2005.

 

The Company is required by the lease related to itsLowell, Massachusetts facility to provide a letter of credit in the amount ofapproximately $143,000 as a security deposit to the landlord of amounts due underthe lease. Cash on deposit providing security in the amount of this letter ofcredit is classified as part of restricted cash in the Company’s consolidated balancesheets as of September 30, 2005 and 2004.

 

The Company is also required by the new subleaseagreement related to its Chelmsford, Massachusetts facility to provide a letterof credit in the amount of approximately $125,000 as a security deposit to thelandlord of amounts due under the lease. Cash on deposit providing security inthe amount of this letter of credit is classified as part of restricted cash inthe Company’s consolidated balance sheets as of September 30, 2005.

 

In the August 2004 Stock Purchase Agreement forthe acquisition of Mergence, the Company made certain warranties regarding,among other things, its legal authority to enter into the agreementconsummating the acquisition and its ability to continue in its business.  The Company further agreed to indemnify thesellers of Mergence and hold them harmless for any damages incurred or sufferedarising out of any misrepresentation or breach of such warranties made by theCompany in the agreement.  The Companybelieves that no such misrepresentations or breaches of warranty exist, or arelikely to exist in the future, and, accordingly, has recorded no liabilitiesrelated to such indemnification.

 

The Company enters into indemnification agreements inthe ordinary course of business. Pursuant to these agreements, the Companyagrees to indemnify, hold harmless, and reimburse the indemnified party forlosses suffered or incurred by the indemnified party, generally its customers,in connection with any patent, copyright or other intellectual propertyinfringement claim by any third party with respect to the Company’s products.The term of these indemnification agreements is generally perpetual. Themaximum potential amount of future payments the Company could be required tomake under these indemnification agreements is unlimited. The Company has neverincurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, the Company believes the estimatedfair value of these agreements is minimal. Accordingly, the Company has noliabilities recorded for these agreements as of September 30, 2005.

 

Certain of the Company’s agreements also provide forthe performance of services at customer sites. These agreements may containindemnification clauses, whereby the Company will indemnify the customer fromany and all damages, losses, judgments, costs and expenses for acts of itsemployees or subcontractors resulting in bodily injury or property damage. Themaximum potential amount of future payments the Company could be required tomake under these indemnification agreements is unlimited; however, the Companyhas general and umbrella insurance policies that would enable us to recover aportion of any amounts paid. The Company has never incurred costs to defendlawsuits or settle claims related to these indemnification agreements. As aresult, the Company believes the estimated fair value of these agreements isminimal. Accordingly, the Company has no liabilities recorded for theseagreements as of September 30, 2005.

 

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Aspermitted under Delaware law, the Company has agreements with its directorswhereby the Company will indemnify them for certain events or occurrences whilethe director is, or was, serving at the Company’s request in such capacity. Theterm of the director indemnification period is for the later of ten years afterthe date that the director ceases to serve in such capacity or the finaltermination of proceedings against the director as outlined in theindemnification agreement. The maximum potential amount of future payments theCompany could be required to make under these indemnification agreements isunlimited; however, the Company’s director and officer insurance policy limitsthe Company’s exposure and enables it to recover a portion of any futureamounts paid. As a result of its insurance policy coverage, the Companybelieves the estimated fair value of these indemnification agreements isminimal. The Company has no liabilities recorded for these agreements as of September 30,2005.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

TheCompany had net income of approximately $800,000 for the year ended September 30,2005 as compared to net income of approximately $1,085,000 and $847,000,respectively, for the years ended September 30, 2004 and 2003.  During the years ended September 30,2005, and 2004, approximately $1,163,000 and $1,665,000 cash was provided bythe Company’s operations, respectively. During fiscal year 2005, the main source of cash from operations was netincome before depreciation and amortization. Net operating cash flow was reduced by cash payments made in fiscal 2005for accrued expenses and accounts payable recorded in fiscal 2004 related toaccounting fees, legal fees and year-end bonus amounts.  Net operating cash flow was also reduced byan increase in the accounts receivable balances, due to the timing of invoicingand cash collections at year end.

 

Net cash used in investing activities for the yearended September 30, 2005 of $523,000 is primarily the result of thepurchase of fixed assets such as computer hardware and software, the purchaseof new telecommunication equipment for the U.S. facility and the cash outlayfor the security deposit on the new sublease.

 

Net cash provided by financing activities for the yearended September 30, 2005 of $82,000 is related to  cash received from the exercise of employeestock options.

 

During fiscal 2004, the Company introduced asubscription sales model for the sale of its enterprise products.  This new pricing model allows customers tobegin using the Company’s products at a lower initial cost of softwareacquisition when compared to the more traditional perpetual license sale.  While this initiative is designed to increasethe number of enterprise solutions sold and also reduce dependency onshort-term sales by building a recurring revenue stream, it introducesincreased risks for the Company primarily associated with the timing of revenuerecognition and reduced cash flows.  Thesubscription model delays revenue recognition when compared to the typical perpetuallicense sale and also, as the Company allows termination of certainsubscriptions with 90 days notice, could result in decreased revenue forsolutions sold under the model if the Company experiences a high percentage ofsubscription cancellations during the first two years of the subscription.  Further, as amounts due from customers areinvoiced over the life of the subscription, there are delayed cash flows fromsubscription sales when compared to perpetual license sales.

 

The Mergence purchase agreement includes a provisionfor quarterly cash payments to the former Mergence shareholders equal to 10% ofrevenue, as defined, of the Datawatch|Researcher product for a period of sixyears, but not all Mergence products are subject to royalties.  As the cash payments are based on recognizedrevenue and no minimum payments are required, they are not expected to have asignificant impact on the Company’s liquidity or cash flows.  See the section titled **OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENTLIABILITIES AND COMMITMENTS** included elsewhere herein for a morecomplete disclosure of the Company’s commitments and contingent liabilities.

 

An existing agreement between Datawatch and MathStrategies grants the Company exclusive worldwide rights to use and distributecertain intellectual property owned by Math Strategies and incorporated by theCompany in its Monarch, Monarch Data Pump, VorteXML and certain other products.In April 2004, the Company entered into an Option Purchase Agreement withMath Strategies giving the Company the option to purchase these intellectualproperty rights for $8 million. This option, if exercised, would provide theCompany with increased flexibility to utilize the purchased technology in thefuture. The option can be exercised by Datawatch at any time during the twoyears following the effective date of the Option Purchase Agreement.

 

Management believes that its current cash balances andcash generated from operations will be sufficient to meet the Company’s cashneeds for working capital and anticipated capital expenditures for at least thenext twelve months. The Company currently anticipates approximately $400,000 ofcash requirements, during that time, to fund capital expenditures for

 

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thenew U.S. facility.  The Company does notcurrently anticipate cash requirements to fund significant growth or theacquisition of complementary technology or businesses.  However, if in the future, such expendituresare anticipated or required, the Company may need to seek additional financingby issuing equity or obtaining credit facilities to fund such requirements.

 

Managementbelieves that the Company’s current operations have not been materiallyimpacted by the effects of inflation.

 

**RECENTACCOUNTING PRONOUNCEMENTS**

 

On December 16,2004, the FASB issued SFAS No. 123(R), *Share-BasedPayment* (“SFAS No. 123(R)”). SFAS No. 123(R) focuses primarily on accounting for transactions inwhich an entity obtains services in share-based payment transactions. TheStatement requires entities to recognize stock compensation expense for awardsof equity instruments to employees based on the grant-date fair value of thoseawards (with limited exceptions). On April 14, 2005, the Securities andExchange Commission adopted a rule amending SFAS 123(R) *“Share-Based Payment”*deferring the effective date of SFAS123(R) for public companies to fiscal years beginning after June 15,2005.  The Company will be required toadopt SFAS 123(R) beginning October 1, 2005 for new awards of stock-basedcompensation granted after that date. At September 30, 2005, alloutstanding options were fully vested, therefore management does not anticipatefuture compensation expense, related to existing options or future optiongrants, to be significant under SFAS 123(R). Future grants of stock-based awards will be recorded at fair value inthe financial statements.

 

**RISKFACTORS**

 

The Company does not provide forecasts of its futurefinancial performance.  However, fromtime to time, information provided by the Company or statements made by itsemployees may contain “forward looking” information that involves risks anduncertainties.  In particular, statementscontained 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 ofFinancial Condition and Results of Operations” of Part II of this AnnualReport on Form 10-K relating to liquidity and capital resources) mayconstitute forward looking statements and are made under the safe harborprovisions of The Private Securities Litigation Reform Act of 1995.  The Company cautions readers not to placeundue reliance on any such forward looking-statements, which speak only as ofthe date they are made.  The Companydisclaims any obligation, except as specifically required by law and the rules ofthe Securities and Exchange Commission, to publicly update or revise any suchstatements to reflect any change in the Company’s expectations or in events,conditions or circumstances on which any such statements may be based, or thatmay affect the likelihood that actual results will differ from those set forthin the forward-looking statements.  TheCompany’s actual results of operations and financial condition have varied andmay in the future vary significantly from those stated in any forward lookingstatements.  Factors that may cause suchdifferences include, without limitation, the risks, uncertainties and otherinformation discussed below and within this Annual Report on Form 10-K, aswell as the accuracy of the Company’s internal estimates of revenue andoperating expense levels.  The followingdiscussion of the Company’s risk factors should be read in conjunction with thefinancial statements contained herein and related notes thereto.  Such factors, among others, may have amaterial adverse effect upon the Company’s business, results of operations andfinancial condition.

 

Subscription Sales Model Risk

 

During fiscal 2004, the Company introduced asubscription sales model for the sale of its enterprise products.  This new pricing model allows customers tobegin using the Company’s products at a lower initial cost of softwareacquisition when compared to the more traditional perpetual license sale.  While this initiative is designed to increasethe number of enterprise

 

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solutionssold and also reduce dependency on short-term sales by building a recurringrevenue stream, it introduces increased risks for the Company primarilyassociated with the timing of revenue recognition and reduced cash flows.  The subscription model delays revenuerecognition when compared to the typical perpetual license sale and also, asthe Company allows termination of certain subscriptions with 90 days notice,could result in decreased revenue for solutions sold under the model if theCompany experiences a high percentage of subscription cancellations during thefirst two years of the subscription. Further, as amounts due from customers are invoiced over the life of thesubscription, there are delayed cash flows from subscription sales whencompared to perpetual license sales.

 

Fluctuations in Quarterly Operating Results

 

The Company’s future operating results could varysubstantially from quarter-to-quarter because of uncertainties and/or risksassociated with such things as technological change, competition, and delays inthe introduction of products or product enhancements and general markettrends.  Historically, the Company hasoperated with little backlog of orders because its software products aregenerally shipped as orders are received. As a result, net sales in any quarter are substantially dependent onorders booked and shipped in that quarter. Further, the Company’s introduction of the subscription sales modelcould result in decreased revenues over the short term.  Because the Company’s staffing and operatingexpenses are based on anticipated revenue levels and a high percentage of theCompany’s costs are fixed in the short-term, small variations in the timing ofrevenues can cause significant variations in operating results fromquarter-to-quarter.  Because of thesefactors, the Company believes that period-to-period comparisons of its resultsof operations are not necessarily meaningful and should not be relied upon asindications of future performance.  Therecan be no assurance that the Company will not experience such variations inoperating results in the future or that such variations will not have amaterial adverse effect on the Company’s business, financial condition orresults of operation.

 

Weakening of World Wide Economic Conditions and theComputer Software Market May Result in Lower Revenue Growth Rates orDecreased Revenues

 

The revenue growth and profitability of the Company’sbusiness depends on the overall demand for computer software and services,particularly in the markets in which it competes.  Because the Company’s sales are primarily tomajor corporate customers, its business also depends on general economic andbusiness conditions.  A softening ofdemand for computer software and services caused by a weakening of the economyin the United States or abroad, may result in lower revenue growth rates,decreased revenues and reduced profitability. In addition, terrorist attacks against the United States, and the UnitedStates military response to these attacks have added to economic and politicaluncertainty which may adversely affect worldwide demand for computer softwareand services and result in significant fluctuations in the value of foreigncurrencies.  In a weakened economy, theCompany cannot be assured that it will be able to effectively promote futuregrowth in its software and services revenues or maintain profitability.

 

Dependence on Principal Products

 

In the year ended September 30, 2005, Monarch,Datawatch|ES and Visual|QSM and Visual|HD accounted for approximately 59%, 15%and 26%, respectively, of the Company’s total revenue.  The Company is wholly dependent on theMonarch, Datawatch|ES, Visual|QSM, Visual|HD and the recently acquiredDatawatch|Researcher and iMergence products. As a result, any factor adversely affecting sales of any of theseproducts could have a material adverse effect on the Company.  The Company’s future financial performancewill depend in part on the successful introduction of its new and enhancedversions of these products and development of new versions of these and otherproducts and subsequent acceptance of such new and enhanced products.  In addition, competitive pressures or otherfactors may result in significant price erosion that could have a materialadverse effect on the Company’s business, financial condition, results ofoperations, or cash flows.

 

International Sales

 

In the year ended September 30, 2005, 2004 and2003, international sales, including export sales from domestic operations,accounted for approximately 38%, 41% and 39%, respectively, of the Company’stotal revenue.  The Company anticipatesthat international sales will continue to account for a significant percentageof its total revenue.  A significantportion of the Company’s total revenue will therefore be subject to risksassociated with international sales, including unexpected changes in legal andregulatory requirements, changes in tariffs, exchange rates and other barriers,political and economic instability, possible effects of war and acts ofterrorism, difficulties in account receivable collection, difficulties inmanaging distributors or representatives, difficulties in staffing and managinginternational operations, difficulties in protecting the Company’s intellectualproperty overseas, seasonality of sales and potentially adverse taxconsequences.

 

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Acquisition Strategy

 

As evidenced by its August 2004 acquisition ofMergence Technologies Corporation and its October 2002 acquisition ofAuxilor Inc., the Company continues to address the need to develop newproducts, in part, through the acquisition of other companies.  Acquisitions involve numerous risks includingdifficulties in the assimilation of the operations, technologies and productsof the acquired companies, the diversion of management’s attention from otherbusiness concerns, risks of entering markets in which the Company has no orlimited direct prior experience and where competitors in such markets havestronger market positions, and the potential loss of key employees of theacquired company.  Achieving andmaintaining the anticipated benefits of an acquisition will depend in part uponwhether the integration of the companies’ business is accomplished in anefficient and effective manner, and there can be no assurance that this willoccur.  The successful combination ofcompanies in the high technology industry may be more difficult to accomplishthan in other industries.

