**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

**(Mark One)**

**xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIESEXCHANGE ACT OF 1934.**

 

**For the Quarterly Period EndedDecember 31, 2006.**

 

**OR**

** **

**oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from                                    to                                     .**

**CommissionFile Number 0-15935**

**SPESCOM SOFTWARE INC.**

(Exact name of registrant as specified in its charter)

 

| **CALIFORNIA**                   |   | **95-3634089**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**10052 MESA RIDGE COURT, SUITE 100, SAN DIEGO, CA92121**

(Address of principal executive offices and zip code)

 

**(858) 625-3000**

(Registrants telephone number, including area code)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

YES       x              NO       o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act  (Check one):

Large Accelerated Filer o                Accelerated Filer o            Non-Accelerated Filer x

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

YES       o              NO       x

 

Number of shares of Common Stock outstanding atFebruary 14, 2007:  37,144,494

 

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** **

**ITEM1.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

**SPESCOM SOFTWARE INC.CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                 | ** ** | **December 31,  2006** | ** ** |   | **September 30,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------|------------------------------|------------|
| ** **                                                                                                                                                                                                 | ** ** | **(Unaudited)**             | ** ** |   | ** **                   | ** ** |
| **ASSETS**                                                                                                                                                                                                 |       |                        |       |   |                         |       |
| Current assets:                                                                                                                                                                                            |       |                        |       |   |                         |       |
| Cash and cash equivalents                                                                                                                                                                                  |       | $                           | 1,304,000  |   |                         | $          | 95,000 |   |
| Receivables, net                                                                                                                                                                                           |       | 964,000                     |       |   | 854,000                      |       |
| Other current assets                                                                                                                                                                                       |       | 154,000                     |       |   | 190,000                      |       |
| Total current assets                                                                                                                                                                                       |       | 2,422,000                   |       |   | 1,139,000                    |       |
|                                                                                                                                                                                                       |       |                        |       |   |                         |       |
| Property and equipment, net                                                                                                                                                                                |       | 119,000                     |       |   | 131,000                      |       |
| Computer software, net                                                                                                                                                                                     |       | 399,000                     |       |   | 425,000                      |       |
| Other assets                                                                                                                                                                                               |       | 31,000                      |       |   | 28,000                       |       |
| Total assets                                                                                                                                                                                               |       | $                           | 2,971,000  |   |                         | $          | 1,723,000 |   |
| **LIABILITIES AND SHAREHOLDERS’ DEFICIT**                                                                                                                                                             |       |                        |       |   |                         |       |
| Current liabilities:                                                                                                                                                                                       |       |                        |       |   |                         |       |
| Accounts payable                                                                                                                                                                                           |       | $                           | 347,000    |   |                         | $          | 792,000 |   |
| Payable to Spescom Ltd.                                                                                                                                                                                    |       | 190,000                     |       |   | 550,000                      |       |
| Notes and accrued interest payable to  Spescom Ltd.                                                                                                                                                        |       | 683,000                     |       |   | —                       |       |
| Preferred stock dividend payable to  Spescom Ltd.                                                                                                                                                          |       | 971,000                     |       |   | 887,000                      |       |
| Accrued liabilities                                                                                                                                                                                        |       | 1,239,000                   |       |   | 1,446,000                    |       |
| Lease obligations—current portion                                                                                                                                                                     |       | 40,000                      |       |   | 44,000                       |       |
| Deferred revenue                                                                                                                                                                                           |       | 5,054,000                   |       |   | 2,752,000                    |       |
| Series I redeemable preferred stock, par  value $0.01 per share, 2,450 shares authorized; 2,450 shares issued and  outstanding at December 31, 2006 and September 30, 2006                                 |       | 2,450,000                   |       |   | 2,450,000                    |       |
| Total current liabilities                                                                                                                                                                                  |       | 10,974,000                  |       |   | 8,921,000                    |       |
|                                                                                                                                                                                                       |       |                        |       |   |                         |       |
| Notes and accrued interest payable to  Spescom Ltd.                                                                                                                                                        |       | —                      |       |   | 664,000                      |       |
| Lease obligations                                                                                                                                                                                          |       | 10,000                      |       |   | 16,000                       |       |
| Total liabilities                                                                                                                                                                                          |       | 10,984,000                  |       |   | 9,601,000                    |       |
|                                                                                                                                                                                                       |       |                        |       |   |                         |       |
| Shareholders’ deficit:                                                                                                                                                                                |       |                        |       |   |                         |       |
| Convertible preferred stock, 243,239  remaining shares authorized Series F - par value $1.00 per share; 5,291  shares authorized, issued and outstanding at December 31, 2006 and September 30,  2006 |       | 6,790,000                   |       |   | 6,790,000                    |       |
| Common stock, no par value, 100,000,000  shares authorized; 37,144,494 shares issued and outstanding at December 31,  2006 and September 30, 2006                                                          |       | 76,556,000                  |       |   | 76,581,000                   |       |
| Common stock warrants                                                                                                                                                                                      |       | 1,505,000                   |       |   | 1,505,000                    |       |
| Accumulated other comprehensive loss                                                                                                                                                                       |       | (500,000                    | )          |   | (441,000                     | )          |
| Accumulated deficit                                                                                                                                                                                        |       | (92,364,000                 | )          |   | (92,313,000                  | )          |
| Total shareholders’ deficit                                                                                                                                                                           |       | (8,013,000                  | )          |   | (7,878,000                   | )          |
|                                                                                                                                                                                                       |       |                        |       |   |                         |       |
| Total liabilities and shareholders’  deficit                                                                                                                                                          |       | $                           | 2,971,000  |   |                         | $          | 1,723,000 |   |

 

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

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**SPESCOMSOFTWARE INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**
| ** **                                          | ** ** | **For the three months ended  December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                                              | ** ** | **2005** | ** ** |
| Revenues:                                           |       |                                                                  |       |   |   |
| Licenses                                            |       | $                                                                     | 390,000    |   | $ | 564,000 |   |
| Services and other                                  |       | 1,337,000                                                             |       | 1,268,000 |   |
| Total revenues                                      |       | 1,727,000                                                             |       | 1,832,000 |   |
|                                                |       |                                                                  |       |   |   |
| Cost of revenues:                                   |       |                                                                  |       |   |   |
| Licenses                                            |       | 38,000                                                                |       | 122,000 |   |
| Services and other                                  |       | 591,000                                                               |       | 540,000 |   |
| Total cost of revenues                              |       | 629,000                                                               |       | 662,000 |   |
|                                                |       |                                                                  |       |   |   |
| Gross profit                                        |       | 1,098,000                                                             |       | 1,170,000 |   |
|                                                |       |                                                                  |       |   |   |
| Operating expenses:                                 |       |                                                                  |       |   |   |
| Research and development                            |       | 258,000                                                               |       | 203,000 |   |
| Marketing and sales                                 |       | 460,000                                                               |       | 653,000 |   |
| General and administrative                          |       | 368,000                                                               |       | 441,000 |   |
|                                                |       | 1,086,000                                                             |       | 1,297,000 |   |
|                                                |       |                                                                  |       |   |   |
| Income (loss) from operations                       |       | 12,000                                                                |       | (127,000 | ) |
|                                                |       |                                                                  |       |   |   |
| Interest expense                                    |       | (63,000                                                               | )          | (52,000 | ) |
| Net loss                                            |       | (51,000                                                               | )          | (179,000 | ) |
|                                                |       |                                                                  |       |   |   |
| Deemed preferred dividend                           |       | —                                                                |       | (500,000 | ) |
| Net loss available after deemed preferred  dividend |       | (51,000                                                               | )          | (679,000 | ) |
|                                                |       |                                                                  |       |   |   |
| Cumulative preferred dividends                      |       | (66,000                                                               | )          | (88,000 | ) |
| Net loss available to common  shareholders          |       | $                                                                     | (117,000   | ) | $ | (767,000 | ) |
|                                                |       |                                                                  |       |   |   |
| Earnings (loss) per share:                          |       |                                                                  |       |   |   |
| Basic and diluted                                   |       | $                                                                     | (0.00      | ) | $ | (0.02 | ) |
| Weighted average shares outstanding:                |       |                                                                  |       |   |   |
| Basic and diluted                                   |       | 37,144,000                                                            |       | 36,819,000 |   |
|                                                |       |                                                                  |       |   |   |
| **Statement of Comprehensive Loss**                 |       |                                                                  |       |   |   |
| Net loss                                            |       | $                                                                     | (51,000    | ) | $ | (179,000 | ) |
| Other Comprehensive income (loss):                  |       |                                                                  |       |   |   |
| Foreign currency translation adjustment             |       | (59,000                                                               | )          | 34,000 |   |
| Comprehensive  loss                                 |       | $                                                                     | (110,000   | ) | $ | (145,000 | ) |

 

