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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2005
 o
    
    TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT
 For the transition period from  to
 Commission
file number 0-22190
 
 VERSO TECHNOLOGIES, INC.
  MINNESOTA
    
    41-1484525(State or Other Jurisdiction
    
    (I.R.S. Employer Identification No.)of Incorporation or Organization)
 
 
 
  þ o
  þ o




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Page No.Part I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004
    
    
    2Condensed Consolidated Statements of Operations for the three months and the six months ended June 30, 2005 and 2004
    
    
    3Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and 2004
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4. Controls and Procedures
    
    
    34PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    35Item 2. Submissions of Matters to a Vote of Security Holders
    
    
    35Item 6. Exhibits
    
    
    35Signature Page
    
    
    36Exhibit Index
    
    
    37EX-3.4 AMENDMENT TO THE AMENDED AND RESTATED ARTICLES OF INCORPORATION OF THE COMPANYEX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CFOEX-32.2 SECTION 906 CERTIFICATION OF CFO
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data)
 June 30,
    
    December 31,2005
    
    2004(Unaudited)ASSETS:Current assets:Cash and cash equivalents
    
    $
    11,193
    
    
    $
    4,234Restricted cash
    
    
    1,620
    
    
    
    Accounts receivable, net of allowance for doubtful accounts of $382
and $255, respectively
    
    
    4,243
    
    
    
    3,961Inventories
    
    
    4,227
    
    
    
    5,362Other current assets
    
    
    2,177
    
    
    
    1,451Current portion of note receivable
    
    
    432
    
    
    
    Assets held for sale
    
    
    
    
    
    
    8,995Total current assets
    
    
    23,892
    
    
    
    24,003Property and equipment, net of accumulated depreciation and amortization
of $7,236 and $7,047, respectively
    
    
    3,187
    
    
    
    3,879Investment
    
    
    677
    
    
    
    729Note receivable, net of current portion
    
    
    3,068
    
    
    
    Other intangibles, net of accumulated amortization of $1,256 and $921,
respectively
    
    
    2,908
    
    
    
    2,304Goodwill
    
    
    2,514
    
    
    
    2,514Total assets
    
    $
    36,246
    
    
    $
    33,429LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Accounts payable
    
    $
    1,718
    
    
    $
    2,095Accrued compensation
    
    
    1,107
    
    
    
    1,356Accrued expenses
    
    
    2,189
    
    
    
    1,973Current portion of accrued loss on sublease
    
    
    1,226
    
    
    
    Current portion of liabilities of discontinued operations
    
    
    2,287
    
    
    
    1,552Liabilities held for sale
    
    
    
    
    
    
    2,001Convertible subordinated debentures
    
    
    4,391
    
    
    
    4,254Unearned revenue and customer deposits
    
    
    2,698
    
    
    
    3,157Total current liabilities
    
    
    15,616
    
    
    
    16,388Accrued loss on sublease, net of current portion
    
    
    1,314
    
    
    
    Liabilities of discontinued operations, net of current portion
    
    
    954
    
    
    
    1,461Other long-term liabilities
    
    
    131
    
    
    
    229Notes payable, net of current portion
    
    
    2,747
    
    
    
    2,711Convertible debentures
    
    
    9,440
    
    
    
    Total liabilities
    
    
    30,202
    
    
    
    20,789Shareholders equity:Preferred stock,no par value, 1,000,000 shares authorized;
780,000 shares issued and none outstanding
    
    
    
    
    
    
    Common stock, $.01 par value, 200,000,000 shares authorized;
134,628,400 and 133,243,205 shares issued and outstanding
    
    
    1,346
    
    
    
    1,332Additional paid-in capital
    
    
    328,547
    
    
    
    322,971Stock payable
    
    
    61
    
    
    
    128Accumulated deficit
    
    
    (323,830
    )
    
    
    (311,931
    )Deferred compensation
    
    
    
    
    
    
    (7
    )Accumulated other comprehensive income (loss)  foreign currency translation
    
    
    (80
    )
    
    
    147Total shareholders equity
    
    
    6,044
    
    
    
    12,640Total liabilities and shareholders equity
    
    $
    36,246
    
    
    $
    33,429
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VERSO TECHNOLOGIES, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except share data)
 For the three months ended June 30,
    

For the six months ended June 30,2005
    
    2004
    
    2005
    
    2004Revenue:Products
    
    $
    4,603
    
    
    $
    2,077
    
    
    $
    7,342
    
    
    $
    8,691Services
    
    
    3,910
    
    
    
    4,554
    
    
    
    7,778
    
    
    
    9,039Total revenue
    
    
    8,513
    
    
    
    6,631
    
    
    
    15,120
    
    
    
    17,730Cost of revenue:Products:Product costs
    
    
    2,257
    
    
    
    1,034
    
    
    
    3,598
    
    
    
    3,558Amortization of intangibles
    
    
    147
    
    
    
    69
    
    
    
    215
    
    
    
    138Total cost of product
    
    
    2,404
    
    
    
    1,103
    
    
    
    3,813
    
    
    
    3,696Services
    
    
    2,355
    
    
    
    2,594
    
    
    
    4,690
    
    
    
    5,187Total cost of revenue
    
    
    4,759
    
    
    
    3,697
    
    
    
    8,503
    
    
    
    8,883Gross profit:Products
    
    
    2,199
    
    
    
    974
    
    
    
    3,529
    
    
    
    4,995Services
    
    
    1,555
    
    
    
    1,960
    
    
    
    3,088
    
    
    
    3,852Total gross profit
    
    
    3,754
    
    
    
    2,934
    
    
    
    6,617
    
    
    
    8,847Operating expenses:General and administrative
    
    
    2,468
    
    
    
    2,982
    
    
    
    5,054
    
    
    
    5,818Sales and marketing
    
    
    2,049
    
    
    
    2,409
    
    
    
    4,195
    
    
    
    4,365Research and development
    
    
    1,737
    
    
    
    1,806
    
    
    
    3,421
    
    
    
    3,387Depreciation and amortization
    
    
    580
    
    
    
    678
    
    
    
    1,240
    
    
    
    1,447Reorganization costs
    
    
    
    
    
    
    
    
    
    
    124
    
    
    
    584Reorganization costs  loss on sublease
    
    
    2,550
    
    
    
    
    
    
    
    2,550
    
    
    
    Reorganization costs  stock related
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    570Total operating expenses
    
    
    9,384
    
    
    
    7,875
    
    
    
    16,584
    
    
    
    16,171Operating loss from continuing operations
    
    
    (5,630
    )
    
    
    (4,941
    )
    
    
    (9,967
    )
    
    
    (7,324
    )Other income (expense), net:Other income (expense)
    
    
    (24
    )
    
    
    103
    
    
    
    (18
    )
    
    
    124Equity in loss of investment
    
    
    (23
    )
    
    
    (45
    )
    
    
    (51
    )
    
    
    (63
    )Interest expense, net
    
    
    (723
    )
    
    
    (267
    )
    
    
    (1,297
    )
    
    
    (532
    )(770
    )
    
    
    (209
    )
    
    
    (1,366
    )
    
    
    (471
    )Loss from continuing operations before income taxes
    
    
    (6,400
    )
    
    
    (5,150
    )
    
    
    (11,333
    )
    
    
    (7,795
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss from continuing operations
    
    
    (6,400
    )
    
