**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 

| **(Mark One)**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | ** ** |
| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | **QUARTERLY  REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| **For the Quarterly Period Ended  June 30, 2004.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| **For the transition period from                                          to                                         .** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| **Commission File Number 0-15935**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |

 

**SPESCOMSOFTWARE INC.**

(Exact name of registrant as specified in itscharter)

 

| **CALIFORNIA**                                                  | ** ** | **95-3634089**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **10052 MESA RIDGE COURT, SUITE 100, SAN  DIEGO, CA 92121**     |
| (Address of principal executive offices and  zip code)          |
|                                                            |       |                                  |
| **(858) 625-3000**                                              |
| (Registrant’s telephone number, including  area code)      |

 

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

 

YES    ý         NO    o

 

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

 

YES    o         NO    ý

 

Number of shares of Common Stock outstanding at August 11,2004: 34,068,278

 

Number of Sequentially Numbered Pages: 27

 

 

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**SPESCOM SOFTWARE INC.**

 

**INDEX**

 
| PART I.                                                                                             | FINANCIAL INFORMATION                                     |   |
|-----------------------------------------------------------------------------------------------------|-----------------------------------------------------------|--------|
|                                                                                                |                                                      |
| Item 1. Financial Statements and  Supplementary Data                                                |                                                      |
|                                                                                                |                                                      |
|                                                                                                | Consolidated Balance Sheets                               |   |
|                                                                                                |                                                      |   |
|                                                                                                | Consolidated Statements of Operations                     |   |
|                                                                                                |                                                      |   |
|                                                                                                | Consolidated Statements of Cash Flows                     |   |
|                                                                                                |                                                      |   |
|                                                                                                | Condensed Notes to the Consolidated  Financial Statements |   |
|                                                                                                |                                                      |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations |                                                      |
|                                                                                                |                                                      |
| Item 3. Quantitative and Qualitative  Disclosures About Market Risk                                 |                                                      |
|                                                                                                |                                                      |
| Item 4. Controls and Procedures                                                                     |                                                      |
|                                                                                                |                                                      |
| PART II.                                                                                            | OTHER INFORMATION                                         |   |
|                                                                                                |                                                      |
| Item 1. Legal Proceedings                                                                           |                                                      |
|                                                                                                |                                                      |
| Item 4. Submission of Matters to a Vote of  Security Holders                                        |                                                      |
|                                                                                                |                                                      |
| Item 6. Exhibits and Reports on Form 8-K                                                            |                                                      |

 

2

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** PART I.  FINANCIAL INFORMATION**

 

** ITEM 1.  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

**SPESCOM SOFTWARE INC.**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                      | ** ** | **June 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                      | ** ** | **(Unaudited)**         | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                                      |       |                    |       |                         |       |
| Current assets:                                                                                                                                 |       |                    |       |                         |       |
| Cash and cash equivalents                                                                                                                       |       | $                       | 1,033,000  |                         | $          | 333,000 |   |
| Receivables, net of allowance for doubtful  accounts of $83,000 and $78,000 respectively                                                        |       | 342,000                 |       | 423,000                      |       |
| Other current assets                                                                                                                            |       | 200,000                 |       | 169,000                      |       |
| Total current assets                                                                                                                            |       | 1,575,000               |       | 925,000                      |       |
|                                                                                                                                            |       |                    |       |                         |       |
| Property and equipment, net                                                                                                                     |       | 119,000                 |       | 213,000                      |       |
| Computer software, net                                                                                                                          |       | 22,000                  |       | 63,000                       |       |
| Other assets                                                                                                                                    |       | 28,000                  |       | 29,000                       |       |
| Total assets                                                                                                                                    |       | $                       | 1,744,000  |                         | $          | 1,230,000 |   |
|                                                                                                                                            |       |                    |       |                         |       |
| **LIABILITIES AND SHAREHOLDERS’ DEFICIT**                                                                                                  |       |                    |       |                         |       |
| Current liabilities:                                                                                                                            |       |                    |       |                         |       |
| Accounts payable                                                                                                                                |       | $                       | 458,000    |                         | $          | 405,000 |   |
| Payable to Spescom Ltd.                                                                                                                         |       | 49,000                  |       | 46,000                       |       |
| Preferred stock dividend payable to Spescom  Ltd.                                                                                               |       | 202,000                 |       | —                       |       |
| Accrued liabilities                                                                                                                             |       | 1,496,000               |       | 1,080,000                    |       |
| Note and accrued interest payable to  Spescom Ltd.                                                                                              |       | 505,000                 |       | —                       |       |
| Lease obligations – current portion                                                                                                        |       | 21,000                  |       | 23,000                       |       |
| Deferred revenue                                                                                                                                |       | 2,228,000               |       | 2,018,000                    |       |
| Fair value of equity instruments redeemable  for common stock                                                                                   |       | —                  |       | 1,233,000                    |       |
| Total current liabilities                                                                                                                       |       | 4,959,000               |       | 4,805,000                    |       |
|                                                                                                                                            |       |                    |       |                         |       |
| Notes and accrued interest payable to  Spescom Ltd.                                                                                             |       | —                  |       | 504,000                      |       |
| Lease obligations                                                                                                                               |       | 48,000                  |       | 62,000                       |       |
| Total liabilities                                                                                                                               |       | 5,007,000               |       | 5,371,000                    |       |
|                                                                                                                                            |       |                    |       |                         |       |
| Shareholders’ deficit:                                                                                                                     |       |                    |       |                         |       |
| Convertible preferred stock, $1,000 stated  value per share, 1,000,000 shares authorized; 5,291 shares issued and  outstanding in 2004 and 2003 |       | 6,790,000               |       | 6,790,000                    |       |
| Common stock, no par value, 100,000,000  shares authorized; 34,068,278 and 33,929,278 issued and outstanding in 2004  and 2003                  |       | 74,764,000              |       | 73,676,000                   |       |
| Common stock warrants                                                                                                                           |       | 278,000                 |       | 278,000                      |       |
| Accumulated other comprehensive loss                                                                                                            |       | (385,000                | )          | (294,000                     | )          |
| Accumulated deficit                                                                                                                             |       | (84,710,000             | )          | (84,591,000                  | )          |
| Total shareholders’ deficit                                                                                                                |       | (3,263,000              | )          | (4,141,000                   | )          |
|                                                                                                                                            |       |                    |       |                         |       |
| Total liabilities and shareholders’ deficit                                                                                                |       | $                       | 1,744,000  |                         | $          | 1,230,000 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

3

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**SPESCOM SOFTWARE INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                          | ** ** | **For the three months  ended June 30,** | ** ** | **For the nine months  ended June 30,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                           |       |                                          |       |                                         |       |   |   |   |   |
| Licenses                                            |       | $                                             | 1,559,000  |                                         | $          | 485,000 |   | $ | 3,037,000 |   | $ | 1,773,000 |   |
| Services and other                                  |       | 1,341,000                                     |       | 1,417,000                                    |       | 3,589,000 |   | 4,233,000 |   |
| Total revenues                                      |       | 2,900,000                                     |       | 1,902,000                                    |       | 6,626,000 |   | 6,006,000 |   |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Cost of revenues:                                   |       |                                          |       |                                         |       |   |   |   |   |
| Licenses                                            |       | 37,000                                        |       | 189,000                                      |       | 178,000 |   | 589,000 |   |
| Services and other                                  |       | 586,000                                       |       | 655,000                                      |       | 1,693,000 |   | 1,749,000 |   |
| Total cost of revenues                              |       | 623,000                                       |       | 844,000                                      |       | 1,871,000 |   | 2,338,000 |   |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Gross profit                                        |       | 2,277,000                                     |       | 1,058,000                                    |       | 4,755,000 |   | 3,668,000 |   |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Operating expenses:                                 |       |                                          |       |                                         |       |   |   |   |   |
| Research and development                            |       | 341,000                                       |       | 364,000                                      |       | 1,008,000 |   | 1,101,000 |   |
| Marketing and sales                                 |       | 871,000                                       |       | 635,000                                      |       | 2,201,000 |   | 1,918,000 |   |
| General and administrative                          |       | 585,000                                       |       | 319,000                                      |       | 1,574,000 |   | 1,090,000 |   |
|                                                |       | 1,797,000                                     |       | 1,318,000                                    |       | 4,783,000 |   | 4,109,000 |   |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Income (loss) from operations                       |       | 480,000                                       |       | (260,000                                     | )          | (28,000 | ) | (441,000 | ) |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Interest and other income                           |       | —                                        |       | 4,000                                        |       | 5,000 |   | 4,000 |   |
| Interest and other expense                          |       | (37,000                                       | )          | (134,000                                     | )          | (96,000 | ) | (393,000 | ) |
| Net income (loss)                                   |       | 443,000                                       |       | (390,000                                     | )          | (119,000 | ) | (830,000 | ) |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Cumulative preferred dividends                      |       | (66,000                                       | )          | —                                       |       | (198,000 | ) | — |   |
| Net income (loss) available to common  shareholders |       | $                                             | 377,000    |                                         | $          | (390,000 | ) | $ | (317,000 | ) | $ | (830,000 | ) |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Earnings per share:                                 |       |                                          |       |                                         |       |   |   |   |   |
| Basic                                               |       | $                                             | 0.01       |                                         | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.03 | ) |
| Diluted                                             |       | $                                             | 0.01       |                                         | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.03 | ) |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| Weighted average shares outstanding:                |       |                                          |       |                                         |       |   |   |   |   |
| Basic                                               |       | 34,068,000                                    |       | 30,890,000                                   |       | 33,992,000 |   | 30,850,000 |   |
| Diluted                                             |       | 35,452,000                                    |       | 30,890,000                                   |       | 33,992,000 |   | 30,850,000 |   |
|                                                |       |                                          |       |                                         |       |   |   |   |   |
| **Statement of  Comprehensive Income**              |       |                                          |       |                                         |       |   |   |   |   |
| Net income (loss)                                   |       | $                                             | 443,000    |                                         | $          | (390,000 | ) | $ | (119,000 | ) | $ | (830,000 | ) |
| Other Comprehensive income (loss):                  |       |                                          |       |                                         |       |   |   |   |   |
| Foreign currency translation adjustment             |       | 80,000                                        |       | (81,000                                      | )          | (119,000 | ) | (99,000 | ) |
| Comprehensive Income                                |       | $                                             | 523,000    |                                         | $          | (471,000 | ) | $ | (238,000 | ) | $ | (929,000 | ) |

 

The accompanying condensed notes are anintegral part of these consolidated financial statements.