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

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**SPESCOMSOFTWARE INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                   | ** ** | **For the three months ended  December 31** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                             | ** ** |   | **2005** | ** ** |
| Cash flows from operating activities:                                        |       |                                                                 |       |   |   |   |
| Net loss                                                                     |       | $                                                                    | (51,000    | ) |   | $ | (179,000 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                                                 |       |   |   |   |
| Depreciation and amortization                                                |       | 46,000                                                               |       |   | 25,000 |   |
| Unpaid interest on notes payable                                             |       | 56,000                                                               |       |   | 48,000 |   |
| Share-based compensation                                                     |       | 42,000                                                               |       |   | 54,000 |   |
| Deferred payment of professional  services by Spescom Ltd.                   |       | —                                                               |       |   | 33,000 |   |
| Compensation for warrants issued to  consultants                             |       | —                                                               |       |   | 4,000 |   |
| Changes in assets and liabilities:                                           |       |                                                                 |       |   |   |   |
| Receivables, net                                                             |       | (104,000                                                             | )          |   | 31,000 |   |
| Other current assets                                                         |       | 37,000                                                               |       |   | (91,000 | ) |
| Accounts payable                                                             |       | (456,000                                                             | )          |   | 165,000 |   |
| Payable to Spescom Ltd.                                                      |       | (359,000                                                             | )          |   | 95,000 |   |
| Accrued liabilities                                                          |       | (244,000                                                             | )          |   | (268,000 | ) |
| Deferred revenue                                                             |       | 2,258,000                                                            |       |   | (192,000 | ) |
| Net cash provided (used) in operating  activities                            |       | 1,225,000                                                            |       |   | (275,000 | ) |
|                                                                         |       |                                                                 |       |   |   |   |
| Cash flows from investing activities:                                        |       |                                                                 |       |   |   |   |
| Purchases of property and equipment                                          |       | (5,000                                                               | )          |   | (1,000 | ) |
| Capitalization of development costs                                          |       | —                                                               |       |   | (35,000 | ) |
| Purchases of software                                                        |       | —                                                               |       |   | (2,000 | ) |
| Net cash used in investing activities                                        |       | (5,000                                                               | )          |   | (38,000 | ) |
|                                                                         |       |                                                                 |       |   |   |   |
| Cash flows from financing activities:                                        |       |                                                                 |       |   |   |   |
| Net proceeds from private placement                                          |       | —                                                               |       |   | 436,000 |   |
| Payments on capital lease obligations                                        |       | (10,000                                                              | )          |   | (11,000 | ) |
| Net cash provided (used) by financing  activities                            |       | (10,000                                                              | )          |   | 425,000 |   |
|                                                                         |       |                                                                 |       |   |   |   |
| Effect of exchange rate changes on cash                                      |       | (1,000                                                               | )          |   | (1,000 | ) |
|                                                                         |       |                                                                 |       |   |   |   |
| Net increase in cash and cash  equivalents                                   |       | 1,209,000                                                            |       |   | 111,000 |   |
| Cash and cash equivalents at beginning  of period                            |       | 95,000                                                               |       |   | 285,000 |   |
|                                                                         |       |                                                                 |       |   |   |   |
| Cash and  cash equivalents at end of period                                  |       | $                                                                    | 1,304,000  |   |   | $ | 396,000 |   |

 

See Note 2 forsupplemental cash flow information.

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

 

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**SPESCOMSOFTWARE INC.CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**Note 1 -Basis of Presentation**

The accompanyingconsolidated financial statements as of December 31, 2006 and for thethree months ended December 31, 2006 and 2005 are unaudited. Theconsolidated financial statements and related notes have been prepared inaccordance with generally accepted accounting principles applicable to interimperiods.  In the opinion of management, the consolidated financialstatements reflect all adjustments, consisting only of normal recurringadjustments, necessary for a fair presentation of the consolidated financialposition, operating results and cash flows for the periods presented.

The information containedin the following Condensed Notes to the Consolidated Financial Statements iscondensed from that which would appear in the annual consolidated financialstatements; accordingly, the consolidated financial statements included hereinshould be reviewed in conjunction with the consolidated financial statementsand related notes thereto contained in the Company’s Annual Report on Form10-K/A for the year ended September 30, 2006.  It should beunderstood that the accounting measurements at an interim date inherentlyinvolve greater reliance on estimates than at year-end.  The results ofoperations for the interim periods presented are not necessarily indicative ofthe results expected for the entire year.

**Note 2 —Summary of Significant Accounting Policies**

***Principles of Consolidation***

The consolidatedfinancial statements are prepared using accounting principles generallyaccepted in the United States of America and include the accounts of theCompany and its wholly-owned United Kingdom subsidiary, Spescom Software, Ltd.All significant intercompany balances and transactions have been eliminated.

***Foreign Currency***

The functional currencyof the Company’s United Kingdom subsidiary is the pound sterling. Assets andliabilities are translated into U.S. dollars at end-of-period exchange rates.Revenues and expenses are translated at average exchange rates in effect forthe period. Net currency exchange gains or losses resulting from suchtranslations are excluded from net income and are accumulated in a separatecomponent of shareholders’ deficit as accumulated other comprehensive income(loss). Gains and losses resulting from foreign currency transactions, whichare not significant, are included in the consolidated statements of operations.

***Use of Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andalso requires disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting periods. Actual results could differ from those estimates.Significant estimates made by management include revenue recognition estimates,the viability of recognizing deferred income tax assets, capitalized softwarecosts and the valuation of equity instruments, and the allowance for doubtfulaccounts.  Significant changes in these estimates may have a materialimpact on the financial statements.

***Revenue Recognition***

The Company’s revenuesare derived from sales of its document and configuration management systemsthat are primarily composed of software and services, including maintenance,training and consulting services, and third party software and hardware. TheCompany recognizes revenue in accordance with Statement of Position (“SOP”)97-2 “Software Revenue Recognition,”  SOP98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect toCertain Transactions”, Staff Accounting Bulletin (“SAB”) No. 101, updated bySAB’s 103 and 104 “Update of Codification of Staff Accounting Bulletins,” andEmerging Issues Task Force No. 00-21 (“EITF 00-21”) “Accounting for RevenueArrangements with Multiple Deliverables.” Revenue through the Company’s Value Added Resellers (“VARS”) are net ofany VAR discount in accordance with EITF 99-19 “Reporting Revenue Gross as aPrincipal versus Net as an Agent.”

Software license andthird party product revenues are recognized upon shipment of the product if nosignificant vendor obligations remain and collection is probable. In caseswhere a significant vendor obligation exists, revenue recognition is delayeduntil such obligation has been satisfied. For new software products where ahistorical record has not yet been demonstrated that acceptance is perfunctory,the Company defers recognition of revenue until acceptance hasoccurred.   If an undelivered element of the arrangement 

5

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exists under the licensearrangement, a portion of revenue is deferred based on vendor-specificobjective evidence (VSOE) of the fair value of the undelivered element untildelivery occurs.  If VSOE does not exist for all undelivered elements, allrevenue is deferred until sufficient evidence exists or all elements have beendelivered.  Annual maintenance revenues, which consist of ongoing support andproduct updates, are recognized on a straight-line basis over the term of thecontract. Payments received in advance of performance of the related servicefor maintenance contracts are recorded as deferred revenue. Revenues fromtraining and consulting services are recognized when the services are performedand adequate evidence of providing such services is available. Contractrevenues for long-term contracts or programs requiring specialized systems arerecognized using the percentage-of-completion method of accounting, primarilybased on contract labor hours incurred to date compared with total estimatedlabor hours at completion. Provisions for anticipated contract losses arerecognized at the time they become known.

Contracts are billedbased on the terms of the contract. There are no retentions in billed contractreceivables. Unbilled contract receivables relate to revenues earned but notbilled at the end of the period.

The Company considersmany factors when applying accounting principles generally accepted in theUnited States of America related to revenue recognition.  These factorsinclude, but are not limited to:

·                           Theactual contractual terms, such as payment terms, delivery dates, and pricing ofthe various product and service elements of a contract

·                           Availabilityof products to be delivered

·                           Timeperiod over which services are to be performed

·                           Creditworthinessof the customer

·                           Thecomplexity of customizations to the Company’s software required by servicecontracts

·                           Thesales channel through which the sale is made (direct, VAR, distributor, etc.)

·                           Discountsgiven for each element of a contract

·                           Anycommitments made as to installation or implementation of “go live” dates

·                           Acceptancecriteria

Each of the relevant factors is analyzed to determineits impact, individually and collectively with other factors, on the revenue tobe recognized for any particular contract with a customer.  Management isrequired to make judgments regarding the significance of each factor inapplying the revenue recognition standards, as well as whether or not eachfactor complies with such standards.  Any misjudgment or error bymanagement in its evaluation of the factors and the application of thestandards, especially with respect to complex or new types of transactions,could have a material adverse effect on the Company’s future operating results.

***Fair Value of Financial Instruments***

Statement of FinancialAccounting Standards (“SFAS”) No. 107, “Disclosures About Fair Value ofFinancial Instruments”, requires management to disclose the estimated fairvalue of certain assets and liabilities defined by SFAS No. 107 as cash ora contractual obligation that both conveys to one entity a right to receivecash or other financial instruments from another entity, and imposes on theother entity the obligation to deliver cash or other financial instruments tothe first entity. At December 31, 2006 and September 30, 2006,management believes that the carrying amounts of cash and cash equivalents,short-term investments, accounts receivable and accounts payable, and accruedexpenses approximate fair value because of the short maturity of thesefinancial instruments. The Company believes that the carrying value of itsloans approximate their fair values based on current market rates of interest.

***Concentration of Credit Risk***

The Company providesproducts and services to customers in a variety of industries worldwide,including local governments, petrochemicals, utilities, manufacturing andtransportation. Concentration of credit risk with respect to trade receivablesis limited due to the geographic and industry dispersion of the Company’scustomer base. The Company has not experienced significant credit losses on itscustomer accounts. Constellation Energy Group and Nuclear Fuel Servicesaccounted for 44% and 12%, respectively, of trade accounts receivable atDecember 31, 2006 as compared to Defense Threat Reductions Agency,Constellation Energy Group, JEA, and Network Rail, which accounted for 25%,18%,11% and 11%, respectively, of trade accounts receivable at September 30, 2006.

A small number ofcustomers have typically accounted for a large percentage of the Company’sannual revenues. Constellation Energy Group and JEA accounted for 17% and 14%,respectively, of revenue for the three months ended December 31, 2006, whileFlorida Power and Light, Constellation Energy Group and W.H. Smith Ltd.accounted for 16%, 13% and 11%, respectively, of revenue for the three monthsended December 31, 2005.  The Company’s reliance on relatively fewcustomers could have a material adverse effect on the results of its operationson a quarterly basis.

6

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*** ***

***Property and Equipment***

Property and equipment isrecorded at cost and depreciated using the straight-line method over usefullives of two to seven years. Leasehold improvements are amortized on astraight-line basis over the shorter of their useful life or the term of therelated lease. Expenditures for ordinary repairs and maintenance are expensedas incurred while major additions and improvements are capitalized.

***Software Development Costs***

Software developmentcosts are capitalized when technological feasibility and marketability of therelated product have been established. Software development costs incurredsolely in connection with a specific contract are charged to cost of revenues.Capitalized software development costs are amortized on a product-by-productbasis, beginning when the product is available for general release tocustomers. Annual amortization expense is calculated using the greater of theratio of each product’s current gross revenues to the total of current andexpected gross revenues or the straight-line method over the estimated usefullife of three to five years. There were no capitalized software developmentcosts for the three months ended December 31, 2006, while the amortizationexpense totaled $26,000 for the same period. For the three months endedDecember 31, 2005 software development costs totaling $35,000 were capitalizedwhile amortization expense was $9,000. As of December 31, 2006 and September30, 2006, the balance of software development capitalized totaled $513,000 forboth dates, with accumulated amortization of $114,000 and $88,000,respectively.

