**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-K**

**ý**                                 ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2006

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934 

**FORTHE TRANSITION PERIOD FROM                        TO                         **

**COMMISSION FILE NUMBER: 000-19960**

**DATAWATCH CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

**271 MILL ROAD**

**QUORUM OFFICE PARK**

**CHELMSFORD, MASSACHUSETTS 01824**

**(978) 441-2200**

(Address and telephone number of principal executiveoffice)

**Securities registered pursuant toSection 12(b) of the Act:**

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

 

Securities registered pursuant to Section 12(g) ofthe Act: **NONE**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act. Yes o No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section15(d) of the Act.Yes o No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x**  **No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to thisForm 10-K.    x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinitions of “accelerated filer” and “large accelerated filer” inRule 12b-2 of the Exchange Act.

Large accelerated filer  o  Accelerated filer  o  Non-acceleratedfiler x

Indicate by check markwhether the registrant is a shell company (as defined in Exchange ActRule 12b-2).Yes o No x

The aggregate market value of voting stock held bynon-affiliates of the registrant, based on the closing price of the registrant’scommon stock on March 31, 2006, the last business day of the Company’s mostrecently completed second fiscal quarter, as reported by the NASDAQ SmallCapMarket was $16,390,909.

The number of shares of the registrant’s common stock,$.01 par value, outstanding as of December 26, 2006 was 5,516,923.

**DocumentsIncorporated By Reference**

Registrant intends to file a definitive ProxyStatement pursuant to Regulation 14A within 120 days of the end of the fiscalyear ended September 30, 2006. Portions of such Proxy Statement areincorporated by reference in Part III of this report.

 

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**DATAWATCH CORPORATION**

**ANNUAL REPORT ONFORM 10-K**

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

** **

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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 EnterpriseInformation Management market space. By providing solutions that build on aService Oriented Architecture (“SOA”) framework and Monarch report miningtechnologies, Datawatch allows organizations to access, archive, enhance,analyze and 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, Extract, Transform, Load (“ETL”) and businessservice management solutions with very high return on investment. Datawatchproducts are used in more than 20,000 companies, institutions and governmentagencies worldwide.

The Company offers itsenterprise products through the sale of perpetual licenses as well as asubscription pricing model that allows customers to begin using the Company’sproducts at a lower initial cost of software acquisition. Subscription termstypically run 90 days or 24 months and automatically renew unless terminatedwith 90 days notice. The subscription arrangement includes software,maintenance and unspecified future upgrades including major version upgrades.During fiscal 2006, sales under the subscription model increased by over 36% asgeneral industry knowledge and acceptance of the model grew substantially inthe fiscal year.

The Company is a Delawarecorporation with executive offices located at 271 Mill Road, Quorum OfficePark, Chelmsford, MA 01824 and the Company’s telephone number is (978)441-2200.  Periodic reports are madeavailable to the public, free of charge, on the Company’s website,www.datawatch.com and through the SEC’s website, www.sec.gov as soon asreasonably practicable after they have 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 Monarchhave been sold, with localized versions in English, French, German and Spanish.Monarch transforms structured text files (reports, statements, etc.) into alive database that users can sort, filter, summarize, graph and export to otherapplications such as Microsoft Corporation’s Excel or Access.  Monarch Professional Edition lets usersextract and work with data in PDF and HTML files, databases, spreadsheets andOpen Data Base Connectivity (“ODBC”) sources as well as reports.  The Monarch product line represented approximately56% of total revenues for the fiscal year 2006.

**Monarch Data Pump** - Monarch Data Pump (“MDP”) provides powerful information delivery anddata ETL capabilities in one automated solution, without programming. CombiningDatawatch’s Monarch Report Mining/Data Mining engine with the Microsoft.NETframework, MDP delivers a highly scalable and easily administered enterprisesolution to acquire, combine, and monitor customized data, and deliver thatdata in a wide variety of formats, on an automatic, scheduled basis.

****Monarch|RMS**** - Monarch|RMS (Report Mining Server) is aweb-based report mining and analysis solution that integrates with any existingComputer Output to Laser Disk/Enterprise Record Management (“COLD/ERM”),document or content management archiving solution. Monarch|RMS opens up thecorporate data locked in stored, static reports, enabling dynamicbusiness-driven analysis of information in users’ web browsers or favoriteproductivity tools with no programming.

****Datawatch|BDS -********Datawatch|BDS(Business Document Server) is a high speed, high volume document archivesystem, storing text as well****************as**** images, intelligent data streams andunstructured content, complete with file compression. Datawatch|BDS is capableof enabling thousands of end users to access and retrieve stored documents 

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in a matter of seconds via the network or web.Datawatch|BDS also offers advanced business benefits, including optionalautomatic email notification to end users of newly archived documents (“e-Notify”),with rules-based options for email content, as well as optional web-enabledtransformation of business documents into customized data for easy analysis.

**Datawatch**|**ES ****–****** Datawatch|ES is a web-enabledbusiness information portal, providing complete report management, businessintelligence and content management, and the ability to analyze data withinreports, all using just a web browser. Datawatch|ES allows organizations toquickly and easily deliver business intelligence and decision support, derivedfrom existing reporting systems and other database sources, with no newprogramming or report writing. Datawatch|ES automatically archives report dataand binary documents in an enterprise report and document warehouse andprovides users a unified point of entry to view, analyze and share informationover the Internet.

**Datawatch|MailManager******–********Datawatch|MailManager****isa highly scalable e-mail management solution that provides complete lifecycle,compliance, and storage management for Microsoft Exchange environments. It is acompliance solution built specifically for the corporate enterprise, able tosupport even the most stringent regulatory requirements. Datawatch|MailManagerautomates the e-mail management lifecycle. It captures internal, outgoing andincoming email correspondence, indexing it and managing its retention based onan organization’s internal policies. In the case of audit or legal discovery,related e-mail can be instantly and accurately retrieved for rapid response.

**Visual|Insight******–********Visual|Insight****isa performance management solution that provides web based scorecarding,knowledge management and Key Performance Indicator (KPI) reporting. Built onthe Datawatch|Researcher .NET platform, Visual|Insight not only allows forperformance management, but can actually facilitate performance improvement.Highly customizable, Visual|Insight can access data from any and allorganizational databases, as well as having the ability to take advantage ofexisting trusted data sources such as reports, for ease and speed of installationand a quick return on investment.

**Datawatch|Researcher******–********Datawatch|Researcher is the tool kit forbuilding performance management and workflow capabilities into Visual|Insight,Datawatch|ES and Visual|QSM. Datawatch|Researcher is a .NET based content anddata aggregation platform that searches inter-related data, documents, andcommunications scattered over multiple and disparate repositories includingdatabases, document and content management systems, email repositories, theInternet and more. It then merges and analyzes the results for uses in balancedscorecards, KPI reporting, problem management and business process management.It also can turn the results into comprehensive actionable case records foreasier compliance, auditing, accounting, and billing processes.

**Visual**|**QSM** - Visual|QSM is a fully internet-enabled IT supportsolution that can scale from a basic help desk system to a full businessmanagement solution that incorporates workflow and network managementcapabilities and provides web access to multiple databases while enablingcustomers to interact via a standard browser. Visual|QSM, a market leader in Europe, also provides advanced servicelevel management capabilities, integrated change management features, businessprocess automation tools and one of the industry’s easiest to learn and useinterfaces.  The Visual|QSM product linerepresented approximately 21% of total revenues for fiscal year 2006.

**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 to deploy, Visual|HD is an enterprise-widesupport solution that supports an organization’s existing IT infrastructure.Visual|HD has the additional ability to utilize XML-based Web Services as wellas 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 

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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 VorteXML Server**,**a scalable, high-volume server that automates theextraction and conversion of text documents into XML.

The Company also receiveslicense royalties for its iMergence iStore product primarily from a provider ofservices to the financial services industry. iMergence iStore is a reportmanagement solution which manages computer-generated reports, mines the datacontained in them, and allows users to interactively merge and transform theminto new reports.

**PRICING**

The Company’s desktopproducts are sold under single and multi-user licenses.  A single user license for Monarch StandardEdition is priced at $659.  Multi-userlicenses for Monarch Standard Edition are typically priced from $340 to $550per user, depending upon the number of users. A single user license for MonarchProfessional Edition is priced at $799. Multi-user licenses for Monarch Professional Edition are typicallypriced from $450 to $685 per user, depending upon the number of users. MonarchData Pump is typically priced at $7,999 per server.  A single user license for VorteXML Designeris priced at $499 and VorteXML Server is typically priced at $7,999 per server.

The Company’s enterprisereport management and business service center products are primarily sold underserver-based licenses with named-user and concurrent-user client licenses.  An entry-level Monarch|RMS system is pricedat $15,000, with the majority of such sales priced in the $25,000 to $50,000range depending on the number of software modules and user licenses sold.Entry-level Datawatch|BDS systems are priced at approximately $55,000. Themajority of our sales of Datawatch|BDS systems are priced in the range of$100,000 to $250,000. Entry-level Datawatch|ES and Visual|Insight systems arepriced at approximately $30,000 and $40,000, respectively. The majority ofsales for these products are priced in the range of $60,000 to $200,000.Entry-level Datawatch|MailManager systems are priced at approximately $12,000with the majority of such sales priced in the range of $18,000 to $250,000. Anentry-level Visual|QSM system is priced at approximately $20,000 with themajority of such sales priced in the range of $35,000 to $200,000. Anentry-level Visual|HD system sells for less than $10,000, with the majority ofsuch sales priced in the $10,000 to $60,000 range. Maintenance agreements,training and implementation services are sold separately.

The Company also sells itsEnterprise Software using a subscription model. Subscription terms typicallyrange from 90 days to 24 months and automatically renew unless terminated with90 days notice. The subscription arrangement includes software, maintenance andunspecified future upgrades including major version upgrades. The subscription pricingdoes not include professional services. Such professional services are invoicedseparately. Prices for Datawatch|BDS subscriptions typically range fromapproximately $4,500 to $11,500 per month. Prices for Datawatch|ES andVisual|Insight subscriptions typically range from approximately $2,000 to$9,000 per month. Prices for Datawatch|MailManager subscriptions typicallyrange from approximately $850 to $11,500 per month. Visual|QSM subscriptionstypically range from approximately $1,500 to $9,000 per month, and Visual|HDsubscriptions typically range from $500 to $2,500 per month.

**MARKETING AND DISTRIBUTION**

Datawatch markets itsproducts through a variety of channels in order to gain broad market exposureand to satisfy the needs of its customers. Datawatch believes that some customers prefer to purchase productsthrough service-oriented resellers, while others buy on the basis of price,purchase convenience, and/or immediate delivery.

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

Datawatch uses a variety ofmarketing programs to create demand for its products. These programs include

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advertising, cooperative advertising with resellerpartners, direct mail, exhibitor participation in industry shows, executiveparticipation in press briefings, Internet-based marketing and on-going communicationwith the trade press.

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

Datawatch warrants thephysical disk media and printed documentation for its products to be free ofdefects in material and workmanship for a period of 30 to 90 days from the dateof purchase depending on the product. Datawatch also offers a 30 day or 60 day money-back guarantee on certainof its products sold directly to end-users. Under the guarantee, customers mayreturn purchased products within the 30 day or 60 day period for a full refundif they are not completely satisfied. To date, the Company has not experiencedany significant product returns under its money-back guarantee.

During fiscal 2006, 2005 and2004, one distributor, Ingram Micro Inc., represented approximately 15%, 19%and 20%, respectively, of the Company’s total revenue.  During fiscal 2006, another distributor, TechData, represented approximately 13% of the Company’s total revenue. No othercustomer accounted for more than 10% of the Company’s total revenue in fiscal2006, 2005 or 2004. Datawatch’s revenues from outside of the U.S. are primarilythe result of sales through the direct sales force of its wholly-ownedsubsidiary, Datawatch International Limited and its subsidiaries (“DatawatchInternational”) and through international resellers. Such international sales(which are primarily in the UK), not including export sales from domesticoperations, represented approximately 32%, 36% and 39% of the Company’s totalrevenue for fiscal 2006, 2005 and 2004, respectively.  See Note 10 to the Company’s ConsolidatedFinancial Statements for segment information.

**RESEARCH AND DEVELOPMENT**

The Company believes thattimely development of new products and enhancements to its existing products isessential to maintain strong positions in its markets. Datawatch intends tocontinue to invest significant amounts in research and product development toensure that its products meet the current and future demands of its markets aswell as to take advantage of evolving technology trends.

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

Datawatch’s product managerswork closely with developers, whether independent or in-house, to defineproduct specifications.  The initialconcept for a product originates from this cooperative effort.  The developer is generally responsible forcoding the development project. Datawatch’s product managers maintain closetechnical control over the products, giving the Company the freedom todesignate which modifications and enhancements are most important and when theyshould be implemented.  The productmanagers and their staff work in parallel with the developers to produceprinted documentation, on-line help files, tutorials and installation software.In some cases, Datawatch may choose to subcontract a portion of this work on aproject basis to third-party suppliers under contracts. Datawatch personnelalso perform extensive quality assurance testing for all products andcoordinate external beta test programs.

An existing agreementbetween Datawatch and Math Strategies grants the Company exclusive worldwiderights to use and distribute certain intellectual property owned by MathStrategies and incorporated by the Company in its Monarch, Monarch Data Pump,VorteXML and certain other products. In February 2006, the Company extended itsexclusive worldwide distribution rights with Math Strategies for the technologyused in the development of Monarch products until April 30, 2015. In addition,an amendment to the purchase option contract 

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with Math Strategies, originally signed on April 29,2004, gives Datawatch the option to purchase the intellectual property rightsto the software source code and any existing patents at any time before April30, 2015. This option, if exercised, would provide the Company with increasedflexibility to utilize the purchased technology in the future.

Other Datawatch productshave been developed through in-house software development or by independentsoftware engineers hired under contract. Datawatch maintains source code andfull product control for these products, which include Datawatch|BDS,Datawatch|ES, Visual|QSM, and Visual|HD products. Datawatch|ES, Visual|QSM, andVisual|HD are trademarks of Datawatch Corporation.  Visual|Help Desk is a registered trademark ofAuxilor, Inc. (“Auxilor”), a wholly-owned subsidiary of DatawatchCorporation.

During fiscal 2004, theCompany acquired Mergence Technologies Corporation which has a branch softwaredevelopment and testing office in the Philippines. Mergence, which was renamedDatawatch Technologies Corporation (“DTC”) coincident with the acquisition,developed the iMergence iStore and Datawatch|Researcher products at itsfacilities in the United States and the Philippines prior to the acquisition.The Company has integrated the Philippines development branch as an alternativedevelopment facility for its other enterprise products.  iMergence is a registered trademark ofDatawatch Technologies Corporation.

Research and developmentexpense was $2,093,707, $2,031,280 and $1,451,533 for fiscal years 2006, 2005and 2004, respectively.

**BACKLOG**

The Company’s softwareproducts are generally shipped within three business days of receipt of anorder.  Accordingly, the Company does notbelieve that backlog for its products is a meaningful indicator of future business.The Company does maintain a backlog of services related to its Datawatch|BDS,Datawatch|ES, Visual|QSM, and Visual|HD business. While this services backlogwill provide future revenue to the Company, the Company believes that it is nota meaningful indicator of future business.

**COMPETITION**

The software industry ishighly competitive and is characterized by rapidly changing technology andevolving industry standards.  Datawatchcompetes with a number of companies including Hyperion, Actuate Corporation,Mobius Management Systems, Inc. and others that have substantially greaterfinancial, marketing and technological resources than the Company. Competitionin the industry is likely to intensify as current competitors expand theirproduct lines and as new competitors enter the market.

**PRODUCT PROTECTION**

In addition to havingcertain patents pending on its software technologies, Datawatch relies on acombination of trade secret, copyright and trademark laws, nondisclosure andother contractual agreements, and technical measures to protect its rights inits products.  Despite these precautions,unauthorized parties may attempt to copy aspects of Datawatch’s products or toobtain and use information 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’sproducts involves the duplication of compact disks and the printing of usermanuals, packaging and other related materials. High volume compact diskduplication is performed by

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non-affiliated subcontractors, while low volumecompact disk duplication is performed in-house. Printing work is also performedby non-affiliated subcontractors. To date, Datawatch has not experienced anymaterial difficulties or delays in production of its software and relateddocumentation and believes that, if necessary, alternative production sourcescould be secured at a commercially reasonable cost.

**EMPLOYEES**

As of December 27,2006, Datawatch had 131 full-time and 5 contract, temporary or part-timeemployees, including 38 engaged in marketing, sales, and customer service; 41engaged in product consulting, training and technical support; 38 engaged inproduct management, development and quality assurance; 17 providing general,administrative, accounting, and IT functions; and 2 engaged in softwareproduction and warehousing.

**Item 1A.  RISK FACTORS**

The Company does not provideforecasts of its future financial performance. However, from time to time, informationprovided by the Company or statements made by its employees may contain “forwardlooking” information that involves risks and uncertainties.  In particular, statements contained in thisAnnual Report on Form 10-K that are not historical facts (including, butnot limited to statements contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” of Part II of this Annual Report on Form 10-K relatingto liquidity and capital resources) may constitute forward looking statementsand are made under the safe harbor provisions of The Private SecuritiesLitigation Reform Act of 1995. The Company cautions readers not to place unduereliance on any such forward looking-statements, which speak only as of the datethey are made. The Company disclaims any obligation, except as specificallyrequired by law and the rules of the Securities and Exchange Commission,to publicly update or revise any such statements to reflect any change in theCompany’s expectations or in events, conditions or circumstances on which anysuch statements may be based, or that may affect the likelihood that actualresults will differ from those set forth in 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 following discussion of the Company’s riskfactors should be read in conjunction with the financial statements containedherein 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, theCompany introduced a subscription sales model for the sale of its enterpriseproducts.  This pricing model allowscustomers to begin using the Company’s products at a lower initial cost ofsoftware acquisition when compared to the more traditional perpetual licensesale. While the subscription sales model is designed to increase the number ofenterprise solutions sold and also reduce dependency on short-term sales bybuilding a recurring revenue stream, it introduces increased risks for theCompany primarily associated with the timing of revenue recognition and reducedcash flows. The subscription model delays revenue recognition when compared tothe typical perpetual license sale and also, as the Company allows terminationof certain subscriptions with 90 days notice, could result in decreased revenuefor solutions sold under the model if the Company experiences a high percentageof subscription cancellations during the first two years of thesubscription.  Further, as amounts duefrom customers are invoiced over the life of the subscription, there aredelayed cash flows from subscription sales when compared to perpetual licensesales.

Fluctuations in Quarterly Operating Results

The Company’s futureoperating results could vary substantially from quarter-to-quarter because of uncertaintiesand/or risks associated with such things as technological change, competition,and delays in the introduction of products or product enhancements and generalmarket trends. Historically, the Company has operated with little backlog oforders because its software products are generally shipped as orders arereceived. 

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As a result, net sales in any quarter aresubstantially dependent on orders booked and shipped in that quarter.  Further, the Company’s introduction of thesubscription sales model could result in decreased revenues over the shortterm.  Because the Company’s staffing andoperating expenses are based on anticipated revenue levels and a highpercentage of the Company’s costs are fixed in the short-term, small variationsin the timing of revenues can cause significant variations in operating resultsfrom quarter-to-quarter. Because of these factors, the Company believes thatperiod-to-period comparisons of its results of operations are not necessarilymeaningful and should not be relied upon as indications of future performance.There can be no assurance that the Company will not experience such variationsin operating results in the future or that such variations will not have amaterial adverse effect on the Company’s business, financial condition orresults of operations.

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

The revenue growth andprofitability of the Company’s business depends on the overall demand forcomputer software and services, particularly in the markets in which itcompetes. Because the Company’s sales are primarily to major corporatecustomers, its business also depends on general economic and businessconditions.  A softening of demand forcomputer software and services caused by a weakening of the economy in theUnited States or abroad, may result in lower revenue growth rates, decreasedrevenues and reduced profitability. In addition, terrorist attacks against theUnited States, and the United States military response to these attacks haveadded to economic and political uncertainty which may adversely affectworldwide demand for computer software and services and result in significantfluctuations in the value of foreign currencies. 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 endedSeptember 30, 2006, Monarch, Visual|QSM and Visual|HD, Datawatch|ES andDatawatch|BDS accounted for approximately 58%, 22%, 15% and 5%, respectively,of the Company’s total revenue. The Company is wholly dependent on the Monarch,Datawatch|ES, Visual|QSM, Visual|HD, Datawatch|Researcher and Datawatch|BDSproducts, the latter of which was introduced during the fiscal year endedSeptember 30, 2006 through the Company’s acquisition of certain assets of theIntegrated Document Archiving and Retrieval Systems (“IDARS”) business ofClearStory Systems, Inc. As a result, any factor adversely affecting sales ofany of these products could have a material adverse effect on the Company. TheCompany’s future financial performance will depend in part on the successfulintroduction of its new and enhanced versions of these products and developmentof new versions of these and other products and subsequent acceptance of suchnew and enhanced products. In addition, competitive pressures or other factorsmay result in significant price erosion that could have a material adverseeffect on the Company’s business, financial condition, results of operations,or cash flows.