    
    (5,150
    )
    
    
    (11,333
    )
    
    
    (7,795
    )Loss from discontinued operations
    
    
    
    
    
    
    (1,130
    )
    
    
    (566
    )
    
    
    (2,221
    )Net loss
    
    $
    (6,400
    )
    
    $
    (6,280
    )
    
    $
    (11,899
    )
    
    $
    (10,016
    )Net loss per common share  basic and diluted:Loss from continuing operations
    
    $
    (0.05
    )
    
    $
    (0.04
    )
    
    $
    (0.09
    )
    
    $
    (0.06
    )Loss from discontinued operations
    
    
    
    
    
    
    (0.01
    )
    
    
    (0.00
    )
    
    
    (0.02
    )$
    (0.05
    )
    
    $
    (0.05
    )
    
    $
    (0.09
    )
    
    $
    (0.08
    )Weighted average shares outstanding  basic and
diluted
    
    
    134,440,552
    
    
    
    132,952,430
    
    
    
    133,919,633
    
    
    
    129,923,784
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands, except share data)
(Unaudited)
 For the six months ended June 30,2005
    
    2004Operating Activities:Continuing operations:Net loss from continuing operations
    
    $
    (11,333
    )
    
    $
    (7,795
    )Adjustments to reconcile net loss from continuing operations to net
cash (used in) provided by continuing operating activities:Equity in loss of investment
    
    
    52
    
    
    
    63Depreciation and amortization
    
    
    1,455
    
    
    
    1,585Provision for doubtful accounts
    
    
    75
    
    
    
    191Amortization of loan fees and discount on convertible subordinated debentures
    
    
    844
    
    
    
    258Reorganization costs  loss on sublease
    
    
    2,550
    
    
    
    Reorganization costs  stock related
    
    
    
    
    
    
    570Other
    
    
    (5
    )
    
    
    (19
    )Changes in current operating assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    (264
    )
    
    
    2,325Inventories
    
    
    1,135
    
    
    
    (1,973
    )Other current assets
    
    
    146
    
    
    
    58Accounts payable
    
    
    (377
    )
    
    
    (179
    )Accrued compensation
    
    
    (249
    )
    
    
    265Accrued expenses
    
    
    (177
    )
    
    
    168Unearned revenue and customer deposits
    
    
    (459
    )
    
    
    (655
    )Net cash used in continuing operating activities
    
    
    (6,607
    )
    
    
    (5,138
    )Discontinued operations:Loss income from discontinued operations
    
    
    (566
    )
    
    
    (2,221
    )Adjustment to reconcile loss from discontinued operations
to net cash used in discontinued operating activities
    
    
    (405
    )
    
    
    4,317Net cash (used in) provided by discontinued operating activities
    
    
    (971
    )
    
    
    2,096Net cash used in operating activities
    
    
    (7,578
    )
    
    
    (3,042
    )Investing Activities:Continuing operations:Net cash (used in) provided by investing activities for continuing operations -
Purchases of property and equipment
    
    
    (397
    )
    
    
    (804
    )Purchase of WSECI
    
    
    (244
    )
    
    
    (Increase) decrease in restricted cash
    
    
    (1,620
    )
    
    
    2,197Net cash (used in) provided by investing activities for continuing operations
    
    
    (2,261
    )
    
    
    1,393Discontinued operations:Purchases of property and equipment
    
    
    
    
    
    
    (237
    )Proceeds from sale of discontinued operations
    
    
    4,015
    
    
    
    Acquisition of MCK Communications, Inc., net of cash acquired
    
    
    
    
    
    
    (3,859
    )Net cash provided by (used in) investing activities for discontinued operations
    
    
    4,015
    
    
    
    (4,096
    )Net cash provided by (used in) investing activities
    
    
    1,754
    
    
    
    (2,703
    )Financing Activities:Proceeds from convertible debentures, net
    
    
    12,757
    
    
    
    Payments of notes payable
    
    
    
    
    
    
    (350
    )Proceeds from private placement, net
    
    
    
    
    
    
    16,474Proceeds from issuances of common stock in connection with the
exercise of options and warrants, net
    
    
    42
    
    
    
    151Net cash provided by financing activities
    
    
    12,799
    
    
    
    16,275Effect of exchange rate changes on cash
    
    
    (16
    )
    
    
    1Increase in cash and cash equivalents
    
    
    6,959
    
    
    
    10,531Cash and cash equivalents at beginning of period
    
    
    4,234
    
    
    
    7,654Cash and cash equivalents at end of period
    
    $
    11,193
    
    
    $
    18,185Supplemental disclosure of cash flow information:Cash payments (receipts) during the periods for:Interest
    
    $
    363
    
    
    $
    178Income taxes
    
    $
    (38
    )
    
    $
    (222
    )Non-cash investing and financing activitiesCommon stock consideration for acquisitions:WSECI  issuance of 950,000 shares of common stock
    
    $
    331
    
    
    $
    Issuance of note receivable in disposition of MCK
    
    
    3,500Common stock and compensatory options issued in reorganization
    
    
    
    
    
    
    570Issuance of warrants in conjunction with convertible debentures
    
    
    5,084
    
    
    
    Issuance of common stock and warrants in exchange for services
    
    
    694
    
    
    
    133Assets acquired and liablities assumed in conjunction with business acquisitions:Fair value of assets acquired, excluding cash and restricted cash
    
    
    1,084
    
    
    
    Liabilities assumed
    
    $
    
    
    
    $
    
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1.
    
    BASIS OF PRESENTATIONVerso Technologies, Inc. and subsidiaries (the Company) is a communications technology and
solutions provider for communications service providers and enterprises seeking to implement
application-based telephony services, Internet usage management tools and outsourced
customer support services. The Companys continuing operations include two separate
business segments (i) the Packet-based Technologies Group, which includes the Companys
softswitching division, the Companys Netperformer division, the Companys subsidiary
Telemate.Net Software, Inc. (Telemate.Net) and the Companys I-Master division; and (ii)
the Advanced Applications Services Group, which includes the Companys technical
applications support group. The Packet-based Technologies Group includes domestic and
international sales of hardware and software, integration, applications and technical
training and support. The Packet-based Technologies Group offers hardware and software for
companies seeking to build private, packet-based voice and data networks. Additionally, the
Packet-based Technologies Group offers software-based solutions for Internet access and
usage management that include call accounting and usage reporting for Internet protocol
network devices. The Advanced Applications Services Group includes outsourced technical
application services and application installation and training services to outside
customers, as well as customers of the Packet-based Technologies Group.In January 2005, the Company sold substantially all of the operating assets of its NACT
Telecommunications, Inc., now known as Provo Pre-Paid (Delaware) Corp. (NACT) and MCK
Communications, Inc., now known as Needham (Delaware) Corp. (MCK) businesses to better
focus the Companys capital and management resources on areas which the Company believes
have greater potential given its strategy to focus on next-generation network and solutions
to improve cash utilization. In addition, the Company disposed of its NACT business
because the Company wanted to move toward an open-standards, pre-paid next-generation
solution that could better address growing market opportunities and enable the Company to
offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the
I-Master platform which the Company acquired from WSECI, Inc., a Delaware corporation
formerly known as Jacksonville Technology Associates, Inc. (WSECI), in March 2005 after
forming a strategic partnership with WSECI in the latter half of 2004 permits the Company to
offer a better solution. Further the Company disposed of its MCK business because the
Company intends to focus on next-generation solutions for service providers and the products
of the MCK business did not fit that profile. The operations of NACT and MCK businesses
have been reclassified as discontinued operations in the Companys consolidated financial
statements.The consolidated financial statements include the accounts of Verso Technologies, Inc. and
its wholly-owned subsidiaries, including Telemate.Net Software, Inc. (Telemate.Net);
Clarent Canada Ltd., now known as Verso Technologies Canada Inc. (Verso Canada), MCK and
NACT are reflected in discontinued operations. These subsidiaries were acquired and were
all accounted for as purchases (see Note 2).Certain prior year amounts in the consolidated financial statements have been reclassified
to conform with the current year presentation. These reclassifications had no effect on
previously reported net loss.The condensed consolidated quarterly financial statements are unaudited. These statements
include all adjustments, including recurring adjustments, considered necessary by management
to present a fair statement of the results of the Companys operations, financial position
and cash flows. The results reported in these condensed consolidated financial statements
should not be regarded as necessarily indicative of results that may be expected for the
entire year.The year-end condensed consolidated balance sheet was derived from audited consolidated
financial statements. The accompanying condensed consolidated unaudited quarterly financial
statements are presented in accordance with the rules and regulations of the Securities and
Exchange Commission (SEC) and do not include all disclosures normally required by
accounting principles generally accepted in the United States of America. For further
information, refer to the audited consolidated financial statements and footnotes thereto
included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004
(the Annual Report).
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2.
    