 

Dependence on New Introductions; New Product Delays

 

Growth in the Company’s business depends insubstantial part on the continuing introduction of new products.  The length of product life cycles depends inpart on end-user demand for new or additional functionality in the Company’sproducts. If the Company fails to accurately anticipate the demand for, orencounters any significant delays in developing or introducing, new products oradditional functionality on its products, there could be a material adverseeffect on the Company’s business. Product life cycles can also be affected bythe introduction by suppliers of operating systems of comparable functionalitywithin their products.  The failure ofthe Company to anticipate the introduction of additional functionality inproducts developed by such suppliers could have a material adverse effect onthe Company’s business.  In addition, theCompany’s competitors may introduce products with more features and lowerprices than the Company’s products.  Suchincrease in competition could adversely affect the life cycles of the Company’sproducts, which in turn could have a material adverse effect on the Company’sbusiness.

 

Software products may contain undetected errors orfailures when first introduced or as new versions are released.  There can be no assurance that, despitetesting by the Company and by current and potential end-users, errors will notbe found in new products after commencement of commercial shipments, resultingin loss of or delay in market acceptance. Any failure by the Company to anticipate or respond adequately tochanges in technology and customer preferences, or any significant delays inproduct development or introduction, could have a material adverse effect onthe Company’s business.

 

Rapid Technological Change

 

The markets in which the Company competes haveundergone, and can be expected to continue to undergo, rapid and significanttechnological change.  The ability of theCompany to grow will depend on its ability to successfully update and improveits existing products and market and license new products to meet the changingdemands of the marketplace and that can compete successfully with the existingand new products of the Company’s competitors. There can be no assurance that the Company will be able to successfullyanticipate and satisfy the changing demands of the personal computer softwaremarketplace, that the Company will be able to continue to enhance its productofferings, or that technological changes in hardware platforms or softwareoperating systems, or the introduction of a new product by a competitor, willnot render the Company’s products obsolete.

 

Competition in the PC Software Industry

 

The software market for personal computers is highlycompetitive and characterized by continual change and improvement intechnology.  Several of the Company’sexisting and potential competitors, including BMC Software, ActuateCorporation, Mobius Management Systems, Inc., and others, havesubstantially greater financial, marketing and technological resources than theCompany.  No assurance can be given thatthe Company will have the resources required to compete successfully in thefuture.

 

Dependence on Proprietary Software Technology

 

The Company’s success is dependent upon proprietarysoftware technology.  Although theCompany does not own all patents on any such technology, it does hold exclusivelicenses to such technology and relies principally on a combination of tradesecret, copyright and trademark laws, nondisclosure and other contractualagreements and technical measures to protect its rights to such proprietarytechnology.  Despite such precautions,there can be no assurance that such steps will be adequate to deter misappropriationof such technology.

 

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Reliance on Software License Agreements

 

Substantially all of the Company’s productsincorporate third-party proprietary technology which is generally licensed tothe Company on an exclusive, worldwide basis. Failure by such third-parties tocontinue to develop technology for the Company and license such technology tothe Company could have a material adverse effect on the Company’s business andresults of operations.

 

Dependence on the Ability to Hire and Retain SkilledPersonnel

 

Qualified personnel are in great demand throughout thesoftware industry.  The Company’s successdepends, in large part, upon its ability to attract, train, motivate and retainhighly skilled employees, particularly, technical personnel and productdevelopment and professional services personnel, sales and marketing personneland other senior personnel. The Company’s failure to attract and retain thehighly trained technical personnel that are integral to the Company’s productdevelopment, professional services and direct sales teams may limit the rate atwhich the Company can generate sales and develop new products or productenhancements. A change in key management could result in transition and attritionin the affected department.  This couldhave a material adverse effect on the Company’s business, operating results andfinancial condition.

 

Indirect Distribution Channels

 

The Company sells a significant portion of itsproducts through resellers, none of which are under the direct control of theCompany. The loss of major resellers of the Company’s products, or asignificant decline in their sales, could have a material adverse effect on theCompany’s operating results. There can be no assurance that the Company will beable to attract or retain additional qualified resellers or that any suchresellers will be able to effectively sell the Company’s products. The Companyseeks to select and retain resellers on the basis of their business credentialsand their ability to add value through expertise in specific vertical marketsor application programming expertise. In addition, the Company relies onresellers to provide post-sales service and support, and any deficiencies insuch service and support could adversely affect the Company’s business.

 

Volatility of Stock Price

 

As is frequently the case with the stocks of hightechnology companies, the market price of the Company’s common stock has been,and may continue to be, volatile. Factors such as quarterly fluctuations inresults of operations, increased competition, the introduction of new productsby the Company or its competitors, expenses or other difficulties associatedwith assimilating companies acquired by the Company, changes in the mix of saleschannels, the timing of significant customer orders, and macroeconomicconditions generally, may have a significant impact on the market price of thestock of the Company. Any shortfall in revenue or earnings from the levelsanticipated by securities analysts could have an immediate and significantadverse effect on the market price of the Company’s common stock in any givenperiod. In addition, the stock market has from time to time experienced extremeprice and volume fluctuations, which have particularly affected the marketprice for many high technology companies and which, on occasion, have appearedto be unrelated to the operating performance of such companies.

 

**Item7(A).  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

DerivativeFinancial Instruments, Other Financial Instruments, and Derivative CommodityInstruments

 

At September 30, 2005, the Company did notparticipate in any derivative financial instruments, or other financial andcommodity instruments.  The Company holdsno investment securities that possess significant market risk.

 

Primary Market RiskExposures

 

The Company’s primary market risk exposure is currencyexchange rate risk.  Internationalrevenues and expenses are generally transacted by the Company’s foreignsubsidiaries in their respective countries and are denominated in localcurrency.  Approximately 36%, 39% and 38%of the Company’s revenues for 2005, 2004 and 2003, respectively, were fromforeign subsidiaries.  In addition,approximately 37%, 37% and 36% of the Company’s expenses for fiscal 2005, 2004and 2003, respectively, were from foreign subsidiaries.

 

The Company’s exposure to currency exchange ratefluctuations has been and is expected to continue to be modest due to the factthat the operations of its international subsidiaries are almost exclusivelyconducted in their respective local

 

24

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currencies,and dollar advances to the Company’s international subsidiaries, if any, areusually considered to be of a long-term investment nature. Therefore, themajority of currency movements are reflected in the Company’s othercomprehensive income. There are, however, certain situations where the Companywill invoice customers in currencies other than its own. Such gains or lossesfrom operating activity, whether realized or unrealized, are reflected in otherincome (expense), net in our consolidated statement of operations. These havenot been material in the past nor does management believe that they will bematerial in the future. Currently the Company does not engage in foreigncurrency hedging activities.

 

25

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**Item 8.   FINANCIAL STATEMENTSAND SUPPLEMENTARY DATA**

 

Thefollowing consolidated financial statements and the related notes thereto ofDatawatch Corporation and the Report of Independent Registered PublicAccounting Firm thereon are filed as part of this Annual Report on Form 10-K.

 
| REPORT OF INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM                                                                                      | 27     |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                          |   |
| CONSOLIDATED  FINANCIAL STATEMENTS AS OF SEPTEMBER 30, 2005 and 2004 AND FOR EACH OF THE  THREE YEARS IN THE PERIOD ENDED SEPTEMBER 30, 2005: |   |
|                                                                                                                                          |   |
| Consolidated Balance Sheets                                                                                                                   | 28     |
|                                                                                                                                          |   |
| Consolidated Statements of  Operations                                                                                                        | 29     |
|                                                                                                                                          |   |
| Consolidated Statements of  Shareholders’ Equity                                                                                         | 30     |
|                                                                                                                                          |   |
| Consolidated Statements of  Cash Flows                                                                                                        | 31     |
|                                                                                                                                          |   |
| Notes to Consolidated  Financial Statements                                                                                                   | 32     |

 

26

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Board of Directorsand Shareholders ofDatawatch CorporationLowell, Massachusetts

 

We have audited theaccompanying consolidated balance sheets of Datawatch Corporation andsubsidiaries (the “Company”) as of September 30, 2005 and 2004, and the relatedconsolidated statements of operations, shareholders’ equity, and cash flows foreach of the three years in the period ended September 30, 2005.  Thesefinancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements basedon our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement.  The Company is not required to have, norwere we engaged to perform, an audit of its internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting.  Accordingly, we express nosuch opinion.  An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of the Datawatch Corporation and subsidiaries as of September30, 2005 and 2004, and the results of their operations and their cash flows foreach of the three years in the period ended September 30, 2005 in conformitywith accounting principles generally accepted in the United States of America.

 

/s/*DELOITTE & TOUCHE LLP*

 

Boston, Massachusetts

December 12, 2005

 

27

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**DATAWATCH CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| ** **                                                                                                                                                                                   | ** ** | ** **        | ** ** | ** **        | ** ** |
| **ASSETS**                                                                                                                                                                                   | ** ** | ** **        | ** ** | ** **        | ** ** |
| CURRENT ASSETS:                                                                                                                                                                              |       |              |       |              |       |
| Cash and equivalents                                                                                                                                                                         |       | $                 | 4,900,873  |              | $          | 4,260,632 |   |
| Restricted cash                                                                                                                                                                              |       | 268,299           |       | —            |       |
| Accounts receivable, less allowance for  doubtful accounts and sales returns of $417,000 in 2005 and $416,000 in 2004                                                                        |       | 4,097,283         |       | 3,672,218         |       |
| Inventories                                                                                                                                                                                  |       | 54,712            |       | 67,955            |       |
| Prepaid expenses                                                                                                                                                                             |       | 541,108           |       | 614,566           |       |
| Total current assets                                                                                                                                                                         |       | 9,862,275         |       | 8,615,371         |       |
|                                                                                                                                                                                         |       |              |       |              |       |
| Property and Equipment:                                                                                                                                                                      |       |              |       |              |       |
| Office furniture and equipment                                                                                                                                                               |       | 1,569,875         |       | 1,711,772         |       |
| Manufacturing and engineering equipment                                                                                                                                                      |       | 205,595           |       | 204,799           |       |
|                                                                                                                                                                                         |       | 1,775,470         |       | 1,916,571         |       |
| Less accumulated depreciation and  amortization                                                                                                                                              |       | (1,259,058        | )          | (1,483,004        | )          |
| Net property and equipment                                                                                                                                                                   |       | 516,412           |       | 433,567           |       |
|                                                                                                                                                                                         |       |              |       |              |       |
| Goodwill                                                                                                                                                                                     |       | 1,630,646         |       | 1,632,646         |       |
| Other intangible assets, net                                                                                                                                                                 |       | 1,250,825         |       | 1,650,507         |       |
| Restricted cash                                                                                                                                                                              |       | 125,000           |       | 268,299           |       |
| Other                                                                                                                                                                                        |       | 27,098            |       | 28,404            |       |
|                                                                                                                                                                                         |       | $                 | 13,412,256 |              | $          | 12,628,794 |   |
|                                                                                                                                                                                         |       |              |       |              |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                               |       |              |       |              |       |
| CURRENT LIABILITIES:                                                                                                                                                                         |       |              |       |              |       |
| Accounts payable                                                                                                                                                                             |       | $                 | 1,042,755  |              | $          | 1,137,539 |   |
| Accrued expenses                                                                                                                                                                             |       | 2,013,994         |       | 2,026,830         |       |
| Deferred revenue                                                                                                                                                                             |       | 2,921,519         |       | 2,903,123         |       |
| Escrow for Mergence shareholders                                                                                                                                                             |       | 128,224           |       | —            |       |
| Total current liabilities                                                                                                                                                                    |       | 6,106,492         |       | 6,067,492         |       |
|                                                                                                                                                                                         |       |              |       |              |       |
| ESCROW FOR MERGENCE SHAREHOLDERS (Note 2)                                                                                                                                                    |       | —            |       | 125,373           |       |
| COMMITMENTS AND CONTINGENCIES (Note 1, 2,  5, 6 and 7)                                                                                                                                       |       |              |       |              |       |
| SHAREHOLDERS’ EQUITY:                                                                                                                                                                   |       |              |       |              |       |
| Common stock, par value $.01- 20,000,000  shares authorized; issued, 5,383,084 shares and 5,315,108 shares,  respectively; outstanding, 5,368,838 shares and 5,300,862 shares,  respectively |       | 53,831            |       | 53,151            |       |
| Additional paid-in capital                                                                                                                                                                   |       | 21,957,409        |       | 21,828,621        |       |
| Accumulated deficit                                                                                                                                                                          |       | (14,187,048       | )          | (14,987,462       | )          |
| Accumulated other comprehensive loss                                                                                                                                                         |       | (378,040          | )          | (317,993          | )          |
|                                                                                                                                                                                         |       | 7,446,152         |       | 6,576,317         |       |
| Less treasury stock, at cost - 14,246  shares                                                                                                                                                |       | (140,388          | )          | (140,388          | )          |
| Total shareholders’ equity                                                                                                                                                              |       | 7,305,764         |       | 6,435,929         |       |
|                                                                                                                                                                                         |       |              |       |              |       |
|                                                                                                                                                                                         |       | $                 | 13,412,256 |              | $          | 12,628,794 |   |

 

*See notes to consolidated financial statements.*

 