International Sales

In the years endedSeptember 30, 2006, 2005 and 2004, international sales, including exportsales from domestic operations, accounted for approximately 32%, 38% and 41%,respectively, of the Company’s total revenue. The Company anticipates that international sales will continue toaccount for a significant percentage of its total revenue.  A significant portion of the Company’s totalrevenue will therefore be subject to risks associated with international sales,including unexpected changes in legal and regulatory requirements, changes intariffs, exchange rates and other barriers, political and economic instability,possible effects of war and acts of terrorism, difficulties in accountreceivable collection, difficulties in managing distributors orrepresentatives, difficulties in staffing and managing internationaloperations, difficulties in protecting the Company’s intellectual propertyoverseas, seasonality of sales and potentially adverse tax consequences.

AcquisitionStrategy

As evidenced by the May 2006acquisition of the IDARS business from ClearStory Systems, Inc., theAugust 2004 acquisition of Mergence Technologies Corporation and theOctober 2002 acquisition of Auxilor Inc., the Company continues to addressthe need to develop new products, in part, through the acquisition of other 

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companies. Acquisitions involve numerous risksincluding difficulties in the assimilation of the operations, technologies andproducts of the acquired companies, the diversion of management’s attentionfrom other business concerns, risks of entering markets in which the Companyhas no or limited direct prior experience and where competitors in such marketshave stronger 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 of companies in the high technology industrymay be more difficult to accomplish than in other industries.

Compliancewith Financial Covenants and other Provisions of the Credit Agreement

The Company currently has a secured credit agreementwith a bank (the “Bank”), which includes certain cash financial covenants thatthe Company must meet on a monthly basis. At June 30, 2006 and September 30, 2006, the Company did not meet thesecovenants, but sought and received waivers from the Bank with respect to thesecovenants and modifications to the credit agreement intended to make futuredefaults less likely.  However, there canbe no assurance that the Company will not violate these financial covenants inthe future or that, if it does, the Bank will grant any further waivers ormodifications.  This may result in theCompany not being able to borrow any additional amounts under the creditagreement, the Company may have to pay back the entire principal amountoutstanding plus accrued interest, or, or if the Company were unable to repaythe outstanding amount, the Bank may seek to sell the Company’s assets, any ofwhich may have a material impact on the Company.

Dependence on New Introductions; New Product Delays

Growth in the Company’sbusiness depends in substantial part on the continuing introduction of newproducts. The length of product life cycles depends in part on end-user demandfor new or additional functionality in the Company’s products. If the Companyfails to accurately anticipate the demand for, or encounters any significantdelays in developing or introducing, new products or additional functionalityon its products, there could be a material adverse effect on the Company’sbusiness. Product life cycles can also be affected by the introduction bysuppliers of operating systems of comparable functionality within theirproducts. The failure of the Company to anticipate the introduction ofadditional functionality in products developed by such suppliers could have amaterial adverse effect on the Company’s business. In addition, the Company’scompetitors may introduce products with more features and lower prices than theCompany’s products. Such increase in competition could adversely affect thelife cycles of the Company’s products, which in turn could have a materialadverse effect on the Company’s business.

Software products maycontain undetected errors or failures when first introduced or as new versionsare released.  There can be no assurancethat, despite testing by the Company and by current and potential end-users,errors will not be found in new products after commencement of commercialshipments, resulting in loss of or delay in market acceptance. Any failure bythe Company to anticipate or respond adequately to changes in technology andcustomer preferences, or any significant delays in product development orintroduction, could have a material adverse effect on the Company’s business.

Rapid Technological Change

The markets in which theCompany competes have undergone, and can be expected to continue to undergo,rapid and significant technological change. The ability of the Company to growwill depend on its ability to successfully update and improve its existingproducts and market and license new products to meet the changing demands ofthe marketplace and that can compete successfully with the existing and newproducts 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.

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Competitionin the PC Software Industry

The software market forpersonal computers is highly competitive and characterized by continual changeand improvement in technology. Several of the Company’s existing and potentialcompetitors, including BMC Software, Actuate Corporation, Hyperion, MobiusManagement Systems, Inc., and others, have substantially greaterfinancial, marketing and technological resources than the Company.  No assurance can be given that the Companywill have the resources required to compete successfully in the future.

Dependence on Proprietary Software Technology

The Company’s success isdependent upon proprietary software technology. Although the Company does notown all patents on any such technology, it does hold exclusive licenses to suchtechnology and relies principally on a combination of trade secret, copyrightand trademark laws, nondisclosure and other contractual agreements andtechnical measures to protect its rights to such proprietary technology.Despite such precautions, there can be no assurance that such steps will beadequate to deter misappropriation of such technology.

Reliance on Software License Agreements

Substantially all of theCompany’s products incorporate third-party proprietary technology which isgenerally licensed to the Company on an exclusive, worldwide basis. Failure bysuch third-parties to continue to develop technology for the Company andlicense such technology to the Company could have a material adverse effect onthe Company’s business and results of operations.

Dependence on the Ability to Hire and Retain SkilledPersonnel

Qualified personnel are ingreat demand throughout the software industry. The Company’s success depends,in large part, upon its ability to attract, train, motivate and retain highlyskilled employees, particularly, technical personnel and product developmentand professional services personnel, sales and marketing personnel and othersenior personnel. The Company’s failure to attract and retain the highlytrained 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 andattrition in the affected department. This could have a material adverse effecton the Company’s business, operating results and financial condition.

Indirect Distribution Channels

The Company sells asignificant portion of its products through resellers, none of which are underthe direct control of the Company. The loss of major resellers of the Company’sproducts, or a significant decline in their sales, could have a materialadverse effect on the Company’s operating results. There can be no assurancethat the Company will be able to attract or retain additional qualifiedresellers or that any such resellers will be able to effectively sell theCompany’s products. The Company seeks to select and retain resellers on thebasis of their business credentials and their ability to add value throughexpertise in specific vertical markets or application programming expertise. Inaddition, the Company relies on resellers to provide post-sales service andsupport, and any deficiencies in such service and support could adverselyaffect the Company’s business.

Volatilityof Stock Price

As is frequently the casewith the stocks of high technology companies, the market price of the Company’scommon stock has been, and may continue to be, volatile. Factors such asquarterly fluctuations in results of operations, increased competition, theintroduction of new products by the Company or its competitors, expenses orother difficulties associated with assimilating companies acquired by theCompany, changes in the mix of sales channels, the timing of significantcustomer orders, and macroeconomic conditions generally, may have a significantimpact on the market price of the stock of the Company. Any shortfall inrevenue or earnings from the levels anticipated by securities analysts couldhave an immediate and significant adverse effect on the market price of theCompany’s common stock in any given period. In addition, the stock market hasfrom time to time experienced extreme price and volume fluctuations, which haveparticularly affected the market price for many high technology companies andwhich, on occasion, have appeared to be unrelated to the operating performanceof such companies.

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**Item 1B.  UNRESOLVED STAFF COMMENTS**

Not applicable.

**Item 2.  PROPERTIES**

TheCompany is currently headquartered in 14,683 square feet of leased office spacein Chelmsford, Massachusetts pursuant to a sublease agreement executed onSeptember 28, 2005. The sublease expires in June 2011. The sublease containsannual rent escalations for each year of the sublease as well as an abatementof rent during the first twelve months of the sublease term. The aggregate rentfor the remaining term of the sublease is approximately $736,000. In additionto rent, the sublease requires the Company to pay certain taxes, insurance andoperating costs related to the leased facility based on the Company’s pro-ratashare of such costs. The Company is also responsible for the costs of certaintenant improvements associated with the new facility but will be entitled toreimbursement for certain of such costs from the sublessor.

The Company also maintains alease on offices in Rutherford, New Jersey and maintains international salesand administrative offices in the United Kingdom and Australia. In addition,the Company maintains leases on offices in France and Germany, and a software developmentand testing facility in the Philippines.

**Item 3.  LEGAL PROCEEDINGS**

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

**Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

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

**Executive Officers of the Registrant**

The names, ages and titlesof the executive officers of the Company as of December 1, 2006 are asfollows:
| Robert  W. Hagger         |   | 58 |   | President, Chief Executive Officer and Director                                        |
|---------------------------|--------|----|--------|----------------------------------------------------------------------------------------|
| John H. Kitchen, III |   | 50 |   | Senior Vice President of Desktop & Server  Solutions and Secretary            |
| John J. Hulburt           |   | 40 |   | Vice President of Finance, Chief Financial Officer,  Treasurer and Assistant Secretary |

 

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

ROBERT W. HAGGER, President,Chief Executive Officer and Director. Mr. Hagger assumed the positions of President, Chief ExecutiveOfficer and Director on July 9, 2001. Prior thereto, and sinceNovember 1, 1997, Mr. Hagger was Senior Vice President ofInternational Operations of the Company. Prior to that and sinceMarch 1997, Mr. Hagger was Managing Director of the Company’swholly-owned subsidiary Datawatch International Limited. Prior to joiningDatawatch, from 1993 to March 1997, Mr. Hagger was founder andManaging Director of Insight Strategy Management Ltd. Prior to that, he wasManaging Director of Byrne Fleming Ltd.

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

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since July 2000, Mr. Kitchen was theCompany’s Vice President of Marketing. Prior to July 2000, and sinceMarch 1998, Mr. Kitchen was the Company’s Director of Marketing.Prior to that, Mr. Kitchen was a marketing consultant to the Company.

JOHN J. HULBURT, VicePresident of Finance, Chief Financial Officer, Treasurer and AssistantSecretary.  Mr. Hulburt assumed theposition of Vice President of Finance on January 11, 2005.  Prior to joining Datawatch, Mr. Hulburtwas Director of Audit and SEC Compliance at Bruker Biosciences Corporation, apublicly traded medical device company, a position he held sinceJuly 2003. Mr. Hulburt served as Chief Financial Officer andTreasurer of Bruker Daltonics Inc. before its merger with Bruker AXS.Mr. Hulburt is a Certified Public Accountant and from 1994 to 2000 he beganhis career with the accounting firms Ernst & Young LLP and ArthurAndersen LLP. On November 1, 2006, Mr. Hulburt resigned from these positions atthe Company effective January 31, 2007.

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**PART II**

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

The Registrant’s commonstock is listed and traded on the Nasdaq Capital Market (formerly the NasdaqSmallCap Market) under the symbol DWCH. The range of high and low closing prices during each fiscal quarter forthe last two fiscal years is set forth below:
| For the Year Ended | ** ** | **Common Stock** |       |
|-----------------------------------|------------|-----------------------|------------|
| **September 30, 2006**  | ** ** | **High**              | ** ** | **Low** |   |
|                              |       |                  |       |   |   |
| 4th Quarter                       |       | 3.68                  |       | 2.47 |   |
| 3rd Quarter                       |       | 3.85                  |       | 3.36 |   |
| 2nd Quarter                       |       | 5.38                  |       | 3.53 |   |
| 1st Quarter                       |       | 4.85                  |       | 3.04 |   |

 
| 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 |   |

 

There are approximately 100shareholders of record as of December 1, 2006.  The Company believes that the number ofbeneficial holders of common stock exceeds 2,000.  The last reported sale of the Company’scommon stock on December 26, 2006 was at $2.61.

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

The information set forthunder the caption “Equity Compensation Plans” appearing in the Company’sdefinitive Proxy Statement for the Annual Meeting of Shareholders for thefiscal year ended September 30, 2006 is incorporated herein by reference.

**Item 6.   SELECTED CONSOLIDATED FINANCIAL DATA**

The following table setsforth selected consolidated financial data of the Company for the periodsindicated.  The selected consolidatedfinancial data for and as of the end of the years in the five-year period endedSeptember 30, 2006 are derived from the Consolidated Financial Statementsof the Company.  The information setforth below should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and the ConsolidatedFinancial Statements and notes which appears elsewhere in this Annual Report onForm 10-K.

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| **Statements of Operations Data**                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Years Ended September 30,**                         | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|                                                                 |       |       |       |       |       |       |       |       |       |       |       |
| Revenue                                                              |       | $          | 20,811,244 |       | $          | 21,511,595 |       | $          | 19,335,146 |       | $          | 17,712,206 |   | $ | 19,440,743 |   |
| Costs and Expenses                                                   |       | 21,345,480 |       | 20,823,225 |       | 18,410,460 |       | 16,886,018 |       | 18,499,009 |       |
| (Loss) Income from  Operations                                       |       | (534,236   | )          | 688,370    |       | 924,686    |       | 826,188    |       | 941,734    |       |
| (Loss) Income from  Continuing Operations                            |       | (554,553   | )          | 800,414    |       | 1,084,776  |       | 846,545    |       | 846,379    |       |
| Discontinued Operations  Income Gain on Sale of Guildsoft Operations |       | —     |       | —     |       | —     |       | —     |       | 17,096     |       |
| Income from  Discontinued Operations                                 |       | —     |       | —     |       | —     |       | —     |       | 17,096     |       |
| Net (Loss) Income                                                    |       | $          | (554,553   | )          | $          | 800,414    |       | $          | 1,084,776  |       | $          | 846,545 |   | $ | 863,475 |   |
|                                                                 |       |       |       |       |       |       |       |       |       |       |       |
| Net (Loss) Income from  Continuing Operations per Common Share:      |       |       |       |       |       |       |       |       |       |       |       |
| Basic                                                                |       | $          | (0.10      | )          | $          | 0.15       |       | $          | 0.21       |       | $          | 0.16 |   | $ | 0.17 |   |
| Diluted                                                              |       | $          | (0.10      | )          | $          | 0.14       |       | $          | 0.19       |       | $          | 0.16 |   | $ | 0.16 |   |
|                                                                 |       |       |       |       |       |       |       |       |       |       |       |
| Net (Loss) Income per  Common Share:                                 |       |       |       |       |       |       |       |       |       |       |       |
| Basic                                                                |       | $          | (0.10      | )          | $          | 0.15       |       | $          | 0.21       |       | $          | 0.16 |   | $ | 0.17 |   |
| Diluted                                                              |       | $          | (0.10      | )          | $          | 0.14       |       | $          | 0.19       |       | $          | 0.16 |   | $ | 0.16 |   |

 
| **Balance Sheet Data  September 30,** | ** ** | **2006**   | ** ** | **2005**  | ** ** | **2004**   | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|-----------|------------|-----------|------------|
|                                                 |       |       |       |      |       |       |       |      |       |      |       |
| Total Assets                                         |       | $          | 16,025,094 |      | $          | 13,412,256 |       | $         | 12,628,794 |      | $          | 10,503,942 |   | $ | 9,454,466 |   |
| Working Capital  (Deficiency)                        |       | (2,466,168 | )          | 3,487,484 |       | 2,547,879  |       | 3,407,639 |       | 2,022,702 |       |
| Long-Term Obligations                                |       | 265,365    |       | —    |       | 125,373    |       | 3,115     |       | 12,795    |       |
| Shareholders’ Equity                            |       | 6,955,374  |       | 7,305,764 |       | 6,435,929  |       | 5,138,115 |       | 4,060,212 |       |
|                                                      |            |            |            |           |            |            |            |           |            |           |            |  |  |  |  |  |

 

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

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

**GENERAL**

**Introduction**

Datawatch is engaged in thedesign, development, manufacture, marketing, and support of business computersoftware primarily for the Windows-based market. Its products address the enterprisecontent management and reporting, business intelligence, data replication,business service management and help desk markets.

Datawatch’s principalproducts included in Desktop and Server Software, Report Management andBusiness Service Management Solutions are: Monarch, a desktop report mining and business intelligence applicationthat lets users extract and manipulate data from ASCII report files, PDF filesor HTML files produced on any mainframe, midrange, client/server or PC system;Monarch Data Pump, a data replication and migration tool that 

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offers a shortcut for populating and refreshing datamarts and data warehouses, for migrating legacy data into new applications andfor providing automated delivery of reports in a variety of formats via email;Monarch|MS, a web-based report mining and analysis solution that integrateswith any existing COLD/ERM, document or content management archiving solution;Datawatch|ES, a web-enabled business information portal, providing completereport management, business intelligence and content management, and theability to analyze data within reports derived from existing reporting systemswith no new programming or report writing; Datawatch|BDS, a system forhigh-volume document capture, archiving, and online presentation;Datawatch|Researcher, a .NET based content and data aggregation solution thatsearches inter-related data, documents, and communications scattered overmultiple and disparate repositories, then merges and analyzes the results intocomprehensive actionable case records; Visual|QSM, a fully internet-enabled ITsupport solution that incorporates workflow and network management capabilitiesand provides web access to multiple databases via a standard browser;Visual|Help Desk or Visual|HD, a web-based help desk and call center solutionoperating on the IBM Lotus Domino platform; and VorteXML, a data transformationproduct for the emerging XML market that easily and quickly converts structuredtext output from any system into valid XML for web services and more using anyDTD or XDR schema without programming.

On August 11, 2004,Datawatch acquired 100% of the shares of Mergence Technologies Corporation,which subsequently changed its name to Datawatch Technologies, in exchange for$2,500,000 in cash and incurred $96,691 in direct costs.  The purchase agreement also included aprovision for quarterly cash payments to the former Mergence shareholders equalto 10% of revenue, as defined, of the Datawatch|Researcher product for a periodof six years, not all Mergence products are subject to royalties. Theactivities of Mergence from August 11, 2004 are included in the Company’sconsolidated financial statements. See Note 2 to the consolidated financialstatements which appear elsewhere herein for more detailed financialinformation on the acquisition of Mergence.

On May 3, 2006, Datawatchacquired certain assets of ClearStory Systems, Inc’s Integrated DocumentArchiving and Retrieval Systems (“IDARS”) business in exchange for $4,349,000in cash and incurred $441,000 in direct costs. The purchase agreement alsoincluded a provision for quarterly cash payments for a period of eighteenmonths equal to 30% of revenue, as defined, of the Datawatch|BDS productexcluding the first $337,500 of revenue. These amounts will be charged togoodwill as additional purchase price, as incurred. At September 30, 2006, theCompany has accrued approximately $215,000 related to future earn out payments.The activities of the IDARS business from May 3, 2006 are included in the Company’sconsolidated financial statements.  SeeNote 2 to the Consolidated Financial Statements for more detailed financialinformation on the acquisition of the IDARS business.

During the first quarter offiscal 2004, the Company introduced a subscription sales model for the sale ofits enterprise products.  The Companycontinues to offer its enterprise products through the sale of perpetuallicenses and introduced the subscription pricing model to allow customers tobegin using the Company’s products at a lower initial cost of softwareacquisition. Subscriptions automatically renew unless terminated with 90 daysnotice.  The subscription arrangementincludes software, maintenance and unspecified future upgrades including majorversion upgrades. The initial subscription rate is the same as the renewalrate. During fiscal 2004, 2005 and 2006, customer interest in and acceptance ofthe subscription model has been increasing as evidenced by a greater than 36%growth in subscription revenue, from approximately $451,000 to approximately$615,000, during fiscal 2006 as compared to fiscal 2005.

**CRITICAL ACCOUNTING POLICIES**

Inthe preparation 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. Certain of those policies are comparatively more important to theCompany’s financial results and condition than others. The policies that theCompany believes are most important for a reader’s understanding of thefinancial information provided in this report are described below.

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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 33%, 31% and 29%, of total sales for fiscal years 2006, 2005and 2004, respectively. Revenue from the sale of all software products isgenerally 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 an arrangement existsand there are no significant obligations remaining.  Both types of the Company’s software productofferings are “off-the-shelf” as such term is defined by Statement of PositionNo. 97-2, “*Software Revenue Recognition*.”The Company’s software products can be installed and used by customers on theirown with little or no customization required. Multi-user licenses marketed bythe Company 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 of the Company.

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.

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. In applying the residual method, theCompany deducts from the sale proceeds the VSOE of fair value of the servicesand post-contract customer support in determining the residual fair value ofthe software license. The VSOE of fair value of the services and post-contractcustomer support is based on the amounts charged for these elements when soldseparately. Professional services include implementation, integration, trainingand consulting services with revenue recognized as the services are performed.These services are generally delivered on a time and materials basis, arebilled on a current basis as the work is performed, and do not involvemodification or customization of the software or any other unusual acceptanceclauses or terms. Post-contract customer support is typically provided under amaintenance agreement which provides technical support and rights tounspecified software maintenance updates and bug fixes on a when-and-ifavailable basis. Revenue from post-contract customer support services isdeferred and recognized ratably over the contract period (generally oneyear).  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 thetime a customer enters into a binding agreement to purchase a subscription, thecustomer is invoiced for an initial 90 day service period and an accountreceivable and deferred revenue are recorded. 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 then invoiced every 90 days and, in accordancewith SOP 97-2, revenue is recognized ratably over the period the service isprovided. The subscription arrangement includes software, maintenance andunspecified future upgrades including major version upgrades. The initialsubscription rate is the same as the renewal rate. Subscriptions can becancelled 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 Statement of FinancialAccounting Standards No. 48, “*Revenue Recognition whenRight of Return Exists*” (“SFAS No. 48”). 