    MERGERS AND ACQUISITIONSWSECI, Inc.On March 31, 2005, the Company acquired substantially all of the operating assets of WSECI
pursuant to the Asset Purchase Agreement (Asset Purchase Agreement) dated as of February
23, 2005 by and among the Company, WSECI and all of the shareholders of WSECI. WSECI is a
provider of an internet protocol-based, revenue assurance platform which enables the
deployment of multiple voice and next-generation services to the carrier market. The fair
value of the acquisition cost was approximately $1.1 million, consisting of 950,000 shares
of the Companys common stock with a fair value of $331,000, $50,000 in cash, the payment of
certain liabilities of approximately $613,000 and acquisition costs of approximately
$106,000. The acquisition is accounted for as a purchase.Pursuant to the Asset Purchase Agreement, the Company may become obligated to issue to WSECI
additional contingent consideration of up to $5.0 million based on the sales of certain
WSECI products and services. The initial $500,000 of such contingent consideration earned
by WSECI is based upon specific customer transactions the Company completes with respect to
the WSECI assets, and the remaining $4.5 million of the contingent consideration may be
earned by WSECI based on the revenue generated from the WSECI assets during the 18-month
period following the acquisition, which revenue must equal a minimum of $88.0 million during
such period in order for all of such remaining contingent consideration to be earned. The
contingent consideration is payable in cash or shares of the Companys common stock at the
election of the Company. It is not possible to estimate what, if any, payment would be due
as additional contingent consideration at this time. When the additional contingent
consideration is determined, it will increase the amount of the purchase price allocated to
other intangible assets and will be amortized over the remaining useful life of the asset.The preliminary allocation of the costs of the acquisition of WSECI are as follows (in
thousands):
 WSECIProperty and equipment
    
    $
    61Accounts receivable
    
    
    100Other intangibles
    
    
    939Cost of acquisition
    
    $
    1,100
 Pro Forma Effect of WSECI, Inc.
  Three months
    
    Three monthsended
    
    endedJune 30, 2004
    
    June 30, 2004Revenues
    
    $
    6,689
    
    
    $
    17,912Net loss from continuing operations
    
    $
    (5,190
    )
    
    $
    (7,812
    )Net loss from continuing operations per common share  basic and diluted
    
    $
    (0.04
    )
    
    $
    (0.06
    )Weighted average shares outstanding
- basic and diluted
    
    
    133,902,430
    
    
    
    130,873,784
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3.
    
    EQUITY INVESTMENTOn October 1, 2002, the Company acquired a 51% interest in Shanghai BeTrue Infotech Co.,
Ltd. (BeTrue). The remaining 49% interest in BeTrue is owned by Shanghai Tangsheng
Investments & Development Co. Ltd (Shanghai Tangsheng). The joint venture provides the
Company with a distribution channel in the China and Asia-Pacific region for the Companys
application-based Voice over Internet Protocol (VoIP) gateway solutions, billing systems,
value-added applications and web filtering solutions. Due to the shared decision making
between the Company and its equity partner, the results of BeTrue are treated as an equity
investment rather than being consolidated. The Company determined that since BeTrue was a
business, BeTrue did not fall under the scope of the Financial Accounting Standards Board
Interpretation No. 46 R, Consolidation of Variable Interest Entities and there was no
impact on the Companys financial position or results of operations.The Company purchased the 51% interest in BeTrue for $100,000 from NeTrue Communications,
Inc., Shanghai Tangshengs former joint venture partner. The Company also contributed to
the joint venture certain next-generation communication equipment and software valued at
approximately $236,000 and cash in the amount of $100,000.Summarized financial information reported by this affiliate for the three and six months
ended June 30, 2005 and 2004 (in thousands) are as follows:
 Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Operating results:Revenues
    
    $
    195
    
    
    $
    130
    
    
    $
    664
    
    
    $
    660Operating loss
    
    $
    (44
    )
    
    $
    (88
    )
    
    $
    (100
    )
    
    $
    (116
    )Net loss
    
    $
    (44
    )
    
    $
    (88
    )
    
    $
    (100
    )
    
    $
    (103
    )
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4.
    
    DISCONTINUED OPERATIONSIn January 2005, the Company sold substantially all of the operating assets of its NACT and
MCK businesses to better focus the Companys capital and management resources on areas which
the Company believes have greater potential given its strategy to focus on next-generation
network and solutions to improve cash utilization. In addition, the Company disposed of
its NACT business because the Company wanted to move toward an open-standards, pre-paid
next-generation solution that could better address growing market opportunities and enable
the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company
believes that the I-Master platform which the Company acquired from WSECI in March 2005,
after forming a strategic partnership with WSECI in the latter half of 2004, permits the
Company to offer a better solution. Further, the Company disposed of its MCK business
because the Company intends to focus on next-generation solutions for service providers and
the products of the MCK business did not fit that profile. The operations of NACT and MCK
businesses have been reclassified as discontinued operations in the Companys consolidated
financial statements.The loss on the sale of the NACT business totaled $11.4 million. The loss includes a
reduction in net asset values of approximately $10.9 million and a provision for estimated
closing costs and expenses of approximately $500,000. The loss on the sale of the MCK
business totaled $3.4 million. The loss includes a reduction in net asset values of
approximately $2.9 million and a provision for estimated closing costs and expenses of
approximately $500,000.Summary operating results of the discontinued operations (in thousands) are as follows:
 Three months ended June 30,
    
    Six months ended June 30,2005
    
    2004
    
    2005
    
    2004Revenue
    
    $
    
    
    
    $
    4,705
    
    
    $
    212
    
    
    $
    10,167Gross (loss) profit
    
    
    
    
    
    
    2,212
    
    
    
    (27
    )
    
    
    4,802Operating loss
    
    
    
    
    
    
    (1,135
    )
    
    
    (566
    )
    
    
    (2,252
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (1,130
    )
    
    $
    (566
    )
    
    $
    (2,221
    )
    8




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##### Table of Contents



4.
    