 

4

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**SPESCOM SOFTWARE INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                 | ** ** | **For the nine months  ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                                      |       |                                         |       |   |   |
| Net loss                                                                                   |       | $                                            | (119,000   | ) | $ | (830,000 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                                         |       |   |   |
| Depreciation and amortization                                                              |       | 154,000                                      |       | 381,000 |   |
| Unpaid interest on notes payable                                                           |       | 22,000                                       |       | 277,000 |   |
| Gain on derivative revaluation                                                             |       | (6,000                                       | )          | — |   |
| Value of stock issued to consultant                                                        |       | 46,000                                       |       | — |   |
| Changes in assets and liabilities, net :                                                   |       |                                         |       |   |   |
| Receivables, net                                                                           |       | 95,000                                       |       | 1,018,000 |   |
| Other assets                                                                               |       | 2,000                                        |       | 518,000 |   |
| Accounts payable                                                                           |       | 48,000                                       |       | (301,000 |   |
| Accrued liabilities                                                                        |       | 343,000                                      |       | (681,000 | ) |
| Deferred revenue                                                                           |       | 145,000                                      |       | 112,000 |   |
| Net cash provided by operating activities                                                  |       | 730,000                                      |       | 494,000 |   |
|                                                                                       |       |                                         |       |   |   |
| Cash flows from investing activities:                                                      |       |                                         |       |   |   |
| Purchases of property and equipment                                                        |       | (5,000                                       | )          | (28,000 | ) |
| Purchases of software                                                                      |       | (10,000                                      | )          | (6,000 | ) |
| Net cash used in investing activities                                                      |       | (15,000                                      | )          | (34,000 | ) |
|                                                                                       |       |                                         |       |   |   |
| Cash flows from financing activities:                                                      |       |                                         |       |   |   |
| Proceeds from shareholder loan                                                             |       | 600,000                                      |       | — |   |
| Payments on shareholder loan                                                               |       | (600,000                                     | )          | — |   |
| Proceeds from exercise of stock options                                                    |       | 13,000                                       |       | 5,000 |   |
| Payments on capital lease obligations                                                      |       | (16,000                                      | )          | (12,000 | ) |
| Net cash used in financing activities                                                      |       | (3,000                                       | )          | (7,000 | ) |
|                                                                                       |       |                                         |       |   |   |
| Effect of exchange rate changes on cash                                                    |       | (12,000                                      | )          | (6,000 | ) |
|                                                                                       |       |                                         |       |   |   |
| Net increase in cash and cash equivalents                                                  |       | 700,000                                      |       | 447,000 |   |
|                                                                                       |       |                                         |       |   |   |
| Cash and cash equivalents at beginning of  period                                          |       | 333,000                                      |       | 87,000 |   |
|                                                                                       |       |                                         |       |   |   |
| Cash and cash equivalents at end of period                                                 |       | $                                            | 1,033,000  |   | $ | 534,000 |   |

 

----

*See Note 2 for supplemental cash flow information.

 

The accompanying condensed notes are an integral part of theseconsolidated financial statements.

 

5

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**SPESCOM SOFTWARE INC.**

**CONDENSED NOTES TO THE CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

**Note 1 - Basis of Presentation**

 

The accompanying consolidated financial statements as of June 30,2004 and for the three and nine months ended June 30, 2004 and 2003 areunaudited. The consolidated financial statements and related notes have beenprepared in accordance with generally accepted accounting principles applicableto interim periods.  In the opinion of management, the consolidatedfinancial statements reflect all adjustments, consisting only of normalrecurring adjustments, necessary for a fair presentation of the consolidatedfinancial position, operating results and cash flows for the periods presented.

 

The information contained in the following Condensed Notes to theConsolidated Financial Statements is condensed from that which would appear inthe annual consolidated financial statements; accordingly, the consolidatedfinancial statements included herein should be reviewed in conjunction with theconsolidated financial statements and related notes thereto contained inSpescom Software Inc.’s (the “Company”) Annual Report on Form 10-K for the yearended September 30, 2003.  It should be understood that theaccounting measurements at an interim date inherently involve greater relianceon estimates than at year-end.  The results of operations for the interimperiods presented are not necessarily indicative of the results expected forthe entire year.

 

The Company’s future liquidity depends on its ability to generate newsystem sales of its eB product suite in the near term, which cannot be assured.Failure to generate sufficient system sales to meet the Company’s cash flowneeds can be expected to have a material adverse effect on the Company’sbusiness, results of operations, and financial condition.  The Company’sfinancial position can be a factor in attracting new customers.  In aneffort to strengthen the Company’s financial condition and provide capital forexpanding marketing and sales capabilities, the Company will continue toexplore additional equity or debt financing from third parties.  There canbe no assurance that additional financing will be available or that the termsof such financing will be acceptable to the Company.  The Company believesthat its current cash and receivables, as well as additional cash that may begenerated from operations, will be sufficient to meet its short-term needs forworking capital. However, the Company may not be able to obtain sufficientorders to enable the Company to continue on a cash flow break-even level, whichwould be necessary to continue operations in the absence of further financing.

 

**Note 2 – Summary of Significant AccountingPolicies**

 

*Principles of Consolidation*

 

The consolidated financial statements are prepared using accountingprinciples generally accepted in the United States of America and include theaccounts of the Company and its wholly-owned United Kingdom subsidiary, SpescomSoftware, Ltd. All significant intercompany balances and transactions have beeneliminated.

 

*Foreign Currency*

 

The functional currency of the Company’s United Kingdom subsidiary isthe pound sterling. Assets and liabilities are translated into U.S. dollars atend-of-period exchange rates. Revenues and expenses are translated at averageexchange rates in effect for the period. Net currency exchange gains or lossesresulting from such translations are excluded from net income and areaccumulated in a separate component of shareholders’ deficit as accumulatedother comprehensive income (loss). Gains and losses resulting from foreigncurrency transactions, which are not significant, are included in the consolidatedstatements of operations.

 

*Use of Estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and also requires disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting periods. Actual results could differfrom those estimates. Significant estimates made by management include revenuerecognition estimates, the viability of recognizing deferred income tax assets,capitalized software costs and the valuation of equity instruments, and theallowance for doubtful accounts.  Significant changes in these estimatesmay have a material impact on the financial statements.

 

6

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*Revenue Recognition*

 

The Company’s revenues are derived from sales of its document andconfiguration management systems that are primarily composed of software andservices, including maintenance, training and consulting services, and thirdparty software and hardware. The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2 “Software Revenue Recognition” and SOP 98-9,“Modification of SOP 97-2, Software Revenue Recognition with Respect to CertainTransactions” and Staff Accounting Bulletin (“SAB”) No. 101, updated by SAB’s103 and 104 “Update of Codification of Staff Accounting Bulletins.”

 

Software license and third party product revenues are recognized uponshipment of the product if no significant vendor obligations remain andcollection is probable. In cases where a significant vendor obligation exists,revenue recognition is delayed until such obligation has been satisfied. Fornew software products where a historical record has not yet been demonstratedthat acceptance is perfunctory, the Company defers recognition of revenue untilacceptance has occurred.   If an undelivered element of thearrangement exists under the license arrangement, a portion of revenue isdeferred based on vendor-specific objective evidence (VSOE) of the fair valueof the undelivered element until delivery occurs.  If VSOE does not existfor all undelivered elements, all revenue is deferred until sufficient evidenceexists or all elements have been delivered.  Annual maintenance revenues,which consist of ongoing support and product updates, are recognized on astraight-line basis over the term of the contract. Payments received in advanceof performance of the related service for maintenance contracts are recorded asdeferred revenue. Revenues from training and consulting services are recognizedwhen the services are performed and adequate evidence of providing suchservices is available. Contract revenues for long-term contracts or programsrequiring specialized systems are recognized using the percentage-of-completionmethod of accounting, primarily based on contract labor hours incurred to datecompared with total estimated labor hours at completion. Provisions foranticipated contract losses are recognized at the time they become known.

 

Contracts are billed based on the terms of the contract. There are noretentions in billed contract receivables. Unbilled contract receivables relateto revenues earned but not billed at the end of the period.

 

The Company considers many factors when applying accounting principlesgenerally accepted in the United States of America related to revenuerecognition.  These factors include, 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

 

Each of the relevant factors is analyzed to determine its impact,individually and collectively with other factors, on the revenue to be recognizedfor any particular contract with a customer.  Management is required tomake judgments regarding the significance of each factor in applying therevenue recognition standards, as well as whether or not each factor complieswith such standards.  Any misjudgment or error by management in itsevaluation of the factors and the application of the standards, especially withrespect to complex or new types of transactions, could have a material adverseeffect on the Company’s future operating results.

 

*Fair Value of Financial Instruments*

 

Statement of Financial Accounting Standards (“SFAS”) No. 107,“Disclosures About Fair Value of Financial Instruments”, requires management todisclose the estimated fair value of certain assets and liabilities defined bySFAS No. 107 as cash or a contractual obligation that both conveys to oneentity a right to receive cash or other financial instruments from anotherentity, and imposes on the other entity the obligation to deliver cash or otherfinancial instruments to the first entity. At June 30, 2004 andSeptember 30, 2003, management believes that the carrying amounts of cashand cash equivalents, short-term investments, accounts receivable and accountspayable, and accrued expenses approximate fair value because of the shortmaturity of these financial instruments. The Company believes that the carryingvalue of its loans approximate their fair values based on current market ratesof interest.