***Long-lived Assets***

The Company assessespotential impairments to its long-lived assets when there is evidence thatevents or changes in circumstances have made recovery of the assets’ carryingvalue unlikely. An impairment loss would be recognized when the sum of theexpected future net cash flows is less than the carrying amount of the asset.

***Share-Based Payments***

The Company recognizesshare-based compensation expense as required by the Financial AccountingStandards Board (FASB) under the Statement of Financial Accounting StandardsNo.123 (revised 2007), “Share-Based Payments” (FAS 123R).  The Company adopted the provisions of FAS123R on October 1, 2005, the first day of the Company’s fiscal year 2006.Share-based compensation cost is measured at the date of grant using theBlack-Scholes option-pricing model, based on the estimated fair value of theaward, and is recognized as expense over the employee’s requisite serviceperiod. The determination of the fair value of share-based payments on the dateof grant using an option-pricing model is affected by our stock price as wellas stock volatility over the term of the awards, actual and projected employeestock option exercise behaviors, risk-free interest rate and expecteddividends. The Company has no awards with market or performance conditions. Thevaluation provisions of FAS 123R apply to new awards and to awards outstandingon October 1, 2005 and subsequently modified or cancelled.

In April 1996, theCompany adopted its 1996 Stock Incentive Plan (the “1996 Plan”).  The 1996Plan is administered by either the Board of Directors or a committee designatedby the Board to oversee the plan.  The total number of authorized sharesunder the 1996 plan is 7,425,000.  As of December 31, 2006, optionsto purchase 4,375,000 shares are outstanding. The 1996 Plan expired as of March 31, 2006 and therefore no furthergrants are available from this Plan.

The option vesting periodunder the plan is determined by the Board of Directors or a Stock Option Committeeand usually provides that 25% of the options granted can be exercised90 days from the date of grant, and thereafter, those options vest andbecome exercisable in additional cumulative annual installments of 25%commencing on the first anniversary of the date of grant. Options granted aregenerally due to expire upon the sooner of ten years from date of grant, thirtydays after termination of services other than by reason of convenience of theCompany, three months after disability, or one year after the date of theoption holder’s death. The option exercise price is equal to the fair marketvalue of the common stock on the date of grant.  Options granted toemployees under the 1996 Plan may be either incentive stock options ornonqualified options. Only nonqualified options may be granted to nonemployeedirectors.

The fair value of eachoption grant is estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted average assumptions used forgrants:
| ** **              | ** ** | **For the three months ended  December 31, ** | ** ** |
|-------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** |
| Dividend Yield          |       | 0                                                                           | %          | 0 | % |
| Expected Volatility     |       | 370                                                                         | %          | 213 | % |
| Risk free interest rate |       | 4.56                                                                        | %          | 4.47 | % |
| Expected lives          |       | 10                                                                          | yrs        | 10 | yrs |

 

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The weighted–averageestimated fair value of employee stock options granted during the three monthsended December 31, 2006 and December 31, 2005 using the Black-Scholes modelwere as follows:

 
| ** **                                                   | ** ** | **For the three months ended   December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** |
| Research and development                                     |       | $                                                                           | 2,000      |   | $ | 3,000 |   |
| Marketing and sales                                          |       | 13,000                                                                      |       | 18,000 |   |
| General and administrative                                   |       | 27,000                                                                      |       | 33,000 |   |
|                                                         |       |                                                                        |       |   |   |
| Share-based compensation                                     |       | $                                                                           | 42,000     |   | $ | 54,000 |   |
|                                                         |       |                                                                        |       |   |   |
| Basic and diluted net loss per share  attributable to common |       |                                                                        |       |   |   |
| Basic                                                        |       | $                                                                           | —     |   | $ | — |   |
| Diluted                                                      |       | $                                                                           | —     |   | $ | — |   |

 

A summary of option activityunder the Plan as of December 31, 2006, and changes during the three monthsthen ended is presented below:
| **Options**                            | ** ** | **Shares   (000)** | ** ** | **Weighted-   Average   Exercise   Price** | ** ** | **Weighted-   Average   Remaining   Contractual  Term** | ** ** | **Aggregate   Intrinsic   Value** | ** ** | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------------|------------|------------|
| Outstanding Options at October 1, 2006 |       | 4,455                   |       | $                                                         | 0.282      |                                                                   |       |                                        |       |       |   |
|                                   |       |                    |       |                                                      |       |                                                                   |       |                                        |       |       |
| Granted                                |       | —                  |       | —                                                    |       |                                                                   |       |                                        |       |       |
|                                   |       |                    |       |                                                      |       |                                                                   |       |                                        |       |       |
| Exercised                              |       | —                  |       | —                                                    |       |                                                                   |       |                                        |       |       |
|                                   |       |                    |       |                                                      |       |                                                                   |       |                                        |       |       |
| Forfeited or expired                   |       | (80                     | )          | $                                                         | 0.310      |                                                                   |       |                                        |       |       |   |
|                                   |       |                    |       |                                                      |       |                                                                   |       |                                        |       |       |
| Outstanding at December 31, 2006       |       | 4,375                   |       | $                                                         | 0.281      |                                                                   | 6.7        |                                        | $          | 800        |   |   |
|                                   |       |                    |       |                                                      |       |                                                                   |       |                                        |       |       |
| Exercisable at December 31, 2006       |       | 3,358                   |       | $                                                         | 0.319      |                                                                   | 6.0        |                                        | $          | 400        |   |   |

 

There were no optionsgranted or exercised for the three months ended December 31, 2006.

***Income Taxes***

Current income taxexpense is the amount of income taxes expected to be payable for the currentyear. A deferred income tax asset or liability is established for the expectedfuture consequences resulting from the differences in the financial reportingand tax bases of assets and liabilities. Deferred income tax expense (benefit) isthe change during the year in the deferred income tax asset or liability.

Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be “more likely than not” realized in the future based on the Company’scurrent and expected operating results.

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

Basic net income (loss)per common share is computed as net income (loss) divided by the weightedaverage number of common shares outstanding during the year. Diluted net income(loss) per common share is computed as net loss divided by the weighted averagenumber of common shares and potential common shares, using the treasury stockmethod, outstanding during the year and assumes conversion into common stock atthe beginning of each period of all outstanding shares of convertible preferredstock, stock options, warrants and other potential common stock. Computationsof diluted net income (loss) per share do not give effect to individualpotential common stock for any period in which their inclusion would beanti-dilutive.

 

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*** ***

***Statements of Cash Flows***

The following tableprovides supplemental cash flow information:
| ** **                                         | ** ** | **For the three months ended December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
| Supplemental cash flow information:                |       |                                                                      |       |   |   |
| Interest paid                                      |       | $                                                                         | 28,000     |   | $ | 4,000 |   |
|                                               |       |                                                                      |       |   |   |
| Non-cash financing and investing  activities:      |       |                                                                      |       |   |   |
| Accrued preferred stock dividends                  |       | $                                                                         | 66,000     |   | $ | 88,000 |   |
| Warrants issued for services                       |       | —                                                                    |       | 39,000 |   |
| Deemed dividend on October 2005 private  placement |       | —                                                                    |       | 500,000 |   |
|                                               |       | $                                                                         | 66,000     |   | $ | 627,000 |   |

 

**Note 3 —Spescom Ltd. Transactions and Related Parties**

As of December 31, 2006and September 30, 2006 there were 5,291 shares of Series F ConvertiblePreferred Stock with a stated value of $1,000 per share held by Spescom Ltd.,the majority shareholder of the Company. The Series F Convertible PreferredStock is convertible into common stock, at a stated conversion price of $0.45per share subject to certain adjustments.  The conversion is at the optionof Spescom Ltd. through September 30, 2008. The outstanding Series FConvertible Preferred Stock is entitled to receive dividends of 5% of thestated value of $1,000 per share per annum, payable on a quarterly basis incash or common stock (valued on the basis of the average per share market valueon the 30 trading days immediately prior to the date on which such dividend isdeclared by the Board of Directors).  Unpaid dividends accrue interest atthe rate of 8% per annum.  As of December 31, 2006, unpaid dividends andaccrued interest amounted to $860,000 and $111,000, respectively. As ofSeptember 30, 2006, unpaid dividends and accrued interest amounted to$794,000 and $93,000, respectively.

Related party liabilitiesconsist of the following:
| ** **                                             | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **2006**              | ** ** | **2006**               | ** ** |
| Payable to Spescom Ltd. UK                             |       | $                     | —     |                   | $          | 213,000 |   |
| Payable to Spescom Ltd.                                |       | 190,000               |       | 337,000                |       |
| Payable to Spescom Ltd. (including  Spescom Ltd. UK)   |       | $                     | 190,000    |                   | $          | 550,000 |   |
|                                                   |       |                  |       |                   |       |
| Notes and  accrued interest payable to Spescom Ltd. UK |       | $                     | 683,000    |                   | $          | 664,000 |   |

 

The Company has twoexisting demand notes payable to Spescom Ltd. UK, a wholly owned subsidiary ofSpescom Ltd., for $400,000 and $100,000, each bearing interest rate of 10% perannum.  As of December 31, 2006 and September 30, 2006, the balance owedon the notes including interest was $683,000 and $680,000, respectively.Spescom Ltd. has agreed that it will not cause Spescom Ltd. UK to demandrepayment under the two notes prior to October 1, 2007.  Interestexpense on the notes was $17,000 and $16,000 for the three months endedDecember 31, 2006 and 2005, respectively.  These notes arecollateralized by a security interest in favor of both Spescom Ltd. and SpescomLtd. UK in respect of all the Company’s assets. In November 2005, the Company’s wholly owned subsidiary, SpescomSoftware Ltd. agreed to guarantee certain loan obligations of Spescom Ltd.which totaled $1.2 million as of December 31, 2006.  The proceeds of theseloans had been used by Spescom Ltd. in prior years to provide working capitalto the Company. The guarantee is secured by the assets of Spescom Software Ltd.which totaled $407,000 as of December 31, 2006.