    DISCONTINUED OPERATIONS, ContinuedThe assets and liabilities of NACT and MCK were classified as assets held for sale at
December 31, 2004 and the significant components (in thousands) were as follows:
 Accounts receivable, net
    
    $
    3,085Inventory
    
    
    2,901Other current assets
    
    
    419Furniture and equipment, net
    
    
    977Goodwill and other intangibles
    
    
    1,613Assets held for sale
    
    $
    8,995Accounts payable
    
    $
    163Accrued compensation
    
    
    465Unearned revenue and customer deposits
    
    
    1,127Other current liabilities
    
    
    246Liabilities held for sale
    
    $
    2,001
  June 30,
    
    December 31,2005
    
    2004Assets of discontinued operations:Notes receivable
    
    $
    3,500
    
    
    $
    Liabilities of discontinued operations:Accrued rent
    
    $
    2,039
    
    
    $
    2,384Other current liabilities
    
    
    1,202
    
    
    
    629Liabilities of discontinued operations
    
    $
    3,241
    
    
    $
    3,013
   9




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##### Table of Contents



4.
    
    DISCONTINUED OPERATIONS, ContinuedThe activity in the liabilities of discontinued operations (in thousands) for the three and
six months ended June 30, 2005 and 2004 was as follows:
 Three months ended June 30,
    
    Six months ended June 30,2005
    
    2004
    
    2005
    
    2004Balance beginning of period
    
    $
    3,504
    
    
    $
    4,395
    
    
    $
    3,013
    
    
    $
    4,579Lease payments, net of sublease receipts
    
    
    (124
    )
    
    
    (173
    )
    
    
    (343
    )
    
    
    (275
    )Other payments
    
    
    (9
    )
    
    
    (890
    )
    
    
    (120
    )
    
    
    (972
    )Estimated costs of disposal of discontinued operations
    
    
    
    
    
    
    
    
    
    
    1,000
    
    
    
    Legal and other costs of disposal
    
    
    (130
    )
    
    
    
    
    
    
    (309
    )
    
    
    Balance June 30
    
    $
    3,241
    
    
    $
    3,332
    
    
    $
    3,241
    
    
    $
    3,332
 5.
    
    INVENTORIESInventories consist primarily of purchased electronic components, and are stated at the
lower of cost or market. Cost is determined by using average cost.Inventories as of June 30, 2005 and December 31, 2004 are comprised of the following (in
thousands):
 June 30,
    
    December 31,2005
    
    2004Raw materials
    
    $
    3,268
    
    
    $
    3,315Work in process
    
    
    5
    
    
    
    9Finished goods
    
    
    954
    
    
    
    2,038Total inventories
    
    $
    4,227
    
    
    $
    5,362
  10




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##### Table of Contents



6.
    
    GOODWILL AND OTHER INTANGIBLESIntangible assets represent the excess of cost over the fair value of net tangible assets
acquired and identified other intangible assets which consist of current technology and a
customer relationship. The current technology is amortized on a straight-line basis over
its estimated useful life of three years. The customer relationship is amortized on a
straight-line basis over its estimated useful life of ten years. Goodwill associated with
acquisitions is not being amortized in accordance with Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS No. 142).Goodwill and other intangible assets consist of the following (in thousands):
 Amortization
    
    June 30,
    
    December 31,Period in months
    
    2005
    
    2004Intangibles subject to amortization:Current technology
    
    36 months
    
    $
    1,760
    
    
    $
    821Customer relationship
    
    120 months
    
    
    2,403
    
    
    
    2,403Weighted average months
    
    85 months
    
    
    4,163
    
    
    
    3,224Accumulated amortization:Current technology
    
    
    
    
    
    
    (655
    )
    
    
    (440
    )Customer relationship
    
    
    
    
    
    
    (600
    )
    
    
    (480
    )Net intangibles subject to amortization
    
    
    
    
    
    
    2,908
    
    
    
    2,304Goodwill
    
    
    
    
    
    
    2,514
    
    
    
    2,514Total goodwill and other intangibles
    
    
    
    
    
    $
    5,422
    
    
    $
    4,818
 11




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##### Table of Contents



7.
    
    LOAN FACILITY WITH SILICON VALLEY BANKIn March 2005, the Company and Silicon Valley Bank, the Companys primary lender, renewed,
and in June and July 2005 further amended, the Companys credit facility with Silicon in
connection with the disposition of the MCK and NACT businesses, the sublease of the
Companys facilities in Atlanta, Georgia and the restructuring of the Companys 7.5%
convertible subordinated debentures (as amended, the Amended Credit Agreement). The
Amended Credit Agreement provides for a credit line of $7.5 million through September 30,
2005 at which time it will increase to $10.0 million subject to the Company meeting certain
financial criteria. The working capital line includes an export-import (EX-IM) facility
that will provide for working capital based on the Companys international accounts
receivable and inventories related to export sales. The Companys borrowings under the
Amended Credit Agreement are secured by substantially all of the assets of the Company.
Interest on borrowings under the Amended Credit Agreement is computed at 2.25% above
Silicons Base Rate, with a minimum Base Rate of 4.25% (6.75% at June 30, 2005). The
Amended Credit Agreement provides for up to $2.5 million in letters of credit. Advances are
limited by a formula based on eligible receivables, inventories, certain cash balances,
outstanding letters of credit and certain subjective limitations. Interest payments are due
monthly, and the Amended Credit Agreement expires in March 2006. The Amended Credit
Agreement includes a loan fee of $130,000 and .375% per annum on unused available
borrowings. The loan fees will be amortized to interest expense over the term of the
Amended Credit Agreement. Under the terms of the Amended Credit Agreement, the Company
must maintain a minimum cash and excess availability covenant, computed monthly, and may not
declare dividends or incur any additional indebtedness without the consent of Silicon, and
must comply with other financial covenants, as defined in the Amended Credit Agreement. The
Company was in compliance with these covenants as of June 30, 2005.The Company had no borrowings under the Amended Credit Agreement as of June 30, 2005. The
availability under the Amended Credit Agreement at June 30, 2005 was $5.9 million. The
Company has outstanding letters of credit in the amount of $1.6 million at June 30, 2005,
which would reduce borrowing capacity under the Amended Credit Agreement.8.
    
    SENIOR UNSECURED CONVERTIBLE DEBENTURESOn February 4, 2005, the Company completed a private placement of senior unsecured
convertible debentures and warrants pursuant to a securities purchase agreement with certain
institutional investors. The Company issued $13.5 million of senior unsecured convertible
debentures, Series A warrants exercisable for 10.8 million shares of the Companys common
stock and Series B warrants exercisable for 10.0 million shares of the Companys common
stock. The debentures have been discounted to reflect the fair value of the warrants
issued, totaling approximately $5.1 million. The discount is being amortized to interest
expense over the life of the senior unsecured convertible debentures. The unamortized
discount totaled approximately $4.1 million at June 30, 2005. The senior unsecured
convertible debentures bear interest at a rate of 6% per annum and are due February 2009 and
are convertible into approximately 27.0 million shares of the Companys common stock at an
initial conversion price of $0.50 per share, subject to anti-dilution adjustments and
certain limitations. Interest is payable on a quarterly basis beginning April 2005 and
principal is payable on a quarterly basis beginning August 2006. The Series A warrants
issued in connection with the private placement are exercisable for a period of five years
commencing on February 4, 2005 and at an exercise price of $0.72 per share. The Series B
warrants issued in connection with the private placement are exercisable for a period of 90
days, commencing on June 16, 2005, and have an exercise price of $0.78 per share. The
Company paid certain private placement fees and attorneys fees totaling $993,000 and issued
Series A warrants, on the same terms as disclosed above, exercisable for 1.5 million shares
of the Companys stock with a value of $561,000, in connection with the private placement.
The fees were recorded as prepaid loan origination fees and are being amortized to interest
expense over the term of the debentures. The unamortized fees totaled approximately $1.4
million at June 30, 2005. In connection with the private placement, the Company received
net proceeds of approximately $12.5 million, including $1.6 million in restricted cash, net
of expenses.
 12




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##### Table of Contents



9.
    