 

7

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*Concentration of Credit Risk*

 

The Company provides products and services to customers in a variety ofindustries worldwide, including local governments, petrochemicals, utilities,manufacturing and transportation. Concentration of credit risk with respect totrade receivables is limited due to the geographic and industry dispersion ofthe Company’s customer base. The Company has not experienced significant creditlosses on its customer accounts. Constellation Energy Group and Network Railaccounted for 31% and 25%, respectively, of trade accounts receivable at June 30, 2004 and there were nocustomers that accounted for more than 10% of trade accounts receivable atSeptember 30, 2003.

 

A small number of customers have typically accounted for a largepercentage of the Company’s annual revenues. Network Rail and ConstellationEnergy Group accounted for 27% and 17%, respectively of revenue for the ninemonths ended June 30, 2004, while Network Rail accounted for 21% ofrevenue for nine months ended June 30, 2003.  The Company’s reliance onrelatively few customers could have a material adverse effect on the results ofits operations on a quarterly basis.

 

*Property and Equipment*

 

Property and equipment is recorded at cost and depreciated using thestraight-line method over useful lives of two to seven years. Leaseholdimprovements are amortized on a straight-line basis over the shorter of theiruseful life or the term of the related lease. Expenditures for ordinary repairsand maintenance are expensed as incurred while major additions and improvementsare capitalized.

 

*Software Development Costs and PurchasedSoftware*

 

Software development costs and purchased software are capitalized underFAS 86, “Accounting for the Costs of Computer Software to Be Sold, Leased orOtherwise Marketed,” 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 to customers.Annual amortization expense is calculated using the greater of the ratio ofeach product’s current gross revenues to the total of current and expectedgross revenues or the straight-line method over the estimated useful life ofthree to four years. Accumulated amortization of capitalized software costs was$266,000 and $215,000 at June 30, 2004 and September 30, 2003,respectively. The related amortization expense was $51,000 and $193,000 for thenine months ended June 30, 2004 and 2003, respectively.

 

*Long-lived Assets*

 

The Company assesses potential impairments to its long-lived assetswhen there is evidence that events or changes in circumstances have made recoveryof the asset’s carrying value unlikely. An impairment loss would be recognizedwhen the sum of the expected future net cash flows is less than the carryingamount of the asset.  The Company concluded in fiscal 2004 that there wereno events or changes in circumstances that would indicate that the carryingamounts of long-lived assets were impaired.

 

*Derivatives*

 

Under Emerging Issues Task Force (EITF) Issue No. 00-19,*Accounting for Derivative Financial InstrumentsIndex to, and Potentially Settle in, a Company’s Own Stock*, theinitial balance sheet classification of contracts that require net cashsettlement are recorded as assets or liabilities and contracts that requiresettlement in shares are recorded as equity instruments. At each balance sheetdate, the Company reviews contracts and equity instruments that are to besettled in common stock to determine if sufficient common shares are availableto satisfy the maximum number of shares that could be required to net-sharesettle the contracts, among other conditions.  If sufficient common sharesdo not exist, then certain contracts are reclassified as a liability based ontheir fair value.  Changes in fair value are accounted for in theconsolidated statements of operations.

 

*Stock-Based Compensation*

 

The Company measures compensation expense for its stock-based employeecompensation plans using the intrinsic value method and provides pro formadisclosures of net loss and basic and diluted net loss per share as if the fairvalue-based method had been applied in measuring compensation expense. TheCompany applies SFAS No.123,*Accounting forStock-Based Compensation* and Accounting Principles Board OpinionNo. 25 and related Interpretations in accounting for its employeestock-based compensation plan.

 

8

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No compensation cost was recognized for employee stock option grantsduring 2004 and 2003 based upon the intrinsic value method, which were fixed innature, as the options were granted at exercise prices equal to fair marketvalue on the date of grant. Had compensation cost for the Company’s employeestock-based compensation plan been determined based on the fair value at thegrant dates the disclosure requirements of SFAS No. 148, which amends thedisclosure requirements of FAS 123, would have been as follows:

 
| ** **                                                                        | ** ** | **For the three months  ended June 30,** | ** ** | **For the nine months  ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss) used in computing net  loss per share                           |       |                                          |       |                                         |       |   |   |   |   |
| As reported                                                                       |       | $                                             | 443,000    |                                         | $          | (390,000 | ) | $ | (119,000 | ) | $ | (830,000 | ) |
| Deduct:                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Stock-based employee compensation expense  determined under the fair value method |       | (112,000                                      | )          | (14,000                                      | )          | (259,000 | ) | (66,000 | ) |
| Pro forma                                                                         |       | $                                             | 331,000    |                                         | $          | (404,000 | ) | $ | (378,000 | ) | $ | (896,000 | ) |

 

Under FAS 123, the fair value of each option grant is estimated on thedate of grant using the Black-Scholes option-pricing model with the followingweighted average assumptions used for grants:

 
| ** **              | ** ** | **For the three months  ended June 30,** | ** ** | **For the nine months  ended June 30,** | ** ** |
|-------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **              | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dividend Yield          |       | 0                                             | %          | 0                                            | %          | 0 | % | 0 | % |
| Expected Volatility     |       | 253                                           | %          | 285                                          | %          | 261 | % | 303 | % |
| Risk free interest rate |       | 4.73                                          |       | 3.33                                         |       | 3.83 |   | 3.33 |   |
| Expected lives (years)  |       | 5                                             |       | 5                                            |       | 5 |   | 5 |   |

 

*Income Taxes*

 

Current income tax expense is the amount of income taxes expected to bepayable for the current year. A deferred income tax asset or liability isestablished for the expected future consequences resulting from the differencesin the financial reporting and tax bases of assets and liabilities. Deferredincome tax expense (benefit) is the change during the year in the deferredincome tax asset or liability. Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be “morelikely than not” realized in the future based on the Company’s current andexpected operating results.

 

*Net Income (Loss) per Common Share*

 

Basic net income (loss) per common share is computed as net income(loss) divided by the weighted average number of common shares outstandingduring the year. Diluted net income (loss) per common share is computed as netloss divided by the weighted average number of common shares and potentialcommon shares, using the treasury stock method, outstanding during the year andassumes conversion into common stock at the beginning of each period of alloutstanding shares of convertible preferred stock, stock options, warrants andother potential common stock. Computations of diluted net income (loss) pershare do not give effect to individual potential common stock for any period inwhich their inclusion would be anti-dilutive.

 

*Statements of Cash Flows*

The following table provides supplemental cash flow information:

 
| ** **                                                                              | ** ** | **For the three months  ended June 30,** | ** ** | **For the nine months  ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Supplemental cash flow information:                                                     |       |                                          |       |                                         |       |   |   |   |   |
| Interest paid                                                                           |       | $                                             | 3,000      |                                         | $          | 1,000 |   | $ | 9,000 |   | $ | 3,000 |   |
|                                                                                    |       |                                          |       |                                         |       |   |   |   |   |
| Non-cash financing and investing  activities:                                           |       |                                          |       |                                         |       |   |   |   |   |
| Accrued preferred stock dividends                                                       |       | $                                             | 66,000     |                                         | $          | — |   | $ | 198,000 |   | $ | — |   |
| Fair value of equity instruments redeemable  for common stock converted to common stock |       | $                                             | —     |                                         | $          | — |   | $ | 1,159,000 |   | $ | — |   |

 

9

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**Note 3 – Related Party Transactions**

 

In September 2003 $5,291,000 of debt owed to Spescom Ltd., theCompany’s principal shareholder, and its subsidiary Spescom, Ltd. UK (“SpescomUK”) was converted into preferred stock.  The debt converted was comprisedof the outstanding principal balance of promissory notes plus accrued butunpaid interest as well as accounts payable due to Spescom UK in the amount of$492,000.  On September 30, 2003, the Company issued 5,291 Series FConvertible Preferred Stock to Spescom Ltd. with a stated value of $1,000 pershare.  The Series F preferred stock are convertible into common stock,beginning 45 days from the issuance date subject to availability of sufficientcommon shares at a stated conversion price of $0.45 per share subject tocertain adjustments.  The conversion is at the option of Spescom Ltd.through September 30, 2008.

 

Related party liabilities consist of the following:

 
| ** **                                              | ** ** | **June 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **(Unaudited)**         | ** ** | ** **                   | ** ** |
| Related party liabilities:                              |       |                    |       |                         |       |
| Notes and accrued interest payable on  demand - Spescom |       | $                       | 505,000    |                         | $          | 504,000 |   |
|                                                    |       |                    |       |                         |       |
| Total liabilities                                       |       | $                       | 505,000    |                         | $          | 504,000 |   |

 

On November 18, 2003 the Company issued a note payable to SpescomUK with a principal balance of $600,000 bearing an interest rate of 5% perannum, with principal payable in two installments of approximately $300,000plus interest at January 31, 2004 and March 31, 2004.  The firstpayment of $305,000 was made on January 29, 2004 to Spescom UK and theremaining balance of  $304,000 was paidon May 18, 2004.  The due date for the second payment had beenextended from March 31, 2004 to May 31, 2004.  Interest expense on the note for the threeand nine months ended June 30, 2004 amounted to $2,000 and $9,000,respectively.

 

In addition, the Company has two existing demand notes payable toSpescom UK for $400,000 and $100,000, each bearing an interest rate of 10% perannum.  Spescom Ltd. has agreed that it will not cause Spescom UK todemand repayment under the two notes prior to October 1, 2004. Interest expense on the notes was $13,000 and $38,000 for the three and ninemonths ended June 30, 2004, respectively compared to $25,000 and $73,000for the same period in 2003, respectively.  These notes are collateralizedby a security interest in favor of Spescom UK in respect of all the Company’sassets.