Under a royaltyarrangement beginning in fiscal 2004, Spescom Ltd. resold the Company’ssoftware and maintenance services in South Africa. In February 2006 the royaltyarrangement with Spescom Ltd. was terminated and the company entered into a newreseller arrangement with a third party company DocQnet International for theSouth African market. There was no royalty revenue recognized under the royaltyagreement with Spescom Ltd. for the three months ended December 31, 2006, while$37,000 was recognized during the three months ended December 31, 2005.  At September 30, 2006 the Company owed$337,000 to Spescom Ltd. primarily for certain marketing and business developmentprojects performed by Spescom Ltd. for the Company along with assistanceprovided by Spescom Ltd.in raising working capital during fiscal 2005.  Interest accrues on the balance owed at arate of 11%.  In October 2006, paymentstotaling $153,000 were made to Spescom Ltd. As of December 31, 2006, the total unpaid services and interest amountedto $150,000 and $40,000, respectively. In January 2007 the Company paid to Spescom Ltd. the outstanding payablebalance including accrued interest.

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Prior to February 10,2006, Spescom Ltd. UK provided certain administrative and accounting functionsfor the Company’s United Kingdom subsidiary.  The Company was billed amonthly fee by Spescom Ltd. UK for reimbursement of certain costs in the UnitedKingdom including the office facilities, all accounting and human resourcesservices, and certain corporate marketing activities. As of February 10, 2006,Spescom Ltd. no longer provides administrative or accounting function and theCompany’s UK subsidiary has relocated to another facility.  For the three months ended December 31, 2006there were no administrative fees as compared to $143,000 for the same periodin 2005.  The administrative fee chargedby Spescom Ltd. UK for the three months ended December 31, 2005 included officerent of $84,000.   At December 31, 2006, the Company had no payable due toSpescom Ltd. UK for administrative fees or rent, while at September 30, 2006,the Company had a payable to Spescom Ltd. UK of $213,000, which was paid infull in October 2006.  In 1999, as partof an agreement to sell a 60% interest in its United Kingdom subsidiary toSpescom Ltd., the lease for the United Kingdom office facility was to beassigned to Spescom Ltd. UK; however, the landlord did not grant its consent tothe assignment and as such Spescom Ltd. UK has paid the lease for the entireoffice directly to the landlord.  The lease expired on March14, 2006.  The landlord has claimed that the Company owes certaindilapidation payments under the lease. The Company has disputed such claims and believes there will be nomaterial effect once resolved.

Spescom Ltd. and theCompany have entered into a license agreement pursuant to which Spescom Ltd.has licensed to the Company the right to use the name “Spescom” and to use atrademark owned by Spescom Ltd. related to certain computer software. TheCompany will not pay any royalties to Spescom Ltd. in connection with thislicense. The license is for an indefinite term, but is

terminable by eitherparty upon 60 days prior written notice. Under the license agreement, SpescomLtd. has agreed to indemnify and hold harmless the Company and its directors,officers, employees and agents against liabilities arising from any claimbrought against the Company that alleges that Spescom Ltd.’s or the Company’suse of the licensed trademark infringes the rights of any third party, providedthat the Company is in material compliance with the provisions of the licenseagreement.

**Note 4 —Receivables**

A summary of receivablesand allowance for doubtful accounts as of December 31, 2006 and September 30,2006 are as follows:
| ** **                                   | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **2006**              | ** ** | **2006**               | ** ** |
| Receivables  consist of:                     |       |                  |       |                   |       |
| Receivables                                  |       | $                     | 927,000    |                   | $          | 767,000 |   |
| Unbilled receivables                         |       | 47,000                |       | 96,000                 |       |
|                                         |       | 974,000               |       | 863,000                |       |
| Less:   allowance for doubtful accounts |       | (10,000               | )          | (9,000                 | )          |
|                                         |       | $                     | 964,000    |                   | $          | 854,000 |   |

 

**Note 5 —Reconciliation of Net Income (Loss) and Shares Used in Per Share Computations:**
| ** **                                  | ** ** | **For three months ended   December 31, ** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                                                 | ** ** | **2005** | ** ** |
| Net loss available for common  shareholders |       | $                                                                        | (117,000   | ) | $ | (767,000 | ) |
|                                        |       |                                                                     |       |   |   |
| Common stock and common stock  equivalents  |       | 37,144,000                                                               |       | 36,819,000 |   |
|                                             |            |                                                                          |            |  |  |  |  |

 

Basic net income (loss)per share is computed using the weighted average number of common sharesoutstanding during the period.  Contingently issued shares are included inthe computation of basic net income (loss) per share when the relatedconditions are satisfied.  Diluted net income (loss) per share is computedusing the weighted average number of common shares and potentially dilutivesecurities outstanding during the period.  Potentially dilutive securitiesconsist of contingently issued shares, the common shares issuable uponconversion of preferred stock or convertible debt and shares issuable upon theexercise of stock options and common stock warrants.  Potentially dilutivesecurities are excluded from the computation if their effect is anti-dilutive.

As of December 31, 2006,a total of 4,375,000 stock options, 6,727,000 common stock warrants and, 5,291and 2,450 shares of Series F and Series I Convertible Preferred Stock,respectively, were excluded from the diluted net income (loss) per sharecalculation, as their effect would be anti-dilutive. As of December 31, 2005, atotal of 5,733,000 stock options, 6,468,000 common stock warrants and, 5,291and 1,950 shares of Series F and Series H Convertible Preferred Stock,respectively, were excluded from the diluted net income (loss) per sharecalculation, as their effect would be anti-dilutive.

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** **

**Note 6 —Segment and Geographic Information**

The Company has onebusiness segment, which consists of the development and sale of a suite ofintegrated document, configuration and records management softwareproducts.   Revenues by customer locationand identifiable assets from continuing operations are as follows:
| ** **                       | ** ** | **For the three months ended December 31, ** | ** ** |
|----------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                                                        | ** ** | **2005** | ** ** |
| United States                    |       | $                                                                               | 1,243,000  |   | $ | 1,209,000 |   |
| Europe, primarily United Kingdom |       | 433,000                                                                         |       | 492,000 |   |
| Other International              |       | 51,000                                                                          |       | 131,000 |   |
|                             |       | $                                                                               | 1,727,000  |   | $ | 1,832,000 |   |

 
| ** **                                       | ** ** | **For the three months ended December 31, ** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                        | ** ** | **2005** | ** ** |
| Identifiable assets from continuing  operations: |       |                                                                            |       |   |   |
| United States                                    |       | $                                                                               | 2,564,000  |   | $ | 1,502,000 |   |
| Europe, United Kingdom                           |       | 407,000                                                                         |       | 342,000 |   |
|                                             |       | $                                                                               | 2,971,000  |   | $ | 1,844,000 |   |

 

**Note 7— Redeemable and Convertible Preferred Stock**

*October2005 Private Placement*

On October 25, 2005, theCompany completed a private placement issuing 1,950 shares of Series HConvertible Preferred Stock (“Series H Preferred Stock”) and warrants for thepurchase of 925,926 common shares in exchange for cash of $500,000 and 1,450shares of previously issued Series G Convertible Preferred Stock. The commonstock warrants have an exercise price of $0.27 per share and expireOctober 25, 2008. In connection with this transaction, the 1,450 shares ofSeries G Convertible Preferred Stock then outstanding were cancelled bythe Company. Expenses relating to the transaction totaled $64,000 primarilyrelating to legal and accounting fees. In accordance with EITF 00-27 “Applicationof Issue No 98-5 to Certain Convertible Instruments,” the Company calculated,using the Black—Scholes method, the intrinsic value of the convertibleinstruments issued and determined that there was a deemed preferred dividendequal to the gross proceeds received of $500,000.  In March 2006 the Company completed a privateplacement exchanging all of the Series H Preferred Stock for Series IConvertible Preferred Stock.  See March2006 Private Placement below.

The shares of Series HPreferred Stock issued were convertible into common stock at the conversionrate in effect at the time of conversion.  The conversion price per shareof the Series H Preferred Stock was equal to 85% of the market price (thevolume weighted average price of the Company’s common stock during the fiveimmediately preceding trading days), provided that in no event shall theconversion price exceed a ceiling price of $0.40 per share, or be less than afloor price which varies with the aggregate gross revenues of the Companyduring the last four fiscal quarters for which revenues have been reported bythe Company prior to such time, but which will not be lower than $0.0725 pershare and not higher than $0.16 per share. The Series H Preferred Stock accrued dividends at 6.75% of the statedvalue of $1,000 per share per annum.  OnMarch 31, 2006 the Company issued 325,966 shares of common stock in payment ofdeclared Series H Preferred Stock dividends of $44,000 based on a fair marketvalue of $0.13 per share.

The terms of the October2005 financing also provided for a second closing to have occurred no laterthan January 20, 2006, under which the Company would issue an additional 500shares of Series H Preferred Stock and additional warrants for the purchase of925,926 common shares in exchange for cash of $500,000. The obligations of thepurchasers to consummate the second closing were subject to certain conditions,including that the closing price of the Company’s common stock would be $0.16or greater for 20 consecutive trading days. This stock price condition was notsatisfied and the second closing was not completed.

*March2006 Private Placement*

On March 10, 2006,the Company completed a private placement issuing 2,450 shares of Series IConvertible Preferred Stock (“Series I Preferred Stock”) and warrants,expiring March 10, 2009, to purchase 925,926 shares of common stock at$0.27 per share in exchange for cash $500,000 and 1,950 shares of the Company’sSeries H Convertible Preferred Stock, which have been cancelled. Expensesrelating to the transaction totaled $98,000 primarily relating to legal andaccounting fees. In accordance with EITF 00-27 “Application of Issue No. 98-5to Certain Convertible Instruments,” the Company calculated, using theBlack—Scholes method, the

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intrinsic value of theconvertible instruments issued and determined that there was a deemed preferreddividend equal to the gross proceeds received of $500,000.  Pursuant to the terms of the financing, theCompany filed a registration statement on April 7, 2006 for the common sharesissuable under the Series I Preferred Stock and related warrants, which becameeffective on July 10, 2006.

Each share of Series IPreferred Stock is convertible into a number of shares of common stockdetermined by dividing $1,000 by the conversion price per share in effect atthe time of conversion, provided that a holder of Series I Preferred Stock mayat any given time convert only that number of shares of Series I PreferredStock so that, upon conversion, the aggregate beneficial ownership of theCompany’s common stock of such holder and all persons affiliated with suchholder is not more than 9.99% of the Company’s common stock then outstanding.The conversion price per share is equal to 85% of the market price (thevolume-weighted average price of the Company’s common stock during the five immediatelypreceding trading days, subject to adjustment), provided that in no event shallthe conversion price exceed a ceiling price of $0.21 per share, or be less thana floor price of $0.0725 per share.