28

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**DATAWATCH CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                     | ** ** | **Year Ended September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| REVENUE:                                       |       |                         |       |   |   |   |   |
| Software licenses and subscriptions            |       | $                            | 14,232,946 |   | $ | 12,441,667 |   | $ | 12,209,857 |   |
| Maintenance and services                       |       | 7,278,649                    |       | 6,893,479 |   | 5,502,349 |   |
| Total Revenue                                  |       | 21,511,595                   |       | 19,335,146 |   | 17,712,206 |   |
| COSTS AND EXPENSES:                            |       |                         |       |   |   |   |   |
| Cost of software licenses and subscriptions    |       | 2,515,060                    |       | 2,582,627 |   | 2,563,400 |   |
| Cost of maintenance and services               |       | 3,438,319                    |       | 2,710,562 |   | 2,368,556 |   |
| Sales and marketing                            |       | 8,686,672                    |       | 7,629,058 |   | 6,128,640 |   |
| Engineering and product development            |       | 2,031,280                    |       | 1,451,533 |   | 1,507,223 |   |
| General and administrative                     |       | 4,151,894                    |       | 4,036,680 |   | 4,136,740 |   |
| Restructuring costs                            |       | —                       |       | — |   | 181,459 |   |
| Total costs and expenses                       |       | 20,823,225                   |       | 18,410,460 |   | 16,886,018 |   |
| INCOME FROM OPERATIONS                         |       | 688,370                      |       | 924,686 |   | 826,188 |   |
| Interest expense                               |       | (2,899                       | )          | (622 | ) | (7,243 | ) |
| Interest income                                |       | 84,687                       |       | 61,062 |   | 40,568 |   |
| Foreign currency transaction gains (losses)    |       | 8,256                        |       | (27,000 | ) | (7,468 | ) |
| INCOME FROM OPERATIONS BEFORE INCOME TAXES     |       | 778,414                      |       | 958,126 |   | 852,045 |   |
| (BENEFIT) PROVISION FOR INCOME TAXES           |       | (22,000                      | )          | (126,650 | ) | 5,500 |   |
|                                           |       |                         |       |   |   |   |   |
| NET INCOME                                     |       | $                            | 800,414    |   | $ | 1,084,776 |   | $ | 846,545 |   |
|                                           |       |                         |       |   |   |   |   |
| Net income per share -Basic:                   |       | $                            | 0.15       |   | $ | 0.21 |   | $ | 0.16 |   |
| Net income per share -Diluted:                 |       | $                            | 0.14       |   | $ | 0.19 |   | $ | 0.16 |   |
|                                           |       |                         |       |   |   |   |   |
| Weighted-Average Shares Outstanding - Basic    |       | 5,317,400                    |       | 5,267,520 |   | 5,196,824 |   |
| Weighted-Average Shares Outstanding -  Diluted |       | 5,773,585                    |       | 5,753,433 |   | 5,444,692 |   |

 

*See notes to consolidated financial statements.*

 

29

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**DATAWATCH CORPORATION**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY**

** **

**Years Ended September 30, 2005, 2004 and 2003**

 
| ** **                                        | ** ** | ** **        | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**   | ** **  | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|-------------------|-------------|---------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                        | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **        | ** ** | **Other**         | ** **  | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **Common  Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Comprehensive** | ** **  | **Treasury  Stock** | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**       | ** ** | **Loss**          | ** **  | **Income**          | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Total**  | ** ** |
|                                              |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| BALANCE,  SEPTEMBER 30, 2002                      |       | 5,175,210         |       | $           | 51,752     |            | $          | 21,583,679        |       | $                 | (16,918,783 | )                   | $          | (516,048   | )          |       |       | (14,246    | )          | $ | (140,388 | ) | $ | 4,060,212 |   |
| Issuance of  common stock for Auxilor acquisition |       | 29,528            |       | 295         |       | 49,705          |       | —            |       | —            |        |                |       | —     |       | —     |       | 50,000     |       |
| Stock options  exercised                          |       | 39,590            |       | 396         |       | 64,102          |       | —            |       | —            |        |                |       | —     |       | —     |       | 64,498     |       |
| Director stock  option acceleration               |       | —            |       | —      |       | 3,811           |       | —            |       | —            |        |                |       | —     |       | —     |       | 3,811      |       |
| Comprehensive  income:                            |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| Translation  adjustments                          |       | —            |       | —      |       | —          |       | —            |       | 113,049           |        | $                   | 113,049    |       | —     |       | —     |       | 113,049    |   |
| Net income                                        |       | —            |       | —      |       | —          |       | 846,545           |       | —            |        | 846,545             |       | —     |       | —     |       | 846,545    |       |
|                                              |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| Total  comprehensive income                       |       |              |       |        |       |            |       |              |       |              |        | $                   | 959,594    |       |       |       |       |       |       |   |
|                                              |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |   |
| BALANCE,  SEPTEMBER 30, 2003                      |       | 5,244,328         |       | 52,443      |       | 21,701,297      |       | (16,072,238       | )          | (402,999          | )           |                |       | (14,246    | )          | (140,388   | )          | 5,138,115  |       |
| Stock options exercised                           |       | 70,780            |       | 708         |       | 127,324         |       | —            |       | —            |        |                |       | —     |       | —     |       | 128,032    |       |
| Comprehensive  income:                            |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| Translation  adjustments                          |       | —            |       | —      |       | —          |       | —            |       | 85,006            |        | $                   | 85,006     |       | —     |       | —     |       | 85,006     |   |
| Net income                                        |       | —            |       | —      |       | —          |       | 1,084,776         |       | —            |        | 1,084,776           |       | —     |       | —     |       | 1,084,776  |       |
|                                              |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| Total  comprehensive income                       |       |              |       |        |       |            |       |              |       |              |        | $                   | 1,169,782  |       |       |       |       |       |       |   |
| BALANCE,  SEPTEMBER 30, 2004                      |       | 5,315,108         |       | 53,151      |       | 21,828,621      |       | (14,987,462       | )          | (317,993          | )           |                |       | (14,246    | )          | (140,388   | )          | 6,435,929  |       |
| Stock options  exercised                          |       | 67,976            |       | 680         |       | 81,788          |       | —            |       | —            |        |                |       | —     |       | —     |       | 82,468     |       |
| Stock option  acceleration expense                |       | —            |       | —      |       | 47,000          |       | —            |       | —            |        |                |       | —     |       | —     |       | 47,000     |       |
| Comprehensive  income:                            |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| Translation  adjustments                          |       | —            |       | —      |       | —          |       | —            |       | (60,047           | )           | $                   | (60,047    | )          | —     |       | —     |       | (60,047    | ) |
| Net income                                        |       | —            |       | —      |       | —          |       | 800,414           |       | —            |        | 800,414             |       | —     |       | —     |       | 800,414    |       |
|                                              |       |              |       |        |       |            |       |              |       |              |        |                |       |       |       |       |       |       |       |
| Total  comprehensive income                       |       |              |       |        |       |            |       |              |       |              |        | $                   | 740,367    |       |       |       |       |       |       |   |
| BALANCE,  SEPTEMBER 30, 2005                      |       | 5,383,084         |       | $           | 53,831     |            | $          | 21,957,409        |       | $                 | (14,187,048 | )                   | $          | (378,040   | )          |       |       | (14,246    | )          | $ | (140,388 | ) | $ | 7,305,764 |   |

 

*See notes to consolidated financial statements.*

 

30

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**DATAWATCH CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                           | ** ** | **Year Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                           | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                                |       |                         |       |   |   |   |   |
| Net income                                                                                                           |       | $                            | 800,414    |   | $ | 1,084,776 |   | $ | 846,545 |   |
| Adjustments to reconcile net income to cash  provided by operating activities:                                       |       |                         |       |   |   |   |   |
| Depreciation and amortization                                                                                        |       | 697,373                      |       | 728,189 |   | 847,068 |   |
| Allowances for doubtful accounts and sales  returns                                                                  |       | 3,404                        |       | (29,425 | ) | (137,904 | ) |
| Loss (gain) on disposal of equipment                                                                                 |       | 20,863                       |       | (9,862 | ) | 89,107 |   |
| Stock-based compensation                                                                                             |       | 47,000                       |       | — |   | 3,811 |   |
| Deferred income taxes                                                                                                |       | —                       |       | (148,000 | ) | — |   |
| Changes in current assets and liabilities,  net of effects of the acquisitions of Auxilor and Mergence Technologies: |       |                         |       |   |   |   |   |
| Accounts receivable                                                                                                  |       | (479,533                     | )          | (347,499 | ) | 501,871 |   |
| Inventories                                                                                                          |       | 12,592                       |       | 38,852 |   | 68,139 |   |
| Prepaid expenses and other                                                                                           |       | 69,295                       |       | (27,568 | ) | 35,360 |   |
| Accounts payable and accrued expenses                                                                                |       | (74,766                      | )          | 596,922 |   | (1,051,460 | ) |
| Deferred revenue                                                                                                     |       | 66,535                       |       | (221,809 | ) | 544,356 |   |
| Cash provided by operating activities                                                                                |       | 1,163,177                    |       | 1,664,576 |   | 1,746,893 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                |       |                         |       |   |   |   |   |
| Purchase of equipment and fixtures                                                                                   |       | (343,309                     | )          | (216,825 | ) | (123,495 | ) |
| Proceeds from sale of equipment                                                                                      |       | 4,364                        |       | 15,188 |   | 9,977 |   |
| Purchase of Auxilor, including direct costs  of $59,855, net of cash acquired                                        |       | —                       |       | — |   | (172,150 | ) |
| Purchase of Mergence Technologies,  including direct costs of $98,691, net of cash acquired                          |       | —                       |       | (2,515,284 | ) | — |   |
| Capitalized software development costs                                                                               |       | (42,775                      | )          | (190,825 | ) | (108,600 | ) |
| (Increase) decrease in restricted cash                                                                               |       | (122,149                     | )          | 373 |   | — |   |
| Other assets                                                                                                         |       | (19,212                      | )          | 133,829 |   | 64,284 |   |
| Cash used in investing activities                                                                                    |       | (523,081                     | )          | (2,773,544 | ) | (329,984 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                |       |                         |       |   |   |   |   |
| Net proceeds from exercise of stock options                                                                          |       | 82,468                       |       | 128,032 |   | 64,498 |   |
| Principal payments on long-term obligations                                                                          |       | —                       |       | (3,115 | ) | (9,680 | ) |
| Cash provided by financing activities                                                                                |       | 82,468                       |       | 124,917 |   | 54,818 |   |
|                                                                                                                 |       |                         |       |   |   |   |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH AND  EQUIVALENTS                                                             |       | (82,323                      | )          | 173,833 |   | (5,921 | ) |
| INCREASE (DECREASE) IN CASH AND EQUIVALENTS                                                                          |       | 640,241                      |       | (810,218 | ) | 1,465,806 |   |
| CASH AND EQUIVALENTS, BEGINNING OF YEAR                                                                              |       | 4,260,632                    |       | 5,070,850 |   | 3,605,044 |   |
| CASH AND EQUIVALENTS, END OF YEAR                                                                                    |       | $                            | 4,900,873  |   | $ | 4,260,632 |   | $ | 5,070,850 |   |
| SUPPLEMENTAL INFORMATION:                                                                                            |       |                         |       |   |   |   |   |
| Interest paid                                                                                                        |       | $                            | 2,899      |   | $ | 622 |   | $ | 7,243 |   |
| Income taxes paid                                                                                                    |       | $                            | —     |   | $ | 43,000 |   | $ | 5,000 |   |
| Income tax refunds received                                                                                          |       | $                            | 63,226     |   | $ | 1,500 |   | $ | — |   |
|                                                                                                                 |       |                         |       |   |   |   |   |
| NONCASH INVESTING AND FINANCING ACTIVITIES:                                                                          |       |                         |       |   |   |   |   |
| Issuance of common stock for acquisition of  Auxilor                                                                 |       | $                            | —     |   | $ | — |   | $ | 50,000 |   |

 

Seenotes to consolidated financial statements.

 

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**DATAWATCHCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Years EndedSeptember 30, 2005, 2004 and 2003**

 

**1.       NATURE OF BUSINESS AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

***Nature of Business*** – Datawatch Corporation (the “Company” or “Datawatch”) designs,develops, markets and distributes business computer software products. TheCompany also provides a wide range of consulting services, includingimplementation and support of its software products, as well as training ontheir use and administration.

 

***Summary of Significant Accounting Policies***

 

***Principles of Consolidation*** – The consolidated financial statementsinclude the accounts of Datawatch Corporation and its wholly ownedsubsidiaries. All intercompany balances and transactions have been eliminatedin consolidation.

 

***Accounting Estimates***– The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and judgments, which are evaluated on an on-goingbasis, that affect the amounts and disclosures reported in the Company’sconsolidated financial statements and accompanying notes. Management bases itsestimates on historical experience and on various other assumptions that itbelieves are reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results could differfrom those estimates and judgments. In particular, significant estimates andjudgments include those related to revenue recognition, allowance for doubtfulaccounts, sales returns reserve, useful lives of property and equipment,valuation of net deferred tax assets, business combinations, and valuation ofgoodwill and other intangible assets.

 

***Revenue Recognition -***The Company has two types of software product offerings: EnterpriseSoftware and Desktop and Server Software. Enterprise Software products aregenerally sold directly to end-users. The Company sells its Desktop and ServerSoftware products directly to end-users and through distributors andresellers.  Sales to distributors andresellers accounted for approximately 31%, 29% and 29%, of total sales for theyear ended September 30, 2005, 2004 and 2003, respectively.  Revenue from the sale of all softwareproducts is generally recognized at the time of shipment, provided there are nouncertainties surrounding product acceptance, the fee is fixed or determinable,collection is considered probable, persuasive evidence of the arrangementexists and there are no significant obligations remaining. Both types of theCompany’s software product offerings are “off-the-shelf” as such term isdefined by Statement of Position No. 97-2, “*SoftwareRevenue Recognition*.”  TheCompany’s software products can be installed and used by customers on their ownwith little or no customization required. Multi-user licenses marketed by theCompany are sold as a right to use the number of licenses and license feerevenue is recognized upon delivery of all software required to satisfy thenumber of licenses sold. Upon delivery, the licensing fee is payable withoutfurther delivery obligations to the Company.

 

Desktop and Server Softwareproducts are generally not sold in multiple element arrangements.  Accordingly, the price paid by the customeris considered the vendor specific objective evidence (“VSOE”) of fair value forthose products. Enterprise Software sales are generally multiple elementarrangements which include software license deliverables, professional servicesand post-contract customer support. In such multiple element arrangements, theCompany applies the residual method in determining revenue to be allocated to asoftware license. In applying the residual method, the Company deducts from thesale proceeds the VSOE of fair value of the services and post-contract customersupport in determining the residual fair value of the software license. TheVSOE of fair value of the services and post-contract customer support is basedon the amounts charged for these elements when sold separately. Professionalservices include implementation, integration, training and consulting serviceswith revenue recognized as the services are performed. These services aregenerally delivered on a time and materials basis, are billed on a currentbasis as the work is performed, and do not involve modification orcustomization of the software or any other unusual acceptance clauses or terms.Post-contract customer support is typically provided under a maintenanceagreement which provides technical support and rights to unspecified softwaremaintenance updates and bug fixes on a when-and-if available basis. Revenuefrom post-contract customer support services is deferred and recognized ratablyover the contract period (generally one year).