 

Spescom UK provides certain administrative and accounting functions forthe Company’s United Kingdom subsidiary.  The Company is billed a monthlyfee by Spescom UK for reimbursement of certain costs in the United Kingdomincluding the office facilities, all accounting and human resources services,and certain corporate marketing activities.  For the three and nine monthsended June 30, 2004 the administrative fees totaled $148,000 and $439,000,respectively, compared to $155,000 and $460,000 for the three and nine monthperiod ended June 30, 2003.  The office rent for the Company’s UnitedKingdom operations included in the administrative fee totaled $86,000 and$257,000, respectively for the three and nine months ended June 30, 2004compared to $69,000 and $205,000, respectively for the three and nine monthsended June 30, 2003.   At June 30, 2004 andSeptember 30, 2003 the Company had a payable to Spescom UK of $49,000 and$46,000, respectively.  In 1999, as part of an agreement to sell the 60%interest in its United Kingdom subsidiary to Spescom Ltd., the lease for theUnited Kingdom office facility was to be assigned to Spescom Ltd.; however, thelandlord did not grant its consent to the assignment.  Since 1999, SpescomUK has paid the lease for the entire office directly to the landlord.  Thelease expires in March 2006 and has an annual rent of $618,000.  Aportion of the office has been subleased to third party tenants for an annualrent of $284,000.  The sublease also expires March 2006.

 

Spescom Ltd. and the Company have entered into a license agreementpursuant to which Spescom Ltd. has licensed to the Company the right to use thename “Spescom” and to use a trademark owned by Spescom Ltd. related to certaincomputer software. The Company will not pay any royalties to Spescom Ltd. inconnection with this license. The license is for an indefinite term, but isterminable by either party upon 60 days prior written notice. Under the licenseagreement, Spescom Ltd. has agreed to indemnify and hold harmless the Companyand its directors, officers, employees and agents against liabilities arisingfrom any claim brought against the Company that alleges that Spescom Ltd.’s orthe Company’s use of the licensed trademark infringes the rights of any thirdparty, provided that the Company is in material compliance with the provisionsof the license agreement.

 

10

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**Note 4 – Receivables**

 
| ** **                                  | ** ** | **June 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **(Unaudited)**         | ** ** | ** **                   | ** ** |
| Receivables consist of:                     |       |                    |       |                         |       |
| Receivables                                 |       | $                       | 426,000    |                         | $          | 501,000 |   |
| Less:  allowance for doubtful accounts |       | (84,000                 | )          | (78,000                      | )          |
|                                        |       | $                       | 342,000    |                         | $          | 423,000 |   |

 

**Note 5 – Reconciliation of Net Income (Loss)and Shares Used in Per Share Computations:**

 

Basic earnings per share is computed on the basis ofthe weighted average number of common shares outstanding. Diluted earnings pershare is computed on the basis of the weighted average number of common sharesoutstanding plus the effect of outstanding stock options, stock awards and sharedperformance stock awards using the “treasury stock” method. The components ofbasic and diluted earnings per share were as follows: 

 
| ** **                                               | ** ** | **For the three months  ended June 30,** | ** ** | **For the nine months  ended June 30,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss) available for common  shareholders(A)  |       | $                                             | 377,000    |                                         | $          | (390,000 | ) | $ | (317,000 | ) | $ | (830,000 | ) |
|                                                     |       |                                          |       |                                         |       |   |   |   |   |
| Weighted average outstanding shares of  common stock (B) |       | 34,068,000                                    |       | 30,890,000                                   |       | 33,992,000 |   | 30,850,000 |   |
| Dilutive effect of employee stock based  compensation    |       | 1,384,000                                     |       | —                                       |       | — |   | — |   |
| Common stock and common stock  equivalents(C)            |       | 35,452,000                                    |       | 30,890,000                                   |       | 33,992,000 |   | 30,850,000 |   |
|                                                     |       |                                          |       |                                         |       |   |   |   |   |
| Earnings per share:                                      |       |                                          |       |                                         |       |   |   |   |   |
| Basic (A/B)                                              |       | $                                             | 0.01       |                                         | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.03 | ) |
| Diluted (A/C)                                            |       | $                                             | 0.01       |                                         | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.03 | ) |

 

For the three months ended June 30, 2003 and2004, 4,080,000 and 2,047,332 shares attributable to outstanding stock optionswere excluded from the calculation of diluted earnings per share because theeffect was antidilutive. For the nine months ended June 30, 2003 and 2004,3,912,964 and 1,295,659 shares attributable to outstanding stock options wereexcluded from the calculation of diluted earnings per share because the effectwas antidilutive.

 

In September 2003, the Company issued an option to purchase2,500,000 shares of common stock to an investment consulting firm involved in aprivate placement and the Company issued 5,291 shares of Series F PreferredStock to Spescom Ltd. and Spescom UK with a stated value of $1,000 per sharewhich are convertible into the Company’s common stock at a stated conversionprice of $0.45 per share representing a total of 11,757,778 shares of commonstock.  In addition in September 2003, the Company issued warrants toinvestors who participated in the private placement to purchase 1,008,335shares of the Company’s common stock.  The stock options, warrants andconvertible preferred stock were excluded from calculations of per shareamounts, because their effect would be antidilutive.

 

**Note 6 – Segment and Geographic Information**

 

The Company has one business segment, which consists of the developmentand sale of a suite of integrated document, configuration and recordsmanagement software products.

 

Revenues for the three and nine month periods ended June 30, 2004and 2003 by customer location were as follows:

 
| ** **                       | ** ** | **For the three months ended  June 30,** | ** ** | **For the nine months ended  June 30,** | ** ** |
|----------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                       | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales:                       |       |                                          |       |                                         |       |   |   |   |   |
| United States                    |       | $                                             | 753,000    |                                         | $          | 1,083,000 |   | $ | 3,165,000 |   | $ | 3,388,000 |   |
| Europe, primarily United Kingdom |       | 2,120,000                                     |       | 816,000                                      |       | 3,326,000 |   | 2,583,000 |   |
| Other International              |       | 27,000                                        |       | 3,000                                        |       | 135,000 |   | 35,000 |   |
|                             |       | $                                             | 2,900,000  |                                         | $          | 1,902,000 |   | $ | 6,626,000 |   | $ | 6,006,000 |   |

 
| ** **                                       | ** ** | **June 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **(Unaudited)**         | ** ** | ** **                   | ** ** |
| Identifiable assets from continuing  operations: |       |                    |       |                         |       |
| United States                                    |       | $                       | 833,000    |                         | $          | 941,000 |   |
| Europe, United Kingdom                           |       | 911,000                 |       | 289,000                      |       |
|                                             |       | $                       | 1,744,000  |                         | $          | 1,230,000 |   |

 

11

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**Note 7 – Equity**

 

In January 2004 the Company reclassified 5,291 shares of preferredstock valued at $6,790,000 related to the conversion of debt owed to SpescomLtd. and Spescom UK to equity from mezzanine equity (see Note 8). For the three and nine months ended June 30, 2004, the Company recordedaccrued dividends on the preferred stock of $66,000 and $198,000,respectively.  In addition interest onunpaid accrued dividends of $3,000 and $4,000 was recorded for the three andnine months ended June 30, 2004.  Finally, the Company issued 90,000shares of common stock valued at $46,000 to the Company’s investor relationsfirm for services rendered.

 

**Note 8 – Derivatives**

 

At September 30, 2003, the Company did not have a sufficientnumber of authorized shares of its common stock to satisfy potential exercisesof 1,108,335 warrants held by investors and 1,150,000 options held bynon-employees.  As a result, the fair value of such equity instruments wasreclassified from shareholders’ deficit to current liabilities.  The fairvalue of the warrants and options was determined using the Black-Scholes modelat the date of reclassification and totaled $1,233,000.  As ofDecember 31, 2003 the total options held by non-employees was reduced by130,000 options from 1,150,000 to 1,020,000 due to the exercise of 50,000options and the expiration of 80,000 options.  The Company recognized again of $5,000 on the revaluation of the remaining warrants and options as ofDecember 31, 2003.  The Annual Meeting of Shareholders was held onJanuary 30, 2004.  At the meeting, the shareholders approved aproposal to amend the Company’s Articles of Incorporation to increase thenumber of shares of authorized common stock from 40,000,000 to 100,000,000shares.  As a result, the Company has sufficient number of shares ofcommon stock authorized to satisfy potential exercises of 1,108,335 warrantsheld by investors and 1,150,000 options held by non-employees.  The fairvalue of such equity instruments of $1,159,000 was reclassified from current liabilitiesto equity and a gain of $1,000 was recognized on the revaluation of thewarrants and options to equity during the quarter ended March 31,2004.  In addition the preferred stock of $6,790,000 was reclassified toequity from mezzanine equity.

 

**Note 9 – Recent Accounting Pronouncements**

 

In November 2002, the FASB issued FASB Interpretation No. 45(FIN No. 45),*Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*. FIN No. 45 expands on the accountingguidance of FASB Statements No. 5, 57, and 107 and incorporates withoutchange the provisions of FASB Interpretation No. 34, which is beingsuperseded. FIN No. 45 will affect leasing transactions involving residualguarantees, vendor and manufacturer guarantees, and tax and environmentalindemnities. All such guarantees will need to be disclosed in the notes to thefinancial statements starting with the period ending after December 15,2002. Existing guarantees will be grandfathered and will not be recognized onthe balance sheet. The provisions related to recognizing a liability atinception of the guarantee do not apply to product warranties, indemnificationprovisions in our software license arrangements or to guarantees accounted foras derivatives. The initial recognition and measurement provision are effectiveprospectively for guarantees issued or modified on or after December 31,2002 and the disclosure requirements apply to guarantees outstanding as ofDecember 31, 2002.  This interpretation did not have a materialeffect on our consolidated financial position or results of operations as wecurrently do not have any guarantees or obligations falling under the scope ofInterpretation No. 45.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation - Transition and Disclosure,” an amendment of SFAS No.123.  SFAS No. 148 provides alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation.  In addition, SFAS No. 148 amends the disclosurerequirements of SFAS No. 123 to require more prominent and more frequentdisclosures in financial statements about the effects of stock-basedcompensation.  This statement is effective for financial statements forfiscal years ending after December 15, 2002. We are currently evaluatingwhich method of transition to fair value accounting we will elect.