The Certificate ofDetermination for the Series I Preferred Stock provides that, if theCompany  has not entered into a bindingagreement to consummate a consolidation, merger, reclassification of the stockof the Company (subject to certain exceptions), or disposition of all orsubstantially all of the assets of the Company on or before April 30,2006, the holders of Series I Preferred Stock may, by the vote not laterthan December 31, 2006 of at least two-thirds of the then-outstandingshares of Series I Preferred Stock, elect to have all of the outstanding sharesof Series I Preferred Stock redeemed by the Company. In that event, theCompany would be obligated to redeem the Series I Preferred Stock at anamount equal to $1,000 per share plus all declared but unpaid dividends. TheCertificate of Determination further provides that, if such election were madeand the Company were to lack sufficient funds available to redeem theSeries I Preferred Stock in accordance with applicable law, the holders ofSeries I Preferred Stock as a class would be entitled to elect thesmallest number of directors of the Company constituting a majority of theauthorized number of directors.  As ofApril 30, 2006 the Company had not entered into a binding agreement toconsummate a consolidation, merger, reclassification of the stock of theCompany or disposition of all or substantially all of the assets of theCompany.  However, the holders of theSeries I Preferred Stock as of December 31, 2006 and as of the date of thisfiling have not notified the Company of any election to redeem the Series IPreferred Stock.  Under FAS 150 “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity” and EITF D-98 “Classification and Measurement of Redeemable Securities”and since a binding agreement was not entered into by April 30, 2006, theCompany has classified the fair value of the Series I Preferred Stock toliabilities as the Company may be obligated to repay all the proceeds received.

Each holder ofSeries I Preferred Stock is entitled to a liquidation preference equal tothe greater of (i) $1,000 per share plus declared but unpaid dividends pershare and (ii) the amount such holder would be entitled to receive had suchholder’s shares been converted into shares of common stock immediately prior tothe distribution in accordance with the terms of the Series I PreferredStock.  Commencing on the issuance dateof the Series I Preferred Stock, the Series I Preferred Stock is entitled toreceive dividends of 6.75% of the stated value of $1,000 per share per annum,only payable until the registration statement for the common stock underlyingthe Series I Preferred Stock is declared effective by the Securities andExchange Commission.  That registrationstatement was declared effective by the Securities and Exchange Commission onJuly 10, 2006.

*Series FConvertible 5% Preferred Stock*

On September 30,2003, the Company issued 5,291 shares of Series F Convertible PreferredStock (the “Series F Preferred Stock”) with a stated value of $1,000 pershare in consideration of the cancellation of $5,291,000 of its debt owed toSpescom Ltd. and its subsidiary (See Note 3).  The Series F PreferredStock is convertible into the Company’s common stock at a stated conversionprice of $0.45 per share, subject to certain adjustments to preventdilution, representing a total of 11,757,778 shares of the Company’scommon stock.  Such conversion may occur at the option of the holder untilSeptember 30, 2008.  On that date, any outstanding Series FPreferred Stock not previously converted will be converted automatically.

The Series FPreferred Stock is entitled to a liquidation preference equal to $1,000 pershare, plus accrued but unpaid dividends per share and interest on all accruedbut unpaid dividends.  The Series F Preferred Stock is also entitledto receive dividends of 5% of the stated value of $1,000 per share per annum,payable on a quarterly basis in cash or common stock (valued on the basis ofthe average per share market value on the 30 trading days immediately prior tothe date on which such dividend is declared by the Board of Directors). Unpaid dividends accrue interest at the rate of 8% per annum.  As ofDecember 31, 2006 and  September30, 2006, unpaid dividends were $860,000 and $794,000, respectively, andrelated accrued interest amounted to $111,000 and $93,000, respectively. As part of the transaction, Spescom Ltd. and its U.K. subsidiary receivedcertain demand and piggyback registration rights with respect to the commonstock underlying the Series F Preferred Stock.  Each holder of theshares of Series F Preferred Stock is entitled to the number of votes equal tothe number of shares of common stock to which such holder would beentitled  upon conversion of the sharesof Series F Preferred Stock held by such holder on all matters submitted to thevote of the holders of common stock, and votes as a class with the holders ofcommon stock.  In a change of control, merger or sale, the Series FPreferred Stock holders would preserve their conversion rights and would beentitled to the same number and amount of shares immediately prior to suchtransaction.

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** **

**Note 8— Shareholders’ Deficit**

*November2004 Private Placement*

On November 5, 2004, theCompany completed a financing arrangement whereby the Company issued 2,200shares of our Series G Preferred Stock along with 2,750,000 common stockwarrants for gross proceeds of $2,200,000. The Series G Preferred Stock wasconvertible into common stock at a price equal to 85% of the volume weightedaverage price of the Company’s common stock during the five trading daysimmediately preceding the conversion date; however, the conversion price couldbe no higher than $0.40 per share and no lower than $0.30 per share. The2,750,000 warrants have an exercise price of $0.44 per share and expireNovember 5, 2007. The Company incurred $418,000 in expenses related to thetransaction and issued 825,000 common stock warrants to an investmentconsulting firm. The 825,000 warrants were comprised of 550,000 warrants withan exercise price of $0.40 per share which expire November 5, 2009 and 275,000warrants with an exercise price of $0.44 per share which expired on November 5,2007. In connection with the financing, the Company recorded a beneficialconversion of $2,200,000 on the Series G Preferred Stock as a deemed dividendfor the three months ended December 31, 2004. During fiscal 2005, 750 shares ofthe Series G Preferred Stock were converted into 2,428,000 shares of commonstock. As part of the private placement in October 2005 the Company exchangedthe 1,450 remaining shares of Series G Preferred Stock for 1,450 shares ofSeries H Preferred Stock. Those 1,450 shares of Series H Preferred Stock wereexchanged for Series I Preferred Stock in March 2006. The shares of theSeries G and H Preferred Stock have been cancelled by the Company. (SeeNote 7)

*Issuanceof Warrants to Investor Relations Firm*

During November 2005, theCompany entered into a six-month engagement with an investment relations firmto develop and implement a marketing program to promote financial market andinvestor awareness for the Company. Under the engagement agreement, theinvestor relations firm was entitled to receive, every month the agreement iseffective, a warrant, expiring three years from the date of issuance, topurchase 50,000 shares of the Company’s common stock  at an exercise price of $0.10 per share for atotal of 300,000 shares over the six-month contract. In addition, theinvestment relations firm was entitled under the agreement to a one timeperformance warrant to purchase 500,000 shares of the Company’s common stock at$0.25 per share, which would vest if, during the term of the agreement, thevolume weighted-average price of the Company’s common stock were to exceed$0.50 for five consecutive days. On March 31, 2006, the Company issued to theinvestor relations firm a warrant, expiring on the third anniversary of itsdate of issuance, for the purchase of 300,000 shares of the Company’s commonstock at an exercise price of $0.10 per share. The investor relations firmagreed to accept that warrant for 300,000 shares in lieu of all of the warrantsissuable to the investor relations firm as monthly compensation during thesix-month term of the agreement and in lieu of the performance warrant.  Under EITF 96-19 the fair value of thewarrant to purchase 300,000 shares of common stock was determined to be $39,000and has been expensed ratably over the six month term of the engagementagreement.

 **Note 9 — Recent Pronouncements**

In July 2006, the FASBissued FIN 48, “Accounting for Uncertainty in Income Taxes” whichprescribes a recognition threshold and measurement process for recording in thefinancial statements uncertain tax positions taken or expected to be taken in atax return. Additionally, FIN 48 provides guidance on derecognition,classification, accounting in interim periods and disclosure requirements foruncertain tax positions. The accounting provisions of FIN 48 will beeffective for us beginning October 1, 2007. The Company is in the processof determining the effect, if any, the adoption of FIN 48 will have on ourfinancial statements.

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

**Forward —LookingStatements**

*Thisreport contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. These forward-looking statements are subjectto certain risks and uncertainties that could cause actual results to differmaterially from historical results or anticipated results, including those setforth under “Certain Factors That May Affect Future Results” below andelsewhere in, or incorporated by reference into, this report.*

*Insome cases, you can identify forward-looking statements by terms such as “may,”“intend,” “might,” “will,” “should,” “could,” “would,” “expect,” “believe,” “anticipate,”“estimate,” “predict,” “potential,” or the negative of these terms, and similarexpressions are intended to identify forward-looking statements. When used inthe following discussion, the words “believes,” “anticipates” and similarexpressions are intended to identify forward-looking statements. Suchstatements are subject to certain risks and uncertainties, which could causeactual results to differ materially from those projected. Readers are cautionednot to place undue reliance on these forward-looking statements, which speakonly as of the date hereof. The forward-looking statements in this report arebased upon management’s current expectations and belief, which managementbelieves are reasonable.  These statements represent our estimates andassumptions only as of the date of this Quarterly Report on Form 10-Q, and weundertake no obligation to publicly release the result of any revisions tothese forward-looking statements, which may be made to reflect events or circumstancesafter the date hereof or to reflect the occurrence of unanticipated events.*

*Thefollowing discussion should be read in conjunction with the SelectedConsolidated Financial Data and the Consolidated Financial Statements,including the Notes thereto.*

**OVERVIEW**

The Company develops,markets and supports*e*B, itsintegrated suite of collaborative document, configuration and recordsmanagement software solutions. The*e*Bsuite enables organizations in a broad range of industries to create, capture,store, manage, share and distribute critical business information regardingtheir customers, products, assets and processes in an efficient manner. The*e*B suite also enables them to maintaincomplete, up-to-date information about the configuration of their products,assets and infrastructures so that they can achieve operational excellence andcompliance with regulatory requirements.*e*Bprovides the capabilities of an Enterprise Content Management (ECM)/ElectronicDocument Management (EDM) System, but extends these capabilities by alsomanaging the “things” that the content/documents relate to such as products,assets , functions, processes, requirements, projects, organizations,locations, work orders, etc. As a result,*e*Bcan be used to manage the lifecycle of physical items (e.g. products, equipmentor assets), and the requirements (e.g. functional, safety, performance,environmental, etc.) that govern them. It enables intelligent relationships tobe defined between these items thereby creating an interdependency model. As aresult, the effects of any change on requirements, documents and items can bedetermined, and change can be managed to effectively ensure informationintegrity. In particular,*e*Benables organizations with extensive and complex physical infrastructures toefficiently identify, classify, structure, link, and manage documents, physicalitems, and requirements throughout their lifecycles and ensure that conformancebetween these is maintained by means of an automated change process.