    OTHER COMPREHENSIVE LOSSComprehensive loss for the three and six months ended June 30, 2005 and 2004 is shown in the
following table (in thousands):
 Three months ended June 30,
    
    Six months ended June 30,2005
    
    2004
    
    2005
    
    2004Net loss
    
    $
    (6,400
    )
    
    $
    (6,280
    )
    
    $
    (11,899
    )
    
    $
    (10,016
    )Other comprehensive loss:Foreign currency translation
    
    
    (36
    )
    
    
    (52
    )
    
    
    (227
    )
    
    
    (111
    )Comprehensive loss
    
    $
    (6,436
    )
    
    $
    (6,332
    )
    
    $
    (12,126
    )
    
    $
    (10,127
    )
 10.
    
    SEGMENT INFORMATIONThe Company reports information for two segments, the Packet-based Technologies Group and
the Advanced Applications Services Group. Previously the Company reported two segments, the
Carrier Solutions Group and the Enterprise Solutions Group. Following the dispositions of
the NACT and MCK businesses, the Company re-evaluated its internal reporting and
decision-making and segregated the activity of the Advanced Applications Services Group and
combined the remaining operations of the Carrier Solutions Group and Enterprise Solutions
Group into the Packet-based Technologies Group. Management evaluates the business segment
performance based on contributions before unallocated items. Inter-segment sales and
transfers are not significant.
 Packet-basedTechnologiesGroup:
    
    The Packet-based Technologies Group consists of the operations of the Companys
softswitching, I-Master and Netperformer divisions and the Companys subsidiary
Telemate.Net. The Packet-based Technologies Group includes domestic and international
sales of hardware and software, integration, applications and technical training and
support. The Packet-based Technologies Group offers hardware and software based
solutions for companies seeking to build private, packet-based voice and data networks.
Additionally, the Packet-based Technologies Group offers software-based solutions for
Internet access and usage management that include call accounting and usage reporting
for Internet protocol network devices.Advanced ApplicationsServicesGroup:
    
    The Advanced Applications Services Group, consists of the Companys technical
applications support group which was previously included as part of the Enterprise
Solutions Group, and includes outsourced technical application services and application
installation and training services to outside customers, as well as customers of the
Packet-based Technologies Group.
 13




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##### Table of Contents



10.
    
    SEGMENT INFORMATION, ContinuedSummarized financial information concerning the Companys reportable segments is shown in
the following table (in thousands):
 Packet-based
    
    AdvancedTechnologies
    
    ApplicationGroup
    
    Services Group
    
    TotalFor the Three Months Ended June 30,
2005Revenue
    
    $
    5,984
    
    
    $
    2,529
    
    
    $
    8,513(Loss) contribution before unallocated items
    
    
    (1,247
    )
    
    
    544
    
    
    
    (703
    )At June 30, 2005Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    10,722
    
    
    
    3,988
    
    
    
    14,710For the Three Months Ended June 30,
2004Revenue
    
    $
    3,350
    
    
    $
    3,281
    
    
    $
    6,631(Loss) contribution before unallocated items
    
    
    (2,864
    )
    
    
    940
    
    
    
    (1,924
    )At December 31, 2004Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    11,104
    
    
    
    4,027
    
    
    
    15,131
  Three months ended June 30,2005
    
    2004Loss before unallocated items, per above
    
    $
    (703
    )
    
    $
    (1,924
    )Corporate general and administrative expenses
    
    
    (1,747
    )
    
    
    (2,228
    )Corporate research and development
    
    
    (50
    )
    
    
    (111
    )Depreciation and amortization
    
    
    (580
    )
    
    
    (678
    )Reorganization costs  loss on sublease
    
    
    (2,550
    )
    
    
    Other
    
    
    (770
    )
    
    
    (209
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (6,400
    )
    
    $
    (5,150
    )
 14




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##### Table of Contents



10.
    
    SEGMENT INFORMATION, ContinuedSummarized financial information concerning the Companys reportable segments is shown in
the following table (in thousands):
 Packet-based
    
    AdvancedTechnologies
    
    ApplicationGroup
    
    Services Group
    
    TotalFor the Six Months Ended June 30,
2005Revenue
    
    $
    10,056
    
    
    $
    5,064
    
    
    $
    15,120(Loss) contribution before unallocated items
    
    
    (3,521
    )
    
    
    1,135
    
    
    
    (2,386
    )For the Six Months Ended June 30,
2004Revenue
    
    $
    11,303
    
    
    $
    6,427
    
    
    $
    17,730(Loss) contribution before unallocated items
    
    
    (2,164
    )
    
    
    1,724
    
    
    
    (440
    )
  Six months ended June 30,2005
    
    2004Loss before unallocated items, per above
    
    $
    (2,386
    )
    
    $
    (440
    )Corporate general and administrative expenses
    
    
    (3,560
    )
    
    
    (4,126
    )Corporate research and development
    
    
    (107
    )
    
    
    (157
    )Depreciation and amortization
    
    
    (1,240
    )
    
    
    (1,447
    )Reorganization costs
    
    
    (124
    )
    
    
    (584
    )Reorganization costs  loss on sublease
    
    
    (2,550
    )
    
    
    Reorganization costs-stock related
    
    
    
    
    
    
    (570
    )Other
    
    
    (1,366
    )
    
    
    (471
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (11,333
    )
    
    $
    (7,795
    )
 15




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##### Table of Contents



10.
    
    SEGMENT INFORMATION, ContinuedThe following table reconciles the segment total assets to the Companys total
assets:
 June 30,
    
    December 31,2005
    
    2004Total assets before unallocated items, per above
    
    $
    14,710
    
    
    $
    15,131Corporate assets:Cash and cash equivalents
    
    
    11,170
    
    
    
    4,234Restricted cash
    
    
    1,620
    
    
    
    Current portion of notes receivable
    
    
    432
    
    
    
    Other current assets
    
    
    1,961
    
    
    
    1,253Assets held for sale
    
    
    
    
    
    
    8,995Property and equipment, net
    
    
    2,608
    
    
    
    3,087Investment
    
    
    677
    
    
    
    729Notes receivable, net of current portion
    
    
    3,068
    
    
    
    $
    36,246
    
    
    $
    33,429
  Canada
    
    United States
    
    TotalFor the Three Months Ended June 30, 2005Revenue
    
    $
    
    
    
    $
    8,513
    
    
    $
    8,513Loss before unallocated items
    
    
    (1,160
    )
    
    
    457
    
    
    
    (703
    )For the Three Months Ended June 30, 2004Revenue
    
    $
    
    
    
    $
    6,631
    
    
    $
    6,631Loss before unallocated items
    
    
    (947
    )
    
    
    (977
    )
    
    
    (1,924
    )For the Six Months Ended June 30, 2005Revenue
    
    $
    
    
    
    $
    15,120
    
    
    $
    15,120Loss before unallocated items
    
    
    (2,352
    )
    
    
    46
    
    
    
    (2,306
    )For the Six Months Ended June 30, 2004Revenue
    
    $
    
    
    
    $
    17,730
    
    
    $
    17,730(Loss) contribution before unallocated items
    
    
    (1,888
    )
    
    
    1,448
    
    
    
    (440
    )At June 30, 2005Total Assets
    
    
    534
    
    
    
    35,712
    
    
    
    36,246At December 31, 2004Total Assets
    
    
    704
    
    
    
    32,725
    
    
    
    33,429
 16




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##### Table of Contents



11.
    