 

The Company also sells itsEnterprise Software using a subscription model. At the time a customer enters into a binding agreement to purchase asubscription, the customer is invoiced for an initial 90 day service period andan account

 

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receivable and deferredrevenue are recorded.  Beginning on thedate the software is installed at the customer site and available for use bythe customer, and provided that all other criteria for revenue recognition aremet, the deferred revenue amount is recognized ratably over the period theservice is provided.  The customer isthen invoiced every 90 days and revenue is recognized ratably over the periodthe service is provided.  Subscriptionscan be cancelled by the customer at any time by providing 90 days writtennotice.

 

The Company’s softwareproducts are sold under warranty against certain defects in material andworkmanship for a period of 30 to 90 days from the date of purchase. Certainsoftware products, including desktop versions of Monarch, Monarch Data Pump andVorteXML sold directly to end-users, include a guarantee under which suchcustomers may return products within 30 to 60 days for a full refund.Additionally, the Company provides its distributors with stock-balancing rightsand applies the guidance found in Statement of Financial Accounting Standards (“SFAS”)No. 48, “*Revenue Recognition when Right ofReturn Exists*.” Revenue from the sale of software products todistributors and resellers is recognized at the time of shipment providing allother criteria for revenue recognition as stated above are met and (i) thedistributor or reseller is unconditionally obligated to pay for the products,including no contingency as to product resale, (ii) the distributor or resellerhas independent economic substance apart from the Company, (iii) the Company isnot obligated for future performance to bring about product resale, and (iv)the amount of future returns can be reasonably estimated. The Company’sexperience and history with its distributors and resellers allows forreasonable estimates of future returns. Among other things, estimates ofpotential future returns are made based on the inventory levels at the variousdistributors and resellers, which the Company monitors frequently. Once theestimates of potential future returns from all sources are made, the Company determinesif it has adequate returns reserves to cover anticipated returns and thereturns reserve is adjusted as required. Adjustments are recorded as increases or decreases in revenue in theperiod of adjustment.  Actual returnshave historically been within the range estimated by management.

 

***Allowance for Doubtful Accounts*** – The Company maintains allowances fordoubtful accounts for estimated losses resulting from the inability ofcustomers to make required payments. The Company analyzes accounts receivableand the composition of the accounts receivable aging, historical bad debts,customer creditworthiness, current economic trends, foreign currency exchangerate fluctuations and changes in customer payment terms when evaluating theadequacy of the allowance for doubtful accounts. Based upon the analysis andestimates of the uncollectibility of its accounts receivable, the Companyrecords an increase in the allowance for doubtful accounts when the prospect ofcollecting a specific account receivable becomes doubtful. Actual results coulddiffer from the allowances for doubtful accounts recorded, and this differencemay have a material effect on the Company’s financial position and results ofoperations.

 

For the fiscal years endedSeptember 30, 2005, 2004 and 2003, changes to and ending balances of theallowance for doubtful accounts were approximately as follows:

 
| ** **                                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                         |       |     |       |     |       |     |       |
| Allowance for Doubtful Accounts Balance -  Beginning of Year |       | $        | 230,000    |     | $          | 230,000  |       | $ | 260,000 |   |
| Additions to the Allowance of Doubtful  Accounts             |       | 75,000   |       | 105,000  |       | 120,000  |       |
| Amounts Applied Against the Allowance for  Doubtful Accounts |       | (11,000  | )          | (105,000 | )          | (150,000 | )          |
| Allowance for Doubtful Accounts Balance -  End of Year       |       | $        | 294,000    |     | $          | 230,000  |       | $ | 230,000 |   |

 

***Capitalized Software Development Costs*** – The Company capitalizes certain softwaredevelopment costs as well as purchased software upon achieving technologicalfeasibility of the related products. Software development costs incurred andsoftware purchased prior to achieving technological feasibility are charged toresearch and development expense as incurred. Commencing upon initial productrelease, capitalized costs are amortized to cost of software licenses andsubscriptions using the straight-line method over the estimated life (whichapproximates the ratio that current gross revenues for a product bear to thetotal of current and anticipated future gross revenues for that product),generally 24 to 72 months.

 

For the fiscal years endedSeptember 30, 2005, 2004 and 2003 amounts related to capitalized softwaredevelopment costs and purchased software were approximately as follows:

 

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| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                           |       |     |       |     |       |     |       |
| Capitalized Software Balance - Beginning of  Year                              |       | $        | 937,000    |     | $          | 697,000  |       | $ | 962,000 |   |
| Capitalized Software Development Costs                                         |       | 42,000   |       | 191,000  |       | 109,000  |       |
| Capitalized Purchased Software                                                 |       | —   |       | 520,000  |       | 124,000  |       |
| Amortization of Capitalized Software  Development Costs and Purchased Software |       | (396,000 | )          | (471,000 | )          | (498,000 | )          |
| Capitalized Software Balance - End of Year                                     |       | $        | 583,000    |     | $          | 937,000  |       | $ | 697,000 |   |

 

***Cash and Equivalents*** – Cash and equivalents include cash on hand, cash deposited with banksand highly liquid securities with remaining maturities, when purchased, of 90days or less.

 

***Concentration of Credit Risks and Major Customers*** – The Company sells its products andservices to U.S. and non-U.S. dealers and other software distributors, as wellas to end users, under customary and normal credit terms. One customer, IngramMicro Inc., individually accounted for 19%, 20% and 19% of total revenue in2005, 2004 and 2003, respectively. Ingram Micro Inc. accounted for 17% and 31%of outstanding gross trade receivables as of September 30, 2005 and 2004, respectively.The Company sells to Ingram Micro Inc. under a distribution agreement, whichautomatically renews for successive one-year terms unless terminated. Otherthan this customer, no other customer constitutes a significant portion (morethan 10%) of sales or accounts receivable. The Company performs ongoing creditevaluations of its customers and generally does not require collateral.Allowances are provided for anticipated doubtful accounts and sales returns.

 

***Deferred Revenue***– Deferred revenue consisted of the followingat September 30:

 
| ** **  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------|------------|----------|------------|----------|------------|
|        |       |     |       |     |       |
| Maintenance |       | $        | 2,531,973  |     | $          | 2,440,719 |   |
| Other       |       | 389,546  |       | 462,404  |       |
|        |       |     |       |     |       |
| Total       |       | $        | 2,921,519  |     | $          | 2,903,123 |   |

 

Maintenance consists of theunearned portion of post-contract customer support services provided by theCompany to customers who purchase maintenance agreements for the Company’sproducts. Maintenance revenues are recognized on a straight-line basis over theterm of the maintenance period, generally 12 months. Other consists of deferredlicense, subscription and professional services revenue generated fromarrangements that are invoiced in accordance with the terms and conditions ofthe arrangement but do not meet all the criteria of the Company’s revenuerecognition policies, and are, therefore, deferred until all revenuerecognition criteria are met.

 

***Inventories***–Inventories consist of software components, primarily software manuals, compactdisks and retail packaging materials. Inventories are valued at the lower ofcost (first-in, first-out) method or market.

 

***Property and Equipment*** – Purchased equipment and fixtures are recorded at cost. Leasedequipment accounted for as capital leases is recorded at the present value ofthe minimum lease payments required during the lease terms. Depreciation andamortization are provided using the straight-line method over the estimateduseful lives of the related assets or over the terms, if shorter, of therelated leases. Useful lives and lease terms range from one to seven years.Depreciation and amortization expense related to property and equipment was$234,620, $255,634 and $338,125, respectively, for the years ended September30, 2005, 2004 and 2003. There were no items under capital leases as ofSeptember 30, 2005 or 2004.

 

***Long-Lived Assets ***– The Company continually evaluates whetherevents or circumstances have occurred that indicate that the estimatedremaining useful lives of long-lived assets and certain identifiableintangibles may warrant revision or that the carrying value of these assets maybe impaired. To compute whether assets have been impaired, the estimatedundiscounted future cash flows for the estimated remaining useful life of therespective assets are compared to the carrying value. To the extent that theundiscounted future cash flows are less than the carrying value, the fair valueof the asset is determined. If such fair value is less than the currentcarrying value, the asset is written down to its estimated fair value. Duringfiscal 2003, the Company determined that the Company’s Quetzal trademark wasimpaired and the full

 

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carrying value of $11,000was written off and expensed.  Thisexpense is included as part of general and administrative expenses in theCompany’s consolidated statement of operations for fiscal 2003.

 

***Goodwill and Other Intangible Assets -***Other intangible assets consist ofcapitalized software cost, acquired technology, patents, customerrelationships, trademarks and trade names acquired through businesscombinations.  The values allocated tothese intangible assets are amortized using the straight-line method over theestimated useful life of the related asset and are recorded in cost of salesfor software license and subscriptions. Intangible assets are reviewed for impairment whenever events or changesin circumstances indicate that the carrying amount of the asset may not berecoverable and an impairment loss is recognized when it is probable that theestimated cash flows are less than the carrying amount of the asset.

 

Goodwill and certaintrademarks are not subject to amortization and are tested annually forimpairment or more frequently if events and circumstances indicate that theasset might be impaired. Goodwill is tested for impairment using a two-stepapproach. The first step is to compare the fair value of the reporting unit toits carrying amount, including goodwill. If the fair value of the reportingunit 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 lossis recognized to the extent that the carrying amount exceeds the asset’s fairvalue.

 

The Company has thefollowing goodwill and intangible assets, as of September 30, 2005 and 2004:

 
| ** **                      | ** ** | **Weighted**                       | ** ** | **September 30, 2005**      | ** ** | **September 30, 2004**        | ** ** |
|---------------------------------|------------|------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| **Identified Intangible Asset** | ** ** | **Average  Useful Life  in Years** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
| Capitalized  software           |       | 3                                  |       | $                           | 1,665,895  |                          | $          | (1,483,015 | ) | $ | 182,880 |   | $ | 1,623,120 |   | $ | (1,194,931 | ) | $ | 428,189 |   |
| Purchased  software             |       | 5                                  |       | 520,000                     |       | (119,722                      | )          | 400,278 |   | 520,000 |   | (11,667 | ) | 508,333 |   |
| Patents                         |       | 20                                 |       | 159,967                     |       | (8,389                        | )          | 151,578 |   | 140,000 |   | (1,167 | ) | 138,833 |   |
| Customer  lists                 |       | 4                                  |       | 130,000                     |       | (36,563                       | )          | 93,437 |   | 130,000 |   | — |   | 130,000 |   |
| Non-compete  agreements         |       | 5                                  |       | 100,000                     |       | (22,500                       | )          | 77,500 |   | 100,000 |   | — |   | 100,000 |   |
| Trademarks                      |       | indefinite                         |       | 345,152                     |       | —                        |       | 345,152 |   | 345,152 |   | — |   | 345,152 |   |
|                            |       |                               |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Total                           |       | 5 Years                            |       | $                           | 2,921,014  |                          | $          | (1,670,189 | ) | $ | 1,250,825 |   | $ | 2,858,272 |   | $ | (1,207,765 | ) | $ | 1,650,507 |   |

 

The intangible asset amountsamortized to cost of software licenses and subscriptions totaled $462,424,$472,331 and $508,943, for fiscal 2005, 2004 and 2003, respectively.

 

Asof September 30, 2005, the estimated future amortization expense related toamortizing intangible assets was as follows:

 
| **Year Ending September 30,**                | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
|                                         |       |       |       |
| 2006                                         |       | $          | 335,571    |   |
| 2007                                         |       | 177,236    |       |
| 2008                                         |       | 121,204    |       |
| 2009                                         |       | 88,861     |       |
| 2010                                         |       | 71,363     |       |
| Thereafter                                   |       | 111,438    |       |
|                                         |       |       |       |
| Total  estimated future amortization expense |       | $          | 905,673    |   |

 

***Restricted Cash –*** At September 30, 2005, amounts of $268,299 for security deposits toprovide credit support for the rent payments to the landlord of the Company’sMassachusetts offices and $125,000 held for the escrow amount for the sellersof Mergence (see Note 2) were classified in the Company’s consolidated balancesheet as restricted cash.

 

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***Fair Value Disclosure ***– The carrying amounts of cash andequivalents, accounts receivable, accounts payable, accrued expenses, deferredrevenue and escrow for Mergence shareholders approximate fair value because oftheir short-term nature.

 

***Income Taxes***– Deferred income taxes are provided for the tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes andoperating loss carryforwards and credits. Valuation allowances are recorded toreduce the net deferred tax assets to amounts the Company believes are morelikely than not to be realized.

 

***Net Income Per Share*** – Basic net income per common share is computed by dividing net incomeby the weighted-average number of common shares outstanding during theperiod.  Diluted net income per sharereflects the impact, when dilutive, of the exercise of options and warrantsusing the treasury-stock method.

 

The following table presentsthe options and warrants that were not included in the computation of dilutednet income per share, because the exercise price of the options or warrants wasgreater than the average market price of the common stock for the years endedSeptember 30, 2005, 2004 and 2003:

 
| ** **                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                 |       |     |       |     |       |     |       |
| Quantity of  option shares and warrants not included |       | 145,870  |       | 120,818  |       | 233,414  |       |
| Weighted-average  exercise price                     |       | $        | 5.86       |     | $          | 6.24     |       | $ | 4.76 |   |
|                                                      |            |          |            |          |            |          |            |  |  |  |

 

***Foreign Currency Translations and Transactions*** – Assets and liabilities of foreignsubsidiaries are translated into U.S. dollars at rates in effect at eachbalance sheet date. Revenues, expenses and cash flows are translated into U.S.dollars at average rates prevailing when transactions occur. The relatedtranslation adjustments are reported as a separate component of shareholders’equity under the heading “Accumulated Other Comprehensive Loss.” Gains andlosses resulting from transactions that are denominated in currencies otherthan the applicable unit’s functional currency are included in the operatingresults of the Company.