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Revenue from the sale ofsoftware products to distributors and resellers is recognized at the time ofshipment providing all other criteria for revenue recognition as stated aboveare met and (i) the distributor or reseller is unconditionally obligatedto pay for the products, including no contingency as to product resale,(ii) the distributor or reseller has independent economic substance apartfrom the Company, (iii) the Company is not obligated for futureperformance to bring about product resale, and (iv) the amount of futurereturns can be reasonably estimated. The Company’s experience and history withits distributors and resellers allows for reasonable estimates of futurereturns. Among other things, estimates of potential future returns are madebased on the inventory levels at the various distributors and resellers, whichthe Company monitors frequently. Once the estimates of potential future returnsfrom all sources are made, the Company determines if it has adequate returnsreserves to cover anticipated returns and the returns reserve is adjusted asrequired. Adjustments are recorded as increases or decreases in revenue in theperiod of adjustment. Actual returns have historically been within the rangeestimated by the Company. The Company’s returns reserves were $78,836 and$123,315 as of September 30, 2006 and 2005, respectively.

TheCompany maintains allowances for doubtful accounts for estimated lossesresulting from the inability of customers to make required payments. The Companyanalyzes accounts receivable and the composition of the accounts receivableaging, historical bad debts, customer creditworthiness, current economictrends, foreign currency exchange rate fluctuations and changes in customerpayment terms when evaluating the adequacy of the allowance for doubtfulaccounts. Based upon the analysis and estimates of the collectibility of itsaccounts receivable, the Company records an increase in the allowance fordoubtful accounts when the prospect of collecting a specific account receivablebecomes doubtful. Actual results could differ from the allowances for doubtfulaccounts recorded, and this difference may have a material effect on theCompany’s financial position and results of operations. The Company’s allowancefor doubtful accounts was $193,426 and $293,943 as of September 30, 2006and 2005, respectively.

Deferred Tax Assets

The Company has deferred tax assets related to net operating losscarryforwards and tax credits that expire at different times through and until2021. At September 30, 2006, the Company had U.S. federal tax losscarryforwards of approximately $7.6 million, expiring at various dates through2021, including $520,000 resulting from the Mergence acquisition undertakenduring 2004 which are subject to additional annual limitations as a result ofthe changes in Mergence’s ownership, and had approximately $2.0 million instate tax loss carryforwards, which also expire at various dates through 2021.An alternative minimum tax credit of approximately $148,000 is available tooffset future regular federal taxes. Research and development credits ofapproximately $418,000 expire beginning in 2011. In addition, the Company hasthe following foreign net operating loss carryforwards: United Kingdom lossesof $8.0 million with no expiration date, France losses of $130,000 with noexpiration date, Germany losses of $2.0 million with no expiration date andAustralia losses of $2.0 million with no expiration date.

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’s domestic operations have been profitableduring the past four years while international operations have continued togenerate operating losses. Accordingly, management does not believe thedeferred tax assets are more likely than not to be realized and a fullvaluation allowance, previously provided against the deferred tax assets,continues to be provided. 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 reporting purposes.Total net deferred tax assets subject to a valuation allowance wereapproximately $4.7 million as of September 30, 2006. In relation to therecent asset purchase of the IDARS business, the applicable goodwill associatedwith this purchase has an indefinite life for US GAAP purposes but isdeductible 

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over a 15 year life for tax reporting purposes. Accordingly, for eachreporting period, the Company will record deferred tax expense and anoffsetting deferred tax liability on this difference in tax amortization ofintangibles with indefinite lives based on the Company’s effective tax rate forthe period. The deferred tax expense recorded for the year ended September 30,2006 was $35,550.

Capitalized Software Development Costs

TheCompany capitalizes certain software development costs as well as purchasedsoftware upon achieving technological feasibility of the related products.Software development 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) whichis generally 24 to 72 months. The Company’s capitalized software was $473,114and $583,158 at September 30, 2006 and 2005, respectively.

Goodwill,Other Intangible Assets and Other Long-Lived Assets

TheCompany performs an evaluation of whether goodwill is impaired annually or whenevents occur or circumstances change that would more likely than not reduce thefair value of the applicable reporting unit below its carrying amount. Theannual impairment analysis is performed each May of the applicable fiscalyear.  Fair value is determined usingmarket comparables for similar businesses, current market valuations of ourcommon stock, or forecasts of discounted future cash flows. The Company alsoreviews other intangible assets and other long-lived assets when an indicationof potential impairment exists, such as a significant reduction in cash flowsassociated with the assets. Should the fair value of the Company’s long-livedassets decline because of reduced operating performance, market declines, orother indicators of impairment, a charge to operations for impairment may benecessary.  No impairment charges weretaken during fiscal 2006.

Accountingfor stock-based compensation

With the adoption of Statement of Financial Accounting Standards No.123(R), *“Share-Based Payment”* (“SFAS No. 123(R)”)on October 1, 2005, the Company is required to record the grant date fair valueof stock-based compensation awards as compensation costs. For the fiscal yearended September 30, 2006, the Company recorded stock-based compensation expenseof $67,137. In order to determine the fair value of stock options on the dateof grant, the Company applies the Black-Scholes option-pricing model. Inherentin this model are assumptions related to expected stock-price volatility,option life, risk-free interest rate and dividend yield. While the risk-freeinterest rate and dividend yield are less subjective assumptions, typicallybased on factual data derived from public sources, the expected stock-pricevolatility and option life assumptions require a greater level of judgmentwhich makes them critical accounting estimates.

The Company uses an expected stock-price volatility assumption that isa combination of both current and historical implied volatilities of theunderlying stock which are obtained from public data sources. The Companybelieves this approach results in a reasonable estimate of volatility. Forstock option grants issued during the fiscal year ended September 30, 2006, theCompany used a weighted-average expected stock-price volatility of 96% basedupon the implied volatility at the time of issuance.

With regard to the weighted-average option life assumption, the Companyconsiders the exercise behavior of past grants and models the pattern ofaggregate exercises. Patterns are determined on specific criteria of theaggregate pool of optionees including the reaction to vesting, realizable valueand short-time-to-maturity effect. For stock option grants issued during theyear ended September 30, 2006, the Company used a weighted-average expectedoption life assumption of 5 years.

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**RESULTS OF OPERATIONS**

The following table setsforth certain statements of operations data as a percentage of total revenuesfor the periods indicated. The data has been derived from the Company’sconsolidated financial statements.  Theoperating results for any period should not be considered indicative of theresults expected for any future period.
|                                             | ** ** | **Year Ended September 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUE:                                    |       |                                        |       |   |   |   |   |
| Software licenses and subscriptions         |       | 63.2                                        | %          | 66.2 | % | 64.3 | % |
| Maintenance and services                    |       | 36.8                                        | %          | 33.8 | % | 35.7 | % |
| Total Revenue                               |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
|                                        |       |                                        |       |   |   |   |   |
| COSTS AND  EXPENSES:                        |       |                                        |       |   |   |   |   |
| Cost of software licenses and subscriptions |       | 10.9                                        | %          | 11.7 | % | 13.4 | % |
| Cost of maintenance and services            |       | 19.0                                        | %          | 16.0 | % | 14.0 | % |
| Sales and marketing                         |       | 43.9                                        | %          | 40.4 | % | 39.5 | % |
| Engineering and product development         |       | 10.1                                        | %          | 9.4 | % | 7.5 | % |
| General and administrative                  |       | 18.7                                        | %          | 19.3 | % | 20.9 | % |
| Total costs and expenses                    |       | 102.6                                       | %          | 96.8 | % | 95.3 | % |
| (LOSS) INCOME  FROM OPERATIONS              |       | (2.6                                        | )%         | 3.2 | % | 4.7 | % |
| Interest expense                            |       | (0.1                                        | )%         | 0.0 | % | 0.0 | % |
| Interest income  and other income, net      |       | 0.2                                         | %          | 0.4 | % | 0.2 | % |
| (LOSS) INCOME  BEFORE INCOME TAXES          |       | (2.5                                        | )%         | 3.6 | % | 4.9 | % |
| (Provision)  benefit for income taxes       |       | (0.2                                        | )%         | 0.1 | % | 0.7 | % |
| NET (LOSS) INCOME                           |       | (2.7                                        | )%         | 3.7 | % | 5.6 | % |

 

*Fiscal Year EndedSeptember 30, 2006 as Compared to*

*Fiscal Year EndedSeptember 30, 2005*

***Total Revenues***

Thefollowing table presents total revenue, total revenue increase (decrease) andpercentage change in total revenue for the years ended September 30, 2006and 2005:
|                                      | ** ** | **Year Ended September 30,** | ** ** | **Increase** | ** ** | **Percentage** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                           | ** ** | **2006**                                    | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Software  licenses and subscriptions |       | $                                           | 13,145,591 |         | $          | 14,232,946     |       | $ | (1,087,355 | ) | (7.6 | )% |
| Maintenance and  services            |       | 7,665,653                                   |       | 7,278,649    |       | 387,004        |       | 5.3 | % |
|                                 |       |                                        |       |         |       |           |       |   |   |
| Total revenue                        |       | $                                           | 20,811,244 |         | $          | 21,511,595     |       | $ | (700,351 | ) | (3.3 | )% |

 

Revenue for the fiscal yearended September 30, 2006 was $20,811,244, which represents a decrease of$700,351 or approximately 3% from revenue of $21,511,595 for the fiscal yearended September 30, 2005. For fiscal 2006 Monarch (including Monarch DataPump and VorteXML), Visual|QSM and Visual|HD, Datawatch|ES (includingMonarch|RMS, Datawatch|Researcher and iMergence iStore) and Datawatch|BDS revenueaccounted for 58%, 22%, 15% and 5% of total revenue, respectively, as comparedto 59%, 26%, 15% and 0%, respectively, for fiscal 2005. The slight decrease inrevenue can be attributed primarily to fewer license sales of Monarch due tofiscal 2006 being a non-upgrade release year for that product.

Softwarelicense and subscription revenue for the fiscal year ended September 30,2006 was $13,145,591 or approximately 63% of total revenue, as compared to$14,232,946 or approximately 66% of total revenue for the fiscal year endedSeptember 30, 2005. This represents a decrease of $1,087,355 or approximately8% from fiscal 2005. The overall decrease in license revenue during fiscal 2006includes a $770,000 decrease in Monarch license revenue (which also includesthe Monarch Data Pump and VorteXML products), a $105,000 decrease in 

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the Report Management license and subscriptionrevenue (which includes Datawatch|ES, Monarch|RMS, Datawatch|Researcher andiMergence iStore) and a $320,000 decrease in Business Service Managementlicense and subscription revenue (which includes Visual|QSM and Visual|HelpDesk), offset by a $108,000 increase in new Datawatch|BDS licenserevenues.  The Datawatch|BDS licenserevenue for fiscal 2006 is attributable to new products which were acquired inconnection with the Company’s acquisition of the Integrated Document Archivingand Retrieval Systems (“IDARS”) business from ClearStory Systems, Inc. in May2006. The Company attributes the decrease in Monarch software license revenueto the lack of a new release during fiscal 2006 as well as reduced customerspending during the year. The Company’s most recent upgrade to Monarch V8 wasreleased in March 2005. The Company partially attributes the overallrevenue decrease in Business Service Management license and subscriptionrevenue to foreign exchange variances as the US dollar strengthened againstmost European currencies during most of the fiscal year ended September 30,2006 as compared to the previous fiscal year.

Maintenance and servicesrevenue for the fiscal year ended September 30, 2006 was $7,665,653 orapproximately 37% of total revenue, as compared to $7,278,649 or approximately34% of total revenue for the fiscal year ended September 30, 2005. Thisrepresents an increase of $387,004 or approximately 5% from fiscal 2005. Theoverall increase in maintenance and service revenue includes a $242,000increase in Monarch revenue and a $921,000 increase in BDS revenue.  These increases were partially offset bydecreases in Report Management maintenance and services revenues of $150,000(which includes maintenance for Datawatch|ES, Monarch|RMS, Datawatch|Researcherand iMergence iStore) and Business Service Management maintenance and servicesrevenues of $626,000 (which includes maintenance for Visual|QSM and Visual|HelpDesk).  The BDS maintenance and servicerevenue for fiscal 2006 is related to the new products which were acquired inconnection with the Company’s acquisition of the Integrated Document Archivingand Retrieval Systems (“IDARS”) business from ClearStory Systems, Inc. in May2006. The Company attributes the overall increases in maintenance and servicesrevenue to continued customer loyalty, which has resulted in high renewal ratesfor annual maintenance service contracts and an increased demand forprofessional services from existing customers, which also includes upgrades andadditional training. The decrease in maintenance revenue for the BusinessService Management product line was the result of lower renewal rates of annualmaintenance contracts from existing customers due a mature market for theproduct. The decrease in Business Service Management maintenance and servicesalso resulted in less demand for professional services work related to thisproduct line.  No significant productupgrades were introduced within the Visual|QSM or Visual|Help Desk productlines during fiscal year 2006.

***Costs and Operating Expenses***

Thefollowing table presents costs and operating expenses, increase/(decrease) incosts and operating expenses and percentage changes in costs and operatingexpenses for the years ended September 30, 2006 and 2005:
|                                               | ** ** | **Year Ended September 30,** | ** ** | **Increase /** | ** ** | **Percentage  Increase /** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|---------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **2006**                                    | ** ** | **2005**            | ** ** | **(Decrease)**                  | ** ** | **(Decrease)** | ** ** |
| Costs of  software licenses and subscriptions |       | $                                           | 2,268,458  |                | $          | 2,515,060                       |       | $ | (246,602 | ) | (9.8 | )% |
| Costs of  maintenance and services            |       | 3,949,314                                   |       | 3,438,319           |       | 510,995                         |       | 14.7 | % |
| Sales and  marketing expenses                 |       | 9,135,527                                   |       | 8,686,672           |       | 448,855                         |       | 5.2 | % |
| Engineering and  product development expenses |       | 2,093,707                                   |       | 2,031,280           |       | 62,427                          |       | 3.1 | % |
| General and  administrative expenses          |       | 3,898,474                                   |       | 4,151,894           |       | (253,420                        | )          | (6.1 | )% |
|                                          |       |                                        |       |                |       |                            |       |   |   |
| Total costs and  operating expenses           |       | $                                           | 21,345,480 |                | $          | 20,823,225                      |       | $ | 522,255 |   | 2.5 | % |

 

Cost of software licensesand subscriptions for the fiscal year ended September 30, 2006 was$2,268,458 or approximately 17% of software license and subscription revenues,as compared to $2,515,060 or approximately 18% of software license revenues forthe fiscal year ended September 30, 2005. Costs of software licenses andsubscriptions as a percentage of software licenses and subscription revenue haveremained consistent year over year.

21

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Cost of maintenance and services for thefiscal year ended September 30, 2006 was $3,949,314 or approximately 52%of maintenance and service revenues, as compared to $3,438,319 or approximately47% of maintenance and service revenues, for the fiscal year endedSeptember 30, 2005. This increase was primarily due to an increase inheadcount of consulting and training staff. The IDARS acquisition added severalindividuals to the consulting staff headcount. The increase can also beattributed to the increasing subscription sales. As the Company continues tosee a slight shift in selling more subscription term licenses, revenues arerecognized over future periods rather than at the point of sale, while theassociated professional services costs and systems installation costs areincurred during the period for the project work associated with theimplementation of the systems for these customers.

Sales and marketing expenseswere $9,135,527 for the fiscal year ended September 30, 2006, whichrepresents an increase of $448,855 or approximately 5%, from $8,686,672 for thefiscal year ended September 30, 2005. This increase is primarilyattributable to increased sales staff personnel, increased headcount from theIDARS acquisition, higher salaries and other related expenses, increasedmarketing expenses for lead generation, and trade show expense. During fiscalyear 2004, the Company made a strategic decision for additional investmentswithin the sales and marketing programs to improve upon the Company’s top-linerevenue growth initiatives. This additional investment focus was continuedthroughout the 2005 and 2006 fiscal years.

During the first quarter offiscal 2007, the Company initiated and completed a restructuring plan in aneffort to reduce costs and focus on key areas of the business.  The restructuring plan was limited to one of the Company’s whollyowned subsidiaries, Datawatch International Limited (“DWI”) and resulted incharges for severance benefits and related costs for nine terminated employeesof approximately $128,000.  All of thesecosts will be charged in the first quarter of fiscal 2007 and none were accruedor incurred in fiscal 2006. The Company anticipates annual sales and marketingexpense savings from this restructuring to approximate $1.2 million.

Engineeringand product development expenses were $2,093,707 for the fiscal year endedSeptember 30, 2006, which represents an increase of $62,427 orapproximately 3% from $2,031,280 for the fiscal year ended September 30,2005. This increase is primarily attributable to the additional headcountresulting from the IDARS acquisition offset by cost savings attributable to thetransitioning of previously outsourced development activities in-house. TheCompany will continue to use third-party development activities in conjunctionwith in-house development for the foreseeable future, but will rely more on theCompany’s in-house engineering and product development capabilities.

Generaland administrative expenses were $3,898,474 for the fiscal year endedSeptember 30, 2006, which represents a decrease of $253,420 orapproximately 6% from $4,151,894 for the fiscal year ended September 30,2005. This decrease is primarily attributable to a reduction in overhead costsincluding a small reduction in headcount and the related wage and employeebenefit savings totaling approximately $99,000. During fiscal 2006 there was anemphasis on managing administrative costs with certain reductions to lowerinvestor relation costs and a reduction in the allowance for doubtful accounts,due to the improvement in overall collection efforts. In addition, the Companyexperienced savings attributable to lower management incentive bonuses ofapproximately $100,000 due to the Company’s net loss for the fiscal year andlower accounting costs attributable to a delay in the Company’s implementationof Section 404 of the Sarbanes-Oxley Act as a result of the one year extensionfor compliance granted by the Securities and Exchange Commission.

Netloss for the year ended September 30, 2006 was $554,553, which compares tonet income of $800,414 for the year ended September 30, 2005. Net loss forfiscal year 2006 includes a tax provision of approximately $36,000 while netincome for fiscal year 2005 includes a tax benefit of $22,000.

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*Fiscal Year EndedSeptember 30, 2005 as Compared to*

*Fiscal Year EndedSeptember 30, 2004*

***Total Revenues***

Thefollowing table presents total revenue, change in total revenue and totalrevenue 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 yearended September 30, 2005 was $21,511,595, which represents an increase of$2,176,449 or approximately 11% from revenue of $19,335,146 for the fiscal yearended September 30, 2004.   Forfiscal 2005 Monarch (including Monarch Data Pump and VorteXML and Redwing),Datawatch|ES (including Monarch|RMS, Datawatch|Researcher and iMergence iStore)and Visual|QSM and Visual|HD revenue accounted for 59%, 15% and 26% of totalrevenue, respectively, as compared to 56%, 14% and 30%, respectively, forfiscal 2004.

Software license andsubscription revenue for the fiscal year ended September 30, 2005 was$14,232,946 or approximately 66% of total revenue, as compared to $12,441,667or approximately 64% of total revenue for the fiscal year endedSeptember 30, 2004.  This representsan increase of $1,791,279 or approximately 14% from fiscal 2004 to fiscal 2005.  The overall increase in license revenueduring fiscal 2005 consists of a $1,421,000 increase in Monarch license revenue(which also includes the Monarch Data Pump and VorteXML products), a $324,000increase in the Report Management license and subscription revenue (whichincludes Datawatch|ES, Monarch|RMS, Datawatch|Researcher and iMergence iStore),and a $46,000 increase in Business Service Management license and subscriptionrevenue (which includes Visual|QSM and Visual|Help Desk).  The $324,000 net increase in the Report Managementlicense and subscription revenue includes an increase of $532,000 from theResearcher and iMergence iStore products, which were new products from theMergence acquisition.  This increaseoffsets a $208,000 decrease in revenues from Datawatch|ES.  The $46,000 net increase in Business ServiceManagement license and subscription revenue consists of a $113,000 increase inVisual|QSM revenue, which offset a $67,000 decrease in Visual|HD revenue.  The Company attributes the increase inMonarch software license revenue to the release of a new version of Monarch V8in March 2005, and also to customers who increased their capital spendingas a result of a an improved domestic economic outlook.  The Company attributes the decrease inVisual|HD software license and subscription revenue to intensified competitivepressure to reduce pricing for a product in a mature market.

Maintenance and servicesrevenue for the fiscal year ended September 30, 2005 was $7,278,649 orapproximately 34% of total revenue, as compared to $6,893,479 or approximately36% of total revenue for the fiscal year ended September 30, 2004.  This represents an increase of $385,170 orapproximately 6% from fiscal 2004 to fiscal 2005. The overall increase inmaintenance and service revenue consists of a $401,000 increase in Monarch revenue,and a $303,000 increase in Report Management revenue (which includesmaintenance for Datawatch|ES, Monarch|RMS, Datawatch|Researcher and iMergenceiStore).  These increases were partiallyoffset by decreases in Business Service Management maintenance and servicesrevenues of $319,000 (which includes maintenance for Visual|QSM and Visual|HelpDesk). The $303,000 net increase in Report Management revenue includes both a$409,000 increase related to Researcher and iMergence iStore products, whichwere new products from the Mergence acquisition, offset by a $106,000 decreasein Datawatch|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 additional training.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. Nosignificant product upgrades were introduced within the Visual product linesduring fiscal year 2005.

