**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**
| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | **QUARTERLY  REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934**       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| **For  the Quarterly Period Ended June 30, 2005.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| **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 ofregistrant as specified in its charter)

 
| **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 markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

 

YES    ý         NO    o

 

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

 

YES    o         NO    ý

 

Number of shares ofCommon Stock outstanding at August 15, 2005: 36,776,028

 

Number of SequentiallyNumbered Pages: 27

 

 

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**SPESCOMSOFTWARE 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 6.  Exhibits and Reports on Form 8-K                                                       |                                                      |

 

2

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**PART I.  FINANCIALINFORMATION**

 

**ITEM1.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

**SPESCOM SOFTWARE INC.**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                        | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2005**          | ** ** | **2004**               | ** ** |
| ** **                                                                                                                                        | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                        |       |              |       |                   |       |
| Current  assets:                                                                                                                                  |       |              |       |                   |       |
| Cash  and cash equivalents                                                                                                                        |       | $                 | 310,000    |                   | $          | 109,000 |   |
| Receivables,  net                                                                                                                                 |       | 769,000           |       | 954,000                |       |
| Other  current assets                                                                                                                             |       | 132,000           |       | 209,000                |       |
| Total  current assets                                                                                                                             |       | 1,211,000         |       | 1,272,000              |       |
|                                                                                                                                              |       |              |       |                   |       |
| Property  and equipment, net                                                                                                                      |       | 148,000           |       | 116,000                |       |
| Computer  software, net                                                                                                                           |       | 423,000           |       | 15,000                 |       |
| Other  assets                                                                                                                                     |       | 30,000            |       | 27,000                 |       |
| Total  assets                                                                                                                                     |       | $                 | 1,812,000  |                   | $          | 1,430,000 |   |
|                                                                                                                                              |       |              |       |                   |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                    |       |              |       |                   |       |
|                                                                                                                                              |       |              |       |                   |       |
| Current  liabilities:                                                                                                                             |       |              |       |                   |       |
| Accounts  payable                                                                                                                                 |       | $                 | 333,000    |                   | $          | 440,000 |   |
| Payable  to Spescom Ltd.                                                                                                                          |       | 99,000            |       | 90,000                 |       |
| Preferred  stock dividend payable to Spescom Ltd.                                                                                                 |       | 492,000           |       | 271,000                |       |
| Accrued  liabilities                                                                                                                              |       | 1,271,000         |       | 1,226,000              |       |
| Note  and accrued interest payable to Spescom Ltd.                                                                                                |       | 610,000           |       | —                 |       |
| Lease  obligations - current portion                                                                                                              |       | 37,000            |       | 19,000                 |       |
| Deferred  revenue                                                                                                                                 |       | 2,415,000         |       | 1,919,000              |       |
| Total  current liabilities                                                                                                                        |       | 5,257,000         |       | 3,965,000              |       |
|                                                                                                                                              |       |              |       |                   |       |
| Notes  payable and accrued interest payable to Spescom Ltd.                                                                                       |       | —            |       | 557,000                |       |
| Lease  obligations                                                                                                                                |       | 65,000            |       | 44,000                 |       |
| Total  liabilities                                                                                                                                |       | 5,322,000         |       | 4,566,000              |       |
|                                                                                                                                              |       |              |       |                   |       |
| Shareholders’  deficit:                                                                                                                      |       |              |       |                   |       |
| Series F  - Convertible preferred stock, $1,000 stated value, 5,291 shares authorized;  5,291 shares issued and outstanding in 2005 and 2004 |       | 6,790,000         |       | 6,790,000              |       |
| Series G  - Convertible preferred stock, $1,000 stated value, 2,420 shares authorized; 1,900  shares issued and outstanding in 2005          |       | 1,900,000         |       | —                 |       |
| Common  stock, no par value, 100,000,000 shares authorized; 35,276,028 and 34,143,278  issued and outstanding in 2005 and 2004                    |       | 75,548,000        |       | 74,726,000             |       |
| Common  stock warrants                                                                                                                            |       | 1,360,000         |       | 278,000                |       |
| Accumulated  other comprehensive loss                                                                                                             |       | (385,000          | )          | (387,000               | )          |
| Accumulated  deficit                                                                                                                              |       | (88,723,000       | )          | (84,543,000            | )          |
| Total  shareholders’ deficit                                                                                                                 |       | (3,510,000        | )          | (3,136,000             | )          |
|                                                                                                                                              |       |              |       |                   |       |
| Total  liabilities and shareholders’ deficit                                                                                                 |       | $                 | 1,812,000  |                   | $          | 1,430,000 |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

3

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**SPESCOM SOFTWARE INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                   | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                   | ** ** | **ended June 30,**  | ** ** | **ended June 30,** | ** ** |
| ** **                                                   | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                    |       |                     |       |                    |       |   |   |   |   |
| Licenses                                                     |       | $                        | 149,000    |                    | $          | 1,559,000 |   | $ | 503,000 |   | $ | 3,037,000 |   |
| Services  and other                                          |       | 1,148,000                |       | 1,341,000               |       | 4,120,000 |   | 3,589,000 |   |
| Total  revenues                                              |       | 1,297,000                |       | 2,900,000               |       | 4,623,000 |   | 6,626,000 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Cost  of revenues:                                           |       |                     |       |                    |       |   |   |   |   |
| Licenses                                                     |       | 62,000                   |       | 37,000                  |       | 170,000 |   | 178,000 |   |
| Services  and other                                          |       | 515,000                  |       | 586,000                 |       | 1,749,000 |   | 1,693,000 |   |
| Total  cost of revenues                                      |       | 577,000                  |       | 623,000                 |       | 1,919,000 |   | 1,871,000 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Gross  profit                                                |       | 720,000                  |       | 2,277,000               |       | 2,704,000 |   | 4,755,000 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Operating  expenses:                                         |       |                     |       |                    |       |   |   |   |   |
| Research  and development                                    |       | 164,000                  |       | 341,000                 |       | 684,000 |   | 1,008,000 |   |
| Marketing  and sales                                         |       | 945,000                  |       | 871,000                 |       | 2,683,000 |   | 2,201,000 |   |
| General  and administrative                                  |       | 441,000                  |       | 585,000                 |       | 1,213,000 |   | 1,574,000 |   |
|                                                         |       | 1,550,000                |       | 1,797,000               |       | 4,580,000 |   | 4,783,000 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Income  (loss) from operations                               |       | (830,000                 | )          | 480,000                 |       | (1,876,000 | ) | (28,000 | ) |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Interest  and other income                                   |       | —                   |       | —                  |       | 1,000 |   | 5,000 |   |
| Interest  and other expense                                  |       | (38,000                  | )          | (37,000                 | )          | (105,000 | ) | (96,000 | ) |
| Net  income (loss)                                           |       | (868,000                 | )          | 443,000                 |       | (1,980,000 | ) | (119,000 | ) |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Deemed  preferred dividend                                   |       | —                   |       | —                  |       | (2,200,000 | ) | — |   |
| Net  income (loss) available after deemed preferred dividend |       | (868,000                 | )          | 443,000                 |       | (4,180,000 | ) | (119,000 | ) |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Cumulative  preferred dividends                              |       | (66,000                  | )          | (66,000                 | )          | (235,000 | ) | (198,000 | ) |
| Net  income (loss) available to common shareholders          |       | $                        | (934,000   | )                       | $          | 377,000 |   | $ | (4,415,000 | ) | $ | (317,000 | ) |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Earnings  per share:                                         |       |                     |       |                    |       |   |   |   |   |
| Basic  net loss per common share                             |       | $                        | (0.03      | )                       | $          | 0.01 |   | $ | (0.13 | ) | $ | (0.01 | ) |
| Diluted  net loss per common share                           |       | $                        | (0.03      | )                       | $          | 0.01 |   | $ | (0.13 | ) | $ | (0.01 | ) |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Weighted  shares outstanding:                                |       |                     |       |                    |       |   |   |   |   |
| Basic                                                        |       | 35,021,956               |       | 34,068,000              |       | 34,465,144 |   | 33,992,000 |   |
| Diluted                                                      |       | 35,021,956               |       | 35,452,000              |       | 34,465,144 |   | 33,992,000 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| **Statement of Comprehensive Income**                        |       |                     |       |                    |       |   |   |   |   |
| Net  loss                                                    |       | $                        | (868,000   | )                       | $          | 443,000 |   | $ | (1,980,000 | ) | $ | (119,000 | ) |
| Other  comprehensive income:                                 |       |                     |       |                    |       |   |   |   |   |
| Foreign  currency translation adjustment                     |       | 46,000                   |       | 80,000                  |       | 2,000 |   | (119,000 | ) |
| Comprehensive  income (loss)                                 |       | $                        | (822,000   | )                       | $          | 523,000 |   | $ | (1,978,000 | ) | $ | (238,000 | ) |