Our revenues in the threemonths ended December 31, 2006 decreased by 6% from the same period in theprior fiscal year primarily due to fewer license sales. The Company’s licenserevenue fluctuates from quarter to quarter as reflected by the decrease inlicense sales during the quarter.

Our revenues are derivedfrom licenses of our software to our customers, services that we provide undermaintenance support contracts and our non-maintenance services, consistingprimarily of design studies, system implementation and training. Of our totalrevenues for the three months ended December 31, 2006, license revenuesaccounted for 23%, maintenance services revenues accounted for 44% andnon-maintenance services represented 33%.

Many of our customers arelocated outside the United States, with foreign-originated revenues accountingfor 28% and 34% of revenues for the three months ended December 31, 2006 and2005, respectively. The decrease in foreign revenues was lessened by a foreigncurrency gain of $68,000 due to the increasing value of the British pound tothe dollar in the first quarter of fiscal 2007 versus the same period duringfiscal 2006

While revenues decreasedslightly during the three months ended December 31, 2006, our cost of revenuesremained relatively unchanged when compared to the same period in the priorfiscal year. Our operating expenses decreased by 16% when compared to the sameperiod in the prior year, primarily as a result of lower personnel relatedexpenses and lower professional fees during the current period.

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At December 31, 2006, ourprincipal sources of liquidity consisted of $1,304,000 of cash and cashequivalents, compared to $95,000 at September 30, 2006. During the three monthsended December 31, 2006, we received $2,000,000 from a large license anddevelopment transaction with the Aveva Group.

**CRITICALACCOUNTING POLICIES**

The consolidatedfinancial statements are prepared in conformity with accounting principlesgenerally accepted in the United States of America. As such, management isrequired to make judgments, estimates and assumptions that affect the reportedamounts of assets and liabilities at the date of the consolidated financialstatements and the reported amounts of revenues and expenses during thereporting period. The significant accounting policies which are most criticalto aid in fully understanding and evaluating reported financial results includethe following:

***Revenue Recognition***

The Company’s revenuesare derived from sales of its document and configuration management systemsthat are primarily composed of software and services, and include maintenance,training and consulting services, and third party software and hardware. TheCompany recognizes revenue in accordance with Statement of Position (“SOP”)97-2 “Software Revenue Recognition,”  SOP98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect toCertain Transactions”, Staff Accounting Bulletin (“SAB”) No. 101, updated bySAB’s 103 and 104 “Update of Codification of Staff Accounting Bulletins,” andEmerging Issues Task Force No. 00-21 (“EITF 00-21”) “Accounting for RevenueArrangements with Multiple Deliverables.” Revenue through the Company’s Value Added Resellers (“VARS”) are net ofany VAR discount in accordance with EITF 99-19 “Reporting Revenue Gross as aPrincipal versus Net as an Agent.”

Software license andthird party product revenues are recognized upon shipment of the product if nosignificant vendor obligations remain and collection is probable. In caseswhere a significant vendor obligation exists, revenue recognition is delayeduntil such obligation has been satisfied. For new software products where ahistorical record has not yet been demonstrated that acceptance is perfunctory,the Company defers recognition of revenue until acceptance has occurred. If anundelivered element of the arrangement exists under the license arrangement, aportion of revenue is deferred based on vendor-specific objective evidence(VSOE) of the fair value of the undelivered element until deliveryoccurs.  If VSOE does not exist for all undelivered elements, all revenueis deferred until sufficient evidence exists or all elements have beendelivered.  Annual maintenance revenues, which consist of ongoing supportand product updates, are recognized on a straight-line basis over the term ofthe contract. Payments received in advance of performance of the related servicefor maintenance contracts are recorded as deferred revenue. Revenues fromtraining and consulting services are recognized when the services are performedand adequate evidence of providing such services is available. Contractrevenues for long-term contracts or programs requiring specialized systems arerecognized using the percentage-of-completion method of accounting, primarilybased on contract labor hours incurred to date compared with total estimatedlabor hours at completion. Provisions for anticipated contract losses arerecognized at the time they become known.

Contracts are billedbased on the terms of the contract. There are no retentions in billed contractreceivables. Unbilled contract receivables relate to revenues earned but notbilled at the end of the period.

The Company considersmany factors when applying accounting principles generally accepted in theUnited States of America related to revenue recognition.  These factorsinclude, but are not limited to:

·                                  Theactual contractual terms, such as payment terms, delivery dates, and pricing ofthe various product and service elements of a contract

·                                  Availabilityof products to be delivered

·                                  Timeperiod over which services are to be performed

·                                  Creditworthinessof the customer

·                                  Thecomplexity of customizations to the Company’s software required by servicecontracts

·                                  Thesales channel through which the sale is made (direct, VAR, distributor, etc.)

·                                  Discountsgiven for each element of a contract

·                                  Anycommitments made as to installation or implementation of “go live” dates

·                                  Acceptancecriteria

 

Each of the relevantfactors is analyzed to determine its impact, individually and collectively withother factors, on the revenue to be recognized for any particular contract witha customer.  Management is required to make judgments regarding thesignificance of each factor in applying the revenue recognition standards, aswell as whether or not each factor complies with such standards.  Anymisjudgment or error by management in its evaluation of the factors and theapplication of the standards, especially with respect to complex or new typesof transactions, could have a material adverse effect on the Company’s futureoperating results.

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*** ***

***Software Development Costs***

Software developmentcosts are capitalized when technological feasibility and marketability of therelated product have been established. Software development costs incurredsolely in connection with a specific contract are charged to cost of revenues.Capitalized software costs are amortized on a product-by-product basis,beginning when the product is available for general release tocustomers.   Annual amortization expense is calculated using thegreater of the ratio of each product’s current gross revenues to the total ofcurrent and expected gross revenues or the straight-line method over theestimated useful life of three to five years.

***Allowance for Doubtful Accounts***

The Company sells itsproducts directly to end-users, generally requiring a significant up-frontpayment and remaining terms appropriate for the creditworthiness of thecustomer. The Company also sells its products to VARs and other softwaredistributors generally under terms appropriate for the creditworthiness of theVAR or distributor. The Company retains no continuing obligations on sales toVARs.  Receivables from customers are generally unsecured. The Companycontinuously monitors its customer account balances and actively pursuescollections on past due balances. The Company maintains an allowance fordoubtful accounts which is comprised of a general reserve based on historicalcollections performance plus a specific reserve for certain known customercollections issues. If actual bad debts are greater than the reservescalculated based on historical trends and known customer issues, the Companymay be required to book additional bad debt expense which could have a materialadverse effect on our business, results of operations and financial conditionfor the periods in which such additional expense occurs.

***Share-Based Payments***

The Company recognizesshare-based compensation expense as required by the Financial AccountingStandards Board (FASB) under the Statement of Financial Accounting StandardsNo.123 (revised 2004), “Share-Based Payments” (FAS 123R).  The Company adopted the provisions of FAS123R on October 1, 2005, the first day of the Company’s fiscal year 2006.Share-based compensation cost is measured at the date of grant using theBlack-Scholes option-pricing model, based on the estimated fair value of theaward, and is recognized as expense over the employee’s requisite serviceperiod. The determination of the fair value of share-based payments on the dateof grant using an option-pricing model is affected by our stock price as wellas stock volatility over the term of the awards, actual and projected employeestock option exercise behaviors, risk-free interest rate and expecteddividends. The Company has no awards with market or performance conditions. Thevaluation provisions of FAS 123R apply to new awards and to awards outstandingon October 1, 2005 and subsequently modified or cancelled.

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** **

**RESULTSOF OPERATIONS**

The following table setsforth the condensed consolidated statement of operations expressed as apercentage of total revenue for the periods indicated:
| ** **                                 | ** ** | **For the three months ended  December 31, ** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** |
| Revenues:                                  |       |                                                                        |       |   |   |
| Licenses                                   |       | 23                                                                          | %          | 31 | % |
| Services and other                         |       | 77                                                                          | %          | 69 | % |
| Total revenues                             |       | 100                                                                         | %          | 100 | % |
|                                       |       |                                                                        |       |   |   |
| Cost of revenues:                          |       |                                                                        |       |   |   |
| Licenses                                   |       | 2                                                                           | %          | 7 | % |
| Services and other                         |       | 34                                                                          | %          | 29 | % |
|                                       |       | 36                                                                          | %          | 36 | % |
|                                       |       |                                                                        |       |   |   |
| Gross profit                               |       | 64                                                                          | %          | 64 | % |
|                                       |       |                                                                        |       |   |   |
| Operating expenses:                        |       |                                                                        |       |   |   |
| Research and development                   |       | 15                                                                          | %          | 11 | % |
| Marketing and sales                        |       | 27                                                                          | %          | 36 | % |
| General and administrative                 |       | 21                                                                          | %          | 24 | % |
|                                       |       | 63                                                                          | %          | 71 | % |
|                                       |       |                                                                        |       |   |   |
| Income (loss) from operations              |       | 1                                                                           | %          | (7 | )% |
|                                       |       |                                                                        |       |   |   |
| Interest expense                           |       | (4                                                                          | )%         | (3 | )% |
|                                       |       |                                                                        |       |   |   |
| Net loss                                   |       | (3                                                                          | )%         | (10 | )% |
|                                       |       |                                                                        |       |   |   |
| Deemed dividend                            |       | —                                                                      |       | (27 | )% |
| Cumulative preferred dividends             |       | (4                                                                          | )%         | (5 | )% |
| Net loss available to common  shareholders |       | (7                                                                          | )%         | (42 | )% |

 

**Revenues**

*License Revenues*

(in thousands)
| ** **                   | ** ** | **For the three months ended  December 31, ** | ** ** | ** ** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------------------|------------|------------|------------|
| ** **                   | ** ** | **2006**                                                                    | ** ** | **2005**   | ** ** | **Change** | ** ** |
| License revenues             |       | $                                                                           | 390        |       | $          | 564 |   | (31 | )% |
| Percentage of total revenues |       | 23                                                                          | %          | 31         | %          |   |   |
|                              |            |                                                                             |            |            |            |  |  |  |  |

 

License revenuesdecreased by $174,000, or 31%, to $390,000 from $564,000 for the three monthsended December 31, 2006 compared to the same period a year ago.  TheCompany’s license revenues fluctuate from quarter to quarter, which isreflected by the decrease in license sales in the current quarter. During thesame quarter in the prior year, a large sale of licenses to Florida Power and Lightamounted to $269,000 while there was no similar size sale in the currentquarter this year.