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***Costs and Operating Expenses***

Thefollowing table presents costs and operating expenses, changes in costs andoperating expenses and costs and operating expenses growth for the year endedSeptember 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 licensesand subscriptions for the fiscal year ended September 30, 2005 was$2,515,060 or approximately 18% of software license and subscription revenues,as compared to $2,582,627 or approximately 21% of software license revenues forthe fiscal year ended September 30, 2004. The decrease in costs of software licenses and subscriptions as apercentage of software licenses and subscription revenue is due to thedecreasing amortization expense of capitalized software costs and the increasedsales of internally-developed products, which do not have any associatedroyalty expenses.

Cost of maintenance andservices for the fiscal year ended September 30, 2005 was $3,438,319 orapproximately 47% of maintenance and service revenues, as compared to$2,710,562 or approximately 39% of maintenance and service revenues, for thefiscal year ended September 30, 2004. During fiscal 2005, gross margins on maintenance and services decreasedand overall costs increased primarily due to the use of third-party consultantsto supplement the Company’s internal consulting and training staff inrevenue-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 expenseswere $8,686,672 for the fiscal year ended September 30, 2005, whichrepresents an increase of $1,057,614 or approximately 14%, from $7,629,058 forthe fiscal year ended September 30, 2004. This increase is primarily attributable to increased sales staffpersonnel, increased salaries and other related expenses, increased marketingexpenses for lead generation, and trade show expense.  Mid-way through fiscal year 2004 the Companymade a strategic decision for additional investments within the sales andmarketing programs to improve upon the Company’s top-line revenue growthinitiatives.  This additional investmentfocus was continued throughout the entire 2005 fiscal year.

Engineeringand product development expenses were $2,031,280 for the fiscal year endedSeptember 30, 2005, which represents an increase of $579,747 orapproximately 40% from $1,451,533 for the fiscal year ended September 30,2004.  This increase is primarilyattributable to an increase of approximately $600,000 in product developmentexpenses resulting from the acquisition of the Datawatch Technologiessubsidiary.  The Company continues totransition some existing outsourced development activities in-house, butcurrently expects to continue to use third-party development activities, aswell as in-house development, in the foreseeable future.

Generaland administrative expenses were $4,151,894 for the fiscal year endedSeptember 30, 2005, which represents an increase of $115,214 orapproximately 3% from $4,036,680 for the fiscal year ended September 30,2004.  This increase is primarilyattributable to overall growth in the business and certain costs incurredduring the year in relation to the Company preparing for its Sarbanes-Oxley 404Internal Control documentation and preparation (“SOX 404”) and acceleration ofun-vested stock options.  The Company’sexternal SOX 404 costs were approximately $35,000.  In September 2005 the Companyaccelerated all un-vested stock options and 

24

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incurred a charge ofapproximately $47,000.  See Note 8 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.

**OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENTLIABILITIES AND COMMITMENTS**

The Company leases various facilities and equipmentin the U.S. and overseas under noncancelable operating leases that expirethrough 2011. The lease agreements generally provide for the payment of minimumannual rentals, pro rata share of taxes, and maintenance expenses. Rentalexpense for all operating leases was approximately $631,899, $663,664 and$678,677 for fiscal 2006, 2005 and 2004, respectively.

Asof September 30, 2006, contractual obligations include minimum rentalcommitments under noncancelable operating leases as follows:
| Contractual Obligations: | ** ** | **Total** | ** ** | **Less than 1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than 5   Years** | ** ** |
|-------------------------------|------------|-----------|------------|-------------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------------|------------|
| Operating Lease Obligations   |       | $         | 1,152,602  |                                | 388,712    |               | 429,175    |               | 334,715    |                                   | —     |   |
|                               |            |           |            |                                     |            |                    |            |                    |            |                                        |            |  |

 

TheCompany is also obligated to pay royalties ranging from 7% to 50% on revenuegenerated by the sale of certain licensed software products. Royalty expenseincluded in cost of software licenses was approximately $1,601,757, $1,659,308and $1,677,231 respectively, for the years ended September 30, 2006, 2005and 2004.  The Company is not obligatedto pay any minimum amounts for royalties.

On August 11, 2004, theCompany acquired 100% of the shares of Mergence Technologies Corporation. Thepurchase agreement includes a provision for quarterly cash payments to theformer Mergence shareholders equal to 10% of revenue, as defined, of theDatawatch|Researcher product until September 30, 2010. Not all Mergenceproducts are subject to royalties. The Company expensed approximately $5,075and $10,400 for the years ended September 30, 2006 and 2005, respectivelyfor royalty payments to Mergence.  SeeNote 2 to the Consolidated Financial Statements for more detailed financialinformation on the acquisition of Mergence.

On May 3, 2006, the Companyacquired certain assets of ClearStory Systems, Inc’s. IDARS business. Theinitial acquisition cost for IDARS was approximately $4,790,000, consisting of$4,349,000 in cash and direct acquisition costs of approximately $441,000.  The acquisition also includes an 18-monthearn-out payment equal to 30% of net revenues of products from the IDARSbusiness excluding the first $337,500 of revenues. The earn-out payment will beconsidered additional purchase price and will be recorded as additionalgoodwill. At September 30, 2006, the Company has accrued approximately $215,000related to such earn-out payments. In accordance with the asset purchaseagreement, the initial earn-out payments are due in March 2007. See Note 2 tothe Consolidated Financial Statements for more detailed financial informationon the acquisition of IDARS.

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. Ifnecessary, the Company would provide for the estimated cost of warranties basedon specific warranty claims and claim history. However, the Company has neverincurred significant expense under its product or service warranties. As aresult, the Company believes the estimated fair value of these warrantyagreements is minimal. Accordingly, there are no liabilities recorded forwarranty claims as of September 30, 2006.

At September 30, 2006,restricted cash consisted of a $125,000 security deposit in the form of anirrevocable letter of credit held in escrow for the landlord of the Company’sChelmsford, MA corporate offices. At September 30, 2005, restricted cashconsisted of $268,299 for security deposits to provide credit support for rentpayments to 

25

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the landlord of the Company’s former headquarterslocated in Lowell, MA, and $125,000 held in escrow for the sellers of Mergence(see Note 2).

The Company enters intoindemnification agreements in the ordinary course of business. Pursuant to theseagreements, the Company agrees to indemnify, hold harmless, and reimburse theindemnified party for losses suffered or incurred by the indemnified party,generally its customers, in connection with any patent, copyright or otherintellectual property infringement claim by any third party with respect to theCompany’s products. The term of these indemnification agreements is generallyperpetual. The maximum potential amount of future payments the Company could berequired to make under these indemnification agreements is unlimited. TheCompany has never incurred costs to defend lawsuits or settle claims related tothese indemnification agreements. As a result, the Company believes theestimated fair value of these agreements is minimal. Accordingly, the Companyhas no liabilities recorded for these agreements as of September 30, 2006.

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 theseindemnification agreements. As a result, the Company believes the estimatedfair value of these agreements is minimal. Accordingly**,**theCompany has no liabilities recorded for these agreements as ofSeptember 30, 2006.

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 ofSeptember 30, 2006.

**LIQUIDITYAND CAPITAL RESOURCES**

Management believes thatits current cash balances, the short-term financing facility and cash generatedfrom operations will be sufficient to meet the Company’s cash needs for workingcapital and anticipated capital expenditures for at least the next twelvemonths. At September 30, 2006, the Company had $1,861,000 of cash andequivalents, a decline of $3,039,214 from September 30, 2005.  This decline is principally attributable tothe acquisition of IDARS of $4,575,392 offset by $1 million borrowing on theCompany’s line of credit with a bank in connection with the IDARS acquisition.At September 30, 2006, the Company had a working capital deficit of $2,466,000as compared to working capital of $3,487,000 as of September 30, 2005, which isprimarily a result of deferred revenue of $4,468,000 as of September 30, 2006.The Company’s deferred revenue balance increased $1,546,000 principally as aresult of the IDARS acquisition. The Company expects cash flows from operationsto improve as the Company anticipates releasing new versions of all of its mainproduct offerings during the fiscal year ended September 30, 2007 and costsavings expected from the first quarter restructuring. However, if the Company’scash flow from operations does not improve, we may need to consider furtherreductions to our operating expenses. The Company does not anticipateadditional cash requirements to fund significant growth or the acquisition ofcomplementary technology or businesses. However, if in the future, suchexpenditures are anticipated or required, the Company may need to seekadditional financing by issuing equity or obtaining credit facilities to fundsuch requirements.

26

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TheCompany had a net loss of approximately $(555,000) for the year endedSeptember 30, 2006 as compared to net income of approximately $800,000 and$1,085,000, respectively, for the years ended September 30, 2005 and2004.  During the years endedSeptember 30, 2006 and 2005, approximately $975,000 and $1,163,000,respectively, of cash was provided by the Company’s operations. During fiscalyear 2006, the main source of cash from operations was a decrease in accountsreceivable as a result of an increase in cash collections during the period andthe main adjustment to reconcile net income to operating cash flows wasdepreciation and amortization. The Company also received proceeds of $139,489from its landlord for tenant improvements related to its Chelmsford facilitywhich is classified as cash provided by operations. Working capital as ofSeptember 30, 2006 was $(2,466,000) as compared to $3,756,000 as of September30, 2005.  The negative working capitalis primarily the result of deferred revenue of $4,468,000 at September 30,2006.

Netcash used in investing activities for the year ended September 30, 2006 of$5,225,579 is primarily the result of the net cash investment in theacquisition of the IDARS business from ClearStory Systems, Inc. and thepurchase of fixed assets which included leasehold improvements, furniture andfixtures and computer equipment and software related to the new US facility andupgrading its IT infrastructure.

Net cash provided byfinancing activities for the year ended September 30, 2006 of $1,181,192is primarily related to cash received from a $1 million borrowing on the Company’sline of credit with a bank and cash received from the exercise of employeestock options.

On April 20, 2006, the Company entered into a one-year Loan andSecurity Agreement (“Loan Agreement”) with a bank, as amended on August 2,2006. The Loan Agreement established two revolving $1.5 million lines ofcredit, for a total of $3.0 million. The Company can borrow under the firstline of credit based on a formula percentage based on the Company’s eligibleaccounts receivable balance. There is no borrowing base formula for the secondline of credit. The Loan Agreement requires the Company to maintain certainspecified cash flow and liquidity levels.

At September 30, 2006, the Company was in default on its Loan Agreementcovenant to maintain the minimum level of Earnings Before Interest, Taxes,Depreciation and Amortization (“EBITDA”) less capital expenditures, asdefined.  Under a Second LoanModification Agreement (“Modification Agreement”) dated as of November 27,2006, the bank has agreed to waive this covenant for the Company for the threemonth period ended September 30, 2006, suspend this covenant for the threemonth periods ended October 31, 2006 and November 30, 2006, and to reduce therequired EBITDA from $500,000 to $250,000 for each of the three month periodsending January 31, 2007 and thereafter. Additionally, the ModificationAgreement changes the interest rate applicable to borrowings under the firstline of credit. Under this line of credit, from July 31, 2006 until November27, 2006, the interest rate was equal to the prime rate plus 1.50%, which wasreduced to the prime rate plus 1.00% until five days after the Company deliversits December 31, 2006 financial statements indicating it is in compliance withall financial covenants under the Loan Agreement. Thereafter, the interest rateis further reduced to prime rate plus 0.50% for the remainder of the LoanAgreement. The interest rate for the second line of credit remains unchanged.No additional borrowings from the June 30, 2006 borrowing level will beavailable to the Company until December 31, 2006.

On May 3, 2006, the Companyacquired certain assets of ClearStory Systems, Inc’s. Integrated DocumentArchiving and Retrieval Systems (“IDARS”) business. The acquisition of IDARSwas consummated pursuant to an asset purchase agreement dated as of March 10,2006 among the Company and Clearstory Systems, Inc. The purchase agreementincludes a provision for quarterly cash payments over an 18 month period equalto 30% of net revenues of products from the IDARS business excluding the first$337,500 of revenues. The earn-out payment will be considered additionalpurchase price and will be recorded as additional goodwill when incurred. AtSeptember 30, 2006, the Company accrued approximately $215,000 related to suchearn-out payments with a corresponding increase in goodwill. In accordance withthe asset purchase agreement, the initial earn-out payments are due in March2007.

The Mergence purchaseagreement includes a provision for quarterly cash payments to the formerMergence shareholders equal to 10% of revenue, as defined, of theDatawatch|Researcher product for a period of six years.  As the cash payments are based on recognizedrevenue and no minimum payments are required, they are not 

27

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expected to have a significant impact on the Company’sliquidity or cash flows. See the section titled “Off Balance SheetArrangements, Contractual Obligations and Contingent Liabilities andCommitments” included elsewhere herein for a more complete disclosure of theCompany’s commitments and contingent liabilities.

An existing agreement between Datawatch andMath Strategies grants the Company exclusive worldwide rights to use anddistribute certain intellectual property owned by Math Strategies andincorporated by the Company in its Monarch, Monarch Data Pump, VorteXML andcertain other products. On April 29, 2004, the Company entered into a twoyear Option Purchase Agreement with Math Strategies giving the Company theoption to purchase these intellectual property rights for $8 million. Thisoption, if exercised, would provide the Company with increased flexibility toutilize the purchased technology in the future. In February 2006, the Companyentered into an amendment to the original agreement with Math Strategies dated January19, 1989.  Pursuant to the amendment tothe license agreement, the term of the license agreement was extended to April30, 2015. In conjunction with the license amendment, the Company also enteredinto an amendment to the Option Purchase Agreement dated as of April 29, 2004.Under the option purchase amendment, the option has been extended until April30, 2015. The option purchase amendment changes the purchase price for theoption to a formula price based on a multiple of the aggregate royalties paidto Math Strategies by the Company for the four fiscal quarters preceding theexercise of the option.

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

**RECENT ACCOUNTING PRONOUNCEMENTS**

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued Interpretation No. 48 (“FIN 48”), *“Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,Accounting for Income Taxes.”* The interpretation prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken, ina tax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties accounting in interim periods, disclosure andtransition. The interpretation is effective for fiscal years beginning afterDecember 15, 2006. The Company is in the process of determining the effectsthat adoption of FIN 48 will have on the Company’s financial position, cashflows and results of operations.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards No. 157, *“Fair**Market Measurements”*(“SFAS 157”), which establishes aframework for measuring fair value and expands disclosures about the use offair value measurements and liabilities in interim and annual reporting periodssubsequent to initial recognition.  Prior to SFAS 157, which emphasizesthat fair value is a market-based measurement and not an entity-specific measurement,there were different definitions of fair value and limited definitions forapplying those definitions in GAAP.  SFAS 157 is effective for the Companyon a prospective basis for the reporting period beginning January 1,2008.  The effect of adoption on the Company’s financial position andresults of operations have not been determined.

In September 2006, the Securities and ExchangeCommission staff published Staff Accounting Bulletin (“SAB”) 108, *“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements”* (“SAB 108”). SAB108 provides interpretive guidance on how the effects of the carryover orreversal of prior year misstatements should be considered in quantifying acurrent year misstatement. The SAB is effective for fiscal years ending afterNovember 15, 2006. Application of this SAB is not expected to impact theCompany’s financial position, results of operations or cash flows.

28

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**Item 7(A).  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

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

At September 30, 2006,the Company did not hold any derivative financial instruments or commodityinstruments.  The Company holds noinvestment securities that possess significant market risk.

*Primary Market Risk Exposures*

The Company’s primary marketrisk exposure is foreign currency exchange rate risk. International revenuesand expenses are generally transacted by the Company’s foreign subsidiaries andare denominated in local currency. Approximately 32%, 36% and 39% of theCompany’s revenues for 2006, 2005 and 2004, respectively, were from foreignsubsidiaries. In addition, approximately 36%, 37% and 37% of the Company’sexpenses for fiscal 2006, 2005 and 2004, respectively, were from foreignsubsidiaries.

The Company’s earningsexposure to currency exchange rate fluctuations has been and is expected tocontinue to be modest due to the fact that the operations of its internationalsubsidiaries are almost exclusively conducted in their respective localcurrencies, and dollar advances to the Company’s international subsidiaries, ifany, are usually considered to be of a long-term investment nature. Therefore,the majority 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 statements 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.

**Item 8.   FINANCIAL STATEMENTSAND SUPPLEMENTARY DATA**

The following consolidatedfinancial statements and the related notes thereto of Datawatch Corporation andthe Report of Independent Registered Public Accounting Firm thereon are filedas part of this Annual Report on Form 10-K.
| Report of Independent  Registered Public Accounting Firm                                                                                      |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                          |   |
| Consolidated  Financial Statements as of September 30, 2006 and 2005 and for Each of the  Three Years in the Period Ended September 30, 2006: |   |
|                                                                                                                                          |   |
| Consolidated  Balance Sheets                                                                                                                  |   |
|                                                                                                                                          |   |
| Consolidated  Statements of Operations                                                                                                        |   |
|                                                                                                                                          |   |
| Consolidated  Statements of Shareholders’ Equity                                                                                         |   |
|                                                                                                                                          |   |
| Consolidated  Statements of Cash Flows                                                                                                        |   |
|                                                                                                                                          |   |
| Notes to  Consolidated Financial Statements                                                                                                   |   |

29

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

To the Board of Directorsand Shareholders of Datawatch CorporationChelmsford, Massachusetts

We have audited the accompanying consolidated balance sheets ofDatawatch Corporation and subsidiaries (the “Company”) as of September 30, 2006and 2005, and the related consolidated statements of operations, shareholders’equity, and cash flows for each of the three years in the period endedSeptember 30, 2006.  These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. TheCompany is not required to have, nor were we engaged to perform, an audit ofits internal control over financial reporting. Our audits included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of Datawatch Corporation andsubsidiaries as of September 30, 2006 and 2005, and the results of theiroperations and their cash flows for each of the three years in the period endedSeptember 30, 2006, in conformity with accounting principles generally acceptedin the United States of America.
| */s/ Deloitte & Touche LLP* | * * |
|---------------------------------|----------|

 

Boston, Massachusetts

December 29, 2006

30

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**DATAWATCH CORPORATION**

**CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2006**               | ** ** | **2005**               | ** ** |
| **ASSETS**                                                                                                                                                                                   | ** ** | ** **             | ** ** | ** **             | ** ** |
| CURRENT ASSETS:                                                                                                                                                                              |       |                   |       |                   |       |
| Cash and  equivalents                                                                                                                                                                        |       | $                      | 1,861,659  |                   | $          | 4,900,873 |   |
| Restricted cash                                                                                                                                                                              |       | —                 |       | 268,299                |       |
| Accounts  receivable, less allowance for doubtful accounts and sales returns of  $272,000 in 2006 and $417,000 in 2005                                                                       |       | 3,786,136              |       | 4,097,283              |       |
| Inventories                                                                                                                                                                                  |       | 37,088                 |       | 54,712                 |       |
| Prepaid expenses                                                                                                                                                                             |       | 653,304                |       | 541,108                |       |
| Total current  assets                                                                                                                                                                        |       | 6,338,187              |       | 9,862,275              |       |
|                                                                                                                                                                                         |       |                   |       |                   |       |
| Property and Equipment:                                                                                                                                                                      |       |                   |       |                   |       |
| Office furniture  and equipment                                                                                                                                                              |       | 2,186,139              |       | 1,569,875              |       |
| Manufacturing  and engineering equipment                                                                                                                                                     |       | 270,105                |       | 205,595                |       |
|                                                                                                                                                                                         |       | 2,456,244              |       | 1,775,470              |       |
| Less accumulated  depreciation and amortization                                                                                                                                              |       | (1,327,121             | )          | (1,259,058             | )          |
| Net property and  equipment                                                                                                                                                                  |       | 1,129,123              |       | 516,412                |       |
|                                                                                                                                                                                         |       |                   |       |                   |       |
| Goodwill                                                                                                                                                                                     |       | 5,236,109              |       | 1,630,646              |       |
| Other intangible  assets, net                                                                                                                                                                |       | 3,154,836              |       | 1,250,825              |       |
| Restricted cash                                                                                                                                                                              |       | 125,000                |       | 125,000                |       |
| Other                                                                                                                                                                                        |       | 41,839                 |       | 27,098                 |       |
|                                                                                                                                                                                         |       | $                      | 16,025,094 |                   | $          | 13,412,256 |   |
|                                                                                                                                                                                         |       |                   |       |                   |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                               | ** ** | ** **             | ** ** | ** **             | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                         |       |                   |       |                   |       |
| Line of credit                                                                                                                                                                               |       | $                      | 1,000,000  |                   | $          | — |   |
| Accounts payable                                                                                                                                                                             |       | 1,302,000              |       | 1,042,755              |       |
| Accrued expenses                                                                                                                                                                             |       | 1,818,930              |       | 2,013,994              |       |
| Deferred revenue                                                                                                                                                                             |       | 4,468,116              |       | 2,921,519              |       |
| Accrued  acquisition costs – IDARS business                                                                                                                                             |       | 215,309                |       | —                 |       |
| Escrow for  Mergence shareholders                                                                                                                                                            |       | —                 |       | 128,224                |       |
| Total current  liabilities                                                                                                                                                                   |       | 8,804,355              |       | 6,106,492              |       |
|                                                                                                                                                                                         |       |                   |       |                   |       |
| LONG-TERM LIABILITIES:                                                                                                                                                                       |       |                   |       |                   |       |
| Deferred rent                                                                                                                                                                                |       | 229,815                |       | —                 |       |
| Deferred tax  liability                                                                                                                                                                      |       | 35,550                 |       | —                 |       |
| Total long-term  liabilities                                                                                                                                                                 |       | 265,365                |       | —                 |       |
|                                                                                                                                                                                         |       |                   |       |                   |       |
| Commitments and  Contingencies                                                                                                                                                               |       |                   |       |                   |       |
| SHAREHOLDERS’ EQUITY:                                                                                                                                                                   |       |                   |       |                   |       |
| Common stock,  par value $.01; 20,000,000 shares authorized; issued, 5,526,485 shares and  5,383,084 shares, respectively; outstanding, 5,512,239 shares and 5,368,838  shares, respectively |       | 55,265                 |       | 53,831                 |       |
| Additional  paid-in capital                                                                                                                                                                  |       | 22,204,304             |       | 21,957,409             |       |
| Accumulated  deficit                                                                                                                                                                         |       | (14,741,601            | )          | (14,187,048            | )          |
| Accumulated  other comprehensive loss                                                                                                                                                        |       | (422,206               | )          | (378,040               | )          |
|                                                                                                                                                                                         |       | 7,095,762              |       | 7,446,152              |       |
| Less treasury  stock, at cost, 14,246 shares                                                                                                                                                 |       | (140,388               | )          | (140,388               | )          |
| Total  shareholders’ equity                                                                                                                                                             |       | 6,955,374              |       | 7,305,764              |       |
|                                                                                                                                                                                         |       |                   |       |                   |       |
|                                                                                                                                                                                         |       | $                      | 16,025,094 |                   | $          | 13,412,256 |   |