 

The accompanying notes are an integralpart 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,**             | ** ** |
| ** **                                                                   | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| Cash  flows from operating activities:                                       |       |                          |       |   |   |
| Net  loss                                                                    |       | $                             | (1,980,000 | ) | $ | (119,000 | ) |
|                                                                         |       |                          |       |   |   |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                          |       |   |   |
| Depreciation  and amortization                                               |       | 61,000                        |       | 154,000 |   |
| Unpaid  interest on notes payable                                            |       | 109,000                       |       | 22,000 |   |
| Warrants  issued for services                                                |       | 30,000                        |       | — |   |
| Gain  on derivative revaluation                                              |       | —                        |       | (6,000 | ) |
| Stock  options issued to consultant                                          |       | —                        |       | 46,000 |   |
| Changes  in assets and liabilities:                                          |       |                          |       | — |   |
| Receivables,  net                                                            |       | 187,000                       |       | 95,000 |   |
| Other  assets                                                                |       | 108,000                       |       | 2,000 |   |
| Accounts  payable                                                            |       | (108,000                      | )          | 48,000 |   |
| Accrued  liabilities                                                         |       | (17,000                       | )          | 343,000 |   |
| Deferred  revenue                                                            |       | 495,000                       |       | 145,000 |   |
| Net  cash used in operating activities                                       |       | (1,115,000                    | )          | 730,000 |   |
| Cash  flows from investing activities:                                       |       |                          |       |   |   |
| Purchases  of property and equipment                                         |       | (15,000                       | )          | (5,000 | ) |
| Capitalization  of software development costs                                |       | (389,000                      | )          | — |   |
| Purchases  of software                                                       |       | (38,000                       | )          | (10,000 | ) |
| Net  cash (used in) provided by investing activities                         |       | (442,000                      | )          | (15,000 | ) |
|                                                                         |       |                          |       |   |   |
| Cash  flows from financing activities:                                       |       |                          |       |   |   |
| Proceeds  from exercise of stock options                                     |       | 6,000                         |       | 13,000 |   |
| Proceeds  from exercise of warrants                                          |       | 17,000                        |       | — |   |
| Proceeds  from shareholder loan                                              |       | —                        |       | 600,000 |   |
| Repayment  of shareholder loan                                               |       | —                        |       | (600,000 | ) |
| Net  proceeds from private placement                                         |       | 1,750,000                     |       | — |   |
| Payments  on capital lease obligations                                       |       | (21,000                       | )          | (16,000 | ) |
| Net  cash provided by financing activities                                   |       | 1,752,000                     |       | (3,000 | ) |
|                                                                         |       |                          |       |   |   |
| Effect  of exchange rate changes on cash                                     |       | 6,000                         |       | (12,000 | ) |
|                                                                         |       |                          |       |   |   |
| Net  decrease in cash and cash equivalents                                   |       | 201,000                       |       | 700,000 |   |
| Cash  and cash equivalents at beginning of period                            |       | 109,000                       |       | 333,000 |   |
|                                                                         |       |                          |       |   |   |
| Cash  and cash equivalents at end of period                                  |       | $                             | 310,000    |   | $ | 1,033,000 |   |

 

----

* See Note 2 forsupplemental cash flow information.

 

The accompanying condensednotes are an integral part of these consolidated financial statements.

 

5

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**SPESCOMSOFTWARE INC.**

**CONDENSEDNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1 -Basis of Presentation**

 

The accompanyingconsolidated financial statements as of June 30, 2005 and for the threeand nine months ended June 30, 2005 and 2004 are unaudited. Theconsolidated financial statements and related notes have been prepared inaccordance with generally accepted accounting principles applicable to interimperiods.  In the opinion of management, the consolidated financialstatements reflect all adjustments, consisting only of normal recurringadjustments, necessary for a fair presentation of the consolidated financialposition, operating results and cash flows for the periods presented.

 

The information containedin the following Condensed Notes to the Consolidated Financial Statements iscondensed from that which would appear in the annual consolidated financial statements;accordingly, the consolidated financial statements included herein should bereviewed in conjunction with the consolidated financial statements and relatednotes thereto contained in Spescom Software Inc.’s (the “Company”) AnnualReport on Form 10-K/A for the year ended September 30, 2004.  Itshould be understood that the accounting measurements at an interim dateinherently involve greater reliance on estimates than at year-end.  Theresults of operations for the interim periods presented are not necessarilyindicative of the results expected for the entire year.

 

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

 

*Principlesof Consolidation*

 

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

 

*ForeignCurrency*

 

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

 

*Use ofEstimates*

 

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

 

6

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*RevenueRecognition*

 

The Company’s revenuesare derived from sales of its document and configuration management systemsthat are primarily composed of software and services, including maintenance,training and consulting services, and third party software and hardware. TheCompany recognizes revenue in accordance with Statement of Position (“SOP”) 97-2“Software Revenue Recognition” and SOP 98-9, “Modification of SOP 97-2,Software Revenue Recognition with Respect to Certain Transactions” and StaffAccounting Bulletin (“SAB”) No. 101, updated by SAB’s 103 and 104 “Updateof Codification of Staff Accounting Bulletins.”

 

Software license andthird party product revenues are recognized upon shipment of the product if nosignificant vendor obligations remain and collection is probable. In caseswhere a significant vendor obligation exists, revenue recognition is delayeduntil such obligation has been satisfied. For new software products where ahistorical record has not yet been demonstrated that acceptance is perfunctory,the Company defers recognition of revenue until acceptance has occurred.  If an undelivered element of the arrangementexists under the license arrangement, a portion of revenue is deferred based onvendor-specific objective evidence (VSOE) of the fair value of the undeliveredelement until delivery occurs.  If VSOE does not exist for all undeliveredelements, all revenue is deferred until sufficient evidence exists or allelements have been delivered.  Annual maintenance revenues, which consistof ongoing support and product updates, are recognized on a straight-line basisover the term of the contract. Payments received in advance of performance ofthe related service for maintenance contracts are recorded as deferred revenue.Revenues from training and consulting services are recognized when the servicesare performed and adequate evidence of providing such services is available.Contract revenues for long-term contracts or programs requiring specializedsystems are recognized using the percentage-of-completion method of accounting,primarily based on contract labor hours incurred to date compared with totalestimated labor hours at completion. Provisions for anticipated contract lossesare recognized at the time they become known.

 

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

 

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

 

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

**•****                                         **Availabilityof products to be delivered

**•****                                         **Timeperiod over which services are to be performed

**•****                                         **Creditworthinessof the customer

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

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

**•****                                         **Discountsgiven for each element of a contract

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

 

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

 

*FairValue of Financial Instruments*

 

Statement of FinancialAccounting Standards (“SFAS”) No. 107, “Disclosures About Fair Value ofFinancial Instruments”, requires management to disclose the estimated fairvalue of certain assets and liabilities defined by SFAS No. 107 as cash ora contractual obligation that both conveys to one entity a right to receivecash or other financial instruments from another entity, and imposes on theother entity the obligation to deliver cash or other financial instruments tothe first entity. At June 30, 2005 and September 30, 2004, managementbelieves that the carrying amounts of cash and cash equivalents, short-terminvestments, accounts receivable and accounts payable, and accrued expensesapproximate fair value because of the short maturity of these financialinstruments. The Company believes that the carrying value of its loansapproximate their fair values based on current market rates of interest.

 

7

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*Concentrationof Credit Risk*

 

The Company providesproducts and services to customers in a variety of industries worldwide,including local governments, petrochemicals, utilities, manufacturing andtransportation. Concentration of credit risk with respect to trade receivablesis limited due to the geographic and industry dispersion of the Company’scustomer base. The Company has not experienced significant credit losses on itscustomer accounts. Ameren UE and CSC International Systems Ltd accounted for20% and 17%, respectively, of trade accounts receivable at June 30, 2005and Network Rail and Constellation Energy Group accounted for 23% and 15%,respectively, of trade accounts receivable at September 30, 2004.