 

In January 2003, the Emerging Issues Task Force (EITF) issued No.00-21,*Accounting for Revenue Arrangementswith Multiple Deliverables*. This EITF establishes the criteria forrecognizing revenue in arrangements when several items are bundled into oneagreement. EITF 00-21 does not allow revenue recognition unless the fair valueof the undelivered element(s) is available and the element has stand-alonevalue to the customer. EITF 00-21 also provides guidance on allocating thetotal contract revenue to the individual elements based upon the available fairvalue of each deliverable. This interpretation is not expected to have amaterial effect on our consolidated financial position or consolidated resultsof operations.

 

In January 2003, the FASB issued Interpretation 46,*Consolidation of Variable Interest Entities.*In general, a variable interest entity is a corporation, partnership, trust, orany other legal structure used for business purposes that either (a) do nothave equity investors with voting rights or (b) have equity investors that donot provide sufficient financial resources for the entity to support itsactivities. Interpretation 46 requires a variable interest entity to beconsolidated by a company if that company is subject to a majority of the riskof loss from the variable interest entity’s activities or entitled to receive amajority of the entity’s residual returns or both. The consolidationrequirements of Interpretation 46 apply immediately to variable interestentities created after January 31, 2003. The consolidation requirementsapply to older entities in the first fiscal year or interim period beginningafter June 15, 2003. Certain of the disclosure requirements apply in allfinancial statements issued after January 31, 2003, regardless of when thevariable interest entity was established.  This interpretation is not expectedto have a material effect on our consolidated financial position orconsolidated results of operations as we currently do not have any variableinterest entities falling within the scope of Interpretation 46.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment ofStatement 133 on Derivative Instruments and Hedging Activities.”

 

12

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SFAS No. 149 amends and clarifies accounting for derivativeinstruments, including certain derivative instruments embedded in other contractsand for hedging activities under SFAS 133, effective for reporting periodsending after June 30, 2003.  In particular, SFAS No. 149 clarifiesunder what circumstances a contract within an initial net investment meets thecharacteristic of a derivative and when a derivative contains a financingcomponent that warrants special reporting in the statement of cash flows. SFAS No. 149 is generally effective for contracts entered into or modifiedafter June 30, 2003.  The adoption of SFAS 149 had a material effecton our consolidated financial position or consolidated results ofoperations.  See Note 8 Derivatives.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity.  It requires that an issuer classify a financial instrument thatis within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity.  SFAS No.150 is effective for financial instruments entered into or modified afterMay 31, 2003, and otherwise is effective at the beginning of the firstinterim period beginning after June 15, 2003.  The adoption of SFASNo. 150 did not have a material effect on our consolidated financialposition or consolidated results of operations as we currently do not have anyfinancial instruments falling within the scope of SFAS No. 150.

 

In December 2003, the FASB issued Interpretation46R (FIN 46R), a revision to Interpretation 46 (FIN 46), *Consolidation of Variable Interest Entities.*FIN 46R clarifies some of the provisions of FIN 46 and exempts certain entitiesfrom its requirements. FIN 46R is effective at the end of the first interimperiod ending after March 15, 2004. Entities that have adopted FIN 46prior to this effective date can continue to apply the provisions of FIN 46until the effective date of FIN 46R or elect early adoption of FIN46R. Thisinterpretation is not expected to have a material effect on our consolidatedfinancial position or consolidated results of operations.

 

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

 

**Forward – Looking Statements**

 

*This report contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934. Theseforward-looking statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from historical results oranticipated results, including those set forth under “Certain Factors ThatMay Affect Future Results” below and elsewhere in, or incorporated byreference into, this report.*

 

*When used in the following discussion, thewords “believes,” “anticipates,” “expects” and similar expressions are intended to identify forward-lookingstatements. Such statements are subject to certain risks and uncertainties,which could cause actual results to differ materially from those projected.Readers are cautioned not to place undue reliance on these forward-lookingstatements, which speak only as of the date hereof. The Company undertakes noobligation to publicly release the result of any revisions to theseforward-looking statements, which may be made to reflect events orcircumstances after the date hereof or to reflect the occurrence ofunanticipated events.*

 

*The following discussion should be read inconjunction with the Selected Consolidated Financial Data and the ConsolidatedFinancial Statements, including the Notes thereto.*

 

**CRITICAL ACCOUNTING POLICIES**

 

The consolidated financial statements are prepared in conformity withaccounting principles generally accepted in the United States of America. Assuch, management is required to make judgments, estimates and assumptions thataffect the reported amounts of assets and liabilities at the date of theconsolidated financial statements and the reported amounts of revenues andexpenses during the reporting period. The significant accounting policies whichare most critical to aid in fully understanding and evaluating reportedfinancial results include the following:

 

*Revenue Recognition*

 

The Company enters into contractual arrangements with end-users thatmay include licensing of the Company’s software products, product support andmaintenance services, consulting services or various combinations thereof,including the sale of such products or services separately.  The Companyrecognizes revenue in accordance with Statement of Position (“SOP”) 97-2“Software Revenue Recognition” and SOP 98-9, “Modification of SOP 97-2,Software Revenue Recognition, with Respect to Certain Transactions” and Staff AccountingBulletin (“SAB”)  No. 101, updated by SAB’s 103 and 104 “Update ofCodification of Staff Accounting Bulletins.”

 

Software license and third party product revenues are recognized uponshipment of the product if no significant vendor obligations remain andcollection is probable. In cases where a significant vendor obligation exists,revenue recognition is delayed until such obligation has been satisfied. Fornew software products where a historical record has not yet been demonstratedthat acceptance is perfunctory, the Company defers recognition of revenue untilacceptance has occurred. If an undelivered element of the arrangement existsunder the license arrangement, a portion of revenue is deferred based onvendor-specific objective evidence (VSOE) of the fair

 

13

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value of the undelivered element until delivery occurs.  If VSOEdoes not exist for all undelivered elements, all revenue is deferred untilsufficient evidence exists or all elements have been delivered.  Annualmaintenance revenues, which consist of ongoing support and product updates, arerecognized on a straight-line basis over the term of the contract. Paymentsreceived in advance of performance of the related service for maintenance contractsare recorded as deferred revenue. Revenues from training and consulting servicesare recognized when the services are performed and adequate evidence ofproviding such services is available. Contract revenues for long-term contractsor programs requiring specialized systems are recognized using thepercentage-of-completion method of accounting, primarily based on contractlabor hours incurred to date compared with total estimated labor hours atcompletion. Provisions for anticipated contract losses are recognized at thetime they become known.

 

Contracts are billed based on the terms of the contract. There are noretentions in billed contract receivables. Unbilled contract receivables relateto revenues earned but not billed at the end of the period.

 

The Company considers many factors when applying accounting principlesgenerally accepted in the United States of America related to revenuerecognition.  These factors include, 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

 

Each of the relevant factors is analyzed to determine its impact,individually and collectively with other factors, on the revenue to berecognized 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 the standards,especially with respect to complex or new types of transactions, could have amaterial adverse effect on the Company’s future operating results.

 

*Allowance for Doubtful Accounts*

 

The Company sells its products directly to end-users, generallyrequiring a significant up-front payment and remaining terms appropriate forthe creditworthiness of the customer. The Company also sells its products toVARs and other software distributors generally under terms appropriate for thecreditworthiness of the VAR or distributor. The Company retains no continuingobligations on sales to VARs.  Receivables from customers are generallyunsecured. The Company continuously monitors its customer account balances andactively pursues collections on past due balances. The Company maintains anallowance for doubtful accounts which is comprised of a general reserve basedon historical collections performance plus a specific reserve for certain knowncustomer collections 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.

 

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**RESULTS OF OPERATIONS**

 

The following table sets forth the condensed consolidated statement ofoperations expressed as a percentage of total revenue for the periods indicated:

 
| ** **                         | ** ** | **For the three months ended  June 30,** | ** ** | **For the nine months ended  June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                           |       |                                          |       |                                         |       |   |   |   |   |
| Licenses                           |       | 54                                            | %          | 25                                           | %          | 46 | % | 30 | % |
| Services and other                 |       | 46                                            | %          | 75                                           | %          | 54 | % | 70 | % |
| Total revenues                     |       | 100                                           | %          | 100                                          | %          | 100 | % | 100 | % |
|                               |       |                                          |       |                                         |       |   |   |   |   |
| Cost of revenues                   |       |                                          |       |                                         |       |   |   |   |   |
| Licenses                           |       | 1                                             | %          | 10                                           | %          | 3 | % | 10 | % |
| Services and other                 |       | 20                                            | %          | 34                                           | %          | 26 | % | 29 | % |
|                               |       | 21                                            | %          | 44                                           | %          | 29 | % | 39 | % |
|                               |       |                                          |       |                                         |       |   |   |   |   |
| Gross profit                       |       | 79                                            | %          | 56                                           | %          | 71 | % | 61 | % |
|                               |       |                                          |       |                                         |       |   |   |   |   |
| Operating expenses:                |       |                                          |       |                                         |       |   |   |   |   |
| Research and development           |       | 12                                            | %          | 19                                           | %          | 15 | % | 18 | % |
| Marketing and sales                |       | 30                                            | %          | 33                                           | %          | 33 | % | 32 | % |
| General and administrative         |       | 20                                            | %          | 17                                           | %          | 24 | % | 18 | % |
|                               |       | 62                                            | %          | 69                                           | %          | 72 | % | 68 | % |
|                               |       |                                          |       |                                         |       |   |   |   |   |
| Income (loss) from operations      |       | 17                                            | %          | (13                                          | )%         | (1 | )% | (7 | )% |
|                               |       |                                          |       |                                         |       |   |   |   |   |
| Interest income and other income   |       | —                                        |       | —                                       |       | 1 | % | — |   |
| Interest expense and other expense |       | (2                                            | )%         | (7                                           | )%         | (2 | )% | (7 | )% |
|                               |       |                                          |       |                                         |       |   |   |   |   |
| Net Income (loss)                  |       | 15                                            | %          | (20                                          | )%         | (2 | )% | (14 | )% |

 

**Revenues**

 

*License Revenues*

(in thousands)

 
| ** **                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                  | ** ** | **2004**                              | ** ** | **2003**            | ** ** | ** **                           | **2004**   | ** **          | **2003**   | ** ** | ** ** |
| License Revenue             |       | $                                     | 1,559      |                | $          | 485                                  |       | 221                 | %          | $ | 3,037 |   | $ | 1,773 |   | 71 | % |
| Percentage of total revenue |       | 54                                    | %          | 25                  | %          |                                 |       | 46                  | %          | 30 | % |   |   |
|                             |            |                                       |            |                     |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |

 

License revenues increased by $1.1 million, or 221%, to $1.6 millionfrom $485,000 for the three months ended June 30, 2004 as compared to thesame period in 2003.  The increase for the quarter was due primarily to asale to an existing customer, Network Rail, of $1.5 million as compared tovarious smaller sales to new and existing customers totaling $400,000 in theprior year.  License revenues increased by $1.3 million, or 71%, to $3.0million from $1.8 million for the nine months ended June 30, 2004 ascompared to the same period in 2003. The increase was due primarily to sales toNetwork Rail and Constellation Energy Group of $1.5 million and $750,000,respectively, compared to sales of $369,000 and $250,000 to Network Rail andBechtel, respectively, during the corresponding period in the prior year. The Company has continued to experience higher sales of the eB product suite asa result of customers expanding their existing software systems and an increasein software orders from new and existing customers in response to a higherdemand for a comprehensive content management solution needed for businessprocess compliance, corporate record keeping and enterprise collaboration.