 

*See notes to consolidated financialstatements.*

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**DATAWATCH CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**
| ** **                                         | ** ** | **Year Ended September 30,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUE:                                           |       |                                        |       |   |   |   |   |
| Software licenses and subscriptions                |       | $                                           | 13,145,591 |   | $ | 14,232,946 |   | $ | 12,441,667 |   |
| Maintenance and services                           |       | 7,665,653                                   |       | 7,278,649 |   | 6,893,479 |   |
| Total Revenue                                      |       | 20,811,244                                  |       | 21,511,595 |   | 19,335,146 |   |
| COSTS AND  EXPENSES:                               |       |                                        |       |   |   |   |   |
| Cost of software licenses and subscriptions        |       | 2,268,458                                   |       | 2,515,060 |   | 2,582,627 |   |
| Cost of maintenance and services                   |       | 3,949,314                                   |       | 3,438,319 |   | 2,710,562 |   |
| Sales and marketing                                |       | 9,135,527                                   |       | 8,686,672 |   | 7,629,058 |   |
| Engineering and product development                |       | 2,093,707                                   |       | 2,031,280 |   | 1,451,533 |   |
| General and administrative                         |       | 3,898,474                                   |       | 4,151,894 |   | 4,036,680 |   |
| Total costs and expenses                           |       | 21,345,480                                  |       | 20,823,225 |   | 18,410,460 |   |
|                                               |       |                                        |       |   |   |   |   |
| (LOSS) INCOME  FROM OPERATIONS                     |       | (534,236                                    | )          | 688,370 |   | 924,686 |   |
| Interest expense                                   |       | (18,114                                     | )          | (2,899 | ) | (622 | ) |
| Interest income                                    |       | 40,715                                      |       | 84,687 |   | 61,062 |   |
| Foreign currency  transaction (losses) gains       |       | (6,912                                      | )          | 8,256 |   | (27,000 | ) |
|                                               |       |                                        |       |   |   |   |   |
| (LOSS) INCOME  FROM OPERATIONS BEFORE INCOME TAXES |       | (518,547                                    | )          | 778,414 |   | 958,126 |   |
| (PROVISION)  BENEFIT FOR INCOME TAXES              |       | (36,006                                     | )          | 22,000 |   | 126,650 |   |
|                                               |       |                                        |       |   |   |   |   |
| NET (LOSS)  INCOME                                 |       | $                                           | (554,553   | ) | $ | 800,414 |   | $ | 1,084,776 |   |
|                                               |       |                                        |       |   |   |   |   |
| Net (loss)  income per share - Basic:              |       | $                                           | (0.10      | ) | $ | 0.15 |   | $ | 0.21 |   |
| Net (loss)  income per share - Diluted:            |       | $                                           | (0.10      | ) | $ | 0.14 |   | $ | 0.19 |   |
|                                               |       |                                        |       |   |   |   |   |
| Weighted-Average  Shares Outstanding - Basic       |       | 5,480,662                                   |       | 5,317,400 |   | 5,267,520 |   |
| Weighted-Average Shares  Outstanding - Diluted     |       | 5,480,662                                   |       | 5,773,585 |   | 5,753,433 |   |

 

*Seenotes to consolidated financial statements.*

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**DATAWATCH CORPORATION**

**CONSOLIDATED STATEMENTS OFSHAREHOLDERS’ EQUITY**

**Years Ended September 30, 2006, 2005 and 2004**
| ** **                                       | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**   | ** **  | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|-------------------|-------------|-------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                       | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **        | ** ** | **Other**         | ** **  | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Comprehensive** | ** **  | **Treasury Stock** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**       | ** ** | **Loss**          | ** **  | **Income (Loss)**  | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Total**  | ** ** |
|                                             |       |                  |       |        |       |            |       |              |       |              |        |                    |       |       |       |       |       |       |       |
| BALANCE, SEPTEMBER  30, 2003                     |       | 5,244,328             |       | $           | 52,443     |            | $          | 21,701,297        |       | $                 | (16,072,238 | )                       | $          | (402,999   | )          |       |       | (14,246    | )          | $ | (140,388 | ) | $ | 5,138,115 |   |
| Issuance of common stock for Auxilor acquisition |       |                  |       |        |       |            |       | —            |       | —            |        |                    |       | —     |       | —     |       |       |       |
| 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     |       |
| 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  |       |
| Stock options exercised                          |       | 143,401               |       | 1,434       |       | 179,758         |       | —            |       | —            |        |                    |       | —     |       | —     |       | 181,192    |       |
| FAS 123(R) expense                               |       |                  |       |        |       | 67,137          |       |              |       |              |        |                    |       |       |       |       |       | 67,137     |       |
| Comprehensive income:                            |       |                  |       |        |       |            |       |              |       |              |        |                    |       |       |       |       |       |       |       |
| Translation adjustments                          |       | —                |       | —      |       | —          |       | —            |       | (44,166           | )           | $                       | (44,166    | )          | —     |       | —     |       | (44,166    | ) |
| Net loss                                         |       | —                |       | —      |       | —          |       | (554,553          | )          | —            |        | (554,553                | )          | —     |       | —     |       | (554,553   | )          |
|                                             |       |                  |       |        |       |            |       |              |       |              |        |                    |       |       |       |       |       |       |       |
| Total comprehensive income (loss)                |       |                  |       |        |       |            |       |              |       |              |        | $                       | (598,719   | )          |       |       |       |       |       |   |
| BALANCE, SEPTEMBER 30,  2006                     |       | 5,526,485             |       | $           | 55,265     |            | $          | 22,204,304        |       | $                 | (14,741,601 | )                       | $          | (422,206   | )          |       |       | (14,246    | )          | $ | (140,388 | ) | $ | 6,955,374 |   |

 

*Seenotes to consolidated financial statements.*

33

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**DATAWATCH CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                                         | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                             |       |                                        |       |   |   |   |   |
| Net (loss) income                                                                                                  |       | $                                           | (554,553   | ) | $ | 800,414 |   | $ | 1,084,776 |   |
| Adjustments to reconcile net (loss) income to cash  provided by operating activities:                              |       |                                        |       |   |   |   |   |
| Depreciation and amortization                                                                                      |       | 831,965                                     |       | 697,373 |   | 728,189 |   |
| Allowances for doubtful accounts and sales returns                                                                 |       | (149,713                                    | )          | 3,404 |   | (29,425 | ) |
| Loss (gain) on disposal of equipment                                                                               |       | 8,307                                       |       | 20,863 |   | (9,862 | ) |
| Stock-based compensation                                                                                           |       | 67,138                                      |       | 47,000 |   | — |   |
| Deferred income taxes                                                                                              |       | 35,550                                      |       | — |   | (148,000 | ) |
| Changes in current assets and liabilities, net of  effects of the acquisitions of Mergence Technologies and IDARS: |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                                |       | 569,090                                     |       | (479,533 | ) | (347,499 | ) |
| Inventories                                                                                                        |       | 22,262                                      |       | 12,592 |   | 38,852 |   |
| Prepaid expenses and other                                                                                         |       | 94,738                                      |       | 69,295 |   | (27,568 | ) |
| Accounts payable and accrued expenses                                                                              |       | (196,833                                    | )          | (74,766 | ) | 596,922 |   |
| Deferred revenue                                                                                                   |       | 246,553                                     |       | 66,535 |   | (221,809 | ) |
| Cash provided by operating activities                                                                              |       | 974,504                                     |       | 1,163,177 |   | 1,664,576 |   |
|                                                                                                               |       |                                        |       |   |   |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                             |       |                                        |       |   |   |   |   |
| Purchase of equipment and fixtures                                                                                 |       | (911,787                                    | )          | (343,309 | ) | (216,825 | ) |
| Proceeds from sale of equipment                                                                                    |       | 2,337                                       |       | 4,364 |   | 15,188 |   |
| Purchase of Mergence Technologies, net of cash  acquired                                                           |       | —                                      |       | — |   | (2,515,284 | ) |
| Purchase of IDARS business, net of cash acquired                                                                   |       | (4,575,392                                  | )          | — |   | — |   |
| Capitalized software development costs                                                                             |       | —                                      |       | (42,775 | ) | (190,825 | ) |
| Decrease (increase) in restricted cash                                                                             |       | 268,299                                     |       | (122,149 | ) | 373 |   |
| Other assets                                                                                                       |       | (9,036                                      | )          | (19,212 | ) | 133,829 |   |
| Cash used in investing activities                                                                                  |       | (5,225,579                                  | )          | (523,081 | ) | (2,773,544 | ) |
|                                                                                                               |       |                                        |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                             |       |                                        |       |   |   |   |   |
| Net proceeds from exercise of stock options                                                                        |       | 181,192                                     |       | 82,468 |   | 128,032 |   |
| Advances on line of credit                                                                                         |       | 1,000,000                                   |       | — |   | — |   |
| Principal payments on long-term obligations                                                                        |       | —                                      |       | — |   | (3,115 | ) |
| Cash provided by financing activities                                                                              |       | 1,181,192                                   |       | 82,468 |   | 124,917 |   |
|                                                                                                               |       |                                        |       |   |   |   |   |
| EFFECT OF EXCHANGE  RATE CHANGES ON CASH AND EQUIVALENTS                                                           |       | 30,669                                      |       | (82,323 | ) | 173,833 |   |
|                                                                                                               |       |                                        |       |   |   |   |   |
| (DECREASE)  INCREASE IN CASH AND EQUIVALENTS                                                                       |       | (3,039,214                                  | )          | 640,241 |   | (810,218 | ) |
| CASH AND  EQUIVALENTS, BEGINNING OF YEAR                                                                           |       | 4,900,873                                   |       | 4,260,632 |   | 5,070,850 |   |
| CASH AND  EQUIVALENTS, END OF YEAR                                                                                 |       | $                                           | 1,861,659  |   | 4,900,873 |   | $ | 4,260,632 |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                                               |       |                                        |       |   |   |   |   |
| Interest paid                                                                                                      |       | $                                           | 30,691     |   | $ | 2,899 |   | $ | 622 |   |
| Income taxes paid                                                                                                  |       | $                                           | 5,963      |   | $ | — |   | $ | 43,000 |   |
| Income tax  refunds received                                                                                       |       | $                                           | —     |   | $ | 63,226 |   | $ | 1,500 |   |

 

Seenotes to consolidated financial statements.

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**DATAWATCH CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**Note1.   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. The Company alsoprovides a wide range of consulting services, including implementation andsupport of its software products, as well as training on their use andadministration. The Company is subject to a number of risks includingdependence on key individuals, competition from substitute products and largercompanies and the need for successful ongoing development and marketing ofproducts.

***Summary of Significant Accounting Policies***

***Principles of Consolidation***

The consolidated financial statements include the accounts of DatawatchCorporation and its wholly owned subsidiaries. All intercompany balances andtransactions have been eliminated in 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 andintangible assets, valuation of net deferred tax assets, business combinations,and valuation of goodwill 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 and resellersaccounted for approximately 33%, 31% and 29%, of total sales for the year endedSeptember 30, 2006, 2005 and 2004, respectively. Revenue from the sale of allsoftware products is generally recognized at the time of shipment, providedthere are no uncertainties surrounding product acceptance, the fee is fixed ordeterminable, collection is considered probable, persuasive evidence of thearrangement exists and there are no significant obligations remaining. Bothtypes of the Company’s software product offerings are “off-the-shelf” as suchterm is defined by the American Institute of Certified Public Accountant’s(AICPA) Statement of Position No. 97-2, “*SoftwareRevenue Recognition*” (“SOP 97-2”). The Company’s software products can be installed and used by customerson their own with little or no customization required. Multi-user licensesmarketed by the Company are sold as a right to use the number of licenses andlicense fee revenue is recognized upon delivery of all software required tosatisfy the number of licenses sold. Upon delivery, the licensing fee ispayable without further delivery obligations to the Company.

Desktop and Server Software products are generally not sold in multipleelement arrangements.  Accordingly, theprice paid by the customer is considered the vendor specific objective evidence(“VSOE”) of fair value for those products. Enterprise Software sales aregenerally multiple element arrangements which include software licensedeliverables, professional services and post-contract customer support. In suchmultiple element arrangements, the Company applies the residual method indetermining revenue to be allocated to a software 

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license.In applying 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 fairvalue of the services and post-contract customer support is based on theamounts charged for these elements when sold separately. Professional servicesinclude implementation, integration, training and consulting services withrevenue recognized as the services are performed. These services are generallydelivered on a time and materials basis, are billed on a current basis as thework is performed, and do not involve modification or customization of thesoftware or any unusual acceptance clauses or terms. Post-contract customersupport is typically provided under a maintenance agreement which providestechnical support and rights to unspecified software maintenance updates andbug fixes on a when-and-if available basis. Revenue from post-contract customersupport services is deferred and recognized ratably over the contract period(generally one year).

The Company also sells its Enterprise Software using a subscriptionmodel. 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 receivable and deferred revenue are recorded. Beginning on the datethe software 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 then invoiced every 90 days and, in accordancewith the SOP 97-2, revenue is recognized ratably over the period the service isprovided.  The subscription arrangementincludes software, maintenance and unspecified future upgrades including majorversion upgrades. The initial subscription rate is the same as the renewalrate. Subscriptions can be cancelled by the customer at any time by providing90 days written notice.

The Company’s software products are sold under warranty against certaindefects in material and workmanship for a period of 30 to 90 days from the dateof purchase. 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 Statement of FinancialAccounting Standards (“SFAS”) No. 48, “*RevenueRecognition when Right of Return Exists*.” Revenue from the sale ofsoftware products to distributors and resellers is recognized at the time ofshipment providing all other criteria for revenue recognition as stated aboveare met and (i) the distributor or reseller is unconditionally obligated to payfor the products, including no contingency as to product resale, (ii) thedistributor or reseller has independent economic substance apart from theCompany, (iii) the Company is not obligated for future performance to bringabout product resale, and (iv) the amount of future returns can be reasonablyestimated. The Company’s experience and history with its distributors andresellers allows for reasonable estimates of future returns. Among otherthings, estimates of potential future returns are made based on the inventorylevels at the various distributors and resellers, which the Company monitorsfrequently. 

***Allowance for Doubtful Accounts***

The Company maintains allowances for doubtful accounts for estimatedlosses resulting 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 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 ended September 30, 2006, 2005 and 2004, changesto and ending balances of the allowance for doubtful accounts wereapproximately as follows:

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|                                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                         |       |     |       |     |       |     |       |
| Allowance for  Doubtful Accounts Balance - Beginning of Year |       | $        | 294,000    |     | $          | 230,000  |       | $ | 230,000 |   |
| Additions to the  Allowance of Doubtful Accounts             |       | 11,000   |       | 75,000   |       | 105,000  |       |
| Deductions  Against the Allowance for Doubtful Accounts      |       | (112,000 | )          | (11,000  | )          | (105,000 | )          |
| Allowance for Doubtful  Accounts Balance - End of Year       |       | $        | 193,000    |     | $          | 294,000  |       | $ | 230,000 |   |

 

***Sales Returns Reserve***

The Company maintains reserves for potential future productreturns.  The Company estimates futureproduct returns based on its experience and history with the Company’s variousdistributors and resellers as well as by monitoring inventory levels at suchcompanies. Once the estimates of potential future returns from all sources aremade, the Company determines if it has adequate returns reserves to coveranticipated returns and the returns reserve is adjusted as required.  Adjustments are recorded as increases ordecreases in revenue in the period of adjustment.  Actual returns have historically been withinthe range estimated by management. Actual results could differ from the reservefor sales returns recorded, and this difference may have a material effect onthe Company’s financial position and results of operations.

For the fiscal years ended September 30, 2006, 2005 and 2004, changesto and ending balances of the sales returns reserve were approximately asfollows:
|                                                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |     |       |
| Sales Returns  Reserve Balance - Beginning of Year |       | $        | 123,000    |     | $          | 186,000  |       | $ | 213,000 |   |
| Additions to the  Sales Returns Reserve            |       | 82,000   |       | 180,000  |       | 165,000  |       |
| Deductions  Against the Sales Returns Reserve      |       | (126,000 | )          | (243,000 | )          | (192,000 | )          |
| Sales Returns Reserve  Balance - End of Year       |       | $        | 79,000     |     | $          | 123,000  |       | $ | 186,000 |   |

 

***Capitalized Software Development Costs***

The Company capitalizes certain software development costs uponachieving technological feasibility of the related products. Softwaredevelopment costs incurred and software purchased prior to achievingtechnological feasibility are charged to research and development expense asincurred. Commencing upon initial product release, capitalized costs areamortized to cost of software licenses and subscriptions using thestraight-line method over the estimated life (which approximates the ratio thatcurrent gross revenues for a product bear to the total of current andanticipated future gross revenues for that product), generally 24 to 72 months.

For the fiscal years ended September 30, 2006, 2005 and 2004 amountsrelated to capitalized and purchased software development costs and purchasedsoftware were approximately as follows:
|                                                                                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                           |       |     |       |     |       |     |       |
| Capitalized and  Purchased Software Balance - Beginning of Year                |       | $        | 583,000    |     | $          | 937,000  |       | $ | 697,000 |   |
| Capitalized  Software Development Costs                                        |       | —   |       | 42,000   |       | 191,000  |       |
| Capitalized  Purchased Software                                                |       | 180,000  |       | —   |       | 520,000  |       |
| Amortization of  Capitalized Software Development Costs and Purchased Software |       | (290,000 | )          | (396,000 | )          | (471,000 | )          |
| Capitalized and  Purchased Software Balance - End of Year                      |       | $        | 473,000    |     | $          | 583,000  |       | $ | 937,000 |   |

 

***Cash and Equivalents***

Cash and equivalents include cash on hand, cash deposited with banksand highly liquid securities with original maturities of 90 days or less.

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***Concentration of Credit Risks and MajorCustomers***

The Company sells its products and services to U.S. and non-U.S.dealers and other software distributors, as well as to end users, undercustomary and normal credit terms. One customer, Ingram Micro Inc.,individually accounted for 15%, 19% and 20% of total revenue in 2006, 2005 and2004, respectively. Ingram Micro Inc. accounted for 12% and 17% of outstandinggross trade receivables as of September 30, 2006 and 2005, respectively. Oneother customer, Tech Data Product Management, individually accounted forapproximately 13% of total revenue in 2006. Tech Data Product Managementaccounted for 16% of outstanding gross trade receivables as of September 30,2006. The Company sells to Ingram Micro Inc. and Tech Data Product Managementunder distribution agreements, which automatically renew for successiveone-year terms unless terminated. Other than these two customers, no othercustomer constitutes a significant portion (more than 10%) of sales or accountsreceivable. The Company performs ongoing credit evaluations of its customersand generally does not require collateral. Allowances are provided for anticipateddoubtful accounts and sales returns.