 

A small number ofcustomers have typically accounted for a large percentage of the Company’sannual revenues. Network Rail and CSC International Systems Ltd accounted for18% and 10%, respectively, of revenue for the nine months ended June 30,2005, while Network Rail and Constellation Energy Group accounted for 27% and17%, respectively of revenue for the nine months ended June 30,2004.  The Company’s reliance on relatively few customers could have amaterial adverse effect on the results of its operations on a quarterly basis.

 

*Propertyand Equipment*

 

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

 

*SoftwareDevelopment Costs and Purchased Software*

 

Software developmentcosts and purchased software are capitalized under FAS 86, “Accounting for theCosts of Computer Software to Be Sold, Leased or Otherwise Marketed,” whentechnological feasibility and marketability of the related product have beenestablished. Software development costs incurred solely in connection with aspecific contract are charged to cost of revenues. Capitalized software costsare amortized on a product-by-product basis, beginning when the product isavailable for general release to customers. Annual amortization expense iscalculated using the greater of the ratio of each product’s current grossrevenues to the total of current and expected gross revenues or thestraight-line method over the estimated useful life of three to five years. Theunamortized value of capitalized software costs was $423,000 and $15,000 at June 30,2005 and September 30, 2004, respectively. The related amortization expense was $19,000 and $51,000 for the ninemonths ended June 30, 2005 and 2004, respectively.

 

*Long-livedAssets*

 

The Company assessespotential impairments to its long-lived assets when there is evidence thatevents or changes in circumstances have made recovery of the asset’s carryingvalue unlikely. An impairment loss would be recognized when the sum of the expectedfuture net cash flows is less than the carrying amount of the asset.  TheCompany concluded for the nine months ended June 30, 2005, that there wereno events or changes in circumstances that would indicate that the carryingamounts of long-lived assets were impaired.

 

*Stock-BasedCompensation*

 

The Company measurescompensation expense for its stock-based employee compensation plans using theintrinsic value method and provides pro forma disclosures of net loss and basicand diluted net loss per share as if the fair value-based method had beenapplied in measuring compensation expense. The Company applies SFAS No.123,*Accounting for Stock-Based Compensation*and Accounting Principles Board Opinion No. 25 and related Interpretationsin accounting for its employee stock-based compensation plan.

 

8

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No compensation cost wasrecognized for employee stock option grants during 2005 and 2004 based upon theintrinsic value method, which were fixed in nature, as the options were grantedat exercise prices equal to fair market value on the date of grant. Hadcompensation cost for the Company’s employee stock-based compensation plan beendetermined based on the fair value at the grant dates the disclosure requirementsof SFAS No. 148, which amends the disclosure requirements of FAS 123,would have been as follows:

 
| ** **                                                                        | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                                        | ** ** | **ended June 30,**  | ** ** | **ended June 30,** | ** ** |
| ** **                                                                        | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  Income (loss) attributable to common stock                                   |       | $                        | (934,000   | )                       | $          | 377,000 |   | $ | (4,415,000 | ) | $ | (317,000 | ) |
| As  reported                                                                      |       |                     |       |                    |       |   |   |   |   |
| Deduct:                                                                           |       |                     |       |                    |       |   |   |   |   |
| Stock-based  employee compensation expense determined under the fair value method |       | (39,000                  | )          | (112,000                | )          | (154,000 | ) | (259,000 | ) |
| Pro  forma                                                                        |       | $                        | (973,000   | )                       | $          | 265,000 |   | $ | (4,569,000 | ) | $ | (576,000 | ) |
|                                                                              |       |                     |       |                    |       |   |   |   |   |
| Basic  and diluted net loss per share                                             |       |                     |       |                    |       |   |   |   |   |
| As  reported                                                                      |       | $                        | (0.03      | )                       | $          | 0.01 |   | $ | (0.13 | ) | $ | (0.01 | ) |
| Pro  forma                                                                        |       | $                        | (0.03      | )                       | $          | 0.01 |   | $ | (0.13 | ) | $ | (0.02 | ) |

 

Under FAS 123, the fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted averageassumptions used for grants:

 
| ** **               | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|--------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **ended June 30,**  | ** ** | **ended June 30,** | ** ** |
| ** **               | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dividend  Yield          |       | 0                        | %          | 0                       | %          | 0 | % | 0 | % |
| Expected  Volatility     |       | 253                      | %          | 253                     | %          | 253 | % | 261 | % |
| Risk  free interest rate |       | 4.00                     |       | 4.73                    |       | 4.00 |   | 3.83 |   |
| Expected  lives (years)  |       | 10                       |       | 10                      |       | 10 |   | 10 |   |

 

*IncomeTaxes*

 

Current income taxexpense is the amount of income taxes expected to be payable for the currentyear. A deferred income tax asset or liability is established for the expectedfuture consequences resulting from the differences in the financial reportingand tax bases of assets and liabilities. Deferred income tax expense (benefit)is the change during the year in the deferred income tax asset or liability.Valuation allowances are established when necessary to reduce deferred taxassets to the amount expected to be “more likely than not” realized in thefuture based on the Company’s current and expected operating results.

 

*NetIncome (Loss) per Common Share*

 

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

 

9

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*Statementsof Cash Flows*

 

The following tableprovides supplemental cash flow information:

 
| ** **                                                                               | ** ** | **For the nine months** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                               | ** ** | **ended June 30,** | ** ** |
| ** **                                                                               | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Supplemental  cash flow information:                                                     |       |                    |       |   |   |
| Interest  paid                                                                           |       | $                       | 8,000      |   | $ | 9,000 |   |
|                                                                                     |       |                    |       |   |   |
| Non-cash  financing and investing activities:                                            |       |                    |       |   |   |
| Deemed  dividend on private placement                                                    |       | $                       | 2,200,000  |   | $ | — |   |
| Expiration  of warrants                                                                  |       | $                       | 133,000    |   | $ | — |   |
| Accrued  preferred stock dividends                                                       |       | $                       | 198,000    |   | $ | 198,000 |   |
| Fair  value of equity instruments redeemable for common stock converted to common  stock |       | $                       | —     |   | $ | 1,159,000 |   |
| Acquisition  of equipment under capital lease                                            |       | $                       | 60,000     |   | $ | — |   |

 

**Note 3 –Related Party Transactions**

 

As of June 30, 2005and September 30, 2004 there were 5,291 shares of Series FConvertible Preferred Stock with a stated value of $1,000 per share held bySpescom Ltd., the majority shareholder of the Company.  The Series F Convertible Preferred Stockis convertible into common stock, at the stated conversion price of $0.45 pershare subject to certain adjustments. The conversion is at the option of Spescom Ltd through September 30,2008.  The outstanding Series FConvertible Preferred Stock is entitled to receive dividends of 5% of thestated value of $1,000 per share per annum, payable on a quarterly basis incash or common stock (valued on the basis of average per share market value onthe 30 trading days immediately prior to the date on which such dividend isdeclared by the Board of Directors). Unpaid dividends accrue interest at the rate of 8% per annum.  As of June 30, 2005, unpaid dividendsand accrued interest amounted to $463,000 and $29,000, respectively as comparedto $198,000 and $4,000, respectively as of June 30, 2004.

 

On November 18, 2003the Company issued a note payable to Spescom UK, a wholly-owned subsidiary ofSpescom Ltd., with a principal balance of $600,000 bearing an interest rate of5% per annum.  The note was repaid duringfiscal 2004.  Interest expense on thenote for fiscal 2004 was $9,000.

 

The Company has twoexisting demand notes payable to Spescom UK for $400,000 and $100,000, eachbearing an interest rate of 10% per annum.  As of June 30, 2005 and September 30,2004, the balance on the notes including interest was $610,000 and $557,000,respectively.  Spescom Ltd. has agreedthat it will not cause Spescom UK to demand repayment under the two notes priorto October 1, 2005.  Interest expense on the notes was $15,000 and$42,000 for the three and nine months ended June 30, 2005, respectivelycompared to $13,000 and $38,000 for the same periods in 2004,respectively.  These notes are collateralized by a security interest infavor of Spescom UK in respect of all the Company’s assets.