 

We anticipate that the demand for enterprise document, configurationand records management software solutions will continue to increase if overalleconomic conditions continue to strengthen.  The Company’s licenserevenues fluctuate from quarter to quarter, but we have experienced and expectto continue to see increased license revenue opportunities as more users aredeployed throughout existing customer enterprises and as we make additionalsales to new customers.

 

15

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Although the Company has historically generated the majority of itsrevenues from its direct sales force, the Company has also established anetwork of third-party VARs, system integrators and OEMs who build and sellsystems (with components or complete systems provided by the Company) thataddress specific customer needs within various industries, including thosetargeted directly by the Company.  Sales through indirect channels for thethree months ended June 30, 2004 amounted to $71,000, or 3% of totalrevenue compared to $83,000 or 4% of total revenue for the same period in2003.    Sales through indirect channels for the nine monthsended June 30, 2004 amounted to $371,000, or 6% of total revenue comparedto $131,000 or 2% of total revenue for the same period in 2003.  The increase in indirect sales of $240,000nine months ended June 30, 2004 is due primarily to increased sales fromone distributor in the United Kingdom.

 

A small number of customers have typically accounted for a largepercentage of the Company’s annual revenues. Network Rail accounted for 61% ofrevenue for the three months ended June 30, 2004, compared to 15% ofrevenue for three months ended June 30, 2003.  Network Rail andConstellation Energy Group accounted for 27% and 17% of revenue for the ninemonths ended June 30, 2004, while Network Rail accounted for 21% ofrevenue for nine months ended June 30, 2003.  The Company’s relianceon relatively few customers could have a material adverse effect on its resultsof operations on a quarterly basis.

 

*Service and Other Revenues*

(in thousands)

 
| ** **                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                  | ** ** | **2004**                              | ** ** | **2003**            | ** ** | ** **                           | **2004**   | ** **          | **2003**   | ** ** | ** ** |
| Service Revenue             |       | $                                     | 1,341      |                | $          | 1,417                                |       | -5                  | %          | $ | 3,589 |   | $ | 4,233 |   | -15 | % |
| Percentage of total revenue |       | 46                                    | %          | 75                  | %          |                                 |       | 54                  | %          | 70 | % |   |   |
|                             |            |                                       |            |                     |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |

 

Services and other revenues are comprised of maintenance andnon-maintenance services.  Non-maintenance services typically relate tobusiness process studies, implementation of systems and training which varywith the level of license revenues while maintenance revenue is primarilydependent on customers renewing their annual maintenance support contracts.

 

Services and other revenue decreased in absolute dollars and as apercentage of total revenue for the three and nine months ended June 30,2004, as compared to the corresponding prior year periods.  The $76,000,or 5%, decrease in the three months ended June 30, 2004 as compared to thesame periods in 2003 was comprised of a $218,000, or 32%, reduction innon-maintenance service revenue which was partially offset by an increase of$142,000, or 20%, in maintenance revenue.  The $644,000, or 15%, decreasein the nine months ended June 30, 2004 as compared to the same period in2003 consisted of a $757,000, or 38% reduction in non-maintenance servicerevenue which was partially offset by an increase of $118,000, or 5% inmaintenance revenue.  The decrease in non-maintenance service revenue inthe three and nine months ended June 30, 2004 resulted from the fact thatthe Company had one large implementation service contract as compared to twolarge implementation service contracts for the same period in 2003.  The increase in maintenance revenue in thethree and nine months ended June 30, 2004 compared to the comparableperiods of 2003 resulted from increased license sales and maintenancerequirements.

 

We anticipate that service and other revenue will fluctuate primarilydue to fluctuations in sales to new customers, which require more services thattypically include a business process study, integration with other businesssystems and training.  In addition, we expect that service and otherrevenues will continue to fluctuate from quarter to quarter based on the timingof customer orders.

 

**Cost of Revenues**

 

*Cost of License Revenues*

(in thousands) 

 
| ** **                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|-------------|------------|--------------------------------------|------------|-------------|------------|
| ** **                    | ** ** | **2004**                              | ** ** | **2003**    | ** ** | **Change**                           | ** ** | **2004**    | ** ** | **2003** | ** ** | **Change** | ** ** |
| Cost of License Revenue       |       | $                                     | 37         |        | $          | 189                                  |       | -80         | %          | $ | 178 |   | $ | 589 |   | -70 | % |
| Percentage of license revenue |       | 2                                     | %          | 39          | %          |                                 |       | 6           | %          | 33 | % |   |   |
|                               |            |                                       |            |             |            |                                      |            |             |            |  |  |  |  |  |  |  |  |

 

Cost of licenses revenues consists of costs associated with resellingthird-party products and amortization of internal software development costs.

 

Cost of license revenue decreased in absolute dollars and as apercentage of associated license revenue in both the three and nine monthsended June 30, 2004, as compared to the same periods in 2003.  Thecosts of licensed revenues in the three months ended June 30, 2004decreased $152,000, or 80% as compared to the same period in 2003.  The decrease was related to a reduction inthird-party software costs of $79,000 due to fewer sales of third-partyproducts as a percentage of total sales. In addition, amortization expense of capitalized software costsdecreased $73,000 as a result of a majority of such costs being fully amortizedin fiscal 2003.  The overall decrease incosts of license revenues and increase in license revenue resulted in animprovement in gross profit margin to 98% for the three months endedJune 30, 2004 as compared to 61% for the same period a year ago.

 

The costs of licensed revenues in the nine months ended June 30,2004 decreased $411,000, or 70% as compared to the same period in

 

16

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2003.  Approximately $230,000 of this decrease was related toreduced amortization expense of capitalized software as mentioned above. The remaining decrease of $181,000, was due to decreased third-party costs dueto lower sales of third-party products as a percentage of total sales. The overall decrease in cost of license revenues resulted in an improvement ingross profit percentage of license revenues to 94% for the nine months endedJune 30, 2004 as compared to 67% for the same period a year ago.

 

We expect the cost of license revenues to fluctuate based on customerrequirements for third-party software products since these costs have thelargest impact on cost of license revenues.

 

*Cost of Services and Other Revenues*

(in thousands) 

 
| ** **                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **2004**                              | ** ** | **2003**            | ** ** | ** **                           | **2004**   | ** **          | **2003**   | ** ** | ** ** |
| Cost of service and other revenue       |       | $                                     | 586        |                | $          | 655                                  |       | -11                 | %          | $ | 1,693 |   | $ | 1,749 |   | -3 | % |
| Percentage of service and other revenue |       | 44                                    | %          | 46                  | %          |                                 |       | 47                  | %          | 41 | % |   |   |
|                                         |            |                                       |            |                     |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |

 

Cost of services and other revenues consists primarily ofpersonnel-related costs in providing consulting services, training to customersand support.  It also includes costs associated with reselling third-partyhardware and maintenance, which includes telephone support costs.

 

Cost of services and other revenue decreased in absolute dollars in thethree and nine months ended June 30, 2004 as compared to the same periodsin 2003.  The $69,000, or 11% and $56,000, or 3%, decrease in the threeand nine months ended June 30, 2004, respectively, as compared to the sameperiods in 2003, was due primarily to decreased third party service costs of$64,000 associated with a customer contract for conversion of data in the prioryear.  The decrease in cost of servicesand other revenue resulted in a slight increase in gross profit to 56% fromservices and other revenue for the three month period ended June 30, 2004as compared to 54% for the same period a year ago.    The grossprofit from services and other revenue as a percentage of services and otherrevenues decreased to 53% for the nine months ended June 30, 2004 from 59%for the same period a year ago.  Thelower gross profit percentage is due to a 15% decrease in service and otherrevenues while cost of revenues decreased only 3% as third party costsdecreased $75,000 and personnel and related costs remained relativelyunchanged.

 

We expect the cost of service and other revenues to fluctuate inabsolute dollar amounts and as a percentage of total revenues as the relatedservice revenue fluctuates.

 

**Operating Expenses**

 

*Research and Development*

(in thousands)

 
| ** **                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                        | ** ** | **2004**                              | ** ** | **2003**            | ** ** | ** **                           | **2004**   | ** **          | **2003**   | ** ** | ** ** |
| Research and development expenses |       | $                                     | 341        |                | $          | 364                                  |       | -6                  | %          | $ | 1,008 |   | $ | 1,101 |   | -8 | % |
| Percentage of total revenue       |       | 12                                    | %          | 19                  | %          |                                 |       | 15                  | %          | 18 | % |   |   |
|                                   |            |                                       |            |                     |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |

 

Research and development expenses consist of salaries and benefits forsoftware developers as well as an allocation of corporate expenses, calculatedon the basis of headcount, such as corporate insurance, facilities, telephoneand other.