 

***Advertising and PromotionalMaterials*** –Advertising costs are expensed as incurred and amounted to $372,813, $254,001and $419,781 in 2005, 2004 and 2003, respectively. Direct mail/direct responsecosts are expensed as the associated revenue is recognized. The amortizationperiod is based on historical results of previous mailers (generally three tosix months from the date of the mailing). Direct mail expense was $112,480,$130,289 and $170,335 in 2005, 2004 and 2003, respectively. At September 30,2005 and 2004, deferred direct mail/direct response costs were $6,157 and $701,respectively, and are included under the caption “prepaid expenses and other”in the accompanying consolidated balance sheets.

 

***Stock-Based Compensation -***The Company uses the intrinsic-value methodof valuing its stock options to measure compensation expense associated withgrants of stock options to employees and directors.  As permitted under SFAS No. 148, “*Accounting for Stock-Based Compensation - Transitionand Disclosure*,” which amended SFAS No. 123, “*Accounting for Stock-Based Compensation*,”the Company has elected to continue to follow the intrinsic-value method inaccounting for its stock-based employee compensation arrangements as defined byAccounting Principles Board Opinion (“APB”) No. 25, “*Accounting for Stock Issued to Employees*,” and relatedinterpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, “*Accounting forCertain Transactions Involving Stock Compensation*,” aninterpretation of APB No. 25.  Nostock-based employee compensation cost is reflected in net income, as alloptions granted under those plans had an exercise price equal to the marketvalue of the underlying common stock on the date of the grant, except for theimpact of acceleration of vesting as discussed below.

 

InSeptember 2005, the Compensation Committee of our Board of Directors approvedthe full vesting of all outstanding options with vesting dates occurring afterSeptember 30, 2005. This action was taken to reduce the expense related tounvested stock option awards upon adoption of Statement of Financial AccountingStandards No. 123(R), “*Share-Based Payment*”(“SFAS 123(R)”). The vesting of approximately 169,040 options was accelerated,of which approximately 64,000 options had an exercise price greater than ourclosing stock price on the modification date. As we estimated that certain ofthese awards would not have vested absent the acceleration, we recognizedstock-based compensation charge of approximately $47,000, which is included inour results for the year ended September 30, 2005 (See Note 9).

 

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Hadthe Company recognized compensation for its stock options and purchase plansbased on the fair value for awards under those plans, pro forma net income andpro forma net income per share would have been as follows:

 
| ** **                                                                                             | ** ** | **Years Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                   |       |                          |       |   |   |   |   |
| Net income, as reported                                                                                |       | $                             | 800,414    |   | $ | 1,084,776 |   | $ | 846,545 |   |
| Add: Stock-based employee compensation expense  included in reported net income                        |       | 47,000                        |       | — |   | 3,811 |   |
| Less: Total stock-based employee  compensation determined under fair-value based method for all shares |       | (589,693                      | )          | (231,242 | ) | (262,912 | ) |
| Pro forma net income                                                                                   |       | $                             | 257,721    |   | $ | 853,534 |   | $ | 587,444 |   |
|                                                                                                   |       |                          |       |   |   |   |   |
| Earnings per share:                                                                                    |       |                          |       |   |   |   |   |
| Basic - as reported                                                                                    |       | $                             | 0.15       |   | $ | 0.21 |   | $ | 0.16 |   |
| Basic - pro forma                                                                                      |       | $                             | 0.05       |   | $ | 0.16 |   | $ | 0.11 |   |
|                                                                                                   |       |                          |       |   |   |   |   |
| Diluted - as reported                                                                                  |       | $                             | 0.14       |   | $ | 0.19 |   | $ | 0.16 |   |
| Diluted - pro forma                                                                                    |       | $                             | 0.04       |   | $ | 0.15 |   | $ | 0.11 |   |

 

The fair values used tocompute pro forma net income and pro forma net income per share were estimatedon the grant date using the Black-Scholes option-pricing model with thefollowing assumptions:

 
| ** **                               | ** ** | **Years Ended September 30,** | ** ** |
|------------------------------------------|------------|-------------------------------|------------|
| ** **                               | ** ** | **2005**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                          |       |   |   |   |   |
| Risk-free  interest rate                 |       | 3.7                           | %          | 3.1 | % | 3.1 | % |
| Expected  life of option grants (years)  |       | 5.0                           |       | 4.1 |   | 4.0 |   |
| Expected  volatility of underlying stock |       | 107.0                         | %          | 114.7 | % | 116.9 | % |
| Expected  dividend payment rate          |       | 0.0                           | %          | 0.0 | % | 0.0 | % |

 

The weighted-average fairvalue of stock options granted was $2.98, $2.57 and $1.28 for the years endedSeptember 30, 2005, 2004 and 2003, respectively.

 

The Company records the fairvalue of stock options and warrants granted to nonemployees in exchange forservices under the fair-value method in accordance with SFAS No. 123 andEmerging Issues Task Force Issue No. 96-18, “Accounting for Equity InstrumentsThat Are Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services,” in the statements of operations. Under thismethod, the resulting compensation is measured at the fair value of the equityinstrument on the date of vesting and recognized as a charge to operations overthe service period, which is usually the vesting period.  There were no such equity awards outstandingduring fiscal 2005 and 2004 and, therefore, no there were no such chargesduring fiscal 2005 or 2004.

 

OnDecember 16, 2004, FASB issued a revision to SFAS No. 123(R).  This revision requires that all share-basedpayments to employees, including grants of employee stock options, berecognized in the financial statements based on their fair values.  The revision is effective for publiccompanies for fiscal years beginning after June 15, 2005.  The standard offers the Company alternativemethods of adopting the standard.  TheCompany will be required to adopt SFAS 123(R) beginning October 1, 2005 for newawards of stock-based compensation granted after that date. At September 30,2005, all outstanding options were fully vested, therefore management does notanticipate future compensation expense, related to existing options or futureoption grants, to be significant under SFAS 123(R).

 

***Comprehensive Income*******–Currently, the only item, in addition to net income, that is included incomprehensive income is foreign currency translation adjustments. Foreigncurrency translation (losses) gains arising during 2005, 2004 and 2003 were($60,047), $85,006 and $113,049, respectively.

 

***Segment Information***  – TheCompany has determined that it has only one reportable segment meeting thecriteria established under SFAS No. 131, “*Disclosuresabout Segments of an Enterprise and Related Information*.”  The

 

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Company’schief operating decision maker, as defined (determined to be the ChiefExecutive Officer), does not manage any part of the Company separately, and theallocation of resources and assessment of performance is based solely on theCompany’s consolidated operating results. See Note 11 for information about theCompany’s revenue by product lines and continuing geographic operations.

 

***Guarantees and Indemnifications*** – The Company’s software products are soldunder warranty against certain defects in material and workmanship for a periodof 30 to 90 days from the date of purchase. If necessary, the Company wouldprovide for the estimated cost of warranties based on specific warranty claimsand claim history. However, the Company has never incurred significant expenseunder its product or service warranties. As a result, the Company believes theestimated fair value of these warranty agreements is minimal. Accordingly, thereare no liabilities recorded for warranty claims as of September 30, 2005 and2004.

 

The Company is required bythe lease related to its Lowell, Massachusetts facility to provide a letter ofcredit in the amount of $143,299 as a security deposit to provide creditsupport for payment to the landlord of amounts due under the lease.  Cash on deposit providing security in theamount of this letter of credit is classified as part of restricted cash in theCompany’s consolidated balance sheets at September 30, 2005 and 2004.  See Note 5 for disclosure of minimum rentalcommitments under noncancelable operating leases.

 

In August 2004, the Companyentered into a Stock Purchase Agreement for the acquisition of Mergence inwhich the Company made certain warranties regarding, among other things, itslegal authority to enter into the agreement consummating the acquisition andits ability to continue in its business. The Company further agreed to indemnify the sellers of Mergence and holdthem harmless for any damages incurred of suffered arising out of anymisrepresentation or breach of such warranties made by the Company in theagreement.  The Company believes that nosuch misrepresentations or breaches of warranty exist, or are likely to existin the future, and, accordingly, has recorded no liabilities related to suchindemnification as of September 30, 2005 and 2004.

 

The Company enters intoindemnification agreements in the ordinary course of business.  Pursuant to these agreements, the Companyagrees to indemnify, hold harmless, and to reimburse the indemnified party forlosses suffered or incurred by the indemnified party, generally its customers,in connection with any patent, copyright or other intellectual propertyinfringement claim by any third party with respect to the Company’sproducts.  The term of theseindemnification agreements is generally perpetual and the maximum potentialamount of future payments the Company could be required to make under theseindemnification agreements is unlimited. The Company has never incurred coststo defend lawsuits or settle claims related to these indemnificationagreements. As a result, the Company believes the estimated fair value of theseagreements is minimal. Accordingly, the Company has no liabilities recorded forthese agreements as of September 30, 2005 and 2004.

 

Certain of the Company’sagreements also provide for the performance of services at customer sites.These agreements may contain indemnification clauses, whereby the Company willindemnify the customer from any and all damages, losses, judgments, costs andexpenses for acts of its employees or subcontractors resulting in bodily injuryor property damage. The maximum potential amount of future payments the Companycould be required to make under these indemnification agreements is unlimited;however, the Company has general and umbrella insurance policies that wouldenable it to recover a portion of any amounts paid. The Company has neverincurred costs to defend lawsuits or settle claims related to these indemnificationagreements. As a result, the Company believes the estimated fair value of theseagreements is minimal. Accordingly, the Company has no liabilities recorded forthese agreements as of September 30, 2005 and 2004.

 

As permitted under Delawarelaw, the Company has agreements with its directors whereby the Company willindemnify 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 directorindemnification period is for the later of ten years after the date that thedirector ceases to serve in such capacity or the final termination ofproceedings against the director as outlined in the indemnification agreement.The maximum potential amount of future payments the Company could be requiredto make under these indemnification agreements is unlimited; however, theCompany’s director and officer insurance policy limits the Company’s exposureand enables it to recover a portion of any future amounts paid. As a result of itsinsurance policy coverage, the Company believes the estimated fair value ofthese indemnification agreements is minimal. The Company has no liabilitiesrecorded for these agreements as of September 30, 2005 and 2004.

 

38

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**2. ****ACQUISITIONS**

 

**MergenceTechnologies Corporation**

 

On August 11, 2004, theCompany acquired 100% of the outstanding shares of Mergence TechnologiesCorporation for an acquisition cost of $2,596,691 comprised of $2,500,000 incash and direct costs of $96,691. The Mergence purchase agreement also includesa provision for quarterly cash payments to the former Mergence shareholdersequal to 10% of the revenues, as defined, of Mergence’s Researcher product fora period of six years, not all Mergence products are subject to royalties.  Payment amounts will be expensed as a cost ofrevenue as the Researcher product is sold. The Company did not expense any such payments during fiscal 2004 as noResearcher products were sold from the date of acquisition through September30, 2004.  The Company expensed $10,400for the year ended September 30, 2005.

 

The Mergence purchaseagreement included an amount of $125,000 to be held in escrow for the sellersof Mergence and was to be paid 55 days after September 30, 2005, unless thesellers owe any damages or unresolved claims to the buyer.  As of September 30, 2005 there were nounresolved claims or damages.

 

Mergence was acquired tobroaden and expand the Company’s product offerings.  Mergence’s results are included with those ofthe Company from the date of acquisition.

 

The following table presentsthe allocation of the purchase price paid for Mergence based on the estimatedfair values of the acquired assets and assumed liabilities of Mergence as ofAugust 11, 2004:

 
| Cash, receivables and other current assets           |   | $         | 238,797   |   |
|------------------------------------------------------|--------|-----------|-----------|--------|
| Property and  equipment, and other noncurrent assets |   | 16,242    |      |
| Current  liabilities                                 |   | (90,994   | )         |
| Deferred tax  liabilities, net                       |   | (148,000  | )         |
| Goodwill                                             |   | 1,630,646 |      |
| Acquired  intangible assets:                         |   |      |      |
| Existing technology                                  |   | 520,000   |      |
| Patents                                              |   | 140,000   |      |
| Customer list                                        |   | 130,000   |      |
| Non-compete agreements                               |   | 100,000   |      |
| Trademark                                            |   | 60,000    |      |
|                                                 |   |      |      |
| Total  purchase price                                |   | $         | 2,596,691 |   |

 

The allocation of thepurchase price was based on an evaluation of assets acquired and liabilitiesassumed. The valuation of the intangible assets is based in part on assistancefrom an independent valuation firm. The valuation method used to determine theintangible asset values was the income approach. The income approach presumesthat the value of an asset can be estimated by the net economic benefit (i.e.cash flows) to be received over the life of the asset, discounted to presentvalue. The discounting process uses a rate of return that accounts for both thetime value of money and investment risk factors. The weighted-average discountrate (or rate of return) used to determine the value of the identifiableintangible assets was 30%.

 

The intangible asset forexisting technology is for two technologies developed and owned byMergence.  Datawatch has estimated thelife of these products as three years and six years, respectively.  The patents have an estimated life of twentyyears, which represents the legal life. The customer list and non-competeagreements have estimated lives of four years and five years, respectively. Thefair values for the existing technology, patents, customer list and non-competeagreements will be amortized over the estimated life, unless, in the future itis determined that the assets are impaired. Amortization of the intangible assets acquired as part of the Mergenceacquisition totaled $12,833 from the date of acquisition through September 30,2004.

 

Datawatch has determinedthat the trademark has an indefinite life and, in accordance with SFAS No. 142,such trademark is not being amortized. The trademark and goodwill will be tested for impairment annually, or onan interim

 

39

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basis, if an event orcircumstance indicates that it is more likely than not that an impairment losshas been incurred.  No portion of thegoodwill is deductible for tax purposes.

 

**Auxilor, Inc.**

 

On October 16, 2002, theCompany acquired 100% of the outstanding shares of Auxilor, Inc. for a totalconsideration of approximately $561,000 comprised of $127,000 in cash, 29,528shares of Datawatch common stock valued at approximately $50,000, direct costsof approximately $60,000, and assumed liabilities totaling approximately$324,000. In exchange, the Company received Auxilor tangible assets valued atapproximately $152,000. An independent valuation analysis subsequentlyallocated approximately $285,000 and $124,000, respectively, to trademarks andpurchased software.  No goodwill wasrecorded as a result of the transaction. The amount recorded as purchasedsoftware was amortized over two years. Amortization expense was $62,000 duringboth fiscal 2004 and 2003 and as of September 30, 2004 the purchased softwarewas fully amortized.