 

Under a royaltyarrangement beginning in fiscal 2004, Spescom Ltd. resells the Company’ssoftware and maintenance services in South Africa.  Royalty revenue recognized under thisagreement for the three and nine months ended June 30, 2005 totaled$19,000 and $40,000, respectively.

 

In December 2004,the Company entered into an agreement with Spescom Ltd. in which the Companyrelocated certain engineering personnel to South Africa to work out of SpescomLtd. facilities.  As part of theagreement Spescom Ltd. bills the Company for wages and an administrative feethat covers office rent and information technology costs on a monthlybasis.  For the nine months ended June 30,2005, total expenses under this arrangement were $64,000.

 

Spescom UK providescertain administrative and accounting functions for the Company’s UnitedKingdom subsidiary.  The Company is billed a monthly fee by Spescom UK forreimbursement of certain costs in the United Kingdom including the officefacilities, all accounting and human resources services, and certain corporatemarketing activities.  For the three and nine months ended June 30,2005 the administrative fees totaled $148,000 and $457,000, respectively,compared to $148,000 and $439,000 for the three and nine months ended June 30,2004.  The office rent for the Company’s United Kingdom operationsincluded in the administrative fee totaled $86,000 and $267,000,respectively for the three and nine months ended June 30, 2005 compared to$86,000 and $257,000, respectively for the three and nine months ended June 30,2004.  At June 30, 2005 and September 30,2004 the Company had a payable to Spescom UK of $99,000 and $90,000,respectively.  In 1999, as part of an agreement to sell the 60% interestin its United Kingdom subsidiary to Spescom Ltd., the lease for the UnitedKingdom 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.

 

10

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Spescom Ltd. and theCompany have entered into a license agreement pursuant to which Spescom Ltd.has licensed to the Company the right to use the name “Spescom” and to use atrademark owned by Spescom Ltd. related to certain computer software. TheCompany will not pay any royalties to Spescom Ltd. in connection with thislicense. The license is for an indefinite term, but is terminable by eitherparty upon 60 days prior written notice. Under the license agreement, SpescomLtd. has agreed to indemnify and hold harmless the Company and its directors,officers, employees and agents against liabilities arising from any claimbrought against the Company that alleges that Spescom Ltd.’s or the Company’suse of the licensed trademark infringes the rights of any third party, providedthat the Company is in material compliance with the provisions of the licenseagreement.

 

**Note 4 –Receivables**

 
| ** **                             | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|----------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                             | ** ** | **2005**          | ** ** | **2004**               | ** ** |
| ** **                             | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| **Receivables consist of:**            |       |              |       |                   |       |
| Receivables                            |       | $                 | 777,000    |                   | $          | 1,037,000 |   |
| Less:  allowance for doubtful accounts |       | (8,000            | )          | (83,000                | )          |
|                                   |       | $                 | 769,000    |                   | $          | 954,000 |   |

 

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

 
| ** **                                            | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                            | ** ** | **ended June 30,**  | ** ** | **ended June 30,** | ** ** |
| ** **                                            | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  income (loss) available for common shareholders  |       | $                        | (934,000   | )                       | $          | 377,000 |   | $ | (4,415,000 | ) | $ | (317,000 | ) |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Weighted  average outstanding shares of common stock  |       | 35,022,000               |       | 34,068,000              |       | 34,465,000 |   | 33,992,000 |   |
| Dilutive  effect of employee stock based compensation |       | —                   |       | 1,384,000               |       | — |   | — |   |
| Common  stock and common stock equivalents            |       | 35,022,000               |       | 35,452,000              |       | 34,465,000 |   | 33,992,000 |   |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Earnings  per share:                                  |       |                     |       |                    |       |   |   |   |   |
| Basic                                                 |       | $                        | (0.03      | )                       | $          | 0.01 |   | $ | (0.13 | ) | $ | (0.01 | ) |
| Diluted                                               |       | $                        | (0.03      | )                       | $          | 0.01 |   | $ | (0.13 | ) | $ | (0.01 | ) |

 

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

 

As of June 30, 2005,a total of 4,030,000 stock options, 3,758,335 common stock warrants, 5,291shares of Series F Convertible Preferred Stock, and 1,900 shares of Series GConvertible Preferred Stock, were excluded from the diluted net income (loss)per share calculation, as their effect would be anti-dilutive.  As of June 30,2004, a total of 3,795,659 stock options, 1,008,335 common stock warrants, and5,291 shares of Series F Convertible Preferred Stock were excluded fromthe diluted net income (loss) per share calculation, as their effect would beanti-dilutive.

 

11

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**Note 6 –Segment and Geographic Information**

 

The Company has onebusiness segment, which consists of the development and sale of a suite ofintegrated document, configuration and records management software products.

 

Revenues for the threeand nine month periods ended June 30, 2005 and 2004 by customer locationwere as follows:

 
| ** **                        | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|-----------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **ended June 30,**  | ** ** | **ended June 30,** | ** ** |
| ** **                        | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  Sales                        |       |                     |       |                    |       |   |   |   |   |
| United  States                    |       | $                        | 714,000    |                    | $          | 753,000 |   | $ | 2,349,000 |   | $ | 3,165,000 |   |
| Europe,  primarily United Kingdom |       | 564,000                  |       | 2,120,000               |       | 2,200,000 |   | 3,326,000 |   |
| Other  international              |       | 19,000                   |       | 27,000                  |       | 74,000 |   | 135,000 |   |
|                              |       | $                        | 1,297,000  |                    | $          | 2,900,000 |   | $ | 4,623,000 |   | $ | 6,626,000 |   |

 
| ** **                                       | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **2005**          | ** ** | **2004**               | ** ** |
| Identifiable  assets from continuing operations: |       |              |       |                   |       |
| United  States                                   |       | $                 | 1,296,000  |                   | $          | 973,000 |   |
| Europe,  United Kingdom                          |       | 516,000           |       | 457,000                |       |
|                                             |       | $                 | 1,812,000  |                   | $          | 1,430,000 |   |

 

**Note 7 –Recent Accounting Pronouncements**

 

In May 2005, theFASB issued Statement of Accounting Standards (SFAS) No. 154, “AccountingChanges and Error Corrections” an amendment to Accounting Principles Bulletin(APB) Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements” though SFAS No. 154carries forward the guidance in APB No. 20 and SFAS No. 3 withrespect to accounting for changes in estimates, changes in reporting entity,and the correction of errors. SFAS No. 154 establishes new standards onaccounting for changes in accounting principles, whereby all such changes mustbe accounted for by retrospective application to the financial statements ofprior periods unless it is impracticable to do so.  SFAS No. 154 iseffective for accounting changes and error corrections made in fiscal yearsbeginning after December 15, 2005, with early adoption permitted forchanges and corrections made in years beginning after May 2005.

 

**Note 8– Equity**

 

**November 2004Private Placement**

 

On November 5, 2004,the Company completed a financing arrangement whereby the Company issued 2,200shares of our Series G Convertible Preferred Stock (“Series G Stock”)along with 2,750,000 common stock warrants for gross proceeds of$2,200,000.  The Series G Stock is convertible into common stock at aprice equal to 85% of the volume weighted average price of the Company’s commonstock during the five trading days immediately preceding the conversion date;however, the conversion price can be no higher than $0.40 per share and nolower than $0.30 per share.  The 2,750,000 warrants have an exercise priceof $0.44 per share and expire November 5, 2007.  The Company incurred$450,000 in expenses related to the transaction and issued 825,000 common stockwarrants to an investment consulting firm.  The 825,000 warrants werecomprised of 550,000 warrants with an exercise price of $0.40 per share whichexpire November 5, 2009 and 275,000 warrants which have an exercise priceof $0.44 which expire on November 5, 2007. In connection with thefinancing, the Company recorded a beneficial conversion of $2,200,000 on the Series GStock as a deemed dividend for the nine months ended June 30, 2005.

 

The Series G Stockis entitled to a liquidation preference equal to $1,000 per share, plusdeclared but unpaid dividends per share.  Commencing on the date ofissuance of the Series G Stock, and continuing until the effective date ofthe registration statement on Form S-2 pursuant to which the Series GStock is registered, the Series G Stock is also entitled to receivedividends of 5% of the stated value of $1,000 per share per annum, payablemonthly in arrears on the last day of each month based on the number of Series GStock outstanding as of the first day of such month.  The dividend for theSeries G Stock is only payable until the registration statement for thecommon stock underlying the Series G Stock is declared effective by theSecurities and Exchange Commission (“SEC”). On March 22, 2005 the SEC declared the registration statementeffective.  Thus the Series G Stockis no longer entitled to dividends.  Forthe nine months ended June 30, 2005, the Company issued 82,050 shares ofcommon stock with a value of $37,000 as a dividend on the Series GStock.  In April 2005, 300 shares ofthe Series G Stock with a value of $300,000 was converted into 928,367shares of the Company’s common stock.