We anticipate that thedemand for our products will increase if overall economic conditions continueto strengthen leading to an increase in overall demand for enterprise document,configuration and records management software solutions.  The Company’slicense revenues can fluctuate from quarter to quarter, based on the timing ofcustomer orders due to the long sales cycle and changes in customers’ internalplans of the rollout of software licenses.

Although the Company hashistorically generated the majority of its revenues from its direct salesforce, the Company has also established a network of third-party VARs, systemintegrators and OEMs who build and sell systems (with components or complete 

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systems provided by theCompany) that address specific customer needs within various industries,including those targeted directly by the Company.  Sales through indirectchannels for the three months ended December 31, 2006 amounted to $127,000or 7% compared to $133,000, or 7% for the same period in the prior year.

A small number ofcustomers have typically accounted for a large percentage of the Company’sannual revenues. Constellation Energy Group and JEA accounted for 17% and 14%,respectively, of revenue for the three months ended December 31, 2006, whileFlorida Power and Light, Constellation Energy Group and W.H. Smith Ltd.accounted for 16%, 13% and 11%, respectively, of revenue for the three monthsended December 31, 2005.  The Company’s reliance on relatively fewcustomers could have a material adverse effect on the results of its operationson a quarterly basis.

*Servicesand Other Revenues*(in thousands)

|                              | ** ** | **For the three months ended  December 31,** | ** ** | ** ** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------------|------------|------------|------------|
| ** **                   | ** ** | **2006**                                                              | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Services and other revenues  |       | $                                                                     | 1,337      |       | $          | 1,268 |   | 5 | % |
| Percentage of total revenues |       | 77                                                                    | %          | 69         | %          |   |   |
|                              |            |                                                                       |            |            |            |  |  |  |  |

 

Services and otherrevenues are comprised of maintenance and non-maintenance services. Non-maintenance services typically relate to business process studies,implementation of systems and training which vary with the level of licenserevenues while maintenance revenue is primarily dependent on customers renewingtheir annual maintenance support contracts.

Services and otherrevenue increased $69,000, or 5%, from $1,268,000 to $1,337,000 for the threemonths ended December 31, 2006 compared to the same period a yearago.  The non-maintenance portion of service revenue increased $33,000, or6% from $535,000 to $568,000 primarily due to a large services project duringthe current quarter.   Also in this quarter, maintenance revenueincreased $37,000, or 5% from $732,000 to $769,000, primarily due to customersexpanding their maintenance on upgraded licenses products.

We anticipate thatservice and other revenue will fluctuate primarily due to sales to newcustomers because they require more services that typically include a businessprocess study, integration with other business systems and training.  Inaddition, service and other revenues will continue to fluctuate from quarter toquarter based on the timing of customer orders.

**Cost ofRevenues**

*Cost ofLicense Revenues*(in thousands)
| ** **                   | ** ** | **For the three months ended   December 31, ** | ** ** | ** ** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------|------------|
| ** **                   | ** ** | **2006**                                                                          | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Cost of license revenues     |       | $                                                                                 | 38         |       | $          | 122 |   | (69 | )% |
| Percentage of total revenues |       | 2                                                                                 | %          | 7          | %          |   |   |
|                              |            |                                                                                   |            |            |            |  |  |  |  |

 

Cost of license revenuesconsists of costs associated with reselling third-party products andamortization of capitalized software development costs.

Cost of license revenuedecreased by $84,000, or 69%, from $122,000 to $38,000 for the three monthsended December 31, 2006 compared to the same period a year ago.  Thedecrease is primarily due to a decrease in the proportion of license revenuebeing attributed to third-party software products, which typically have ahigher associated cost than the Company’s own proprietary software.  The decrease was partially offset by anincrease in amortization expense of $15,000 for capitalized software costs withcompletion and general release of our *e*B Version 14software product in November 2005.  The decrease in third-party costsresulted in an increase in the gross profit percentage of license revenues to90% for the three months ended December 31, 2006 as compared to 78% forthe same period a year ago.

We expect the cost oflicense revenues to fluctuate based on fluctuations in license revenues and incustomer requirements for third-party software products since the cost ofmeeting these customer requirements have the largest impact on cost of licenserevenues.

 

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*Cost ofServices and Other Revenues*(in thousands)
| ** **                                 | ** ** | **For the three months ended   December 31, ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------|------------|
| ** **                                 | ** ** | **2006**                                                                          | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Cost of services and other revenues        |       | $                                                                                 | 591        |       | $          | 540 |   | 9 | % |
| Percentage  of services and other revenues |       | 34                                                                                | %          | 29         | %          |   |   |
|                                            |            |                                                                                   |            |            |            |  |  |  |  |

 

Cost of services andother revenues consists primarily of personnel-related costs in providingconsulting services, training to customers and support.  It also includescosts associated with reselling third-party hardware and maintenance, whichincludes telephone support costs.

Cost of services andother revenue increased $51,000, or 9%, from $540,000 to $591,000 for the threemonths ended December 31, 2006 compared to the same period a yearago.  The increase was primarily due to higher personnel related expensesand travel costs related to customer projects.  The gross profit from services and other revenue as a percentage ofservices and other revenues decreased slightly to 56% for the three monthsended December 31, 2006 as compared to 57% for the same period a year ago.

We expect the cost ofservice and other revenues to fluctuate in absolute dollar amounts and as apercentage of total revenues as the related service revenue fluctuates.

**OperatingExpenses**

*Researchand Development*(in thousands)
| ** **                        | ** ** | **For the three months ended   December 31, ** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------|------------|
| ** **                        | ** ** | **2006**                                                                          | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Research and development expenses |       | $                                                                                 | 258        |       | $          | 203 |   | 27 | % |
| Percentage  of total revenue      |       | 15                                                                                | %          | 11         | %          |   |   |
|                                   |            |                                                                                   |            |            |            |  |  |  |  |

 

Research and developmentexpenses consist of salaries and benefits for software developers as well as anallocation of corporate expenses, calculated on the basis of headcount, such ascorporate insurance, facilities, telephone and other.

Research and developmentexpenses increased $55,000, or 27%, from $203,000 to $258,000 for the threemonths ended December 31, 2006 compared to the same period a yearago.   The increase was due tohigher personnel related costs, a result of more developers working on researchand development projects during the current quarter versus customer projects.The increase is also due to the capitalization of $35,000 of development costsduring the three months ended December 31, 2005, while no development costswere capitalized in the current quarter.

We believe that continuedinvestment in research and development is a critical factor in maintaining ourcompetitive position and we expect research and development costs to remain atthe current levels in absolute dollar amounts in the next several quarters.

*Marketingand Sales*(in thousands)
| ** **                     | ** ** | **For the three months ended   December 31, ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------|------------|
| ** **                     | ** ** | **2006**                                                                          | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Marketing & sales expenses |       | $                                                                                 | 460        |       | $          | 653 |   | (30 | )% |
| Percentage  of total revenue   |       | 27                                                                                | %          | 36         | %          |   |   |
|                                |            |                                                                                   |            |            |            |  |  |  |  |

 

Marketing and salesexpenses consist of salaries, cost of benefits, sales commissions and otherexpenses related to the direct sales force, as well as allocation of overallcorporate expenses, calculated on the basis of headcount, related to items suchas corporate insurance, facilities, telephone and other.

Marketing and salesexpenses decreased $193,000, or 30%, from $653,000 to $460,000 for the threemonths ended December 31, 2006 compared to the same period a yearago.  The decrease in marketing and sales expenses is a result of lowerpersonnel related expenses with fewer employees currently in the department,primarily due to attrition, when compared to the same period a year ago.

We expect marketing andsales expense to decrease in absolute dollar amounts and as a percentage oftotal revenue in the current fiscal year.

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* *

*Generaland Administrative*(in thousands)
| ** **                          | ** ** | **For the three months ended   December 31, ** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2006**                                                                          | ** ** | **2005**   | ** ** | **Change** | ** ** |
| General and administrative expenses |       | $                                                                                 | 368        |       | $          | 441 |   | (17 | )% |
| Percentage of total revenue         |       | 21                                                                                | %          | 24         | %          |   |   |
|                                     |            |                                                                                   |            |            |            |  |  |  |  |

 

General andadministrative expenses consist primarily of personnel costs for finance, informationtechnology, human resources and general management, as well as outsideprofessional services and an allocation of overall corporate expenses,calculated on the basis of headcount, such as corporate insurance, facilities,telephone and other.

General andadministrative expenses decreased by $73,000, or 17%, from $441,000 to $368,000for the three months ended December 31, 2006 compared to the same period ayear ago.  The decrease was due to decreases in personnel related cost of$28,000, in legal and professional fees of $36,000, and in other miscellaneousexpenses of $9,000.

We expect that generaland administrative expenses will remain relatively constant in absolutedollars.

**InterestExpense**

Interest expense consistsprimarily of fixed interest obligations on our outstanding debt to Spescom Ltd.as well as interest paid on capital lease obligations.  Interest expensewas $63,000 for the three months ended December 31, 2006 as compared to$52,000 for the same period a year ago.  The increase is due primarily toincreased debt balances owed to Spescom Ltd. on outstanding notes payable aswell as interest on accrued preferred dividends.

**DeemedDividends**

In October 2005 theCompany completed a financing arrangement whereby the Company issued 1,950 sharesof our Series H Preferred Stock along with 925,926 common stock warrantsfor gross proceeds of $500,000 and the exchange and cancellation of 1,450shares of Series G Convertible Preferred Stock. In accordance with EITF00-27 “Application of Issue No 98-5 to Certain Convertible Instruments,” theCompany calculated using the Black—Scholes method the intrinsic value of theconvertible instruments issued and determined that there was a deemed preferreddividend equal to the gross proceeds received of $500,000.

**CumulativePreferred Dividends**

The outstanding Series FConvertible Preferred Stock was entitled to receive dividends of 5% of thestated value of $1,000 per share per annum, payable on a quarterly basis incash or common stock (valued on the basis of the average per share market valueon the 30 trading days immediately prior to the date on which such dividend isdeclared by the Board of Directors).  Cumulative preferred dividendsearned for both three month periods ended December 31, 2006 and December 31,2005 were $66,000. Unpaid dividends accrue interest at the rate of 8% perannum.  As of December 31, 2006, unpaid dividends and accrued interestamounted to $860,000 and $111,000, respectively.