 

The Auxilor purchaseagreement also includes a clause, which provided for a cash payout equal to 10%of the sales of Auxilor products in fiscal 2003.  Such amounts were expensed as a cost ofrevenue as Auxilor products and services were sold. The Company expensed paymentsof approximately $45,000 during fiscal 2003.

 

Auxilor was acquired tobroaden and expand the Company’s product offerings. Auxilor’s results areincluded with those of the Company from the date of acquisition. The results ofoperations of Auxilor for periods prior to its acquisition by the Company arenot significant.

 

**3.****                   ****INVENTORIES**

 

Inventories consisted of thefollowing at September 30:

 
| ** **      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
|            |       |     |       |     |       |
| Materials       |       | $        | 28,406     |     | $          | 46,931 |   |
| Finished  goods |       | 26,306   |       | 21,024   |       |
|            |       |     |       |     |       |
| Total           |       | $        | 54,712     |     | $          | 67,955 |   |

 

**4.****                     ****ACCRUED EXPENSES**

 

Accrued expenses consistedof the following at September 30:

 
| ** **                         | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------------|------------|-----------|------------|-----------|------------|
|                               |       |      |       |      |       |
| Accrued  salaries and benefits     |       | $         | 280,136    |      | $          | 221,541 |   |
| Accrued  royalties and commissions |       | 1,095,758 |       | 1,165,553 |       |
| Accrued  professional fees         |       | 312,606   |       | 305,636   |       |
| Accrued  severance                 |       | —    |       | 5,401     |       |
| Other                              |       | 325,494   |       | 328,699   |       |
|                               |       |      |       |      |       |
| Total                              |       | $         | 2,013,994  |      | $          | 2,026,830 |   |

 

 

**5.       COMMITMENTS**

 

***Leases –***The Company leases various facilities, equipment and automobiles in the U.S.and overseas under noncancelable operating leases which expire through 2011.The lease agreements generally provide for the payment of minimum annualrentals, pro-rata share of taxes, and maintenance expenses. Rental expense forall operating leases was $663,664, $678,677 and $766,416 for the years ended September30, 2005, 2004 and 2003, respectively. Certain of the Company’s facility leases include options to renew.

 

40

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As of September 30, 2005,minimum rental commitments under noncancelable operating leases are as follows:

 
| **Year Ending September 30,** | ** ** | ** ** | ** ** |
|-------------------------------|------------|------------|------------|
| ** **                    | ** ** | ** ** | ** ** |
| 2006                          |       | $          | 253,587    |   |
| 2007                          |       | 139,096    |       |
| 2008                          |       | 169,916    |       |
| 2009                          |       | 167,185    |       |
| 2010                          |       | 170,690    |       |
| Thereafter                    |       | 133,065    |       |
|                          |       |       |       |
| Total  minimum lease payments |       | $          | 1,033,539  |   |

 

***Royalties***– The Company is committed to pay royalties ranging from 7% to 50% on revenuegenerated by the sale of certain licensed software products.  Royalty expense included in cost of softwarelicenses and subscriptions was $1,659,308, $1,677,231 and $1,583,921 for theyears ended September 30, 2005, 2004 and 2003, respectively. The Companyis not obligated to pay minimum royalty amounts.

 

***Mergence Royalties*****–**As a result of the acquisition of Mergence (see Note 2), the Company isrequired to make quarterly cash payments equal to 10% of the revenues, asdefined, of Mergence’s Researcher product for a period of six years, but notall Mergence products are subject to royalties. The Company is not required to pay any minimum amounts unless theCompany ceases to compete in the markets, as defined, in which the Researcherproduct competes.  The Company fullyintends to continue to compete in these markets.

 

**6.****      ****LITIGATION**

 

In May 2004, the Company wasserved with a charge of discrimination filed with the Massachusetts CommissionAgainst Discrimination (MCAD) by a current employee. In addition to theCompany, the employee has named an executive of the Company as well as theemployee’s former supervisor as defendants. The employee alleges that herformer supervisor engaged in sexually harassing conduct. The employee accusesthe executive of engaging in retaliation upon learning of the employee’scomplaint.  The complaint was withdrawnfrom the MCAD in August 2004, with the stated intent of pursuing the claim in SuperiorCourt in the state of Massachusetts. To date, the Company has not been notifiedof any further filing. Given the early stage and current status of the claim,the Company is unable to predict the ultimate outcome. The Company intends tovigorously defend the claims.

 

From time to time, theCompany receives other claims and may be party to other actions that arise inthe normal course of business. Other than as noted above, the Company does notbelieve the eventual outcome of any other pending matters will have a materialeffect on the Company’s consolidated financial condition or results ofoperations.

 

**7.****      ****FINANCING ARRANGEMENTS**

 

***Letter of Credit –***The Company has an irrevocable standby letter of credit with a banksecuring performance of a five-year property lease. The Company has reserved acash term deposit in the amount of $143,299 to secure the letter ofcredit.  This amount is included as partof restricted cash in the Company’s consolidated balance sheets at September30, 2005 and 2004.

 

The Company is also requiredby the new sublease agreement entered into in September 2005 related to itsChelmsford, Massachusetts facility to provide an irrevocable standby letter ofcredit with a bank securing performance of a sixty-six month propertylease.   The Company has reserved a cashterm deposit in the amount of $125,000 to secure the letter of credit.  This amount is included as part of restrictedcash in the Company’s consolidated balance sheets at September 30, 2005.

 

41

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**8.****      ****INCOME TAXES**

 

Income (loss) fromoperations before income taxes consists of the following for the years endedSeptember 30:

 
| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
|       |       |     |       |     |       |     |       |
| Domestic   |       | $        | 1,645,322  |     | $          | 980,486  |       | $ | 1,140,752 |   |
| Foreign    |       | (866,908 | )          | (22,360  | )          | (288,707 | )          |
|       |       |     |       |     |       |     |       |
| Total      |       | $        | 778,414    |     | $          | 958,126  |       | $ | 852,045 |   |

 

The (benefit) provision forincome taxes consisted of the following for the years ended September 30:

 
| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |     |       |
| Current:                      |       |     |       |     |       |     |       |
| Federal                       |       | $        | (12,000    | )        | $          | 21,350   |       | $ | 5,500 |   |
| State                         |       | (10,000  | )          | —   |       | —   |       |
| Foreign                       |       | —   |       | —   |       | —   |       |
|                          |       |     |       |     |       |     |       |
|                          |       | (22,000  | )          | 21,350   |       | 5,500    |       |
|                          |       |     |       |     |       |     |       |
| Deferred:                     |       |     |       |     |       |     |       |
| Federal                       |       | (18,000  | )          | 9,000    |       | 285,000  |       |
| State                         |       | 11,000   |       | 171,000  |       | 48,500   |       |
| Foreign                       |       | —   |       | 120,000  |       | (140,500 | )          |
| Change in valuation allowance |       | 7,000    |       | (448,000 | )          | (193,000 | )          |
|                          |       |     |       |     |       |     |       |
|                          |       | —   |       | (148,000 | )          | —   |       |
|                          |       |     |       |     |       |     |       |
| Total                         |       | $        | (22,000    | )        | $          | (126,650 | )          | $ | 5,500 |   |

 

At September 30, 2005, theCompany had cumulative U.S. federal tax loss carryforwards of approximately $5.6million, expiring at various dates through 2020, including $520,000 resultingfrom the Mergence acquisition undertaken during 2004 which are subject toadditional annual limitations as a result of the changes in Mergence’sownership, and had approximately $2 million in state tax loss carryforwards,which commence expiration in 2006. An alternative minimum tax credit ofapproximately $148,000 is available to offset future regular federal taxes.Research and development credits of approximately $512,000 expire beginning in2013. In addition, tax loss carryforwards in certain foreign jurisdictionstotal approximately $6 million.

 

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

 

42

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| ** **                             | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| Deferred tax  liabilities:             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Depreciation and amortization          |       | $          | —     |       | $          | (141,000 | ) |
| Prepaid expenses                       |       | (66,000    | )          | (37,000    | )          |
| Acquired intangibles                   |       | (356,000   | )          | —     |       |
|                                   |       |       |       |       |       |
|                                   |       | (422,000   | )          | (178,000   | )          |
| Deferred tax  assets:                  |       |       |       |       |       |
| Net operating loss carryforwards       |       | 4,062,000  |       | 3,914,000  |       |
| Research and development credits       |       | 512,000    |       | 503,000    |       |
| Accounts and notes receivable reserves |       | 150,000    |       | 204,000    |       |
| Accrued severance                      |       | 15,000     |       | 7,000      |       |
| Alternative minimum tax credits        |       | 148,000    |       | 148,000    |       |
| Depreciation and amortization          |       | 176,000    |       | —     |       |
| Other                                  |       | 49,000     |       | 85,000     |       |
|                                   |       |       |       |       |       |
|                                   |       | 5,112,000  |       | 4,861,000  |       |
|                                   |       |       |       |       |       |
| Total                                  |       | 4,690,000  |       | 4,683,000  |       |
|                                   |       |       |       |       |       |
| Valuation  allowance                   |       | (4,690,000 | )          | (4,683,000 | )          |
|                                   |       |       |       |       |       |
| Deferred  taxes, net                   |       | $          | —     |       | $          | — |   |

 

The Company had profitabledomestic operations but continued to have operating losses from internationaloperations for the years ended September 30, 2005, 2004 and 2003.  This followed significant losses fromoperations, both domestically and internationally, over several prioryears.  Accordingly, management does notbelieve the tax assets are more likely than not to be realized and a fullvaluation allowance has been provided. The valuation allowance increased by approximately $7,000 in 2005 anddecreased by $448,000 in 2004 primarily because the Company maintains a fullvaluation allowance against the tax assets and such assets increased ordecreased primarily as a result of utilization of net operating losscarryforwards in each respective year. In both 2005 and 2004, domestic net operating loss carryforwardsdecreased as a result of income recorded domestically, partially offset by anincrease in international loss carryforwards as a result of operating losses,resulting in an overall increase in the related asset.

 

SFAS No. 109, “*Accounting for Income Taxes*,” requiresrecognition of deferred tax liabilities and deferred tax assets (and relatedvaluation allowances, if necessary) for the deferred tax consequences ofdifferences between the assigned values and the tax bases of the assets andliabilities recognized in a business combination. As Datawatch has deferred taxassets, against which a full valuation allowance has been provided, and theacquisition of Mergence resulted in the recording of a net deferred taxliability, the Company during fiscal year 2004 recorded a benefit for incometaxes of $148,000 for the recognition of a reduction in the valuation allowanceas a result of realizing the benefit of certain of the Company’s deferred taxassets resulting from the deferred tax liabilities associated with the Mergenceacquisition.

 

The following tablereconciles the Company’s tax provision based on its effective tax rate to itstax provision based on the federal statutory rate of 34% for the years endedSeptember 30, 2005, 2004 and 2003:

 

43

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| ** **                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Provision at  federal statutory rate        |       | $          | 265,000    |       | $          | 326,000    |       | $ | 289,000 |   |
| State, net  of federal impact               |       | (7,000     | )          | 113,000    |       | 59,500     |       |
| Foreign  taxes                              |       | (60,000    | )          | (137,000   | )          | (150,000   | )          |
| Valuation  allowance increase (decreased)   |       | 7,000      |       | (448,000   | )          | (193,000   | )          |
| Extra-territorial  income exclusion         |       | (120,000   | )          | —     |       | —     |       |
| Effect of  prior year permanent differences |       | (116,000   | )          | —     |       | —     |       |
| Other                                       |       | 9,000      |       | 19,350     |       | —     |       |
|                                        |       |       |       |       |       |       |       |
| (Benefit)  provision for income taxes       |       | $          | (22,000    | )          | $          | (126,650   | )          | $ | 5,500 |   |

 

**9.****      ****SHAREHOLDERS’ EQUITY**

 

***Stock Option Plans –*** The Company’s two stock option plans described below provide forgranting of options and other stock rights to purchase common stock of theCompany to employees, officers, consultants, and directors who are nototherwise employees. The options granted are exercisable as specified at thedate of grant and generally expire five to ten years from the date ofgrant.  Generally, options and otherstock rights are granted at exercise prices not less than fair market value atthe date of the grant.

 

On October 4, 1996, theCompany established the 1996 International Employee Non-Qualified Stock OptionPlan (the “1996 International Plan”). Pursuant to this plan, nonqualifiedoptions may be granted to any employee or consultant of any of the Company’sforeign subsidiaries through October 4, 2006.

 

On December 10, 1996, theCompany established the Datawatch Corporation 1996 Stock Plan (the “1996 StockPlan”), which provides for the granting of both incentive stock options andnonqualified options, the award of Company common stock, and opportunities tomake direct purchases of Company common stock (collectively, “Stock Rights”),as determined by a committee appointed by the Board of Directors. Optionspursuant to this plan may be granted through December 10, 2006 and shall vestas specified by this committee.

 

On September 26, 2005, theCompensation and Stock Committee (the “Committee”) of the Board of Directors ofthe Company approved the immediate and full acceleration of the vesting of eachotherwise unvested stock option granted under the 1996 Stock Plan and the 1996International Plan (collectively, the “1996 Plans”). Stock options granted from2002 through 2005 with respect to 169,040 shares of the Company’s Common Stock,including an aggregate of approximately 98,120 options held by executiveofficers and directors, are subject to this acceleration. Based on the closingprice of the Company’s common stock of $3.55 per share on September 26, 2005,approximately 105,000 of the accelerated options were in-the-money (i.e., theoption exercise price was less than $3.55 per share) including anaggregate of 63,165 options held by directors and executive officers. Each directorand executive officer has agreed pursuant to a lock-up agreement (a “Lock-upAgreement”) to refrain from selling Common Shares acquired upon the exercise ofaccelerated options (other than shares needed to cover the exercise price andsatisfy withholding taxes) until the date on which the exercise would have beenpermitted under the option’s pre-acceleration vesting terms or, if earlier, theofficer’s last day of service or upon an “Acquisition” as defined in the 1996Plans.