 

12

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**Warrantsfor Services**

 

On November 4, 2004,the Company issued to a public relations firm warrants to purchase 1,000,000shares of its common stock at $0.40 per share, expiring November 3, 2007.The warrants vest and become exercisable as follows: (i) 500,000 warrantsvest on the date that the average of the last sale price of the Company’s stockon the OTC Bulletin Board for the ten trading days immediately preceding suchdate (the “Market Price”) exceeds $0.60 per share, (ii) 250,000 warrantsvest on the date that the Market Price exceeds $0.70 per share, and (iii) theremaining 250,000 warrants vest on the date that the Market Price exceeds $0.80per share.  The fair value of the warrants, which was determined to be$30,000, was recognized ratably over the six months of the service agreement.

 

**Note 9– Subsequent Event**

 

On August 8, 2005,Carl H. Mostert resigned as Chief Executive Officer and Director of theCompany, effective as of August 16, 2005. In accordance with the Company’sagreement with Mr. Mostert requiring 6 months’ notice of termination, theCompany intends to continue to pay Mr. Mostert’s salary for a period ofsix months and to provide him with continued medical and life insurancebenefits during that period.

 

On August 8, 2005,the Company appointed Keith Stentiford as interim Chief Executive Officereffective as of August 16, 2005.  Mr. Stentifordjoined the Company on January 3, 2005 as Vice President Business Development.  Mr. Stentiford joined Spescom afterhaving worked at Siemens AG (“Siemens”) for over 25 years in various seniorbusiness development and sales management positions.  In the past five years prior to joining theCompany, he served as Vice President in the Siemens Transportation and SystemsCompany, responsible for the Americas Turnkey Business Operations.

 

13

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

 

**Forward-LookingStatements**

 

*Thisreport contains forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934.  These forward-lookingstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from historical results or anticipatedresults, including those set forth under “Certain Factors That May AffectFuture Results” below and elsewhere in, or incorporated by reference into, thisreport.*

 

*In somecases, you can identify forward looking statements by terms such as “may,” “intend,”“might,” “will,” “should,” “could,” “would,” “expect,” “believe,” “anticipate,”“estimate,” “predict,” “potential,” or the negative of these terms.  These and similar expressions are intended toidentify forward-looking statements.  Whenused in the following discussion, the words “believes,” “anticipates” andsimilar expressions are intended to identify forward-looking statements.  Such statements are subject to certain risksand uncertainties, which could cause actual results to differ materially fromthose projected.  Readers are cautionednot to place undue reliance on these forward-looking statements, which speakonly as of the date hereof  Theforward-looking statements in this report are based upon management’s currentexpectations and belief, which management believes are reasonable.  Thesestatements represent our estimates and assumptions only as of the date of thisQuarterly Report on Form 10-Q, and we undertakes no obligation to publiclyrelease the result of any revisions to these forward-looking statements, whichmay be made to reflect events or circumstances after the date hereof or toreflect the occurrence of unanticipated events.*

 

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

 

**OVERVIEW**

The Company develops,markets and supports*eB*, itsintegrated suite of collaborative document, configuration and recordsmanagement software solutions.  The*eB* suite enables organizations in a broadrange of industries to create, capture, store, manage, share and distributecritical business information regarding their customers, products, assets andprocesses in an efficient manner.  The*eB* suite also enables them to maintaincomplete, up-to-date information about the configuration of their products,assets and infrastructures so that they can achieve operational excellence andcompliance with regulatory requirements.*  eB* provides the capabilities of anEnterprise Content Management (ECM)/Electronic Document Management (EDM)System, but extends these capabilities by also managing the “things’ that thecontent/documents relate to such as products, assets, functions, processes,requirements, projects, organizations, locations, work orders, etc.  As a result, *eB*can be used to manage the lifecycle of physical items (e.g. products, equipmentor assets), and the requirements (e.g. functional, safety, performance,environmental, etc.) that govern them. It enables intelligent relationships to be defined between these itemsthereby creating an interdependency model. As a result, the effects of any change on requirements, documents and itemscan be determined and change can be managed to effectively ensure informationintegrity.  In particular,*eB* enables organizations with extensiveand complex physical infrastructures to efficiently identify, classify,structure, link, and manage documents, physical items, and requirementsthroughout their lifecycles and ensure that conformance between these ismaintained by means of an automated change process.

 

We develop, market andsupport*eB*.  Our revenues in the three months ended June 30,2005 decreased by 55% from the same period in the prior fiscal year due tolower license and services revenue.  For the nine months ended June 30,2005 our revenues decreased by 30% from the same period in the prior fiscalyear due to the fact that the Company in the prior year had several largelicense sales to a new and existing customers, while there was no similarlylarge sale in the current year.  The Company’s license revenue fluctuatesfrom quarter to quarter as reflected by the decrease in license and servicesales during the quarter.

 

Our revenues are derivedfrom licenses of our software to our customers, services that we provide undermaintenance support contracts and our non-maintenance services, consistingprimarily of design studies, system implementation and training.  Of ourtotal revenues for the three months ended June 30, 2005, license revenuesaccounted for 11%, maintenance services revenues accounted for 56% andnon-maintenance services revenues represented 33%.  For the nine months ended June 30, 2005,license revenues accounted for 11%, maintenance services revenues accounted for50% and non-maintenance services revenues represented 39%.

 

Many of our customers arelocated outside the United States, with foreign-originated revenues accountingfor 45% and 73% of revenues for the three months ended June 30, 2005 and2004, respectively and 49% and 50% of revenues for the nine months ended June 30,2005 and 2004, respectively.  Our revenues for the nine months ended June 30,2005 reflect a foreign currency loss of $119,000 as compared to last year, dueto the declining value of the dollar during the year.

 

The decrease in revenuesduring the three and nine months ended June 30, 2005 resulted in adecrease in our gross profit from 79% to 56% of revenues and 72% to 58% ofrevenues, respectively.  Operating expenses increased during the three andnine months ended June 30, 2005 from 62% to 96% of revenues and 72% to 99%of revenues, respectively.

 

At June 30, 2005,our principal sources of liquidity consisted of $310,000 of cash and cashequivalents, compared to $109,000 at September 30, 2004.  On November 5,2004, we completed a private placement of preferred stock which resulted ingross proceeds of $2,200,000.

 

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**CRITICALACCOUNTING POLICIES**

 

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

 

*RevenueRecognition*

 

The Company enters intocontractual arrangements with end-users that may include licensing of theCompany’s software products, product support and maintenance services,consulting services or various combinations thereof, including the sale of suchproducts or services separately.  The Company recognizes revenue inaccordance with Statement of Position (“SOP”) 97-2 “Software Revenue Recognition”and SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, withRespect to Certain Transactions” and Staff Accounting Bulletin (“SAB”)  No. 101,updated by SAB’s 103 and 104 “Update of Codification of Staff AccountingBulletins.”