    REORGANIZATION COSTSIn the second quarter of 2005, the Company entered into a sublease agreement with an
unrelated party to sublease excess office space at its facility in Atlanta, Georgia. The
excess space was primarily due to reductions in the corporate staffing over the past year.
As a result of these actions, the Company recorded an accrual for all remaining payments due
on this lease, less amounts to be paid by the sublessor. There is one lease with total
payments remaining through January 31, 2010 of $3.5 million and the sublease has total
payments of $1.6M over the remaining term of the lease. The Company recorded reorganization
costs of $2.6 million during the three months ended June 30, 2005. The
   charge represents the difference between the lease and the sublease for the entire remaining
term, as well as write-offs for furniture and leasehold improvements. The Company expects
to save approximately $1.6 million over the remaining term of the original lease, which
expires January 31, 2010.In January 2005, the Company disposed of substantially all of the operating assets of NACT
and MCK, which resulted in six corporate positions being eliminated. The Company recorded
reorganization costs of $124,000 during the three months ended March 31, 2005.In the first quarter of 2004, the Company terminated a senior executive. As a result of
this action, the Company recorded reorganization costs of $1.2 million during the three
months ended March 31, 2004. The reorganization costs consist of severance costs of
$584,000 and non-cash stock compensation of $570,000 related to the write-off of unamortized
deferred compensation.12.
    
    STOCK OPTIONS AND WARRANTSThe Company has a stock option plan for employees, members of the board of directors,
consultants, and other individual contributors to the Company. In addition, in connection
with various financing and acquisition transactions, and for services provided to the
Company, the Company has issued warrants to purchase the Companys common stock. A summary
of stock options and warrants outstanding at June 30, 2005 is as follows:
 OPTIONS AND WARRANTS ISSUED TO EMPLOYEES
 Options and Warrants Outstanding
    
    Options and Warrants ExercisableRange of Exercise
    
    Outstanding at
    
    Weighted Average
    
    Exercisable at
    
    Weighted AveragePrices
    
    June 30, 2005
    
    Exercise Price
    
    June 30, 2005
    
    Exercise Price$0.19-$0.50
    
    
    3,021,761
    
    
    $
    0.42
    
    
    
    2,447,761
    
    
    $
    0.43$0.51-$1.00
    
    
    1,959,453
    
    
    $
    0.64
    
    
    
    754,578
    
    
    $
    0.64$1.01-$1.50
    
    
    860,600
    
    
    $
    1.31
    
    
    
    524,115
    
    
    $
    1.35$1.51-$2.13
    
    
    773,605
    
    
    $
    1.73
    
    
    
    724,855
    
    
    $
    1.73$2.14-$2.14
    
    
    3,762,500
    
    
    $
    2.14
    
    
    
    3,762,500
    
    
    $
    2.14$2.15-$3.05
    
    
    271,970
    
    
    $
    2.76
    
    
    
    271,220
    
    
    $
    2.76$3.06-$4.00
    
    
    1,394,359
    
    
    $
    3.42
    
    
    
    1,179,109
    
    
    $
    3.42$4.01-$5.00
    
    
    1,156,880
    
    
    $
    4.21
    
    
    
    1,154,130
    
    
    $
    4.21$5.01-$18.00
    
    
    661,455
    
    
    $
    6.76
    
    
    
    661,455
    
    
    $
    6.76Total
    
    
    13,862,583
    
    
    $
    2.01
    
    
    
    11,479,723
    
    
    $
    2.24
  17




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##### Table of Contents



12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of stock options and warrants granted to employees as of June 30,
2005, and the changes during the six months ended June 30, 2005 is presented below :
 Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseOptions
    
    PricesOutstanding at
beginning of the period
    
    
    16,210,941
    
    
    $
    2.04Granted
    
    
    544,750
    
    
    
    0.43Exercised
    
    
    (81,833
    )
    
    
    0.19Forfeited
    
    
    (2,811,275
    )
    
    
    2.92Expired
    
    
    
    
    
    
    Outstanding at end of period
    
    
    13,862,583
    
    
    $
    2.01Exercisable at end of period
    
    
    11,479,723
    
    
    $
    2.24
   Number of
    
    Weighted AverageExercise Price
    
    Outstanding Warrants
    
    Exercise Price
    
    Expiration Date$0.01
    
    
    37,532
    
    
    $
    0.01
    
    
    September 2005-October 2006$0.72
    
    
    12,312,000
    
    
    $
    0.72
    
    
    February 2010$0.78
    
    
    10,000,000
    
    
    $
    0.78
    
    
    September 2005$1.34-$1.50
    
    
    1,491,432
    
    
    $
    1.35
    
    
    January 2006$1.81-$2.81
    
    
    3,119,961
    
    
    $
    2.02
    
    
    July 2005-February 2011$4.03-$5.25
    
    
    2,120,374
    
    
    $
    4.13
    
    
    November 2005-October 2006$5.65
    
    
    4,502,811
    
    
    $
    5.65
    
    
    August 2005-September 2005$6.00
    
    
    150,000
    
    
    $
    6.00
    
    
    October 2006Total
    
    
    33,734,110
    
    
    $
    1.78
   18




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##### Table of Contents



12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of warrants issued primarily in connection with financing as of June
30, 2005, and the changes during the three months ended June 30, 2005 is presented
below :
 Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseWarrants
    
    PricesOutstanding at beginning of period
    
    
    10,551,807
    
    
    $
    4.25Granted
    
    
    22,312,000
    
    
    
    0.75Exercised
    
    
    
    
    
    
    Expired
    
    
    (37,364
    )
    
    
    5.26Effects of anti-dilutive provisions
    
    
    907,667Outstanding and exercisable at end of period
    
    
    33,734,110
    
    
    $
    1.78
  Three months ended June 30,
    
    Six months ended June 30,2005
    
    2004
    
    2005
    
    2004Net loss, as reported
    
    $
    (6,400
    )
    
    $
    (6,280
    )
    
    $
    (11,899
    )
    
    $
    (10,016
    )Add: Stock-based compensation
expense included in net loss
    
    
    
    
    
    
    90
    
    
    
    7
    
    
    
    256Less: Total stock-based employee
compensation expense determined
under fair value based method
for all awards
    
    
    (187
    )
    
    
    (767
    )
    
    
    91
    
    
    
    (1,230
    )Pro forma net loss
    
    $
    (6,587
    )
    
    $
    (6,957
    )
    
    $
    (11,801
    )
    
    $
    (10,990
    )Net loss per common shareAs reported
    
    $
    (0.05
    )
    
    $
    (0.05
    )
    
    $
    (0.09
    )
    
    $
    (0.08
    )Pro forma
    
    
    (0.05
    )
    
    
    (0.05
    )
    
    
    (0.09
    )
    
    
    (0.08
    )
 19




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##### Table of Contents



13.
    