***Deferred Revenue***

Deferred revenue consistedof the following at September 30:
|             | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------|------------|----------|------------|----------|------------|
|        |       |     |       |     |       |
| Maintenance |       | $        | 3,690,034  |     | $          | 2,531,973 |   |
| Other       |       | 778,082  |       | 389,546  |       |
|        |       |     |       |     |       |
| Total       |       | $        | 4,468,116  |     | $          | 2,921,519 |   |

 

Maintenance deferred revenue consists of the unearned portion ofpost-contract customer support services provided by the Company to customerswho either purchased maintenance agreements for the Company’s products orrepresents the assumed contracts from the IDARS acquisition. Maintenancerevenues are recognized on a straight-line basis over the term of themaintenance period, generally 12 months. 

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

***Inventories***

Inventories consist of software components, primarily software manuals,compact disks and retail packaging materials. Inventories are valued at thelower of cost (first-in, first-out) method or market.

***Property and Equipment***

 Purchased equipment and fixturesare recorded at cost. Leased equipment accounted for as capital leases isrecorded at the present value of the minimum lease payments required during thelease terms. Depreciation and amortization are provided using the straight-linemethod over the estimated useful lives of the related assets or over the terms,if shorter, of the related leases. Useful lives and lease terms range from oneto seven years. Depreciation and amortization expense related to property andequipment was $362,769, $234,620 and $255,634 respectively, for the years endedSeptember 30, 2006, 2005 and 2004. There were no items under capital leases asof September 30, 2006 or 2005.

***Long-Lived Assets***

 The Company continuallyevaluates whether events or circumstances have occurred that indicate that theestimated remaining 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 

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comparedto the carrying value. To the extent that the undiscounted future cash flowsare less than the carrying value, the fair value of the asset is determined. Ifsuch fair value is less than the current carrying value, the asset is writtendown to its estimated fair value. 

***Goodwill and Other Intangible Assets***

Other intangible assets consist of capitalized software costs, acquiredtechnology, patents, customer relationships, trademarks, trade names andnon-compete agreements acquired through business combinations.  The values allocated to capitalized andpurchased software costs, acquired technology, patents, tradenames andtrademarksare amortizedusing the straight-line method over the estimated useful life of the relatedasset and are recorded in cost of sales for software license and subscriptions.The values allocated to customer relationships and non-compete agreements areamortized using the straight-line method over the estimated useful life of therelated asset and are recorded in sales and marketing expenses. Intangibleassets are reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of the asset may not be recoverable and animpairment loss is recognized when it is probable that the estimated cash flowsare less than the carrying amount of the asset.

Goodwill and certain trademarks are not subject to amortization and aretested annually for impairment or more frequently if events and circumstancesindicate that the asset might be impaired. Goodwill is tested for impairmentusing a two-step approach. The first step is to compare the fair value of thereporting unit to its carrying amount, including goodwill. If the fair value ofthe reporting unit is greater than its carrying amount, goodwill is notconsidered impaired, but if the fair value of the reporting unit is less thanits carrying amount, the amount of the impairment loss, if any, must bemeasured (Step 2). An impairment loss is recognized to the extent that thecarrying amount exceeds the asset’s fair value.

The Company has the following intangible assets, as of September 30,2006 and 2005:
|                                           | ** ** | **Weighted**                                 | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **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                     |       | 2                                            |       | 1,665,895                        |       | $                                | 1,648,058  |   | $ | 17,837 |   | $ | 1,665,895 |   | $ | (1,483,015 | ) | $ | 182,880 |   |
| Purchased  software                       |       | 5                                            |       | 700,000                          |       | 244,723                          |       | 455,277 |   | 520,000 |   | (119,722 | ) | 400,278 |   |
| Patents                                   |       | 20                                           |       | 159,967                          |       | 16,417                           |       | 143,550 |   | 159,967 |   | (8,389 | ) | 151,578 |   |
| Customer lists                            |       | 10                                           |       | 1,790,000                        |       | 138,230                          |       | 1,651,770 |   | 130,000 |   | (36,563 | ) | 93,437 |   |
| Non-compete  agreements                   |       | 4                                            |       | 640,000                          |       | 98,750                           |       | 541,250 |   | 100,000 |   | (22,500 | ) | 77,500 |   |
| Trademarks                                |       | indefinite                                   |       | 345,152                          |       | —                           |       | 345,152 |   | 345,152 |   | — |   | 345,152 |   |
|                                      |       |                                         |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Total                                     |       | 8 Years                                      |       | $                                | 5,301,014  |                             | $          | 2,146,178 |   | $ | 3,154,836 |   | $ | 2,921,014 |   | $ | (1,670,189 | ) | $ | 1,250,825 |   |
|                                           |            |                                              |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The intangible asset amounts amortized to cost of software licenses andsubscriptions totaled $350,573, $462,424 and $472,331, for fiscal 2006, 2005and 2004, respectively.

As of September 30, 2006,the estimated future amortization expense related to amortizing intangibleassets was as follows:
| Year Ending September 30,     | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
|                                         |       |       |       |
| 2007                                         |       | $          | 514,236    |   |
| 2008                                         |       | 458,204    |       |
| 2009                                         |       | 425,861    |       |
| 2010                                         |       | 352,113    |       |
| 2011                                         |       | 195,028    |       |
| Thereafter                                   |       | 864,243    |       |
|                                         |       |       |       |
| Total estimated future  amortization expense |       | $          | 2,809,685  |   |

 

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***Restricted Cash***

At September 30, 2006, restricted cash consisted of a $125,000 securitydeposit in the form of an irrevocable letter of credit held in escrow for thelandlord of the Company’s Chelmsford, MA corporate offices. At September 30,2005, restricted cash consisted of $268,299 for security deposits to providecredit support for rent payments to the landlord of the Company’s formercorporate headquarters located in Lowell, MA, and $125,000 held in escrow forthe sellers of Mergence (see Note 2).

***Fair Value Disclosure***

The carrying amounts of cash and equivalents, accounts receivable,accounts payable and accrued expenses approximate fair value because of theirshort-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 income bythe 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 presents the options and warrants that were notincluded in the computation of diluted net income per share, because theexercise price of the options or warrants was greater than the average marketprice of the common stock for the years ended September 30, 2006, 2005 and2004:
|                                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                 |       |     |       |     |       |     |       |
| Quantity of option shares  and warrants not included |       | 255,753  |       | 145,870  |       | 120,818  |       |
| Weighted-average  exercise price                     |       | $        | 4.76       |     | $          | 5.86     |       | $ | 6.24 |   |
|                                                      |            |          |            |          |            |          |            |  |  |  |

 

***Foreign Currency Translations andTransactions***

Assets and liabilities of foreign subsidiaries are translated into U.S.dollars at rates in effect at each balance sheet date. Revenues, expenses andcash flows are translated into U.S. dollars at average rates prevailing whentransactions occur. The related translation adjustments are reported as aseparate component of shareholders’ equity under the heading “Accumulated OtherComprehensive Loss.” Gains and losses resulting from transactions that aredenominated in currencies other than the applicable unit’s functional currencyare included in the operating results of the Company and were not material.

***Advertising and PromotionalMaterials***

Advertising costs areexpensed as incurred and amounted to $324,810, $372,813 and $254,001 in 2006,2005 and 2004, respectively. Direct mail/direct response costs are expensed asthe associated revenue is recognized. The amortization period is based onhistorical results of previous mailers (generally three to six months from thedate of the mailing). Direct mail expense was $32,860, $112,480 and $130,289 in2006, 2005 and 2004, respectively. At September 30, 2006 and 2005, deferreddirect mail/direct response costs were $4,424 and $6,157, respectively, and areincluded under the caption “prepaid expenses and other” in the accompanyingconsolidated balance sheets.

***Stock-Based Compensation***

On December 16, 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 

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2004) (“SFAS 123(R)”), *“Share-Based Payment,”*which is a revision of SFAS 123, “*Accounting for Stock BasedCompensation”* and supersedes Accounting Principles Bulletin (“APB”)No. 25, “*Accounting for Stock Issued to Employees,”*and amends SFAS 95, *“Statement of Cash Flows.”*  SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. SFAS 123(R) eliminates thealternative to use the intrinsic value method of accounting.

On October 1, 2005 (thefirst day of the Company’s 2006 fiscal year), the Company adopted SFAS 123(R).The Company adopted SFAS 123(R) using a modified prospective applicationmethod, as permitted under SFAS 123(R). Accordingly, prior period amounts havenot been restated. Under this approach, the Company is required to recordcompensation cost for all share-based awards granted after the date of adoptionand for the unvested portion of previously granted stock-based awards at thedate of adoption. See additional Stock-Based Compensation disclosure in Note 8to the Company’s Consolidated Financial Statements.

***Comprehensive Income*****(Loss)**

Currently, the only item other than net income (loss) that is includedin comprehensive income (loss) is foreign currency translation adjustments.Foreign currency translation (losses) gains arising during 2006, 2005 and 2004were ($44,166), ($60,047) and, $85,006 respectively.

***Segment Information***

The Company has determined that it has only one reportable segmentmeeting the criteria established under SFAS No. 131, “*Disclosures about Segments of an Enterprise andRelated Information*.” The Company’s chief operating decision maker,(determined to be the Chief Executive Officer), does not manage any part of theCompany separately, and the allocation of resources and assessment ofperformance is based on the Company’s consolidated operating results. See Note10 for information about the Company’s revenue by product lines and geographicoperations.

***Guarantees and Indemnifications***

The Company’s software products are sold under warranty against certaindefects in material and workmanship for a period of 30 to 90 days from the dateof purchase. The Company has never incurred significant expense under itsproduct or service warranties. As a result, the Company believes the estimatedfair value of these warranty agreements is minimal. Accordingly, there are noliabilities recorded for warranty claims as of September 30, 2006 and 2005.

The Company is required by the lease related to its Chelmsford,Massachusetts facility to provide a letter of credit in the amount of $125,000as a security deposit to provide credit support for payment to the landlord ofamounts due under the lease.  Aspreviously disclosed, cash on deposit providing security in the amount of thisletter of credit is classified as part of restricted cash in the Company’sconsolidated balance sheets at September 30, 2006. See Note 5 for disclosure ofminimum rental commitments under non-cancelable operating leases.

In August 2004, the Company entered into a Stock Purchase Agreement forthe acquisition of Mergence in which the Company made certain warrantiesregarding, 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 Company believes that no such misrepresentationsor breaches of warranty exist, or are likely to exist in the future, and,accordingly, has recorded no liabilities related to such indemnification as ofSeptember 30, 2006 and 2005.

The Company enters into indemnification agreements in the ordinarycourse of business.  Pursuant to theseagreements, the Company agrees to indemnify, hold harmless, and to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally its customers, in connection with any patent, copyright or otherintellectual property infringement claim by any third party with respect to theCompany’s products. The term of these indemnification agreements is generallyperpetual and the maximum potential amount of future payments the Company couldbe required to make under these indemnification agreements is unlimited. The 

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Companyhas never incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, the Company believes the estimated fairvalue of these agreements is minimal. Accordingly, the Company has noliabilities recorded for these agreements as of September 30, 2006 and 2005.

Certain of the Company’s agreements also provide for the performance ofservices at customer sites. These agreements may contain indemnificationclauses, whereby the Company will indemnify the customer from any and alldamages, losses, judgments, costs and expenses for acts of its employees orsubcontractors resulting in bodily injury or property damage. The maximumpotential amount of future payments the Company could be required to make underthese indemnification agreements is unlimited; however, the Company has generaland umbrella insurance policies that would enable it to recover a portion ofany amounts paid. The Company has never incurred costs to defend lawsuits orsettle claims related to these indemnification agreements. As a result, theCompany believes the estimated fair value of these agreements is minimal.Accordingly, the Company has no liabilities recorded for these agreements as ofSeptember 30, 2006******and 2005.

As permitted under Delaware law, the Company has agreements with itsdirectors whereby the Company will indemnify them for certain events oroccurrences while the director is, or was, serving at the Company’s request insuch capacity. The term of the director indemnification period is for the laterof ten years after the date that the director ceases to serve in such capacityor the final termination 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 ofSeptember 30, 2006 and 2005.

***Recent Accounting Pronouncements***

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued Interpretation No. 48 (“FIN 48”), *“Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,Accounting for Income Taxes.”* The interpretation prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken, ina tax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties accounting in interim periods, disclosure andtransition. The interpretation is effective for fiscal years beginning afterDecember 15, 2006. The Company is in the process of determining the effectsthat adoption of FIN 48 will have on the Company’s financial position, cashflows and results of operations.

In September 2006, the FASB issued SFAS No. 157, *“Fair Market Measurements”* (“SFAS 157”), whichestablishes a framework for measuring fair value and expands disclosures aboutthe use of fair value measurements and liabilities in interim and annualreporting periods subsequent to initial recognition.  Prior to SFAS 157,which emphasizes that fair value is a market-based measurement and not anentity-specific measurement, there were different definitions of fair value andlimited definitions for applying those definitions in GAAP.  SFAS 157 iseffective for the Company on a prospective basis for the reporting period beginningJanuary 1, 2008.  The effect of adoption on the Company’s financialposition and results of operations have not been determined.

In September 2006, the Securities and ExchangeCommission staff published Staff Accounting Bulletin (“SAB”) 108, *“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements”* (“SAB 108”). SAB108 provides interpretive guidance on how the effects of the carryover orreversal of prior year misstatements should be considered in quantifying acurrent year misstatement. The SAB is effective for fiscal years ending afterNovember 15, 2006. Application of this SAB is not expected to impact theCompany’s financial position, results of operations or cash flows.

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**2.  ACQUISITIONS**

Integrated DocumentArchiving and Retrieval Systems Business 

OnMay 3, 2006, the Company acquired certain assets and assumed certainliabilities of ClearStory Systems, Inc’s. Integrated Document Archiving andRetrieval Systems (“IDARS”) business. The acquisition of IDARS was consummatedpursuant to an asset purchase agreement dated as of March 10, 2006 among theCompany and Clearstory Systems, Inc. The acquisition cost for IDARS wasapproximately $4,790,000, consisting of $4,349,000 in cash and directacquisition costs of approximately $441,000. Additional acquisition costsinclude an 18- month earn-out payment equal to 30% of net revenues of productsfrom the IDARS business excluding the first $337,500 of revenues. The earn-outpayment will be considered additional purchase price and will be recorded asadditional goodwill when incurred. At September 30, 2006, the Company accruedapproximately $215,000 related to such earn-out payments with a correspondingincrease in goodwill. In accordance with the asset purchase agreement, theinitial earn-out payments are due in March 2007. The Company borrowed $1million from its existing line of credit prior to the May 3, 2006 closing tofinance part of the acquisition price. IDARS’s results are included with thoseof the Company from the date of acquisition.

Thefollowing table presents the allocation of the purchase price paid for IDARSbased on the estimated fair values of the acquired assets and assumedliabilities of IDARS as of May 3, 2006:
| Current assets               |   | $          | 56,000    |   |
|------------------------------|--------|------------|-----------|--------|
| Property and  equipment, net |   | 64,000     |      |
| Current  liabilities         |   | (125,000   | )         |
| Deferred  revenues           |   | (1,190,000 | )         |
| Goodwill                     |   | 3,605,000  |      |
| Acquired  intangible assets: |   |       |      |
| Existing technology          |   | 180,000    |      |
| Customer list                |   | 1,660,000  |      |
| Non-compete agreement        |   | 540,000    |      |
|                         |   |       |      |
| Total purchase price         |   | $          | 4,790,000 |   |

 

Theallocation of the purchase price was based on an evaluation of the fair valueof assets acquired and liabilities assumed. The valuation method used todetermine the intangible asset values was the income approach. The incomeapproach presumes that the value of an asset can be estimated by the neteconomic benefit (i.e. cash flows) to be received over the life of the asset,discounted to present value. The discounting process uses a rate of return thataccounts for both the time value of money and investment risk factors. Theweighted-average discount rate (or rate of return) used to determine the valueof the identifiable intangible assets was 32%.

The intangible asset for existing technology is for technologiesdeveloped by IDARS.  The Company hasestimated the life of these products as five years.  The IDARS customer list and non-competeagreements have estimated lives of ten years and four years, respectively. Thefair values for the existing technology, customer list and non-competeagreements will be amortized over their estimated life, subject to appropriateasset impairment assessments. Amortization of the intangible assets acquired aspart of the IDARS acquisition totaled $140,417 from the date of acquisitionthrough September 30, 2006.

The goodwill will be tested for impairment annually, or on an interimbasis, if an event or circumstance indicates that it is more likely than notthat an impairment loss has been incurred. Goodwill associated with this acquisition is deductible for tax purposesand has a 15 year amortization period for tax purposes.

The following(unaudited) pro forma consolidated results of operations have been prepared asif the acquisition of IDARS had occurred on October 1, 2004:

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|                              | ** ** | **Years Ended September 30,** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                     | ** ** | **2005** | ** ** |
|                         |       |                                         |       |   |   |
| Sales                        |       | $                                            | 23,348,000 |   | $ | 28,409,000 |   |
| Net income                   |       | $                                            | 316,000    |   | $ | 2,899,000 |   |
|                         |       |                                         |       |   |   |
| Earnings per  share - basic  |       | $                                            | 0.06       |   | $ | 0.55 |   |
| Earnings per share - diluted |       | $                                            | 0.06       |   | $ | 0.50 |   |

 

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(a) Based on the historical statements ofoperations of Datawatch for the years ended September 30, 2006 and 2005, andthe historical statements of operations of IDARS for the years ended March 31,2006 and 2005.

Thepro forma information is presented for informational purposes only and is notnecessarily indicative of the results of operations that actually would havebeen achieved had the acquisition been consummated as of that time, nor is itintended to be a projection of future results.

MergenceTechnologies Corporation

On August 11, 2004, the Company acquired 100% of the outstanding sharesof Mergence Technologies Corporation for an acquisition cost of $2,596,691comprised of $2,500,000 in cash and direct costs of $96,691. The Mergencepurchase agreement also includes a provision for quarterly cash payments to theformer Mergence shareholders equal to 10% of the revenues, as defined, ofMergence’s Researcher product for a period of six years, not all Mergenceproducts are subject to royalties. Such amounts were expensed as a cost ofrevenue as the Researcher products were sold. The Company expensed $5,075 and$10,400 for 2006 and 2005, respectively.

The Mergence purchase agreement included an amount of $125,000 to beheld in escrow for the sellers of Mergence and was to be paid 55 days afterSeptember 30, 2005, unless the sellers owe any damages or unresolved claims tothe buyer. The escrow amount was paid to the sellers of Mergence during fiscal2006.

Mergence was acquired to broaden and expand the Company’s productofferings. Mergence’s results are included with those of the Company from thedate of acquisition.

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

Inventories consisted of thefollowing at September 30:
|                | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
|           |       |     |       |     |       |
| Raw materials  |       | $        | 17,900     |     | $          | 28,406 |   |
| Finished goods |       | 19,188   |       | 26,306   |       |
|           |       |     |       |     |       |
| Total          |       | $        | 37,088     |     | $          | 54,712 |   |

 

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

Accrued expenses consistedof the following at September 30:
|                                    | ** ** | **2006** | ** ** | **2005**  | ** ** |
|------------------------------------|------------|----------|------------|-----------|------------|
|                               |       |     |       |      |       |
| Accrued salaries  and benefits     |       | $        | 347,144    |      | $          | 280,136 |   |
| Accrued  royalties and commissions |       | 932,890  |       | 1,095,758 |       |
| Accrued  professional fees         |       | 255,285  |       | 312,606   |       |
| Other                              |       | 283,611  |       | 325,494   |       |
|                               |       |     |       |      |       |
| Total                              |       | $        | 1,818,930  |      | $          | 2,013,994 |   |

 

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**5.****                     ****COMMITMENTS**

***Leases***

The Company leases various facilities and equipment in the U.S. andoverseas under non-cancelable operating leases which expire through 2011. Thelease agreements generally provide for the payment of minimum annual rentals,pro-rata share of taxes, and maintenance expenses. Rental expense for alloperating leases was $631,899, $663,664 and $678,677 for the years endedSeptember 30, 2006, 2005 and 2004, respectively.  Certain of the Company’s facility leasesinclude options to renew.

Asof September 30, 2006, minimum rental commitments under noncancelable operatingleases are as follows:
| Year Ending September 30, | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
| ** **                               | ** ** | ** ** | ** ** |
| 2007                                     |       | $          | 388,712    |   |
| 2008                                     |       | 237,222    |       |
| 2009                                     |       | 191,953    |       |
| 2010                                     |       | 195,458    |       |
| 2011                                     |       | 139,257    |       |
|                                     |       |       |       |
| Total minimum lease  payments            |       | $          | 1,152,602  |   |

 

***Royalties***

The Company is committed to pay royalties ranging from 7% to 50% onrevenue generated by the sale of certain licensed software products.  Royalty expense included in cost of softwarelicenses and subscriptions was $1,601,757, $1,659,308 and $1,677,231 for the yearsended September 30, 2006, 2005 and 2004, respectively. The Company is notobligated to pay minimum royalty amounts.