 

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

 

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

 

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

 

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

**•**                                          Availabilityof products to be delivered

**•**                                          Time periodover which services are to be performed

**•**                                          Creditworthinessof the customer

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

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

 

*Allowancefor Doubtful Accounts*

 

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

 

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**RESULTSOF OPERATIONS**

 

The following table setsforth the condensed consolidated statement of operations expressed as apercentage of total revenue for the periods indicated:

 
| ** **                  | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|-----------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                  | ** ** | **ended June 30,**  | ** ** | **ended June 30,** | ** ** |
| ** **                  | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                    |       |                     |       |                    |       |   |   |   |   |
| Licenses                    |       | 11                       | %          | 54                      | %          | 11 | % | 46 | % |
| Services  and other         |       | 89                       | %          | 46                      | %          | 89 | % | 54 | % |
| Total  revenues             |       | 100                      | %          | 100                     | %          | 100 | % | 100 | % |
|                        |       |                     |       |                    |       |   |   |   |   |
| Cost  of revenues           |       |                     |       |                    |       |   |   |   |   |
| Licenses                    |       | 5                        | %          | 1                       | %          | 4 | % | 3 | % |
| Services  and other         |       | 40                       | %          | 20                      | %          | 38 | % | 26 | % |
| Total  cost of revenues     |       | 45                       | %          | 21                      | %          | 42 | % | 29 | % |
|                        |       |                     |       |                    |       |   |   |   |   |
| Gross  profit               |       | 55                       | %          | 79                      | %          | 58 | % | 71 | % |
|                        |       |                     |       |                    |       |   |   |   |   |
| Operating  expenses:        |       |                     |       |                    |       |   |   |   |   |
| Research  and development   |       | 13                       | %          | 12                      | %          | 15 | % | 15 | % |
| Marketing  and sales        |       | 73                       | %          | 30                      | %          | 58 | % | 33 | % |
| General  and administrative |       | 34                       | %          | 20                      | %          | 26 | % | 24 | % |
|                        |       | 120                      | %          | 62                      | %          | 99 | % | 72 | % |
|                        |       |                     |       |                    |       |   |   |   |   |
| Loss  from operations       |       | -65                      | %          | 17                      | %          | -41 | % | -1 | % |
|                        |       |                     |       |                    |       |   |   |   |   |
| Interest  and other income  |       | 0                        | %          | 0                       | %          | 0 | % | 1 | % |
| Interest  and other expense |       | -3                       | %          | -2                      | %          | -2 | % | -2 | % |
|                        |       |                     |       |                    |       |   |   |   |   |
| Net  loss                   |       | -68                      | %          | 15                      | %          | -43 | % | -2 | % |

 

**Revenues**

 

*LicenseRevenues*

(in thousands)

 
| ** **                   | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                   | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                   | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| License  Revenue             |       | $                      | 149        |        | $          | 1,559                 |       | -90         | %          | $ | 503 |   | $ | 3,037 |   | -83 | % |
| Percentage  of total revenue |       | 11                     | %          | 54          | %          |                  |       | 11          | %          | 46 | % |   |   |
|                              |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

License revenuesdecreased by $1,410,000, or 90%, to $149,000 from $1,559,000 for the threemonths ended June 30, 2005 compared to the same period a year ago. The Company’s license revenues fluctuate from quarter to quarter which isreflected in the decrease in license sales in the current quarter. License revenue decreased $2,534,000, or 83%, to $503,000 from $3,037,000 forthe nine months end June 30, 2005 as compared to the same period a yearago.  In the prior year two large salesof licenses to Network Rail and Constellation Energy amounted to $1.5 millionand $750,000, respectively, while there were no similar size sales in thecurrent year.  The length of time it takes to establish new customerrelationships typically ranges from 6 to 12 months, and as such the timing ofsales can fluctuate significantly from quarter to quarter.

 

Despite the relativelyweak license revenue in the three and nine months ended June 30, 2005, webelieve that if the Company is successful in capitalizing on its pipeline ofsales opportunities, license revenues will increase.  The Company’slicense revenues can fluctuate from quarter to quarter, based on the timing ofcustomer orders due to the long sales cycle and changes in customers’ internalplans for the rollout of software licenses.

 

16

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Although the Company hashistorically generated the majority of its revenues from its direct salesforce, the Company has also established a network of third-party VARs, systemintegrators and OEMs who build and sell systems (with components or completesystems provided by the Company) that address specific customer needs withinvarious industries, including those targeted directly by the Company. Sales through indirect channels for the three months ended June 30, 2005amounted to $89,000 or 7% of total revenue compared to $71,000 or 3% of totalrevenue for the same period in 2004. Sales through indirect channels for the nine months ended June 30,2005 amounted to $322,000 or 7% of total revenue compared to $371,000 or 6% oftotal revenue for the same period in 2004.

 

A small number ofcustomers have typically accounted for a large percentage of the Company’sannual revenues. Network Rail and CSC International Systems Ltd accounted for18% and 10%, respectively, of revenue for the nine months ended June 30,2005, while Network Rail and Constellation Energy Group accounted for 27% and17%, respectively of revenue for the nine months ended June 30,2004.  The Company’s reliance on relatively few customers could have a materialadverse effect on the results of its operations on a quarterly basis.

 

*Serviceand Other Revenues*

(in thousands)

 
| ** **                   | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                   | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                   | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| Service  Revenue             |       | $                      | 1,148      |        | $          | 1,341                 |       | -14         | %          | $ | 4,120 |   | $ | 3,589 |   | 15 | % |
| Percentage  of total revenue |       | 89                     | %          | 46          | %          |                  |       | 89          | %          | 54 | % |   |   |
|                              |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

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

 

Services and otherrevenue decreased $193,000, or 14%, from $1,341,000 to $1,148,000 for the threemonths ended June 30, 2005 compared to the same period a year ago.  The decrease is primarily due to lowermaintenance service revenue of $143,000, relating to a reduction in customermaintenance requirements of several existing customers.  Also in thisquarter non-maintenance revenue decreased by $50,000, as compared to the sameperiod a year ago, related to delayed expansion of customer systems andupgrades from older legacy systems to newer versions of eB.

 

Services and otherrevenue increased $531,000, or 15%, from $3,589,000 to $4,120,000 for the ninemonths ended June 30, 2005 compared to the same period a year ago.  The increase is primarily due to highernon-maintenance service revenue of $558,000, relating to an increased demandfor consulting services relating to customers expanding the integration of *e*B into additional departments and toupgrading from older legacy systems to the current versions of *e*B. The increase in non-maintenance service revenue was partially offset bya reduction in maintenance revenue of $27,000 as compared to the same period ayear ago, which reflects decreased customer maintenance requirements forcertain existing customers.

 

Fluctuations in licenserevenue can impact service revenues in future periods as customers implementthe software licensed by the Company and require maintenance support.  As such, we anticipate service and otherrevenue will fluctuate primarily with sales to new customers because newcustomers require more services that typically include a business processstudy, integration with other business systems and training.  In addition,service and other revenues will continue to fluctuate from quarter to quarterbased on the timing of customer orders.

 

**Cost ofRevenues**

 

*Cost ofLicense Revenues*

(in thousands)

 
| ** **                     | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|--------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                     | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                     | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| Cost  of License Revenue       |       | $                      | 62         |        | $          | 37                    |       | 68          | %          | $ | 170 |   | $ | 178 |   | -4 | % |
| Percentage  of license revenue |       | 42                     | %          | 2           | %          |                  |       | 34          | %          | 6 | % |   |   |
|                                |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

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

 

Cost of license revenueincreased by $25,000, or 68%, from $37,000 to $62,000 for the three monthsended June 30, 2005 compared to the same period a year ago.  Theincrease is due primarily to $31,000 in higher third-party costs as the Companyexperienced an increase in sales of third-party products during the quarterwhich was partially offset by a decrease of $6,000 in amortization expense ofsoftware costs as a result of a majority of such costs being fully amortized infiscal 2004.  The 90% decrease in license revenue resulted in a reduced grossprofit percentage of license revenues to 58 % for the three months ended June 30,2005 as compared to 98% for the same period a year ago.  Also contributing to the decrease was theproportional increase in third party products which typically have a lowermargin than the sale of the Company’s proprietary software products.

 

17

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Cost of license revenuedecreased by $8,000, or 4%, from $178,000 to $170,000 for the nine months endedJune 30, 2005 compared to the same period a year ago.  The decreasewas primarily due to the reduced amortization expense of $24,000 related tocapitalized software as mentioned above. The 83% decrease in license revenue combined with costs of licenserevenue decreasing 4% resulted in a reduction in gross profit percentage oflicense revenues to 66% for the nine months ended June 30, 2005 ascompared to 94% for the same period a year ago.

 

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

 

*Cost ofServices and Other Revenues*

(in thousands)

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|------------------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                               | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                               | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| Cost  of Services and Other Revenues     |       | $                      | 515        |        | $          | 586                   |       | -12         | %          | $ | 1,749 |   | $ | 1,693 |   | 3 | % |
| Percentage  of service and other revenue |       | 45                     | %          | 44          | %          |                  |       | 42          | %          | 47 | % |   |   |
|                                          |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

Cost of services andother revenues consists primarily of personnel-related costs in providingconsulting services, training to customers and support as well as costsassociated with reselling third-party hardware and maintenance, which includestelephone support costs.