    NET LOSS PER SHAREBasic and diluted net loss per share are computed in accordance with SFAS No. 128, Earnings
Per Share, using the weighted average number of common shares outstanding. The diluted net
loss per share for the three months ended June 30, 2005 does not include the effect of the
common stock equivalents, calculated by the treasury stock method, as their impact would be
antidilutive. Using the treasury stock method, common stock equivalents are as follows:
 For the three months ended
    
    For the six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Shares issuable under stock options
    
    
    36,954
    
    
    
    3,198,440
    
    
    
    119,261
    
    
    
    3,611,830Shares issuable pursuant to warrants
to purchase common stock
    
    
    36,237
    
    
    
    41,008
    
    
    
    36,517
    
    
    
    147,34573,191
    
    
    
    3,239,448
    
    
    
    155,778
    
    
    
    3,759,175
 14.
    
    SUBSEQUENT EVENTOn July 25, 2005, the Company announced that it had restructured its outstanding 7.5%
convertible debenture with an aggregate principal amount of $4.5 million due November 22,
2005. Pursuant to the restructuring, $1.1 million of the aggregate principal amount was
paid on July 26, 2005, $675,000 will be paid in equal monthly installments between August 1,
2005 and October 1, 2005, $450,000 will be paid on November 22, 2005, and the remaining
principal amount of $2.3 million will be paid in equal monthly installments starting January
2006 and continuing through October 2006. The interest rate on the unpaid principal remains
at the current rate of 7.5% through November 22, 2005 and then increases to 12% through the remaining term of the amended debentures.In connection with the restructuring, the Company issued warrants to purchase an aggregate
of 4.0 million shares of the Companys common stock at an exercise price of $0.50 per share
exercisable beginning on November 22, 2005. Of these warrants, three million expire January
1, 2007 and are cancelable if the debentures are repaid by November 22, 2005. The remaining
one million warrants are not cancelable and have a five year term. The fair value of the
warrants issued, totaled approximately $912,000 and will be recorded as other expense in the
quarter ended September 30, 2005.15.
    
    LITIGATIONExcept for the pending matters described in Note 16 to the Companys audited consolidated
financial statements included in the Annual Report, the Company is not a party to any
material legal proceedings other than ordinary routine claims and proceedings incidental to
its business, and the Company does not expect these ordinary routine claims and proceedings,
either individually or in the aggregate, to have a material adverse effect on the Company.
There have been no material developments regarding the pending matters described in Note 16
to the Companys audited consolidated financial statements included in the Annual Report
during the six months ended June 30, 2005.
 20




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##### Table of Contents



ITEM 2: Managements Discussion and Analysis of Financial Condition and Results of Operations
   
    
    the volatility of the price of the Companys common stock;
    
    the Company may be unable to fund future growth;
    
    the Companys ability to be profitable;
    
    the Companys ability to attract and retain qualified personnel;
    
    economic conditions of the telecommunications market;
    
    market demand for and market acceptance of the Companys products;
    
    legal claims against the Company, including, but not limited to, claims of patent infringement;
    
    the Companys ability to protect the Companys intellectual property;
    
    defects in the Companys products;
    
    the Companys obligations to indemnify certain customers;
    
    the Companys exposure to risks inherent in international operations;
    
    the Companys dependence on contract manufacturers and suppliers;
    
    general economic and business conditions; and
    
    other risks and uncertainties disclosed in the Annual Report and in the Companys other filings
with the SEC.
  Overview
  21




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##### Table of Contents



Results of Operations
 Three Months Ended June 30, 2005, compared to Three Months Ended June 30, 2004
  Continuing Operations
  22




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23




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##### Table of Contents



Business Unit Performance
 Packet-based
    
    AdvancedTechnologies
    
    ApplicationsDollars in thousands
    
    Group
    
    Services Group
    
    ConsolidatedFor the Three MonthsEnded June 30,
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005
    
    2004Revenue
    
    $
    5,984
    
    
    $
    3,350
    
    
    $
    2,529
    
    
    $
    3,281
    
    
    $
    8,513
    
    
    $
    6,631Gross profit
    
    
    2,977
    
    
    
    1,698
    
    
    
    777
    
    
    
    1,236
    
    
    
    3,754
    
    
    
    2,934Gross margin
    
    
    50
    %
    
    
    51
    %
    
    
    31
    %
    
    
    38
    %
    
    
    44
    %
    
    
    44
    %General and administrative
    
    
    513
    
    
    
    499
    
    
    
    208
    
    
    
    255
    
    
    
    721
    
    
    
    754Sales and marketing
    
    
    2,024
    
    
    
    2,368
    
    
    
    25
    
    
    
    41
    
    
    
    2,049
    
    
    
    2,409Research and development
    
    
    1,687
    
    
    
    1,695
    
    
    
    
    
    
    
    
    
    
    
    1,687
    
    
    
    1,695(Loss) contribution before
unallocated items
    
    $
    (1,247
    )
    
    $
    (2,864
    )
    
    $
    544
    
    
    $
    940
    
    
    
    (703
    )
    
    
    (1,924
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,747
    
    
    
    2,228Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    50
    
    
    
    111Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    580
    
    
    
    678Reorganization costs  loss on sublease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,550
    
    
    
    Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,630
    )
    
    
    (4,941
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (770
    )
    
    
    (209
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (6,400
    )
    
    $
    (5,150
    )
 Packet-based Technologies Group
    24




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##### Table of Contents



Advanced Applications Services Group
    Discontinued Operations
   For the three months ended June 30,2005
    
    2004Revenue
    
    $
    
    
    
    $
    4,705Gross (loss) profit
    
    
    
    
    
    
    2,212Operating loss
    
    
    
    
    
    
    (1,135
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (1,130
    )
  Six months Ended June 30, 2005, Compared to Six Months Ended June 30, 2004
  Continuing Operations
  25




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26




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##### Table of Contents



Business Unit Performance
 Packet-based
    
    AdvancedTechnologies
    
    ApplicationsDollars in thousands
    
    Group
    
    Services Group
    
    ConsolidatedFor the Six MonthsEnded June 30,
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005
    
    2004Revenue
    
    $
    10,056
    
    
    $
    11,303
    
    
    $
    5,064
    
    
    $
    6,427
    
    
    $
    15,120
    
    
    $
    17,730Gross profit
    
    
    5,013
    
    
    
    6,546
    
    
    
    1,604
    
    
    
    2,301
    
    
    
    6,617
    
    
    
    8,847Gross margin
    
    
    50
    %
    
    
    58
    %
    
    
    32
    %
    
    
    36
    %
    
    
    44
    %
    
    
    50
    %General and administrative
    
    
    1,074
    
    
    
    1,193
    
    
    
    420
    
    
    
    499
    
    
    
    1,494
    
    
    
    1,692Sales and marketing
    
    
    4,146
    
    
    
    4,287
    
    
    