***ClearStory Systems Royalties***

As a result of theacquisition of certainassets of ClearStory Systems, Inc’s. Integrated Document Archiving andRetrieval Systems (“IDARS”) business (see Note 2), the Company is required tomake quarterly cash payments equal to 30% of net revenues of products from theIDARS business excluding the first $337,500 of revenues through an 18 monthearn-out period.

***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 topay any minimum amounts unless the Company ceases to compete in the markets, asdefined, in which the Researcher product competes.  The Company fully intends to continue tocompete in these markets.

**Contingencies**

The Company is occasionallyinvolved in legal proceedings and other claims arising out of our operations inthe normal course of business. The Company is not party to any litigation thatmanagement believes will have a material effect on the Company’s consolidatedfinancial condition, results of operations, or cash flows.

**6.****                   ****FINANCING ARRANGEMENTS**

***Borrowings***

On April 20, 2006, the Company entered into aone-year Loan and Security Agreement (“Loan Agreement”) with a bank.  The loan agreement establishes two revolving$1.5 million lines of credit, for a total of $3.0 

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million.  As of September 30, 2006, advances on theCompany’s two credit lines amounted to $1,000,000. The Company can borrow underthe first line of credit based on a formula percentage based on the Company’seligible accounts receivable balance. There is no borrowing base formula forthe second line of credit. The first line of credit bears an interest rateequal to the prime rate plus 0.50% and the second line of credit bears aninterest rate equal to the prime rate plus 1.00%. Amounts borrowed under theLoan Agreement are secured by all of the assets of the Company, including itsintellectual property. Additionally, the Loan Agreement requires the Company tomaintain certain specified cash flow and liquidity levels. In addition, theLoan Agreement requires that the Company maintain at all times unrestrictedcash with the bank of not less than $500,000. 

As of September 30, 2006 the Company was in default onits covenant to maintain the minimum level of Earnings Before Interest, Taxes,Depreciation and Amortization (“EBITDA”) less capital expenditures. Pursuant toa Loan Modification Agreement between the Company and the bank dated as ofNovember 27, 2006, the Company agreed with the bank to waive this covenantuntil the period ended December 31, 2006 and to modify the minimum cash flowratios during the next fiscal year. Pursuant to the Loan ModificationAgreement, the interest rate on the first line of credit was amended to reflecta rate equal to the prime rate plus 1.50% for the period from July 31, 2006through November 26, 2006, a rate equal to the prime rate plus 1.00% for theperiod from November 27, 2006 through approximately January 31, 2007, and arate equal to the prime rate plus 0.50% thereafter.

***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 provided acash term deposit in the amount of $125,000 to secure the letter of credit.This amount is included as part of restricted cash in the Company’sconsolidated balance sheets at September 30, 2006.

**7.****                   ****INCOME TAXES**

Income (loss) from operations before income taxes consists of thefollowing for the years ended September 30:
|          | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004**  | ** ** |
|----------|------------|------------|------------|----------|------------|-----------|------------|
|     |       |       |       |     |       |      |       |
| Domestic |       | $          | 1,550,985  |     | $          | 1,645,322 |       | $ | 980,486 |   |
| Foreign  |       | (2,069,532 | )          | (866,908 | )          | (22,360   | )          |
|     |       |       |       |     |       |      |       |
| Total    |       | $          | (518,547   | )        | $          | 778,414   |       | $ | 958,126 |   |

 

The provision (benefit) for income taxes consisted of the following forthe years ended September 30:
|                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |     |       |
| Current:                      |       |     |       |     |       |     |       |
| Federal                       |       | $        | —     |     | $          | (12,000  | )          | $ | 21,350 |   |
| State                         |       | 456      |       | (10,000  | )          | —   |       |
| Foreign                       |       | —   |       | —   |       | —   |       |
|                          |       |     |       |     |       |     |       |
|                          |       | 456      |       | (22,000  | )          | 21,350   |       |
|                          |       |     |       |     |       |     |       |
| Deferred:                     |       |     |       |     |       |     |       |
| Federal                       |       | (26,300  | )          | (18,000  | )          | 9,000    |       |
| State                         |       | 9,500    |       | 11,000   |       | 171,000  |       |
| Foreign                       |       | (31,650  | )          | —   |       | 120,000  |       |
| Change in valuation allowance |       | 84,000   |       | 7,000    |       | (448,000 | )          |
|                          |       |     |       |     |       |     |       |
|                          |       | 35,550   |       | —   |       | (148,000 | )          |
|                          |       |     |       |     |       |     |       |
| Total                         |       | $        | 36,006     |     | $          | (22,000  | )          | $ | (126,650 | ) |

 

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At September 30, 2006, the Company had U.S. federal tax losscarryforwards of approximately $7.6 million, expiring at various dates through2021, including $520,000 resulting from the Mergence acquisition undertakenduring 2004 which are subject to additional annual limitations as a result ofthe changes in Mergence’s ownership, and had approximately $2.0 million instate tax loss carryforwards, which also expire at various dates through 2021.Net state tax carryforwards of approximately $118,000 expired during the yearended September 30, 2006. An alternative minimum tax credit of approximately$148,000 is available to offset future regular federal taxes. Research anddevelopment credits of approximately $418,000 expire beginning in 2011. Inaddition, the Company has the following net operating loss carryforwards:United Kingdom losses of $8.0 million with no expiration date, France losses of$130,000 with no expiration date, Germany losses of $2.0 million with noexpiration date and Australia losses of $2.0 million with no expiration date.

The components of the Company’s net deferred tax assets are as followsat September 30:
|                                        | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| Deferred tax  liabilities:             |       |       |       |       |       |
| Goodwill amortization                  |       | $          | (35,500    | )          | $          | — |   |
| Prepaid expenses                       |       | (58,000    | )          | (66,000    | )          |
| Acquired intangibles                   |       | (356,000   | )          | (356,000   | )          |
|                                   |       |       |       |       |       |
|                                   |       | (449,500   | )          | (422,000   | )          |
| Deferred tax  assets:                  |       |       |       |       |       |
| Net operating loss carryforwards       |       | 4,147,000  |       | 4,062,000  |       |
| Research and development credits       |       | 418,000    |       | 512,000    |       |
| Accounts and notes receivable reserves |       | 144,000    |       | 150,000    |       |
| Alternative minimum tax credits        |       | 148,000    |       | 148,000    |       |
| Depreciation and amortization          |       | 181,750    |       | 176,000    |       |
| Deferred rent                          |       | 95,000     |       | —     |       |
| Other                                  |       | 54,000     |       | 64,000     |       |
|                                   |       |       |       |       |       |
|                                   |       | 5,187,750  |       | 5,112,000  |       |
|                                   |       |       |       |       |       |
| Total                                  |       | 4,738,250  |       | 4,690,000  |       |
|                                   |       |       |       |       |       |
| Valuation  allowance                   |       | (4,773,800 | )          | (4,690,000 | )          |
|                                   |       |       |       |       |       |
| Deferred tax liability,  net           |       | $          | (35,550    | )          | $          | — |   |

 

The Company had profitable domestic operations but continued to have significantoperating losses from international operations for the years ended September30, 2006, 2005 and 2004. This followed significant losses from operations, bothdomestically and internationally, over several prior years. Accordingly,management does not believe the tax assets are more likely than not to berealized and a full valuation allowance has been provided.  The valuation allowance increased byapproximately $87,000 in 2006 and increased by $7,000 in 2005 as the Companymaintains a full valuation allowance against the tax assets and such assetsincreased or decreased primarily as a result of utilization or expiration ofnet operating loss carryforwards in each respective year.

SFAS No. 109, “*Accounting for IncomeTaxes*,” requires recognition of deferred tax liabilities anddeferred tax assets (and related valuation allowances, if necessary) for theexcess of tax-deductible goodwill over goodwill for financial reportingpurposes. The tax benefit for the excess tax-deductible goodwill is recognizedwhen realized on the tax return. During fiscal year 2006, Datawatch acquiredthe business assets of IDARS that resulted in tax-deductible amortization beingrecognized as a deferred tax expense in 2006. As the goodwill is deducted fortax purposes, a deferred tax expense will be recognized each year with acorresponding deferred tax liability equal to the excess of tax amortizationover the amortization for financial reporting purposes.

The following table reconciles the Company’s tax provision based on itseffective tax rate to its tax provision based on the federal statutory rate of34% for the years ended September 30, 2006, 2005 and 2004:

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|                                          | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Provision at  federal statutory rate     |       | $          | (176,300   | )          | $          | 265,000    |       | $ | 326,000 |   |
| State, net of  federal impact            |       | 5,600      |       | (7,000     | )          | 113,000    |       |
| Foreign taxes                            |       | (75,500    | )          | (60,000    | )          | (137,000   | )          |
| Valuation  allowance increase (decrease) |       | 349,800    |       | 7,000      |       | (448,000   | )          |
| Extra-territorial  income exclusion      |       | (71,600    | )          | (120,000   | )          | —     |       |
| Other                                    |       | 4,006      |       | (107,000   | )          | 19,350     |       |
|                                     |       |       |       |       |       |       |       |
| Provision (benefit) for  income taxes    |       | $          | 36,006     |       | $          | (22,000    | )          | $ | (126,650 | ) |

 

**8.****                   ****SHAREHOLDERS’ EQUITY**

***Stock Option Plans***

The Company provides its employees, officers, consultants, anddirectors stock options and other stock rights to purchase common stock of theCompany on a discretionary basis pursuant to three stock compensation plansdescribed more fully below. All option grants are subject to the terms andconditions determined by the Compensation Committee of the Board of Directors,and generally vest over a three-year period beginning three months from date ofgrant and expire seven to ten years from date of grant depending on the plan.Generally, options and other stock rights are granted at exercise prices notless than the fair market value at the date of grant.

On October 4, 1996, the Company established the 1996 InternationalEmployee Non-Qualified Stock Option Plan (the “1996 International Plan”).Pursuant to this plan, nonqualified options may be granted to any employee orconsultant of any of the Company’s foreign subsidiaries through October 4,2006.

On December 10, 1996, the Company established the Datawatch Corporation1996 Stock Plan (the “1996 Stock Plan”), which provides for the granting ofboth incentive stock options and nonqualified options, the award of Companycommon stock, and opportunities to make direct purchases of Company commonstock (collectively, “Stock Rights”), as determined by a committee appointed bythe Board of Directors. Options pursuant to this plan may be granted throughDecember 10, 2006 and shall vest as specified by this committee.

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

On December 16, 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS 123 (revised 2004) (“SFAS123(R)”), *“Share-Based Payment,”* which is arevision of SFAS 123, “*Accounting for Stock BasedCompensation”* and supersedes Accounting Principles Bulletin (“APB”)No. 25, “*Accounting for Stock Issued to Employees,”*and amends SFAS 95, *“Statement of Cash Flows.”*  SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. SFAS 123(R) eliminates thealternative to use the intrinsic value method of accounting that was providedin SFAS 123.

On October 1, 2005 (thefirst day of the Company’s 2006 fiscal year), the Company adopted SFAS 123(R).The Company adopted SFAS 123(R) using a modified prospective applicationmethod, as permitted under SFAS 123(R). Accordingly, prior period amounts havenot been restated. Under this approach, the Company is required to recordcompensation cost for all share-based awards granted after the date of adoptionand for the unvested portion of previously granted stock-based awards at thedate of adoption.

48

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InSeptember 2005, prior to the adoption of SFAS 123(R), the CompensationCommittee of the Board of Directors approved the full vesting of alloutstanding options with vesting dates occurring after September 30, 2005. Thevesting of approximately 169,040 options was accelerated, of whichapproximately 64,000 options had an exercise price greater than the closingstock price on the modification date. As the Company estimated that certain ofthese awards would not have vested absent the acceleration, the Companyrecognized stock-based compensation charge of approximately $47,000, which isincluded in the results for the year ended September 30, 2005. The purpose ofthis modification was to eliminate the future compensation expense of the outstandingawards.  As all outstanding awards werefully vested, the adoption of FAS123(R) did not have any impact on thefinancial statements from awards outstanding as of the date of adoption.

Under the provisions of SFAS No. 123(R), theCompany recognizes the fair value of stock compensation cost over the requisiteservice period of the individual awards, which generally equals the vestingperiod. All of the Company’s stock compensation awards are accounted for asequity instruments and there have been no liability awards granted.

Prior to the adoption of SFAS 123(R), the Companyapplied APB 25 to account for stock-based awards.  The following table illustrates the effect onearnings and earnings per share had compensation cost for the employee stock-basedawards been recorded for the years ended September 30, 2005 and 2004 based onthe fair value method under SFAS 123:

**Datawatch Corporation**

**Stock-Based Compensation Disclosures**

**Years Ended September 30, 2006, 2005and 2004**

 
|                                                                                                                       | ** ** | **Years Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2005**                                     | ** ** | **2004** | ** ** |
|                                                                                                                  |       |                                         |       |   |   |
| Net income, as  reported                                                                                              |       | $                                            | 800,414    |   | $ | 1,084,776 |   |
| Add:                                                                                                                  |       |                                         |       |   |   |
| Total stock-based employee compensation expense included  in net income                                               |       | 47,000                                       |       | — |   |
| Less:                                                                                                                 |       |                                         |       |   |   |
| Total stock-based employee compensation expense determined  under fair value base method for all awards, net of taxes |       | (589,693                                     | )          | (231,242 | ) |
| Pro forma net  income                                                                                                 |       | $                                            | 257,721    |   | $ | 853,534 |   |
|                                                                                                                  |       |                                         |       |   |   |
| Basic net income  per share:                                                                                          |       |                                         |       |   |   |
| As reported                                                                                                           |       | $                                            | 0.15       |   | $ | 0.21 |   |
| Pro forma                                                                                                             |       | $                                            | 0.05       |   | $ | 0.16 |   |
|                                                                                                                  |       |                                         |       |   |   |
| Diluted net  income per share:                                                                                        |       |                                         |       |   |   |
| As reported                                                                                                           |       | $                                            | 0.14       |   | $ | 0.19 |   |
| Pro forma                                                                                                             |       | $                                            | 0.04       |   | $ | 0.15 |   |

 

Beginning with the 2006 fiscal year, with the adoption of SFAS 123(R), the Company recorded stock-based compensation expense for the fair value of stock options. Stock-based compensation expense for the fiscal year ended September 30, 2006 was $67,137 which was included in the following expense categories:
| Sales and marketing                  |   | $      | 25,074 |   |
|--------------------------------------|--------|--------|--------|--------|
| Engineering and  product development |   | 7,015  |   |
| General and  administrative          |   | 35,048 |   |
|                                 |   |   |   |
|                                 |   | $      | 67,137 |   |

 

The Company uses the Black-Scholes option-pricing model to calculate the fair value of options. The key assumptions for this valuation method include the expected life of the option, stock price volatility, risk-free interest rate, dividend yield, exercise price and forfeiture rate. The weighted-average fair values of the options granted under the stock options plans were $3.10, $2.98 and $2.57 for the years ended September 30, 2006, 2005 and 2004, respectively.

49

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Many of these assumptions are judgmental and highly sensitive in the determination of compensation expense. The table below indicates the weighted-average key assumptions used in the option valuation calculations for options granted for the year ended September 30, 2006:
| Expected life            |   | 5 years |   |
|--------------------------|--------|---------|--------|
| Expected  volatility     |   | 96.25   | %      |
| Risk-free  interest rate |   | 4.62    | %      |
| Dividend yield           |   | 0.0     | %      |
| Forfeiture rate          |   | 10      | %      |

 

The dividend yield of zero is based on the fact that the Company hasnever paid cash dividends and has no present intention to pay cash dividends.The Company uses an expected stock-price volatility assumption that is acombination of both historical and current implied volatilities of theunderlying stock which are obtained from public data sources. The risk-freeinterest rate is the U.S. Treasury bill rate with constant maturities with aremaining term equal to the expected life of the option. The expected life isbased on historical trends and data.  Withregard to the weighted-average option life assumption, the Company considersthe exercise behavior of past grants and models the pattern of aggregateexercises. Patterns are determined on specific criteria of the aggregate poolof optionees including the reaction to vesting, realizable value andshort-time-to-maturity effect. Based on the Company’s historical voluntaryturnover rates, an annualized estimated forfeiture rate of 10% has been used incalculating the estimated cost. Additional expense will be recorded if theactual forfeiture rate is lower than estimated, and a recovery of prior expensewill be recorded if the actual forfeiture is higher than estimated.

Selected information regarding the Company’s stock option plans as ofand for the year ended September 30, 2006 is as follows:
|                                                                    | ** ** | **Shares**         | ** ** |
|--------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                         | ** ** | **Authorized**     | ** ** | **Reserved for** | ** ** |
| ** **                                                         | ** ** | **for Grant** | ** ** | **Future Issuance** | ** ** |
| ** **                                                         | ** ** | ** **         | ** ** | ** ** | ** ** |
| 1996 International  Employee Non-Qualified Stock Option Plan       |       | 88,888             |       | 1,042 |   |
| Datawatch Corporation  1996 Stock Plan                             |       | 1,248,000          |       | 10,818 |   |
| Datawatch Corporation  2006 Equity Compensation and Incentive Plan |       | 600,000            |       | 595,000 |   |
|                                                               |       |               |       |   |   |
|                                                               |       | 1,936,888          |       | 606,860 |   |

 

The following table is a summary of combined activity for all of theCompany’s stock option plans:
|                                  | ** ** | ** **         | ** ** | **Weighted-** | ** ** |
|----------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                       | ** ** | **Number of** | ** ** | **Average**   | ** ** |
| ** **                       | ** ** | **Options**        | ** ** | **Exercise**  | ** ** |
| ** **                       | ** ** | **Outstanding**    | ** ** | **Price**     | ** ** |
| ** **                       | ** ** | ** **         | ** ** | ** **    | ** ** |
| 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          |       |
| Granted                          |       | 100,000            |       | 4.14          |       |
| Canceled                         |       | (16,325            | )          | 6.89          |       |
| Exercised                        |       | (143,401           | )          | 1.26          |       |
| Outstanding, September  30, 2006 |       | 852,316            |       | $             | 2.65       |   |
|                             |       |               |       |          |       |
| Exercisable, September  30, 2006 |       | 771,908            |       | $             | 2.50       |   |
| Exercisable, September 30, 2005  |       | 912,042            |       | $             | 2.39       |   |

 

50

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The following table presents weighted-average price and lifeinformation regarding options outstanding and exercisable at September 30,2006:
| Options Outstanding | ** ** | **Options Exercisable** | ** ** |                  |
|--------------------------|------------|------------------------------|------------|-----------------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted-**         | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **               | ** ** | **Remaining**                | ** ** | **Average**           | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Exercise**             | ** ** | **Number of**           | ** ** | **Contractual**       | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Prices**               | ** ** | **Shares**                   | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                     |       |                         |       |                  |   |   |   |   |   |   |   |   |
| $ 0.55-3.62         |       |                         | 605,006    |                  | 5.91 |   | $ | 1.78 |   | 584,171 |   | $ | 1.71 |   |
| 3.62-6.69                |       |                         | 230,192    |                  | 6.48 |   | 4.55 |   | 170,619 |   | 4.64 |   |
| 6.69-9.75                |       |                         | 17,118     |                  | 3.18 |   | 7.81 |   | 17,118 |   | 7.81 |   |
|                     |       |                         |       |                  |   |   |   |   |   |   |   |   |
|                     |       |                         | 852,316    |                  | 6.00 |   | $ | 2.65 |   | 771,908 |   | $ | 2.50 |   |
|                          |            |                              |            |                       |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**9.****                   ****RETIREMENT SAVINGS PLAN**

The Company has a 401(k) retirement savings plan covering substantiallyall of the Company’s full-time domestic employees. Under the provisions of theplan, employees may contribute a portion of their compensation within certainlimitations. The Company, at the discretion of the Board of Directors, may makecontributions on behalf of its employees under this plan. Such contributions,if any, become fully vested after five years of continuous service. The Companyhas not made any contributions during 2006, 2005 or 2004.