 

Research and development expenses decreased in absolute dollars and asa percentage of total revenue in the three and nine months ended June 30,2004, as compared to the same periods in 2003.  The $23,000, or 6%,decrease for the three months ended June 30, 2004 was due primarily to areduction in facility costs of $10,000 associated with the Company moving to asmaller facility in June of fiscal year 2003 and reduced labor and relatedcosts of $8,000.

 

The $93,000, or 8% decrease for the nine months ended June 30,2004 was due primarily to a reduction in facility costs of $118,000 associatedwith the Company moving to a smaller facility in June of fiscal year2003.  The decrease was partially offsetby an increase of $25,000 in labor and related costs associated with theCompany adding additional personnel dedicated to quality assurance.

 

We believe that continued investment in research and development is acritical factor in maintaining our competitive position and we expect researchand development costs to remain at the current levels in absolute dollaramounts in the next several quarters.

 

17

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*Marketing and Sales*

(in thousands)

 
| ** **                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** |
|------------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **2003**            | ** ** | ** **                           | **2004**   | ** **          | **2003**   | ** ** | ** ** |
| Marketing and sales expenses |       | $                                     | 871        |                | $          | 635                                  |       | 37                  | %          | $ | 2,201 |   | $ | 1,918 |   | 15 | % |
| Percentage of total revenue  |       | 30                                    | %          | 33                  | %          |                                 |       | 33                  | %          | 32 | % |   |   |
|                              |            |                                       |            |                     |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |

 

Marketing and sales expenses consist of salaries, cost of benefits,sales commissions and other expenses related to the direct sales force, as wellas allocation of overall corporate expenses, calculated on the basis ofheadcount, related to items such as corporate insurance, facilities, telephoneand other.

 

Marketing and sales expenses increased in absolute dollars for thethree and nine months ended June 30, 2004, as compared to the same periodsin 2003.  The increase of $236,000, or 37%, for the three months endedJune 20, 2004 as compared to the same period in 2003 was due primarily toan increase of $92,000 in marketing labor and related costs associated with additionalmarketing and sales personnel, $68,000 in commission expenses related to higherrevenues, $65,000 in marketing costs primarily related to user conferences andtravel and $50,000 in trade shows.  Theincrease in marketing costs was partially offset by reduced facility costs of$34,000 associated with the Company moving into a smaller facility inJune of fiscal year 2003.

 

Marketing and sales expenses increased $283,000, or 15%, for the ninemonths ended June 20, 2004 as compared to the same period in 2003 due primarilyto an increase of $127,000 in marketing labor and related costs associated withadditional marketing and sales personnel, $129,000 in commission expensesrelated to higher revenues, $74,000 in marketing costs primarily related touser conferences and travel and $53,000 in trade shows.  The increase in marketing costs was partiallyoffset by reduced facility costs of $66,000 associated with the Company movinginto a smaller facility in June of fiscal year 2003 and a reductionof  $45,000 in consultants expenses dueto the Company performing certain marketing and sales services in-house whichwere previously performed by outside consultants.

 

We expect marketing and sales expense to increase in absolute dollaramounts and as a percentage of total revenue as a result of the plannedexpansion of our sales and marketing efforts in the next several quarters.

 

*General and Administrative*

(in thousands

 
| ** **                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended  June 30,** | ** ** | **Percent  Change** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                          | ** ** | **2004**                              | ** ** | **2003**            | ** ** | ** **                           | **2004**   | ** **          | **2003**   | ** ** | ** ** |
| General and administrative expenses |       | $                                     | 585        |                | $          | 319                                  |       | 83                  | %          | $ | 1,574 |   | $ | 1,090 |   | 44 | % |
| Percentage of total revenue         |       | 20                                    | %          | 17                  | %          |                                 |       | 24                  | %          | 18 | % |   |   |
|                                     |            |                                       |            |                     |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |

 

General and administrative expenses consist primarily of personnelcosts for finance, information technology, human resources and generalmanagement, as well as outside professional services and an allocation ofoverall corporate expenses, calculated on the basis of headcount, such ascorporate insurance, facilities, telephone and other.

 

General and administrative expenses increased in absolute dollars andas a percentage of total revenue for the three and nine months endedJune 30, 2004, as compared to the same period in 2003.  The 83%, or$266,000 increase in the three months ended June 30, 2004 as compared tothe same period in 2003, was primarily due to increased accounting and legalfees of $142,000 relating to several registration statement filings andincreased investor relations costs of $44,000 relating to a new publicrelations firm engaged in September 2003.

 

The $484,000 increase in the nine months ended June 30, 2004 ascompared to the same period in 2003 was due primarily to an increase inaccounting and legal fees of $273,000 relating to routine SEC review of theCompany’s Annual Report on Form 10-K for the year ended September 30, 2002and several registration filings.  In addition, the Company incurredadditional expenses of $109,000 relating to a new public relations firm engagedin September, 2003, and increased costs of $30,000 associated with theannual shareholder meeting held in January, 2004.

 

We expect that general and administrative expenses will fluctuate inabsolute dollars based on the timing of accounting and legal matters such asthe Company’s recent registration statement filings.

 

**INTEREST EXPENSE**

 

Interest expense consists primarily of fixed interest obligations onour outstanding debt to Spescom Ltd. as well as interest paid on capital leaseobligations.  Interest expense was $37,000 and $96,000 for the three andnine months ended June 30, 2004, respectively, as compared to $134,000 and$393,000 for the comparable periods in 2003.  The decrease is due todecreased debt balances owed to

 

18

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Spescom UK due to the conversion of debt to convertible preferred stockin September 2003.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

At June 30, 2004, the Company’s cash and cash equivalents totaled$1,033,000 as compared to $333,000 at June 30, 2003.  Its currentratio (current assets divided by current liabilities) was .32 at June 30,2004.

 

For the nine months ended June 30, 2004, cash used by financingactivities totaled $3,000, primarily due to payments on capital leases of$16,000 which was partially offset by cash received of $13,000 from the exerciseof stock options. Cash provided by operating activities totaled $730,000 andprimarily relates to the sale and collection of a large software license feeduring the quarter.

 

The Company has received loans from Spescom Ltd. in the past to meetits obligations.  The outstanding balance of its loans from Spescom wasrelatively unchanged at $505,000 at June 30, 2004 as compared to $504,000at September 30, 2003.  These notesare due in October 2004.  InNovember 2003, the Company issued a short-term note payable to Spescom UKof $600,000 which was repaid prior to June 30, 2004.  The first payment of $305,000 was made onJanuary 29, 2004 and the second payment of $304,000 was made on May 18,2004.

 

In fiscal year 2003, Spescom Ltd. supported the Company’s operations byextending the due dates of notes payable and by converting $5.3 million in debtand other obligations owed to Spescom Ltd. to preferred stock.  Thepreferred stock is entitled to receive dividends of 5% of the stated value pershare per annum, payable on a quarterly basis in cash or common stock. Unpaid dividends accrue at 8% per annum compounded annually from the date ofaccrual until paid.  The Company has recorded accrued dividends on thepreferred stock of $198,000 and interest of $4,000 as of June 30,2004.  Spescom Ltd. has stated that it has the ability and will continueto fund the Company’s operations through October 1, 2004, if necessary.

 

However, the funding of such loans may be delayed or prevented asa result of, among other factors, currency exchange regulations of the Republicof South Africa, under which Spescom is required to apply for and obtain theapproval of the South African Reserve Bank before providing any funds to theCompany. Spescom Ltd. is presently unaware of any reason why such Reserve Bankapproval should not be given.

 

The Company’s future liquidity depends on its ability to generate newsystem sales of its eB product suite in the near term, which cannot be assured.Failure to generate sufficient system sales to meet the Company’s cash flowneeds can be expected to have a material adverse effect on the Company’sbusiness, results of operations, and financial condition.  The Company’sfinancial position can be a factor in attracting new customers.  In aneffort to strengthen the Company’s financial condition and provide capital forexpanding marketing and sales capabilities, the Company will continue toexplore additional equity or debt financing from third parties.  There canbe no assurance that additional financing will be available or that the termsof such financing will be acceptable to the Company.  The Company believesthat its current cash and receivables, as well as additional cash that may begenerated from operations, will be sufficient to meet its short-term needs forworking capital. However, the Company may not be able to obtain sufficientorders to enable the Company to continue on a cash flow break-even level, whichwould be necessary to continue operations in the absence of further financing.

 

**CONTRACTUAL OBLIGATIONS AND COMMERCIALCOMMITMENTS**

 

The following summarizes our contractual obligations and othercommitments at June 30, 2004, and the effect such obligations could haveon our liquidity and cash flow in future periods:

 
| ** **                            | ** ** | **Amount of Commitment Expiring by Period** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **Less  Than  1 Year**                      | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **Over 5  Years** | ** ** | **Total** | ** ** |
| Notes and Accounts Payable to Spescom |       | $                                           | 554,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 554,000 |   |
| Capital Lease Obligations             |       | 21,000                                      |       | 48,000 |   | — |   | — |   | 69,000 |   |
| Operating Lease Obligations           |       | 237,000                                     |       | 749,000 |   | 371,000 |   | — |   | 1,357,000 |   |
| Total                                 |       | $                                           | 812,000    |   | $ | 797,000 |   | $ | 371,000 |   | $ | — |   | $ | 1,980,000 |   |

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

At June 30, 2004 and September 30, 2003, we did not have anyother relationships with unconsolidated entities or financial partnerships,including entities often referred to as structured finance or special purposeentities that would have been established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limited purposes. Therefore, we are not materially exposed to any financing, liquidity,market or credit risk that could arise if we were engaged in suchrelationships.