The outstanding Series HPreferred Stock during the three months ended December 31, 2005 was entitled toreceive dividends of 6.75% of the stated value of $1,000 per share per annum,payable monthly in arrears on the last day of each month based on the number ofSeries H Preferred Stock outstanding as of the first day of each such month.For the three months ended December 31, 2005 dividends on the Series HPreferred Stock totaled $22,000. In March 2006 the Series H Preferred Stock wasexchanged for Series I Preferred Stock and cancelled.

**LIQUIDITYAND CAPITAL RESOURCES**

At December 31, 2006, ourprincipal sources of liquidity consisted of $1,304,000 of cash and cashequivalents compared to $95,000 at September 30, 2006. Our liquidity could benegatively impacted by a decrease in demand for our products, which are subjectto rapid technological changes, reductions in capital expenditures by ourcustomers and intense competition, among other factors.

In past years, theCompany has received loans from Spescom Ltd. to meet its obligations.  Theoutstanding balance of its demand notes owed to Spescom Ltd. including interestwas $683,000 at December 31, 2006 as compared to $680,000 at September 30,2006.  Spescom Ltd. has agreed not tocall the notes prior to October 1, 2007. In addition at December 31, 2006, the Company had a payable to SpescomLtd. of $190,000 as compared to $550,000 at September 30, 2006.  The payable primarily related to marketingresearch and analysis that Spescom Ltd. performed on behalf of the Company infiscal 2005 and administrative services and facilities that Spescom Ltd. hasprovided to the Company in the United Kingdom. In January 2007 the Company paid to Spescom Ltd. the $190,000 payablebalance owed.

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Cash provided byoperating activities was $1,225,000 during the three months ended December 31,2006 related to the increase in deferred revenue of $2,258,000 primarily due topayment of $2,000,000 relating to a large license and development transaction withAveva Solutions Limited signed in October 2006, offset by reductions inaccounts payable of $456,000, in a payable to Spescom Ltd. of $359,000 and inaccrued liabilities of $244,000, and by a net loss during the current quarterof $51,000.  The operating loss wasadjusted for non-cash activities of $144,000 comprised primarily of $46,000 indepreciation and amortization, $42,000 for FAS 123R period charge for employeestock options, and $56,000 in unpaid interest on notes payable to Spescom Ltd.

During the three monthsended December 31, 2005 we used cash in operating activity of $275,000 primarilyrelated to a net loss for the quarter of $179,000 and reductions in deferredrevenues and accrued liabilities of $192,000 and $268,000, respectively. Theoperating loss was adjusted for non-cash activities of $164,000 comprisedprimarily of $25,000 in depreciation and amortization, $48,000 in unpaidinterest on notes payable to Spescom Ltd., $54,000 for FAS 123R period chargefor employee stock options, and $33,000 in deferred payment professionalservices performed by Spescom Ltd.

Cash used in investingactivities was $5,000 for the three months ended December 31, 2006 forpurchases of property and equipment.  Ourinvesting activities used $38,000 for the three months ended December 31, 2005primarily relating to the capitalization of software development costsassociated with the Company’s release of its*e*B product with a new architecture.

Cash used in financingactivities was $10,000 for the three months ended December 31, 2006 forpayments on capital lease obligations. Cash provided in financing activities for three months ended December31, 2005 was from a private placement of Series H Convertible Preferred Stockfor net proceeds of $436,000, which was offset by $11,000 for payments oncapital lease obligations. (See “October 2005 Private Placement” in Note 7 tothe Consolidated Financial Statements for further information regarding thatprivate placement.)

On March 10, 2006,the Company completed a private placement issuing 2,450 shares of Series IConvertible Preferred Stock and warrants, expiring March 10, 2009, topurchase 925,926 shares of common stock at $0.27 per share in exchange for cash$500,000 and 1,950 shares of the Company’s Series H Convertible PreferredStock, which have been cancelled. (See “March 2006 Private Placement” in Note 7to the Consolidated Financial Statements for further information regarding thatprivate placement.)

The Company believes itscapital requirements will continue to vary greatly from quarter to quarter,depending on, among other things, capital expenditures, fluctuations in itsoperating results, financing activities, and investments and third partyproducts and receivables management.  The Company’s future liquidity willdepend on its ability to generate new system sales of its*e*B product suite in the near term, whichcannot be assured. Management believes that the Company’s current cash andreceivables and cash that may be generated from operations, will be sufficientto meet its short-term needs for working capital for at least the nextyear.  However, the Company may not be able to obtain sufficient orders toenable the Company to continue on a cash flow break-even level, which would benecessary to continue operations in the absence of further financing. Future equity financings, if available to the Company, would be dilutive to theexisting holders of the Company’s common stock.  Future debt financings,if available to the Company, would likely involve restrictive covenants.

**Off-BalanceSheet Arrangements**

At December 31, 2006 andSeptember 30, 2006, we did not have any relationships with unconsolidatedentities or financial partnerships, including entities often referred to asstructured finance or special purpose entities that would have been establishedfor the purpose of facilitating off-balance sheet arrangements or othercontractually narrow or limited purposes.  Therefore, we are notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we were engaged in such relationships.

**Inflation**

The Company believes thatinflation has not had a material effect on its operations to date. Although theCompany enters into fixed-price contracts, management does not believe thatinflation will have an adverse material impact on its operations for theforeseeable future, as the Company takes into account expected inflation in itscontract proposals and is generally able to project its costs based onforecasted contract requirements.

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** **

**ContractualObligations and Commercial Commitments**

The following summarizesour contractual obligations and other commitments at December 31, 2006, and theeffect such obligations could have on our liquidity and cash flow in futureperiods:
| ** **                                | ** ** | **Amount of Commitment Expiring by Period** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Total **                                                      | ** ** | **Less  Than  1 Year ** | ** ** | **1-3  Years ** | ** ** | **3-5  Years** | ** ** | **Over  5 Years ** | ** ** |
| Notes and Accounts Payable to             |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Spescom Ltd.                              |       | $                                                                    | 873,000    |   | $ | 873,000 |   | — |   | — |   | — |   |
| Lease commitments — Operating Leases |       | 1,024,000                                                            |       | 337,000 |   | 598,000 |   | 89,000 |   | — |   |
| Lease commitments — Capital Leases   |       | 50,000                                                               |       | 40,000 |   | 10,000 |   | — |   | — |   |
| Total                                     |       | $                                                                    | 1,947,000  |   | $ | 1,250,000 |   | $ | 608,000 |   | $ | 89,000 |   | — |   |
|                                           |            |                                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

**InterestRate Risk**

The Company’s exposure tomarket rate risk for changes in interest rates relates primarily to the Company’sinvestment portfolio.  The Company does not use derivative financialinstruments in its investment portfolio. The Company places its investment withhigh quality issuers and follows internally developed guidelines to limit theamount of credit exposure to any one issuer. Additionally, in an attempt tolimit interest rate risk, the Company follows guidelines to limit the averageand longest single maturity dates. The Company is adverse to principal loss andensures the safety and preservation of its invested funds by limiting default,market and reinvestment risk. As of December 31, 2006 and September 30,2006, the Company did not have any investments in money market accounts.

**ForeignCurrency Exchange Risk**

The Company’s geographicmarkets are primarily in the United States and Europe, with some sales in otherparts of the world. For the three months ended December 31, 2006, revenuesrecorded in the United States were 72% of total revenues, and revenues fromEurope and other locations were 28% of total revenues. This compares to 66% and34% for the same period a year ago.

Revenues from our UnitedKingdom subsidiary can fluctuate from quarter to quarter based on the timing ofcustomer orders.  The decrease in revenue for the three months endedDecember 31, 2006 versus the same period in the prior year was lessened by aforeign currency gain of $68,000 due to a weaker dollar value compared to theBritish pound sterling.  Changes in foreign currency rates, the conditionof local economies, and the general volatility of software markets may resultin a higher or lower proportion of foreign revenues in the future. Although theCompany’s operating and pricing strategies take into account changes inexchange rates over time, future fluctuations in the value of foreigncurrencies may have a material adverse effect on the Company’s business,operating results and financial condition.

**ITEM4.    CONTROLS AND PROCEDURES**

The Company carried outan evaluation under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as of December 31, 2006 pursuant to ExchangeAct Rule 13a-15. Based upon that evaluation, we have concluded that as ofDecember 31, 2006, the Company’s disclosure controls and procedures areeffective in ensuring that information required to be disclosed by the Companyin the reports that it files or submits under the Securities Exchange Act 1934is (i) recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms and (ii)accumulated and communicated to the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, as appropriate to allowtimely decisions regarding required disclosure.

During the last fiscalquarter, there was no change in the Company’s internal control over financialreporting that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PARTII.   OTHER INFORMATION**

**ITEM 1 —LEGAL PROCEEDINGS**

The Company is involvedfrom time to time in litigation arising in the normal course of business.Management believes that any liability with respect to such routine litigation,individually or in the aggregate, is not likely to be material to the Company’sconsolidated financial position or results of operations.

**ITEM 6 — EXHIBITS**

| 10.1   |   | Source Code License  between Spescom Software Inc. and Aveva Solutions Limited, dated October 2,  2006 (incorporated by reference to Exhibit 10.13 to the Form 10-K filed on  December 26, 2006)     |   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                                                                                                 |   |
| 31.1   |   | Certification by the  Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |   |
|   |   |                                                                                                                                                                                                 |   |
| 31.2   |   | Certification by the  Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |   |
|   |   |                                                                                                                                                                                                 |   |
| 32.1   |   | Certification by the  Chief Executive Officer and 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.       |   |

 

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
| Signature       | ** ** | **Title**                                                                                 | ** ** | **Date**               |
|-----------------|------------|-------------------------------------------------------------------------------------------|------------|------------------------|
| ** **      | ** ** | ** **                                                                                | ** ** | ** **             |
| /s/ Alan Kiraly |       | Director and Chief Executive Officer (Principal Executive  Officer)                       |       | February 14, 2007 |
| Alan Kiraly     |       |                                                                                      |       |
|            |       |                                                                                      |       |                   |
|            |       |                                                                                      |       |                   |
| /s/ John W. Low |       | Chief Financial Officer and Secretary (Principal Financial  and Accounting Officer)  |       | February 14, 2007 |
| John W. Low     |       |                                                                                      |       |

 

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