 

Selected information regardingthe above stock option plans as of and for the year ended September 30, 2005 isas follows:

 
| ** **                                                   | ** ** | **Shares**     | ** ** |
|--------------------------------------------------------------|------------|----------------|------------|
| ** **                                                   | ** ** | **Authorized** | ** ** | **Reserved for** | ** ** |
| ** **                                                   | ** ** | **for Grant**  | ** ** | **Future Issuance** | ** ** |
| ** **                                                   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 1996  International Employee Non-Qualified Stock Option Plan |       | 88,888         |       | 8,042 |   |
| Datawatch  Corporation 1996 Stock Plan                       |       | 1,248,000      |       | 87,849 |   |
|                                                         |       |           |       |   |   |
|                                                         |       | 1,336,888      |       | 95,891 |   |

 

44

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

 
| ** **                       | ** ** | ** **      | ** ** | **Weighted-** | ** ** |
|----------------------------------|------------|-----------------|------------|---------------|------------|
| ** **                       | ** ** | **Number of**   | ** ** | **Average**   | ** ** |
| ** **                       | ** ** | **Options**     | ** ** | **Exercise**  | ** ** |
| ** **                       | ** ** | **Outstanding** | ** ** | **Price**     | ** ** |
| ** **                       | ** ** | ** **      | ** ** | ** **    | ** ** |
| Outstanding,  September 30, 2002 |       | 804,494         |       | 2.28          |       |
| Granted                          |       | 283,334         |       | 1.66          |       |
| Canceled                         |       | (100,776        | )          | 2.51          |       |
| Exercised                        |       | (39,590         | )          | 1.63          |       |
| Outstanding,  September 30, 2003 |       | 947,462         |       | 2.10          |       |
| Granted                          |       | 127,000         |       | 3.38          |       |
| Canceled                         |       | (83,712         | )          | 3.46          |       |
| Exercised                        |       | (70,780         | )          | 1.81          |       |
| Outstanding,  September 30, 2004 |       | 919,970         |       | 2.17          |       |
| Granted                          |       | 115,334         |       | 3.78          |       |
| Canceled                         |       | (55,286         | )          | 3.06          |       |
| Exercised                        |       | (67,976         | )          | 1.21          |       |
| Outstanding,  September 30, 2005 |       | 912,042         |       | $             | 2.39       |   |
|                             |       |            |       |          |       |
| Exercisable,  September 30, 2005 |       | 912,042         |       | $             | 2.39       |   |
| Exercisable,  September 30, 2004 |       | 635,934         |       | $             | 2.21       |   |

 

The following table presentsweighted-average price and life information regarding options outstanding and exercisableat September 30, 2005:

 
| **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | ** **              | ** ** | **Weighted-Average** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **              | ** ** | ** **              | ** ** | **Remaining** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Exercise**            | ** ** | **Number of**           | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Prices**              | ** ** | **Shares**              | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                    |       |                    |       |   |   |   |   |   |   |   |   |
| $ 0.55-3.62        |       |                    | 724,246    |   | 7 |   | $ | 1.61 |   | 724,246 |   | $ | 1.61 |   |
| 3.62-6.69               |       |                    | 156,896    |   | 6 |   | 4.67 |   | 156,896 |   | 4.67 |   |
| 6.69-9.75               |       |                    | 25,566     |   | 4 |   | 7.74 |   | 25,566 |   | 7.74 |   |
| 12.82-15.89             |       |                    | 5,334      |   | 1 |   | 15.89 |   | 5,334 |   | 15.89 |   |
|                    |       |                    |       |   |   |   |   |   |   |   |   |
|                    |       | 912,042                 |       | 7 |   | $ | 2.39 |   | 912,042 |   | $ | 2.39 |   |

 

**10.****   ****RETIREMENT SAVINGS PLAN**

 

The Company has a 401(k)retirement savings plan covering substantially all of the Company’s full-timedomestic employees. Under the provisions of the plan, employees may contributea portion of their compensation within certain limitations. The Company, at thediscretion of the Board of Directors, may make contributions on behalf of itsemployees under this plan. Such contributions, if any, become fully vestedafter five years of continuous service. The Company has not made anycontributions during 2005, 2004 or 2003.

 

45

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**11.****   ****SEGMENT INFORMATION**

 

The following table presentsinformation about the Company’s revenue by product lines for the years endedSeptember 30, 2005, 2004 and 2003:

 
| ** **                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                          |       |     |       |     |       |     |       |
| Desktop (primarily Monarch)                                                   |       | 59       | %          | 56       | %          | 59       | %          |
| Datawatch|ES (including Datawatch|RMS,  Datawatch|Researcher & iMergence) |       | 15       |       | 14       |       | 12       |       |
| Visual|QSM and Visual|HD                                                      |       | 26       |       | 30       |       | 29       |       |
|                                                                          |       |     |       |     |       |     |       |
|                                                                          |       | 100      | %          | 100      | %          | 100      | %          |

 

The Company conductsoperations in the U.S. and internationally (principally in the UnitedKingdom).  The following table presentsinformation about the Company’s continuing geographic operations:

 
| ** **                         | ** ** | ** **   | ** ** | **International** | ** ** | ** **       | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------|------------|-------------------|------------|------------------|------------|------------|------------|
| ** **                         | ** ** | ** **   | ** ** | **(Principally**  | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Domestic** | ** ** | **U.K.)**         | ** ** | **Eliminations** | ** ** | **Total**  | ** ** |
| ** **                         | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **Year  Ended September 30, 2005** | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Total revenue                      |       | $            | 14,726,803 |              | $          | 7,847,803        |       | $          | (1,063,011 | ) | $ | 21,511,595 |   |
| Operating income (loss)            |       | 1,639,882    |       | (951,512          | )          | —           |       | 688,370    |       |
| Non-current assets                 |       | 3,456,146    |       | 93,835            |       | —           |       | 3,549,981  |       |
| ** **                         | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **Year  Ended September 30, 2004** | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Total revenue                      |       | $            | 12,782,198 |              | $          | 7,573,558        |       | $          | (1,020,610 | ) | $ | 19,335,146 |   |
| Operating income (loss)            |       | 1,166,971    |       | (242,285          | )          | —           |       | 924,686    |       |
| Non-current assets                 |       | 3,896,946    |       | 116,477           |       | —           |       | 4,013,423  |       |
| ** **                         | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **Year  Ended September 30, 2003** | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Total revenue                      |       | $            | 12,014,158 |              | $          | 6,745,762        |       | $          | (1,047,714 | ) | $ | 17,712,206 |   |
| Operating income (loss)            |       | 1,188,102    |       | (361,914          | )          | —           |       | 826,188    |       |
| Non-current assets                 |       | 1,544,382    |       | 189,209           |       | —           |       | 1,733,591  |       |

 

The reconciliations of totallong-lived assets to the amounts contained in the Company’s consolidatedfinancial statements at September 30, 2005 and 2004 are as follows:

 

46

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| ** **                                     | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                           |       |      |       |      |       |
| Property and  equipment, net                   |       | $         | 516,412    |      | $          | 433,567 |   |
| Goodwill                                       |       | 1,630,646 |       | 1,632,646 |       |
| Acquired  software, net *                      |       | 400,278   |       | 508,333   |       |
| Trademarks *                                   |       | 345,152   |       | 345,152   |       |
| Capitalized  software development costs, net * |       | 182,880   |       | 428,189   |       |
| Patents, net  *                                |       | 151,578   |       | 138,833   |       |
| Customer  list *                               |       | 93,437    |       | 130,000   |       |
| Non -compete  agreements *                     |       | 77,500    |       | 100,000   |       |
| Restricted  cash                               |       | 125,000   |       | 268,299   |       |
| Deposits **                                    |       | 27,098    |       | 28,404    |       |
|                                           |       |      |       |      |       |
| Total long-lived assets                        |       | $         | 3,549,981  |      | $          | 4,013,423 |   |

 

----

| *  |   | Included in other  intangible assets, net in the accompanying consolidated financial statements. |
|----|--------|--------------------------------------------------------------------------------------------------|
| ** |   | Included in other assets  in the accompanying consolidated financial statements.                 |

 

Export revenue aggregated$3,386,650, $3,261,252 and $3,292,638 in 2005, 2004 and 2003, respectively.

 

**12.     RESTRUCTURINGCOSTS**

 

During the first quarter offiscal 2003, the Company approved and completed a restructuring undertaken toreduce costs related to its international operations. In accordance with SFASNo. 146, “*Accounting for Costs Associatedwith Exit or Disposal Activities*,” the Company recorded arestructuring charge of approximately $181,000 for severance benefits for fiveterminated employees and costs resulting from the cancellation of leases andthe disposal of fixed assets related to a relocation to smaller facilities. Thecharges for this restructuring were fully paid in February 2003.

 

The following tablesummarizes the restructuring activity related to the Company’s restructurings:

 
| Restructuring Reserve as of September 30,  2002 |   | $        | 169,000 |   |
|-------------------------------------------------|--------|----------|---------|--------|
| Fiscal 2003  Restructuring Charge               |   | 181,000  |    |
| Cash  Payments - Fiscal 2003                    |   | (334,000 | )       |
| Restructuring  Reserve as of September 30, 2003 |   | 16,000   |    |
| Cash  Payments - Fiscal 2004                    |   | (12,000  | )       |
| Restructuring  Reserve as of September 30, 2004 |   | 4,000    |    |
| Cash  Payments - Fiscal 2005                    |   | (4,000   | )       |
| Restructuring  Reserve as of September 30, 2005 |   | $        | —  |   |

 

At September 30, 2004 therewas an additional accrued severance amount of approximately $1,000, which wasnot related to restructuring activities.

 

**13.    QUARTERLY RESULTS (UNAUDITED)**

 

Supplementary Information:

 

47

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| ** **                                  | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|---------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|
|                                        |       |      |       |       |       |      |       |       |       |
| **Year  Ended September 30, 2005:**         |       |      |       |       |       |      |       |       |       |
| Software license and subscription revenue   |       | $         | 3,216,938  |       | $          | 3,307,340 |       | $          | 3,757,458  |   | $ | 3,951,210 |   |
| Maintenance and service revenue             |       | 1,870,390 |       | 1,801,407  |       | 1,861,474 |       | 1,745,378  |       |
| Cost of software licenses and subscriptions |       | 593,915   |       | 566,311    |       | 698,675   |       | 656,159    |       |
| Cost of maintenance and services            |       | 915,937   |       | 840,503    |       | 822,671   |       | 859,208    |       |
| Expenses                                    |       | 3,757,437 |       | 3,718,117  |       | 3,777,879 |       | 3,616,413  |       |
| (Loss) income from operations               |       | (179,961  | )          | (16,184    | )          | 319,707   |       | 564,808    |       |
| Net (loss) income                           |       | (153,782  | )          | 6,764      |       | 330,064   |       | 617,368    |       |
|                                        |       |      |       |       |       |      |       |       |       |
| Net (loss) income per share - basic         |       | $         | (0.03      | )          | $          | 0.00      |       | $          | 0.06       |   | $ | 0.12 |   |
| Net (loss) income per share - diluted       |       | $         | (0.03      | )          | $          | 0.00      |       | $          | 0.06       |   | $ | 0.11 |   |
|                                        |       |      |       |       |       |      |       |       |       |
| **Year  Ended September 30, 2004:**         |       |      |       |       |       |      |       |       |       |
| Software license and subscription revenue   |       | $         | 2,953,896  |       | $          | 3,483,773 |       | $          | 2,933,547  |   | $ | 3,070,451 |   |
| Maintenance and service revenue             |       | 1,453,192 |       | 1,710,830  |       | 1,775,807 |       | 1,953,650  |       |
| Cost of software licenses and subscriptions |       | 630,093   |       | 760,288    |       | 590,786   |       | 601,460    |       |
| Cost of maintenance and services            |       | 611,677   |       | 661,190    |       | 681,089   |       | 756,606    |       |
| Expenses                                    |       | 2,854,496 |       | 3,363,184  |       | 3,317,948 |       | 3,581,643  |       |
| Income (loss) from operations               |       | 310,822   |       | 409,941    |       | 119,531   |       | 84,392     |       |
| Net income (loss)                           |       | 323,525   |       | 395,563    |       | 99,650    |       | 266,038    |       |
|                                        |       |      |       |       |       |      |       |       |       |
| Net income (loss) per share - basic         |       | $         | 0.06       |       | $          | 0.08      |       | $          | 0.02       |   | $ | 0.05 |   |
| Net income (loss) per share - diluted       |       | $         | 0.06       |       | $          | 0.07      |       | $          | 0.02       |   | $ | 0.05 |   |

 

48

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**Item9.  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not Applicable.

 

**Item 9A. CONTROLS AND PROCEDURES**

 

(a)     Evaluation of disclosurecontrols and procedures

 

As of a date (the“Evaluation Date”) within ninety days prior to the filing date of this AnnualReport on Form 10-K, the Company, under the supervision and with theparticipation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofthe design and operation of the Company’s disclosure controls and procedurespursuant to Rules 13(a)-15(e) promulgated under the Securities Exchange Act of1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer andChief Financial Officer concluded that, as of the Evaluation Date, theCompany’s disclosure controls and procedures are effective in ensuring thatmaterial information relating to the Company (including its consolidatedsubsidiaries) required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, including ensuring that such material informationis accumulated and communicated to the Company’s management, including theCompany’s Chief Executive Officer and Chief Financial Officer, as appropriateto allow timely decisions regarding required disclosure.  It should be noted that any system ofcontrols is designed to provide reasonable, but not absolute, assurances thatthe system will achieve its stated goals under all reasonably foreseeablecircumstances.  Our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsare effective at a level that provides such reasonable assurances.

 

(b)     Changes in internal controls

 

There were no changes in theCompany’s internal controls or, to the knowledge of the Company, in otherfactors that could significantly affect the Company’s internal controlssubsequent to the date of their evaluation, including any corrective actionswith regard to significant deficiencies and material weaknesses.

 

49

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**PART III**

 

**Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Information with respect toDirectors may be found under the caption “Election of Directors” appearing inthe Company’s definitive Proxy Statement for the Annual Meeting of Shareholdersfor the fiscal year ended September 30, 2005. Such information is incorporated herein by reference.   Information with respect to the Company’sexecutive officers may be found under the caption “Executive Officers of theRegistrant” appearing in Part I of this Annual Report on Form 10-K.

 

**Item 11. EXECUTIVE COMPENSATION**

 

The information set forthunder the captions “Compensation and Other Information Concerning Directors andOfficers” appearing in the Company’s definitive Proxy Statement for the AnnualMeeting of Shareholders for the fiscal year ended September 30, 2005 isincorporated herein by reference.