 

19

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**CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS**

 

*Foreign Currency*

 

The Company’s geographic markets are primarily in the United States andEurope, with some sales in other parts of the world. For the nine months endedJune 30, 2004, revenues from the United States were 48% of total revenues,and revenues from Europe and other locations were 52% of total revenues. This compares to 56% and 44% respectively for the same period a year ago.Revenues from our United Kingdom subsidiary can fluctuate from quarter toquarter based on the timing of customer orders.  The increased revenue inthe current quarter was improved by a foreign currency gain of $309,000 due toa weakened dollar value compared to the pound sterling.  Changes inforeign currency rates, the condition of local economies, and the general volatilityof software markets may result in a higher or lower proportion of foreignrevenues in the future. Although the Company’s operating and pricing strategiestake into account changes in exchange rates over time, future fluctuations inthe value of foreign currencies may have a material adverse effect on theCompany’s business, operating results and financial condition.

 

*Inflation*

 

The Company believes that inflation has not had a material effect onits operations to date. Although the Company enters into fixed-price contracts,management does not believe that inflation will have an adverse material impacton its operations for the foreseeable future, as the Company takes into accountexpected inflation in its contract proposals and is generally able to projectits costs based on forecasted contract requirements.

 

20

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**ITEM 3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

**Interest Rate Risk**

 

The Company’s exposure to market rate risk for changes in interestrates relates primarily to the Company’s investment portfolio. As ofJune 30, 2004 the Company had investments in money market accountstotaling $1 million.  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. The following table summarizes our securitiesand weighted average yields, as of June 30, 2004:

 
| ** **              | ** ** | **Expected Maturity Date** | ** ** |
|-------------------------|------------|----------------------------|------------|
| ** **              | ** ** | **2004**                   | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **Total** | ** ** |
| Certificates of Deposit |       | $                          | 642,000    |   | $ | — |   | $ | — |   | — |   | $ | 642,000 |   |
| Weighted Average Yield  |       | 2.63                       | %          |   |   |   |   |   |   |   |   |
| Money Market            |       | 376,000                    |       | — |   | — |   | — |   | 376,000 |   |
| Weighted Average Yield  |       | 0.50                       | %          |   |   |   |   |   |   |   |   |
| Total                   |       | $                          | 1,018,000  |   | $ | — |   | $ | — |   | — |   | $ | 1,018,000 |   |

 

**ITEM4. CONTROLS AND PROCEDURES**

 

The Company carried out an evaluation, under the supervision and withthe participation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedurespursuant to Exchange Act Rule 13a-15. Based upon that evaluation, we haveconcluded that, as of June 30, 2004, the Company’s disclosure controls andprocedures are effective in recording, processing, summarizing and reportingwithin the time periods specified in the SEC’s rules and forms materialinformation relating to the Company (including its consolidated subsidiaries)required to be included in the Company’s periodic SEC filings.

 

During the last fiscal quarter, there were no significant changes inthe Company’s internal control over financial reporting or in other factors thatmaterially affected, or are reasonably likely to materially affect, theCompany’s internal controls over financial reporting.

 

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**PARTII.   OTHER INFORMATION**

 

**ITEM1 – LEGAL PROCEEDINGS**

 

The Company is involved from time to time in litigation arising in thenormal course of business. Management believes that any liability with respectto such routine litigation, individually or in the aggregate, is not likely tobe material to the Company’s consolidated financial position or results ofoperations.

 

**ITEM4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None.

 

**ITEM6 – EXHIBITS AND REPORTS ON FORM 8-K:**

 
| (a)      | Exhibits                                                                                                                                                                                                             |
|----------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |                                                                                                                                                                                                                 |
| 3.1*     | Registrant’s Articles of Incorporation, as amended.                                                                                                                                                             |
|     |                                                                                                                                                                                                                 |
| 3.2*     | Registrant’s Bylaws, as amended.                                                                                                                                                                                |
|     |                                                                                                                                                                                                                 |
| 10.1 (1) | Lease between The Irvine Company and Spescom Software Inc., dated  February 25, 2001.                                                                                                                           |
|     |                                                                                                                                                                                                                 |
| 10.2 (2) | 10.0% promissory note due October 15, 2003 in principal amount  of $1,235,076 issued by Spescom Software Inc. to Spescom Ltd. South Africa on  February 15, 2002.                                          |
|     |                                                                                                                                                                                                                 |
| 10.3 (3) | 10.0% promissory note due October 15, 2003 in principal amount  of $1,810,383 issued by Spescom Software Inc. to Spescom Ltd., a United  Kingdom corporation, on February 15, 2002.                        |
|     |                                                                                                                                                                                                                 |
| 10.4 (4) | Security agreement between Spescom Software Inc. and Spescom Limited,  a United Kingdom corporation and Spescom Limited, a South African corporation  and collectively with Spescom UK dated February 15, 2002. |
|     |                                                                                                                                                                                                                 |
| 10.5 (5) | 10% promissory note due upon demand in principal amount of $400,000  issued by Spescom Software Inc. to Spescom Ltd., a United Kingdom  corporation, on March 15, 2002.                                         |
|     |                                                                                                                                                                                                                 |
| 10.6 (6) | Security agreement dated March 15, 2002 between Spescom Software  Inc., a California corporation and Spescom Ltd., a United Kingdom corporation.                                                                |
|     |                                                                                                                                                                                                                 |
| 10.7 (7) | Pledge agreement executed March 15, 2002 by and between Spescom  Software Inc., a California corporation, Spescom Ltd., a United Kingdom  corporation, and Solomon Ward Seidenwurm & Smith, LLP.            |
|     |                                                                                                                                                                                                                 |
| 10.8 (8) | 10.0% promissory note due upon demand in principal amount of $500,000  issued by Spescom Software Inc. to Spescom Ltd., a United Kingdom  corporation, on April 19, 2002.                                       |

 

22

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| 10.9 (9)   | 10.0% promissory note due upon demand in principal amount of $700,000  issued by Spescom Software Inc. to Spescom Ltd., a United Kingdom  corporation, on May 31, 2002.                                                                                                                                                                         |
|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                                                                                                                                                                 |
| 10.10 (10) | 5.0% promissory note due in two payments of $300,000 in principal and  accrued interest on January 31, 2004 and March 31, 2004,  respectively issued by Spescom Software Inc. to Spescom Ltd., a United  Kingdom corporation, on November 18, 2003.                                                                                   |
|       |                                                                                                                                                                                                                                                                                                                                                 |
| 31.1       | Section 302 Certification by Carl Mostert, Chief Executive  Officer.                                                                                                                                                                                                                                                                            |
|       |                                                                                                                                                                                                                                                                                                                                                 |
| 31.2       | Section 302 Certification by John W. Low, Chief Financial  Officer.                                                                                                                                                                                                                                                                             |
|       |                                                                                                                                                                                                                                                                                                                                                 |
| 32.1       | Certification pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                   |
|       |                                                                                                                                                                                                                                                                                                                                                 |
| 32.2       | Certification pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                   |
|       |                                                                                                                                                                                                                                                                                                                                                 |
| (b)        | Reports on Form 8-K.                                                                                                                                                                                                                                                                                                                                 |
|       |                                                                                                                                                                                                                                                                                                                                                 |
|       | We furnished the SEC a report on Form 8-K dated February 2, 2004  that announced the approval from the Company’s shareholders an amendment to  the Articles of Incorporation to change the name from Altris Software Inc. to  Spescom Software Inc.                                                                                        |
|       |                                                                                                                                                                                                                                                                                                                                                 |
|       | We furnished to the SEC two reports on Form 8-K dated April 21,  2004. The first 8-K announced the dismissal of Grant Thornton, LLP as the  principal independent accountants of the Company. In addition, the Company  announced the appointment of Singer, Lewak, Greenbaum and Goldstein, LLP as  the new principal independent accountants. |
|       |                                                                                                                                                                                                                                                                                                                                                 |
|       | The second April 21, 2004 8-K announced the appointment of  Michael Silverman to the Board of Directors of the Company.                                                                                                                                                                                                                         |
|       |                                                                                                                                                                                                                                                                                                                                                 |
|       | We furnished the SEC a report on Form 8-K dated April 26, 2004  that announced preliminary results for the Company’s second fiscal quarter  ended March 31, 2004. Revenues were approximately $1.6 million with an  estimated loss of approximately $573,000 or $0.02 per share.                                                      |

 

----

| (1)  | Incorporated by reference to Exhibit 10.27 to the Form 10-K filed on  November 23, 2001.             |
|------|-----------------------------------------------------------------------------------------------------------|
| (2)  | Incorporated by reference to Exhibit 10.28 to the Form 10-Q filed on  May 15, 2002.                  |
| (3)  | Incorporated by reference to Exhibit 10.29 to the Form 10-Q filed on  May 15, 2002.                  |
| (4)  | Incorporated by reference to Exhibit 10.30 to the Form 10-Q filed on  May 15, 2002.                  |
| (5)  | Incorporated by reference to Exhibit 10.31 to the Form 10-Q filed on  May 15, 2002.                  |
| (6)  | Incorporated by reference to Exhibit 10.32 to the Form 10-Q filed on  May 15, 2002.                  |
| (7)  | Incorporated by reference to Exhibit 10.33 to the Form 10-Q filed on  May 15, 2002.                  |
| (8)  | Incorporated by reference to Exhibit 10.34 to the Form 10-Q filed on  August 14, 2002.               |
| (9)  | Incorporated by reference to Exhibit 10.35 to the Form 10-Q filed on  August 14, 2002.               |
| (10) | Incorporated by reference to Exhibit 10.10 to the Form 10-Q filed on  February 13, 2004.             |
| *    | Incorporated herein by this reference from previous filings with the  Securities and Exchange Commission. |

 

23

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

SPESCOM SOFTWARE INC.

 
| **Signature**    | ** ** | **Title** | ** **                                                                          | **Date** |
|------------------|------------|-----------|-------------------------------------------------------------------------------------|----------|
|             |       |      |                                                                                |     |
| /s/ Carl Mostert |       |      | Director and Chief Executive Officer (Principal Executive Officer)                  |     | August 12, 2004 |
| Carl Mostert     |       |      |                                                                                |     |
|             |       |      |                                                                                |     |
| /s/ John W. Low  |       |      | Chief Financial Officer and Secretary (Principal Financial and  Accounting Officer) |     | August 12, 2004 |
| John W. Low      |       |      |                                                                                |     |

 

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