 

Cost of services andother revenue decreased $71,000, or 12%, from $586,000 to $515,000 for thethree months ended June 30, 2005 compared to the same period a yearago.  The decrease was primarily due to a decrease of $47,000 inpersonnel-related costs and $30,000 of travel expenses in connection with thereduced requirements as a result of the decrease in service revenue.  Thegross profit from services and other revenue as a percentage of services andother revenues decreased to 55% for the three months ended June 30, 2005as compared to 56% for the same period a year ago.  The slight reductionin gross profit percentages is due to the 14% decrease in service and otherrevenues while cost of revenues decreased only 12%.

 

Cost of services and otherrevenue slightly increased $56,000, or 3%, from $1,693,000 to $1,749,000 forthe nine months ended June 30, 2005 compared to the same period a yearago.  The increase was primarily due to an increase of $67,000 inpersonnel-related costs.  These increases were associated with theadditional service requirements as a result of the $531,000 increase inservices and other revenues.  The gross profit from services and otherrevenue as a percentage of services and other revenues increased to 58% for thenine months ended June 30, 2005 as compared to 53% for the same period ayear ago.  The improvement in gross profit percentages is due to the 15%increase in service and other revenues while cost of revenues increased only3%.

 

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

 

**OperatingExpenses**

 

*Researchand Development*

(in thousands)

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|------------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                         | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                         | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| Research  and development expenses |       | $                      | 164        |        | $          | 341                   |       | -52         | %          | $ | 684 |   | $ | 1,008 |   | -32 | % |
| Percentage  of total revenue       |       | 13                     | %          | 12          | %          |                  |       | 15          | %          | 15 | % |   |   |
|                                    |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

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

 

Research and developmentexpenses decreased $177,000, or 52%, from $341,000 to $164,000 for the threemonths ended June 30, 2005 compared to the same period a year ago. The decrease was due primarily to the capitalization of $180,000 in costsdirectly associated with the development of a new architecture for the *e*B platform.  In June 2005 the Company reduced thenumber of personnel, the effect of which will decrease research and developmentexpenses beginning in the fourth quarter. Although the Company has reduced the number of development personnel, webelieve that the Company still maintains the core resources for continuedinvestment in research and development which is a critical factor inmaintaining our competitive position.

 

Research and developmentexpenses decreased $324,000, or 32%, from $1,008,000 to $684,000 for the ninemonths ended June 30,

 

18

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2005 compared to the sameperiod a year ago.  The decrease was due primarily to the capitalizationof $389,000 in costs directly associated with the development of a newarchitecture for the *e*Bplatform.  The decrease was partiallyoffset by an increase of $50,000 in compensation and related benefitsassociated with increased headcount during the last half of fiscal 2004 and thecosts of the relocation of certain employees to the Spescom Ltd. facilities inSouth Africa.

 

*Marketingand Sales*

(in thousands)

 
| ** **                    | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|-------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                    | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                    | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| Marketing  and sales expenses |       | $                      | 945        |        | $          | 871                   |       | 8           | %          | $ | 2,683 |   | $ | 2,201 |   | 22 | % |
| Percentage  of total revenue  |       | 73                     | %          | 30          | %          |                  |       | 58          | %          | 33 | % |   |   |
|                               |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

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

 

Marketing and salesexpenses increased $74,000, or 8%, from $871,000 to $945,000 for the threemonths ended June 30, 2005 compared to the same period a year ago. The increase in marketing and sales expenses is primarily due to an increase of$77,000 in marketing costs primarily related to public relations campaign, auser conference and travel.

 

Marketing and salesexpenses increased $482,000, or 22%, from $2,201,000 to $2,683,000 for the ninemonths ended June 30, 2005 compared to the same period a year ago. The increase in marketing and sales expenses is primarily due to increases of$464,000 in additional marketing and sales personnel, $275,000 in marketingcosts primarily related to public relations campaign, a user conference, tradeshows and travel.  The increase was partially offset by a decrease incommissions of $263,000 relating to lower sales during fiscal 2005 as comparedto the same period a year ago.

 

We do not expectmarketing and sales expense to change significantly in the next severalquarters; however, marketing and sales expense will fluctuate as a percentageof total revenue based on changes in revenue.

 

*Generaland Administrative*

(in thousands

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------|------------|-----------------------|------------|-------------|------------|
| ** **                           | ** ** | **June 30,**      | ** ** | **Percent** | ** ** | **June 30,**     | ** ** | **Percent** | ** ** |
| ** **                           | ** ** | **2005**               | ** ** | **2004**    | ** ** | **Change**            | ** ** | **2005**    | ** ** | **2004** | ** ** | **Change** | ** ** |
| General  and administrative expenses |       | $                      | 441        |        | $          | 585                   |       | -25         | %          | $ | 1,213 |   | $ | 1,574 |   | -23 | % |
| Percentage  of total revenue         |       | 34                     | %          | 20          | %          |                  |       | 26          | %          | 24 | % |   |   |
|                                      |            |                        |            |             |            |                       |            |             |            |  |  |  |  |  |  |  |  |

 

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

 

General andadministrative expenses decreased by $144,000, or 25%, from $585,000 to$441,000 for the three months ended June 30, 2005 compared to the sameperiod a year ago.  The overall decrease was due primarily to decreases of$102,000 in legal fees as during the prior year, additional work was requiredfor a routine SEC review of the Company’s Annual Report on Form 10-K forthe year ended September 30, 2002 and $62,000 in investor relationsexpenses related to the expiration of a contract with an investor relationsfirm.  These decreases were partiallyoffset by an increase of $27,000 in costs incurred for consultants andincreased accounting fees associated with the Company’s compliance effortsunder the Sarbanes-Oxley Act.

 

General andadministrative expenses decreased by $361,000, or 23%, from $1,574,000 to$1,213,000 for the nine months ended June 30, 2005 compared to the sameperiod a year ago.  The overall decrease was due primarily to decreases of$176,000 in legal and SEC filing fees as during the prior year additional workwas required for a routine SEC review of the Company’s Annual Report on Form 10-Kfor the year ended September 30, 2002, $160,000 in investor relationsexpenses related to the expiration of a contract with an investor relationsfirm and a $78,000 reduction in the allowance for uncollectible accounts.  These decreases were partially offset by anincrease of $84,000 in costs incurred for consultants and increased accountingfees associated with the Company’s compliance efforts under the Sarbanes-OxleyAct.

 

We do not expect generaland administrative expenses to change significantly in the next severalquarters in absolute dollar amounts due to the continued benefits of costoversight keeping general and administrative expenses in line with currentrevenues.

 

19

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**InterestExpense**

 

Interest expense consistsprimarily of fixed interest obligations on our outstanding debt to Spescom LtdUK. as well as interest paid on capital lease obligations.  Interestexpense was $38,000 and $105,000 for the three and nine months ended June 30,2005, respectively, as compared to $37,000 and $96,000 for the comparableperiods in 2004.  The increase is due to increased debt balances owed toSpescom Ltd. and higher outstanding dividends payable to Spescom Ltd. UK.

 

**PreferredDividends**

 

The outstanding Series FConvertible Preferred Stock is entitled to receive dividends of 5% of thestated value of $1,000 per share per annum, payable on a quarterly basis incash or common stock (valued on the basis of the average per share market valueon the 30 trading days immediately prior to the date on which such dividend isdeclared by the Board of Directors).  Cumulative preferred dividendsearned for the three and nine months ended June 30, 2005 were $66,000 and$235,000.  Unpaid dividends accrueinterest at the rate of 8% per annum.  As of June 30, 2005, unpaiddividends and accrued interest amounted to $463,000 and $29,000, respectively.

 

The outstanding Series GStock is entitled to receive dividends of 5% of the stated value of $1,000 pershare per annum, payable monthly in arrears on the last day of each month basedon the number of Series G Stock outstanding as of the first day of eachsuch month.  For the nine months ended June 30, 2005, the Companyissued 82,050 shares of common stock with a value of $37,000 as a dividend onthe Series G Stock.  In connection with the Series G Stockfinancing, the Company recorded a beneficial conversion of $2,200,000 as adeemed dividend for the nine months ended June 30, 2005.  The dividend for the Series G Stock isonly payable until the registration statement for the common stock underlyingthe Series G Stock is declared effective by the Securities and ExchangeCommission (“SEC”).  On March 22,2005 the SEC declared the registration statement effective.  Thus the Series G Stock is no longerentitled to dividends.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

At June 30, 2005,our principal sources of liquidity consisted of $310,000 of cash and cashequivalents compared to $109,000 at September 30, 2004.  Our liquidity could be negatively impacted bya decrease in demand for our products, which are subject to rapid technologicalchanges, reductions in capital expenditures by our customers and intensecompetition, among other factors.