 

**Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The information set forthunder the caption “Principal Holders of Voting Securities” and “EquityCompensation Plans” appearing in the Company’s definitive Proxy Statement forthe Annual Meeting of Shareholders for the fiscal year ended September 30, 2005is incorporated herein by reference.

 

**Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information set forthunder the caption “Certain Transactions” appearing in the Company’s definitiveProxy Statement for the Annual Meeting of Shareholders for the fiscal yearended September 30, 2005 is incorporated herein by reference.

 

**Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

The information set forthunder the caption “Principal Accountant Fees and Services” appearing in theCompany’s definitive Proxy Statement for the Annual Meeting of Shareholders forthe fiscal year ended September 30, 2005 is incorporated herein by reference.

 

50

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**PART IV**

 

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

 

The following documents arefiled as part of this report:

 

**(a)   1.  Consolidated Financial Statements**

 

Report of IndependentRegistered Public Accounting Firm

Consolidated Balance Sheetsas of September 30, 2005 and 2004

Consolidated Statements ofOperations for the Years Ended September 30, 2005, 2004 and 2003

Consolidated Statements ofShareholders’ Equity for the Years Ended September 30, 2005, 2004 and 2003

Consolidated Statements ofCash Flows for the Years Ended September 30, 2005, 2004 and 2003

Notes to ConsolidatedFinancial Statements

 

**2.  Financial Statement Schedule**

 

All schedules are omitted asthe required information is not applicable or is included in the financialstatements or related notes.

 

**3.  List of Exhibits**

 
| **Ex. No.** | ** ** | **Description** |
|-------------|------------|-----------------|
|        |       |            |   |   |
| (1)         |       | 3.1             |   | Restated Certificate of  Incorporation of the Registrant (Exhibit 3.2) |
| (7)         |       | 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) |
| (5)         |       | 4.2             |   | Warrant to Purchase Stock  issued to Silicon Valley Bank, dated January 17, 2001 (Exhibit 4.1) |
| (7)         |       | 4.3             |   | Warrant to Purchase Stock  issued to Silicon Valley Bank, dated October 30, 2001 (Exhibit 4.3) |
| (1)         |       | 10.1*           |   | 1987 Stock Plan (Exhibit  10.7) |
| (13)        |       | 10.2*           |   | Form of Incentive Stock  Option Agreement of the Registrant (Exhibit 10.2) |
| (13)        |       | 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) |
| (11)        |       | 10.5            |   | Option Purchase Agreement  by and among Datawatch Corporation, Personics Corporation and Raymond J.  Huger dated April 29, 2005. (Exhibit 10.1) |
| (10)        |       | 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) |
| (10)        |       | 10.9*           |   | 1996 Stock Plan as amended  as of March 7, 2003 (Exhibit 10.1) |
| (3)         |       | 10.10           |   | Lease, dated August 31,  2000, by and between Fortune Wakefield, LLC and Datawatch Corporation  (Exhibit 10.27) |
| (4)         |       | 10.11           |   | Indemnification Agreement  between Datawatch Corporation and James Wood, dated January 12, 2001 (Exhibit  10.1) |
| (4)         |       | 10.12           |   | Indemnification Agreement  between Datawatch Corporation and Richard de J. Osborne, dated January  12,2001 (Exhibit 10.2) |
| (6)         |       | 10.13           |   | Form of Indemnification  Agreement between Datawatch Corporation and each of its Non-Employee  Directors (Exhibit 10.1) |
| (6)         |       | 10.14*          |   | Advisory Agreement, dated  April 5, 2001, by and between Datawatch Corporation and Richard de J. Osborne  (Exhibit 10.2) |
| (7)         |       | 10.15*          |   | Executive Agreement, dated  July 9, 2001, between the Company and Robert W. Hagger (Exhibit 10.24) |
| (7)         |       | 10.16*          |   | Management Transition  Agreement, dated July 6, 2001, between the Company and Bruce R. Gardner  (Exhibit 10.25) |
| (9)         |       | 10.17*          |   | Executive Agreement, dated  April 25, 2002, by and between Datawatch Corporation and John Kitchen  (Exhibit 10.2) |

 

51

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| (9)    |   | 10.18  |   | Professional Services  Agreement, dated May 16, 2002, by and between Vested Development Inc. and  Datawatch Corporation (Exhibit 10.3)                                        |
|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | 10.19* |   | Severance Agreement  between Datawatch Corporation and John Hulburt, dated November 19, 2004.  (filed herewith)                                                               |
| (12)   |   | 10.20  |   | Stock Purchase Agreement  among Datawatch Corporation, Mergence Technologies Corporation and the  Management Sellers, dated as of August 11, 2005 (Exhibit 2.1).              |
| (12)   |   | 10.22  |   | 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)   |
| (13)   |   | 10.22* |   | Description of Fiscal  Executive Sales Incentive Plan (Exhibit 10.4)                                                                                                          |
| (14)   |   | 10.23* |   | Management Transition  Agreement, dated February 1, 2005, between the Company and Alan R. MacDougall  (Exhibit 10.1)                                                          |
| (15)   |   | 10.24* |   | Form of Lock-up Agreement  between Datawatch Corporation and each Executive Officer of Datawatch  Corporation, dated September 26, 2005 (Exhibit 99.1)                        |
| (15)   |   | 10.25  |   | Sublease Agreement, dated  September 28, 2005, between Tellabs Operations, Inc., and Datawatch  Corporation (Exhibit 99.2)                                                    |
|   |   | 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 orcontract.

 
| (1)  |   | Previously filed as an  exhibit to Registration Statement 33-46290 on Form S-1 and incorporated  herein by reference (the number given in parenthesis indicates the corresponding  exhibit in such Form S-1).                                                |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-K). |
| (3)  |   | Previously filed as an  exhibit to Registrant’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2000 and incorporated herein by reference (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-K). |
| (4)  |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated February 2, 2001 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                              |
| (5)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).   |
| (6)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).      |
| (7)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-K). |
| (8)  |   | Previously filed as an  exhibit to Registrant’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2002 and incorporated herein by reference (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).      |
| (9)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).       |
| (10) |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).      |

 

52

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| (11) |   | Previously filed as an  exhibit to Registrant’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2005 and incorporated herein by reference (the number given in  parenthesis indicates the corresponding exhibit is such Form 10.Q). |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (12) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated August 20, 2004 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                          |
| (13) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated November 2, 2004 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                         |
| (14) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated February 4, 2005 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                         |
| (15) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated September 26, 2005  and incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                       |

 

53

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**(c)  Exhibits**

 

The Company hereby files asexhibits to this Annual Report on Form 10-K those exhibits listed in Item15(a)3 above.

 

**(d)  Financial Statement Schedules**

 

The Company hereby files asfinancial statement schedules to this Annual Report on Form 10-K theConsolidated Financial Statement Schedules listed in Item 15(a)2 above whichare attached hereto.

 

54

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**SIGNATURES**

 

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

 
|   |              | Datawatch Corporation |
|--------|-------------------|-----------------------|
|   |              |                  |   |
| Date:  | December 12, 2005 | By:                   | /s/ Robert W. Hagger |   |
|   |              |                  | Robert W. Hagger |
|   |              |                  | President, Chief Executive  Officer  and Director |

 

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

 
| **SIGNATURE**             | ** ** | **TITLE**                                     | ** **                                           | **DATE**          |
|---------------------------|------------|-----------------------------------------------|------------------------------------------------------|-------------------|
|                      |       |                                          |                                                 |              |
| /s/ Robert W. Hagger      |       |                                          | President, Chief Executive  Officer and Director     |              | December 12, 2005 |
| Robert W. Hagger          |       | (Principal Executive  Officer)                |                                                 |              |
|                      |       |                                          |                                                 |              |
| /s/ John J. Hulburt       |       |                                          | Vice President of Finance,  Chief Financial Officer, |              | December 12, 2005 |
| John J. Hulburt           |       | Treasurer and Assistant  Secretary            |                                                 |              |
|                      |       | (Principal Financial and  Accounting Officer) |                                                 |              |
|                      |       |                                          |                                                 |              |
| /s/ Richard de J. Osborne |       |                                          | Chairman of the Board                                |              | December 12, 2005 |
| Richard de J. Osborne     |       |                                          |                                                 |              |
|                      |       |                                          |                                                 |              |
| /s/ Thomas H. Kelly       |       | Director                                      |                                                 | December 12, 2005 |
| Thomas H. Kelly           |       |                                          |                                                 |              |
|                      |       |                                          |                                                 |              |
| /s/ Terry W. Potter       |       |                                          | Director                                             |              | December 12, 2005 |
| Terry W. Potter           |       |                                          |                                                 |              |   |
|                      |       |                                          |                                                 |              |   |
| /s/ David T. Riddiford    |       |                                          | Director                                             |              | December 12, 2005 |
| David T. Riddiford        |       |                                          |                                                 |              |   |
|                      |       |                                          |                                                 |              |   |
| /s/ James Wood            |       |                                          | Director                                             |              | December 12, 2005 |
| James Wood                |       |                                          |                                                 |              |   |
|                           |            |                                               |                                                      |                   |  |  |  |

 

55

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**EXHIBITINDEX**

 
| (1)    |   | 3.1    |   | Restated Certificate of  Incorporation of the Registrant (Exhibit 3.2)                                                                                                        |
|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (7)    |   | 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)                                                                                                             |
| (5)    |   | 4.2    |   | Warrant to Purchase Stock  issued to Silicon Valley Bank, dated January 17, 2001 (Exhibit 4.1)                                                                                |
| (7)    |   | 4.3    |   | Warrant to Purchase Stock  issued to Silicon Valley Bank, dated October 30, 2001 (Exhibit 4.3)                                                                                |
| (1)    |   | 10.1*  |   | 1987 Stock Plan (Exhibit  10.7)                                                                                                                                               |
| (13)   |   | 10.2*  |   | Form of Incentive Stock  Option Agreement of the Registrant (Exhibit 10.2)                                                                                                    |
| (13)   |   | 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)                                 |
| (11)   |   | 10.5   |   | Option Purchase Agreement  by and among Datawatch Corporation, Personics Corporation and Raymond J.  Huger dated April 29, 2005. (Exhibit 10.1)                               |
| (10)   |   | 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)                                                                                                  |
| (10)   |   | 10.9*  |   | 1996 Stock Plan as amended  as of March 7, 2003 (Exhibit 10.1)                                                                                                                |
| (3)    |   | 10.10  |   | Lease, dated August 31,  2000, by and between Fortune Wakefield, LLC and Datawatch Corporation  (Exhibit 10.27)                                                               |
| (4)    |   | 10.11  |   | Indemnification Agreement  between Datawatch Corporation and James Wood, dated January 12, 2001 (Exhibit  10.1)                                                               |
| (4)    |   | 10.12  |   | Indemnification Agreement  between Datawatch Corporation and Richard de J. Osborne, dated January  12,2001 (Exhibit 10.2)                                                     |
| (6)    |   | 10.13  |   | Form of Indemnification  Agreement between Datawatch Corporation and each of its Non-Employee  Directors (Exhibit 10.1)                                                       |
| (6)    |   | 10.14* |   | Advisory Agreement, dated  April 5, 2001, by and between Datawatch Corporation and Richard de J. Osborne  (Exhibit 10.2)                                                      |
| (7)    |   | 10.15* |   | Executive Agreement, dated  July 9, 2001, between the Company and Robert W. Hagger (Exhibit 10.24)                                                                            |
| (7)    |   | 10.16* |   | Management Transition  Agreement, dated July 6, 2001, between the Company and Bruce R. Gardner  (Exhibit 10.25)                                                               |
| (9)    |   | 10.17* |   | Executive Agreement, dated  April 25, 2002, by and between Datawatch Corporation and John Kitchen  (Exhibit 10.2)                                                             |
| (9)    |   | 10.18  |   | Professional Services  Agreement, dated May 16, 2002, by and between Vested Development Inc. and  Datawatch Corporation (Exhibit 10.3)                                        |
|   |   | 10.19* |   | Severance Agreement  between Datawatch Corporation and John Hulburt, dated November 19, 2004.  (filed herewith)                                                               |
| (12)   |   | 10.20  |   | Stock Purchase Agreement  among Datawatch Corporation, Mergence Technologies Corporation and the  Management Sellers, dated as of August 11, 2005 (Exhibit 2.1).              |
| (12)   |   | 10.22  |   | 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)   |
| (13)   |   | 10.22* |   | Description of Fiscal  Executive Sales Incentive Plan (Exhibit 10.4)                                                                                                          |
| (14)   |   | 10.23* |   | Management Transition  Agreement, dated February 1, 2005, between the Company and Alan R. MacDougall  (Exhibit 10.1)                                                          |
| (15)   |   | 10.24* |   | Form of Lock-up Agreement  between Datawatch Corporation and each Executive Officer of Datawatch  Corporation, dated September 26, 2005 (Exhibit 99.1)                        |
| (15)   |   | 10.25  |   | Sublease Agreement, dated  September 28, 2005, between Tellabs Operations, Inc., and Datawatch  Corporation (Exhibit 99.2)                                                    |
|   |   | 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) |

 

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|   |   | 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) |
|--------|--------|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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| * |   | Indicates a management  contract or compensatory plan or contract. |
|---|--------|--------------------------------------------------------------------|

 
| (1)  |   | Previously filed as an  exhibit to Registration Statement 33-46290 on Form S-1 and incorporated  herein by reference (the number given in parenthesis indicates the  corresponding exhibit in such Form S-1).                                                |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-K). |
| (3)  |   | Previously filed as an  exhibit to Registrant’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2000 and incorporated herein by reference (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-K). |
| (4)  |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated February 2, 2001 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                              |
| (5)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).   |
| (6)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).      |
| (7)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-K). |
| (8)  |   | Previously filed as an  exhibit to Registrant’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2002 and incorporated herein by reference (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).      |
| (9)  |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).       |
| (10) |   | 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 (the number given in  parenthesis indicates the corresponding exhibit in such Form 10-Q).      |
| (11) |   | Previously filed as an  exhibit to Registrant’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2005 and incorporated herein by reference (the number given in  parenthesis indicates the corresponding exhibit is such Form 10.Q).      |
| (12) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated August 20, 2004 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                               |
| (13) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated November 2, 2004 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                              |
| (14) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated February 4, 2005 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                              |
| (15) |   | Previously filed as an  exhibit to Registrant’s Current Report on Form 8-K dated September 26, 2005  and incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 8-K).                            |

 

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