**10.****            ****SEGMENT INFORMATION**

Thefollowing table presents information about the Company’s revenues by productline for the years ended September 30, 2006, 2005 and 2004:
|                                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                          |       |     |       |     |       |     |       |
| Desktop (primarily  Monarch)                                                  |       | 58       | %          | 59       | %          | 56       | %          |
| Visual|QSM and  Visual|HD                                                     |       | 22       |       | 26       |       | 30       |       |
| Datawatch|ES (including  Datawatch|RMS, Datawatch|Researcher & iMergence) |       | 15       |       | 15       |       | 14       |       |
| Datawatch|BDS                                                                 |       | 5        |       | —   |       | —   |       |
|                                                                          |       |     |       |     |       |     |       |
|                                                                          |       | 100      | %          | 100      | %          | 100      | %          |

 

The Company conducts operations in the U.S. and internationally(principally in the United Kingdom).  Thefollowing table presents information about the Company’s continuing geographicoperations:
|                                   | ** ** | ** **   | ** ** | **International** | ** ** | ** **       | ** ** | ** ** | ** ** |
|-----------------------------------|------------|--------------|------------|-------------------|------------|------------------|------------|------------|------------|
| ** **                        | ** ** | ** **   | ** ** | **(Principally**  | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Domestic** | ** ** | **U.K.)**         | ** ** | **Eliminations** | ** ** | **Total**  | ** ** |
| ** **                        | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **Year Ended September 30, 2006** | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Total revenue                     |       | $            | 15,110,134 |              | $          | 6,675,569        |       | $          | (974,459   | ) | $ | 20,811,244 |   |
| Operating income  (loss)          |       | 564,554      |       | (1,098,790        | )          | —           |       | (534,236   | )          |
| Non-current  assets               |       | 8,806,029    |       | 880,878           |       | —           |       | 9,686,907  |       |
| ** **                        | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **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  |       |

 

51

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The reconciliations of total long-lived assets to the amounts containedin the Company’s consolidated financial statements at September 30, 2006 and2005 are as follows:
|                                                | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                           |       |      |       |      |       |
| Property and  equipment, net                   |       | $         | 1,129,123  |      | $          | 516,412 |   |
| Goodwill                                       |       | 5,236,109 |       | 1,630,646 |       |
| Acquired  software, net *                      |       | 455,278   |       | 400,278   |       |
| Trademarks *                                   |       | 345,152   |       | 345,152   |       |
| Capitalized  software development costs, net * |       | 17,836    |       | 182,880   |       |
| Patents, net *                                 |       | 143,549   |       | 151,578   |       |
| Customer list *                                |       | 1,651,771 |       | 93,437    |       |
| Non -compete  agreements *                     |       | 541,250   |       | 77,500    |       |
| Restricted cash                                |       | 125,000   |       | 125,000   |       |
| Deposits **                                    |       | 41,839    |       | 27,098    |       |
|                                           |       |      |       |      |       |
| Total long-lived  assets                       |       | $         | 9,686,907  |      | $          | 3,549,981 |   |

 

----

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

 

Export revenue totaled $2,529,210, $3,386,650 and $3,261,252 in 2006,2005 and 2004, respectively.

**11.****            ****QUARTERLY RESULTS(UNAUDITED)**

SupplementaryInformation:
| ** **                                   | ** ** | **First**  | ** ** | **Second** | ** ** | **Third**  | ** ** | **Fourth** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
|                                         |       |       |       |       |       |       |       |       |       |
| **Year Ended September 30, 2006:**           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software license  and subscription revenue   |       | $          | 3,154,717  |       | $          | 3,444,402  |       | 3,385,560  |       | 3,160,912 |   |
| Maintenance and  service revenue             |       | 1,592,840  |       | 1,949,201  |       | 1,958,481  |       | 2,165,131  |       |
| Cost of software  licenses and subscriptions |       | 572,890    |       | 590,975    |       | 579,990    |       | 524,603    |       |
| Cost of  maintenance and services            |       | 840,649    |       | 963,710    |       | 999,861    |       | 1,145,094  |       |
| Expenses                                     |       | 3,284,333  |       | 3,630,821  |       | 4,055,621  |       | 4,156,933  |       |
| Income (loss)  from operations               |       | 49,685     |       | 208,097    |       | (291,431   | )          | (500,587   | )          |
| Net income (loss)                            |       | 64,140     |       | 226,635    |       | (315,162   | )          | (530,166   | )          |
|                                         |       |       |       |       |       |       |       |       |       |
| Net income  (loss) per share - basic         |       | $          | 0.01       |       | $          | 0.04       |       | $          | (0.06      | ) | $ | (0.09 | ) |
| Net income  (loss) per share - diluted       |       | $          | 0.01       |       | $          | 0.04       |       | $          | (0.06      | ) | $ | (0.09 | ) |
|                                         |       |       |       |       |       |       |       |       |       |
| **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  |       |
| Income (loss)  from operations               |       | (179,961   | )          | (16,184    | )          | 319,707    |       | 564,808    |       |
| Net income  (loss)                           |       | (153,782   | )          | 6,764      |       | 330,064    |       | 617,368    |       |
|                                         |       |       |       |       |       |       |       |       |       |
| Net income  (loss) per share - basic         |       | $          | (0.03      | )          | $          | 0.00       |       | $          | 0.06       |   | $ | 0.12 |   |
| Net income (loss) per  share - diluted       |       | $          | (0.03      | )          | $          | 0.00       |       | $          | 0.06       |   | $ | 0.11 |   |

 

52

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**12.****            ****SUBSEQUENT EVENT-RESTRUCTURING**

InOctober 2006,****the Companyinitiated and completed a restructuring plan in an effort to reduce costs andfocus resources on key areas of the business. The restructuring plan was limited to one of the Company’s wholly ownedsubsidiaries, Datawatch International Limited (“DWI”) and resulted in chargesfor severance benefits and related costs for nine terminated employees ofapproximately $128,000.  All of thesecosts will be charged in the first quarter of fiscal 2007.

**Item 9.  CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

NotApplicable.

**Item 9A. CONTROLS AND PROCEDURES**

(a)     Evaluation of disclosure controls andprocedures

The principal executiveofficer and principal financial officer, with the participation of the Company’smanagement, evaluated the effectiveness of the Company’s “disclosure controlsand procedures” (as defined in Exchange Act Rule 13(a)-15(e)) as of the end ofthe period covered by this Annual Report on Form 10-K.  Based on our evaluation, we have determinedthat in the area of revenue recognition, we did not have adequate controls toprovide reasonable assurance that non-standard revenue contracts weresufficiently evaluated including consideration of customer acceptance terms anddocumentation of vendor specific objective evidence of services. As a result ofthis material weakness, with respect to the fourth quarter of fiscal 2006,certain contracts were not initially recorded in accordance with generallyaccepted accounting principles resulting in material revenue-relatedpost-closing adjustments to our books and records. These adjustments totalingapproximately $200,000, which are reflected in our financial statements as of,and for the year ended, September 30, 2006 (as set forth in Item 8 of this Form10-K), had the effect of decreasing revenue, accounts receivable and accruedexpenses, and increasing deferred revenue. These adjustments did not affect thepreviously reported results for the first, second or third quarters of fiscal2006.

In designing and evaluatingour disclosure controls and procedures, our management recognized that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving their objectives, and our managementnecessarily applied its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.  Basedon this evaluation, our principal executive officer and principal financialofficer concluded that, as of September 30, 2006, as a result of thematerial weakness in our internal controls over financial reporting describedabove, our disclosure controls and procedures were not effective.

The following initiativesare being taken to address the material weakness described above:

·               hiring of additional personnel with softwarerevenue recognition experience;

·               initiate additional training of salesorganization regarding revenue recognition rules and best practices;

·               formulate checklists to define revenuerecognition criteria and to document related transactionalinformation; and

·               implement a policy requiring quarterlycertifications from all sales personnel, in order to assist management indetecting issues that may affect revenue recognition and the accuracy of ourfinancial statements.

53

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As we proceed in the implementation of thesestrategies, additional changes may be made to our internal controls andprocedures.

(b)               Changes in internal controls

As discussed above, management identified a material weakness relatedto controls over revenue recognition for non-standard contracts during thequarter ended September 30, 2006. No other changes in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the quarter ended September 30, 2006 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

**Item 9B. OTHER INFORMATION**

None.

54

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**PART III**

**Item 10.  DIRECTORS ANDEXECUTIVE OFFICERS OF THE REGISTRANT**

Information with respect to Directors may be found under the caption “Electionof Directors” appearing in the Company’s definitive Proxy Statement for theAnnual Meeting of Shareholders for the fiscal year ended September 30,2006.  Such information is incorporatedherein by reference. Information with respect to the Company’s executiveofficers may be found under the caption “Executive Officers of the Registrant”appearing in Part I of this Annual Report on Form 10-K.

**Item 11.  EXECUTIVECOMPENSATION**

The information set forth under the captions “Compensation and OtherInformation Concerning Directors and Officers” appearing in the Company’sdefinitive Proxy Statement for the Annual Meeting of Shareholders for thefiscal year ended September 30, 2006 is incorporated herein by reference.

**Item 12.  SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

The information set forth under the caption “Principal Holders ofVoting Securities” and “Equity Compensation Plans” appearing in the Company’sdefinitive Proxy Statement for the Annual Meeting of Shareholders for thefiscal year ended September 30, 2006 is incorporated herein by reference.

**Item 13.  CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

The information set forth under the caption “Certain Transactions”appearing in the Company’s definitive Proxy Statement for the Annual Meeting ofShareholders for the fiscal year ended September 30, 2006 is incorporatedherein by reference.

**Item 14.  PRINCIPALACCOUNTANT FEES AND SERVICES**

The information set forth under the caption “Principal Accountant Feesand Services” appearing in the Company’s definitive Proxy Statement for theAnnual Meeting of Shareholders for the fiscal year ended September 30, 2006 isincorporated herein by reference.

55

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**PART IV**

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

Thefollowing documents are filed as part of this report:

**(a)   1. Consolidated Financial Statements**
|   | Report of Independent Registered Public  Accounting Firm                                                    |
|--------|-------------------------------------------------------------------------------------------------------------|
|   | Consolidated Balance Sheets as of September 30, 2006  and 2005                                              |
|   | Consolidated Statements of Operations for the Years  Ended September 30, 2006, 2005 and 2004                |
|   | Consolidated Statements of Shareholders’ Equity for  the Years Ended September 30, 2006, 2005 and 2004 |
|   | Consolidated Statements of Cash Flows for the Years  Ended September 30, 2006, 2005 and 2004                |
|   | Notes to Consolidated Financial Statements                                                                  |

 

**2.  Financial StatementSchedule**

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) |
| (6)     |       | 3.2             |   | Certificate of Amendment of Restated Certificate of  Incorporation of the Registrant (Exhibit 3.2) |
| (1)     |       | 3.3             |   | By-Laws, as amended, of the Registrant (Exhibit 3.3) |
| (1)     |       | 4.1             |   | Specimen certificate representing the Common Stock  (Exhibit 4.4) |
| (4)     |       | 4.2             |   | Warrant to Purchase Stock issued to Silicon Valley  Bank, dated January 17, 2001 (Exhibit 4.1) |
| (6)     |       | 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) |
| (11)    |       | 10.2*           |   | Form of Incentive Stock Option Agreement of the  Registrant (Exhibit 10.2) |
| (11)    |       | 10.3*           |   | Form of Nonqualified Stock Option Agreement of the  Registrant (Exhibit 10.3) |
| (1)     |       | 10.4            |   | Software Development and Marketing Agreement by and  between Personics Corporation and Raymond Huger, dated January 19, 1989  (Exhibit 10.12) |
| (9)     |       | 10.5            |   | Option Purchase Agreement by and among Datawatch  Corporation, Personics Corporation and Raymond J. Huger dated April 29, 2005.  (Exhibit 10.1) |
| (8)     |       | 10.6            |   | Distribution Agreement, dated December 10, 1992, by  and between Datawatch Corporation and Ingram Micro Inc. (Exhibit 10.2) |
| (2)     |       | 10.7*           |   | 1996 Non-Employee Director Stock Option Plan, as  amended on December 10, 1996 (Exhibit 10.30) |
| (2)     |       | 10.8*           |   | 1996 International Employee Non-Qualified Stock  Option Plan (Exhibit 10.31) |
| (8)     |       | 10.9*           |   | 1996 Stock Plan as amended as of March 7, 2003  (Exhibit 10.1) |
| (3)     |       | 10.10           |   | Indemnification Agreement between Datawatch  Corporation and James Wood, dated January 12, 2001 (Exhibit 10.1) |
| (3)     |       | 10.11           |   | Indemnification Agreement between Datawatch  Corporation and Richard de J. Osborne, dated January 12, 2001 (Exhibit 10.2) |
| (5)     |       | 10.12           |   | Form of Indemnification Agreement between Datawatch  Corporation and each of its Non-Employee Directors (Exhibit 10.1) |
| (5)     |       | 10.13*          |   | Advisory Agreement, dated April 5, 2001, by and  between Datawatch Corporation and Richard de J. Osborne (Exhibit 10.2) |
| (6)     |       | 10.14*          |   | Executive Agreement, dated July 9, 2001, between the  Company and Robert W. Hagger (Exhibit 10.24) |
| (7)     |       | 10.15*          |   | Executive Agreement, dated April 25, 2002, by and  between Datawatch Corporation and John Kitchen (Exhibit 10.2) |
| (7)     |       | 10.16           |   | Professional Services Agreement, dated May 16, 2002,  by and between Vested Development Inc. and Datawatch Corporation (Exhibit  10.3) |

 

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| (13)   |   | 10.17* |   | Severance Agreement between Datawatch Corporation  and John Hulburt, dated November 19, 2004. (Exhibit 10.19)                                                                                           |
|--------|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10)   |   | 10.18  |   | Stock Purchase Agreement among Datawatch  Corporation, Mergence Technologies Corporation and the Management Sellers,  dated as of August 11, 2005 (Exhibit 2.1).                                        |
| (10)   |   | 10.19  |   | 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)                             |
| (11)   |   | 10.20* |   | Description of Fiscal Executive Sales Incentive Plan  (Exhibit 10.4)                                                                                                                                    |
| (12)   |   | 10.21* |   | Form of Lock-up Agreement between Datawatch Corporation  and each Executive Officer of Datawatch Corporation, dated September 26, 2005  (Exhibit 99.1)                                                  |
| (12)   |   | 10.22  |   | Sublease Agreement, dated September 28, 2005,  between Tellabs Operations, Inc., and Datawatch Corporation (Exhibit 99.2)                                                                               |
| (14)   |   | 10.23  |   | February 2006 Amendment to Software Development and  Marketing Agreement, dated February 21, 2006 by and among the Company,  Personics Corporation, Raymond J. Huger and Math Strategies (Exhibit 10.1) |
| (14)   |   | 10.24  |   | Amendment to Option Purchase Agreement, dated February  21, 2006 by and among the Company, Personics Corporation,**** ****Raymond  J. Huger and Math Strategies (Exhibit 10.2)                     |
| (15)   |   | 10.25* |   | 2006 Equity Compensation and Incentive Plan                                                                                                                                                             |
|   |   | 10.26* |   | Form of 2006 Non-Qualified Stock Option Agreement  for Directors (filed herewith)                                                                                                                       |
|   |   | 10.27* |   | Form of 2006 Non-Qualified Stock Option Agreement  for Officers (filed herewith)                                                                                                                        |
|   |   | 10.28* |   | Form of 2006 Incentive Stock Option Agreement for  Officers (filed herewith)                                                                                                                            |
| (16)   |   | 10.29  |   | Asset Purchase Agreement dated as of March 10, 2006  between Datawatch Corporation and ClearStory Systems, Inc. (Exhibit 10.1)                                                                          |
| (17)   |   | 10.30  |   | Loan and Security Agreement dated April 20,  2006 between Silicon Valley Bank, Datawatch Corporation, and Datawatch  Technologies Corporation (Exhibit 10.1)                                       |
| (18)   |   | 10.31  |   | First Loan Modification Agreement dated August 2,  2006 between Silicon Valley Bank, Datawatch Corporation and Datawatch  Technologies Corporation (Exhibit 10.1)                                       |
| (19)   |   | 10.32  |   | Second Loan Modification Agreement dated November  27, 2006 between Silicon Valley Bank, Datawatch Corporation, and Datawatch  Technologies Corporation (Exhibit 10.1)                                  |
|   |   | 21.1   |   | Subsidiaries of the Registrant (filed herewith)                                                                                                                                                         |
|   |   | 23.1   |   | Consent of Independent Registered Pubic Accounting  Firm (filed herewith)                                                                                                                               |
|   |   | 31.1   |   | Certification of the Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (filed herewith)                                                                               |
|   |   | 31.2   |   | Certification of the Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (filed herewith)                                                                               |
|   |   | 32.1   |   | Certification of the Chief Executive Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. (furnished herewith)                           |
|   |   | 32.2   |   | Certification of the Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. (furnished herewith)                           |

 

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*                                         Indicatesa 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  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).                              |
| (4) |   | Previously filed as an exhibit to Registrant’s  Quarterly Report on Form 10-Q for the quarter ended December 31, 2000 and  incorporated herein by reference (the number given in parenthesis indicates  the corresponding exhibit in such Form 10-Q).   |
| (5) |   | Previously filed as an exhibit to Registrant’s  Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 and  incorporated herein by reference (the number given in parenthesis indicates  the corresponding exhibit in such Form 10-Q).      |
| (6) |   | Previously filed as an exhibit to Registrant’s  Annual Report on Form 10-K for the fiscal year ended September 30, 2001 and  incorporated herein by reference (the number given in parenthesis indicates  the corresponding exhibit in such Form 10-K). |

 

57

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| (7)  |   | Previously filed as an exhibit to Registrant’s  Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 and  incorporated herein by reference (the number given in parenthesis indicates  the corresponding exhibit in such Form 10-Q).       |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (8)  |   | Previously filed as an exhibit to Registrant’s  Quarterly Report on Form 10-Q for the quarter ended March 31, 2003 and  incorporated herein by reference (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 March 31, 2004 and  incorporated herein by reference (the number given in parenthesis indicates  the corresponding exhibit is such Form 10-Q).      |
| (10) |   | 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).                               |
| (11) |   | 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).                              |
| (12) |   | 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).                            |
| (13) |   | Previously filed as an exhibit to Registrant’s  Annual Report on Form 10-K for the fiscal year ended September 30, 2005 and  incorporated herein by reference (the number given in parenthesis indicates  the corresponding exhibit in such Form 10-K). |
| (14) |   | Previously filed as an exhibit to Registrant’s  Current Report on Form 8-K dated February 21, 2006 and incorporated herein by  reference (the number in parenthesis indicates the corresponding exhibit in  such Form 8-K).                             |
| (15) |   | Previously filed as Appendix A to Registrant’s  Definitive Proxy Statement dated January 30, 2006 and incorporated herein by  reference.                                                                                                                |
| (16) |   | Previously filed as an exhibit to Registrant’s  Current Report on Form 8-K dated March 10, 2006 and incorporated herein by  reference (the number in parenthesis indicates the corresponding exhibit in  such Form 8-K).                                |
| (17) |   | Previously filed as an exhibit to Registrant’s  Current Report on Form 8-K dated April 20, 2006 and incorporated herein by  reference (the number in parenthesis indicates the corresponding exhibit in  such Form 8-K).                                |
| (18) |   | Previously filed as an exhibit to Registrant’s  Quarterly Report on Form 10-Q for the quarter ended June 20, 2006 and  incorporated herein by reference (the number in parenthesis indicates the  corresponding exhibit in such Form 10-Q).             |
| (19) |   | Previously filed as an exhibit to Registrant’s  Current Report on Form 8-K dated November 27, 2006 and incorporated herein by  reference (the number in parenthesis indicates the corresponding exhibit in  such Form 8-K).                             |

 

**(b)****            ****Exhibits**

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

**(c)****            ****Financial Statement Schedules**

Not applicable.

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|        |              | Datawatch Corporation |
|--------|-------------------|-----------------------|
|   |              |                  |
| Date:  | December 29, 2006 | By:                   | /s/ Robert W. Hagger |   |
|   |              |                  | Robert W. Hagger |
|   |              |                  | President, Chief Executive Officer |
|   |              |                  | and Director |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.
| SIGNATURE                 | ** ** | **TITLE**                                    | ** **                                          | **DATE**          |
|---------------------------|------------|----------------------------------------------|-----------------------------------------------------|-------------------|
|                      |       |                                         |                                                |              |
| /s/ Robert W. Hagger      |       |                                         | President, Chief Executive Officer and Director     |              | December 29, 2006 |
| Robert W. Hagger          |       | (Principal Executive Officer)                |                                                |              |
|                      |       |                                         |                                                |              |
| /s/ John J. Hulburt       |       |                                         | Vice President of Finance, Chief Financial Officer, |              | December 29, 2006 |
| John J. Hulburt           |       | Treasurer and Assistant Secretary            |                                                |              |
|                      |       | (Principal Financial and Accounting Officer) |                                                |              |
|                      |       |                                         |                                                |              |
| /s/ Richard de J. Osborne |       |                                         | Chairman of the Board                               |              | December 29, 2006 |
| Richard de J. Osborne     |       |                                         |                                                |              |
|                      |       |                                         |                                                |              |
| /s/ Thomas H. Kelly       |       | Director                                     |                                                | December 29, 2006 |
| Thomas H. Kelly           |       |                                         |                                                |              |
|                      |       |                                         |                                                |              |
| /s/ Terry W. Potter       |       |                                         | Director                                            |              | December 29, 2006 |
| Terry W. Potter           |       |                                         |                                                |              |
|                      |       |                                         |                                                |              |
| /s/ David T. Riddiford    |       |                                         | Director                                            |              | December 29, 2006 |
| David T. Riddiford        |       |                                         |                                                |              |
|                      |       |                                         |                                                |              |
| /s/ James Wood            |       |                                         | Director                                            |              | December 29, 2006 |
| James Wood                |       |                                         |                                                |              |
|                           |            |                                              |                                                     |                   |  |  |  |  |  |

 

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