 

The Company has receivedloans from Spescom Ltd. in the past to meet its obligations.  Theoutstanding balance of our demand notes owed to Spescom Ltd. including interestwas $610,000 at June 30, 2005 as compared to $557,000 at September 30,2004.  Spescom Ltd. has agreed not to call the notes prior to October 1,2005.  The Company has not received anyfurther extension on the notes.  Therecan be no assurance that Spescom Ltd. will extend the notes or that the termsof such an extension will be acceptable to the Company.

 

We used cash in operatingactivities of $1,112,000 during the nine months ended June 30, 2005primarily related to a net loss during that period of $1,980,000 which wasoffset by increases in deferred revenue, accounts receivable, other assets andunpaid interest on notes payable of $495,000, $187,000, $108,000 and $109,000,respectively.

 

Our investing activitiesused $442,000 during the nine months ended June 30, 2005 primarilyrelating to the capitalization of internal development costs.  In addition the Company acquired $60,000 ofequipment and software through capital asset purchases in the nine months endedJune 30, 2005.

 

Financing activitiesprovided cash of $1.8 million for the nine months ended June 30, 2005primarily from the issuance of preferred stock through a private placement on November 5,2004.  The Company has used the funds from this private placement toexpand its sales and marketing efforts and improve its liquidity.  Inconnection with the private placement, the Company issued 2,200 shares of Series GConvertible Preferred Stock, and warrants, expiring November 5, 2007, topurchase 2,750,000 shares of common stock at $0.44 per share.  Thepreferred stock is convertible into up to 7,333,334 shares of commonstock.  The net proceeds from the private placement totaled $1,738,000.

 

For the three and ninemonths ended June 30, 2005 the Company has incurred net losses of $868,000and $1,980,000.  The Company hasresponded to the losses and corresponding use of cash by cutting certain costsin development and administration.  However,even with these cost reductions, the Company’s future liquidity depends on itsability to generate new system sales of its *e*Bproduct suite in the near term, which cannot be assured. Failure to generatesufficient system sales to meet the Company’s cash flow needs can be expectedto have a material adverse effect on the Company’s business, results ofoperations, and financial condition.  The Company on a quarterly basisrequires approximately $2.2 million in order to fund its ongoingoperations.  The Company believes that itcan generate sufficient revenues to support its requirements and from July 1,2005 to the date of this filing the Company has secured total orders of $906,000.  The Company’s financial position can be afactor in attracting new customers.  In an effort to strengthen theCompany’s financial condition and provide capital for expanding marketing andsales capabilities, the Company will continue to explore additional equity ordebt financing from third parties.  There can be no assurance thatadditional financing will be available or that the terms of such financing willbe acceptable to the Company.  The Company may not be able to obtainsufficient orders to enable the Company to achieve a cash flow break-evenlevel, which would be necessary to continue operations in the absence offurther financing.

 

20

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**ContractualObligations and Commercial Commitments**

 

The following summarizesour contractual obligations and other commitments at June 30, 2005, andthe effect such obligations could have on our liquidity and cash flow in futureperiods:

 
| ** **                             | ** ** | **Amount of Commitment Expiring by Period** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                             | ** ** | ** **                                  | ** ** | **Less than 1** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Total**                                   | ** ** | **year** | ** ** | **1 - 3 Years** | ** ** | **Over 5 Years** | ** ** |
| Notes  and Accounts Payable to Spescom | ** ** | $                                           | 709,000    |   | $ | 709,000 |   | $ | — |   | $ | — |   |
| Lease  commitments - Operating leases  |       | 927,000                                     |       | 61,000 |   | 756,000 |   | 110,000 |   |
| Lease  commitments - Capital leases    |       | 120,000                                     |       | 12,000 |   | 108,000 |   | — |   |
| Total                                  |       | $                                           | 1,756,000  |   | $ | 782,000 |   | $ | 864,000 |   | $ | 110,000 |   |

 

**Off-BalanceSheet Arrangements**

 

At June 30, 2005 andSeptember 30, 2004, we did not have any other relationships withunconsolidated entities or financial partnerships, including entities oftenreferred to as structured finance or special purpose entities that would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes.  Therefore, we are notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we were engaged in such relationships.

 

**Inflation**

 

The Company believes thatinflation has not had a material effect on its operations to date.  Although the Company enters into fixed-pricecontracts, management does not believe that inflation will have an adverse materialimpact on its operations for the foreseeable future, as the Company takes intoaccount expected inflation in its contract proposals and is generally able toproject its costs based on forecasted contract requirements.

 

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

 

**InterestRate Risk**

 

The Company’s exposure tomarket rate risk for changes in interest rates relates primarily to the Company’sinvestment portfolio.  The Company does not use derivative financialinstruments in its investment portfolio. The Company places its investmentswith high quality issuers and follows internally developed guidelines to limitthe amount 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.  TheCompany’s investments included money market accounts as of June 30, 2005.

 

**ForeignCurrency Exchange Risk**

 

The Company’s geographicmarkets are primarily in the United States and Europe, with some sales in otherparts of the world. For the three months ended June 30, 2005, revenues recordedin the United States were 55% of total revenues, and revenues from Europe andother locations were 45% of total revenues as compared to 27% and 73% for thesame period a year ago.

 

For the nine months endedJune 30, 2005, revenues recorded in the United States were 51% of totalrevenues, and revenues from Europe and other locations were 49% of totalrevenues as compared to 50% and 50% for the same period a year ago.

 

Revenues from our UnitedKingdom subsidiary can fluctuate from quarter to quarter based on the timing ofcustomer orders.  The decreased revenue in fiscal 2005 was worsened by aforeign currency loss of $119,000 due to a weakened dollar value compared tothe pound sterling.  Changes in foreign currency rates, the condition oflocal economies, and the general volatility of software markets may result in ahigher or lower proportion of foreign revenues in the future. Although theCompany’s operating and pricing strategies take into account changes inexchange rates over time, future fluctuations in the value of foreigncurrencies may have a material adverse effect on the Company’s business,operating results and financial condition.

 

**ITEM4.    CONTROLS AND PROCEDURES**

 

The Company carried outan evaluation under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as of June 30, 2005 pursuant to ExchangeAct Rule 13a-14. Based upon that evaluation, we have concluded that as of June 30,2005, the Company’s disclosure controls and procedures are effective inrecording, processing, summarizing and reporting within the time periodsspecified in the SEC’s rules and forms material information relating tothe Company (including its consolidated subsidiaries) required to be includedin the Company’s periodic SEC filings.

 

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

 

**PART II.  OTHER INFORMATION**

 

**ITEM 1 — LEGAL PROCEEDINGS**

 

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

 

**ITEM 6 — EXHIBITS**

 
| ** ** | ** ** | **Exhibits**                                                                                                                        |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                |
| (a)        |       | Exhibiits                                                                                                                           |
|       |       |                                                                                                                                |
| 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. |
|       |       |                                                                                                                                |
| (b)        |       | Reports on Form 8-K                                                                                                            |

 

We furnished to the SECreports on Form 8-K on August 15, 2005.  The Form 8-K was for the purpose ofannouncing the resignation of Carl H. Mostert, the Company’s Chief ExecutiveOfficer effective August 8, 2005 and the appointment of Keith Stentifordas interim Chief Executive Officer.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
| August 15, 2005 | **SPESCOM  SOFTWARE INC.**                                                           |
|----------------------|--------------------------------------------------------------------------------------|
|                 |                                                                                 |
|                 |                                                                                 |
|                 | /s/ Carl Mostert                                                                     |   |
|                 | Carl Mostert                                                                         |
|                 | Director and Chief  Executive Officer (Principal Executive Officer)                  |
|                 |                                                                                 |
|                 |                                                                                 |
|                 | /s/ John W. Low                                                                      |   |
|                 | John W. Low                                                                          |
|                 | Chief Financial Officer  and Secretary (Principal Financial and  Accounting Officer) |
|                      |                                                                                      |  |  |

 

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