    49
    
    
    
    78
    
    
    
    4,195
    
    
    
    4,365Research and development
    
    
    3,314
    
    
    
    3,230
    
    
    
    
    
    
    
    
    
    
    
    3,314
    
    
    
    3,230(Loss) contribution before
unallocated items
    
    $
    (3,521
    )
    
    $
    (2,164
    )
    
    $
    1,135
    
    
    $
    1,724
    
    
    
    (2,386
    )
    
    
    (440
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,560
    
    
    
    4,126Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    107
    
    
    
    157Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,240
    
    
    
    1,447Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    124
    
    
    
    584Reorganization costs-loss on sublease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,550Reorganization costs-stock related
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    570Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,967
    )
    
    
    (7,324
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,366
    )
    
    
    (471
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (11,333
    )
    
    $
    (7,795
    )
 Packet-based Technologies Group
  27




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##### Table of Contents



Advanced Applications Services Group
    Discontinued Operations
   For the six months ended June 30,2005
    
    2004Revenue
    
    $
    212
    
    
    $
    10,167Gross (loss) profit
    
    
    (27
    )
    
    
    4,802Operating loss
    
    
    (566
    )
    
    
    (2,252
    )Loss from discontinued operations
    
    $
    (566
    )
    
    $
    (2,221
    )
  28




---



##### Table of Contents



Critical Accounting Policies
   Allowance for Doubtful Accounts
  Inventory Obsolescence
  Liabilities of Discontinued Operations
    29




---



##### Table of Contents



Deferred Tax Asset Valuation Allowance
  Litigation and Related Contingencies
  Goodwill, Intangible Assets and Long-Lived Assets
   30




---



##### Table of Contents



Liquidity and Capital Resources
 Summary
      Cash Flow
   31




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##### Table of Contents



Contractual Obligations and Commercial Commitments
  Less than
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    1 year
    
    1-3 years
    
    4-5 years
    
    5 yearsLine of credit
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Additional payments for the acquisition of
Encore Group
    
    
    339
    
    
    
    208
    
    
    
    131
    
    
    
    
    
    
    
    Notes payable for the purchase of Clarent
    
    
    3,000
    
    
    
    
    
    
    
    3,000
    
    
    
    
    
    
    
    Convertible subordinated debentures
    
    
    4,500
    
    
    
    4,500
    
    
    
    
    
    
    
    
    
    
    
    Senior unsecured convertible debentures
    
    
    13,500
    
    
    
    
    
    
    
    7,875
    
    
    
    5,625
    
    
    
    Operating leases:Continuing operations
    
    
    7,364
    
    
    
    2,003
    
    
    
    3,053
    
    
    
    2,308
    
    
    
    Discontinued operations
    
    
    4,130
    
    
    
    1,732
    
    
    
    1,779
    
    
    
    619
    
    
    
    Total contractual cash obligations
    
    $
    32,833
    
    
    $
    8,443
    
    
    $
    15,838
    
    
    $
    8,552
    
    
    $
    
  Sources of Cash
  32




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##### Table of Contents



ITEM
3: Quantitative and Qualitative Disclosures About Market Risk
       33




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##### Table of Contents



ITEM 4: Controls and Procedures
   34




---



##### Table of Contents



PART II  OTHER INFORMATION
 
 Legal Proceedings
  
 Submission of Matters to a Vote of Security Holders
      
 Exhibits
  35




---



##### Table of Contents



SIGNATURE
  VERSO TECHNOLOGIES, INC.Date: August 8, 2005
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer(duly authorized signatory andPrincipal Financial and Accounting Officer)
 36




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##### Table of Contents



EXHIBIT INDEX
 Exhibit No.
    
    Exhibit
    
    Method of Filing3.1
    
    Amended and Restated Articles of
Incorporation of the Company.
    
    Incorporated by
reference to Exhibit
3.1 to the Companys
Registration
Statement on Form
S-18 (File No.
33-51456).3.2
    
    Amendment to the Amended and
Restated Articles of Incorporation
of the Company, as amended.
    
    Incorporated by
reference to Exhibit
3.1 to the Companys
Current Report on
Form 8-K filed
October 2, 2000.3.3
    
    Amendment to the Amended and
Restated Articles of Incorporation
of the Company, as amended.
    
    Incorporated by
reference to Exhibit
4.1 to the Companys
Current Report on
Form 8-K filed
November 19, 2001.3.4
    
    Amendment to the Amended and
Restated Articles of Incorporation
of the Company, amended.
    
    Filed herewith.3.5
    
    Bylaws of the Company, as amended.
    
    Incorporated by
reference to Exhibit
3.2 to the Companys
Registration
Statement on Form
S-4 filed August 7,
2000 (File No.
333-43224).3.6
    
    Amendment to the Bylaws of the
Company, as amended.
    
    Incorporated by
reference to Exhibit
4.2 to the Companys
Current Report on
Form 8-K filed
November 19, 2001.3.7
    
    Amendment to the Bylaws of the
Company, as amended.
    
    Incorporated by
reference to Exhibit
3.1 to the Companys
Current Report on
Form 8-K filed
November 9, 2004.3.8
    
    Bylaws of the Company, as amended
and currently in effect.
    
    Incorporated by
reference to Exhibit
3.2 to the Companys
Current Report on
Form 8-K filed
November 9, 2004.4.1
    
    Warrant issued July 25, 2005 to
Mainfield Enterprises Inc. to
purchase 1,500,000 shares of the
Companys common stock.
    
    Incorporated by
reference to Exhibit
4.1 to the Companys
Current Report on
Form 8-K filed on
July 29, 2005.4.2
    
    Warrant issued July 25, 2005 to
Heimdall Investments, Ltd. to
purchase 1,500,000 shares of the
Companys common stock.
    
    Incorporated by
reference to Exhibit
4.2 to the Companys
Current Report on
Form 8-K filed on
July 29, 2005.4.3
    
    Warrant issued July 25, 2005 to
Mainfield Enterprises Inc. to
purchase 500,000 shares of the
Companys common stock.
    
    Incorporated by
reference to Exhibit
4.3 to the Companys
Current Report on
Form 8-K filed on
July 29, 2005.4.4
    
    Warrant issued July 25, 2005 to
Heimdall Investments, Ltd. to
purchase 500,000 shares of the
Companys common stock.
    
    Incorporated by
reference to Exhibit
4.4 to the Companys
Current Report on
Form 8-K filed on
July 29, 2005.
 37




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##### Table of Contents



Exhibit No.
    
    Exhibit
    
    Method of Filing4.5
    
    Registration Rights Agreement
dated as of July 25, 2005, among
the Company and the investors
signatory thereto.
    
    Incorporated by
reference to Exhibit
4.5 to the Companys
Current Report on
Form 8-K filed on
July 29, 2005.10.1
    
    Assumption Agreement dated April
14, 2005, among the Company,
Needham (Delaware) Corp., Provo
Prepaid (Delaware) Corp.,
Telemate.Net Software, Inc. and
Silicon Valley Bank.
    
    Incorporated by
reference to Exhibit
10.32 to the
Companys Quarterly
Report on Form 10-Q
for the quarter
ended March 31,
2005.10.2
    
    Borrower Agreement dated April 14,
2005, among the Company, Needham
(Delaware) Corp., Provo Prepaid
(Delaware) Corp., Telemate.Net
Software, Inc. and Silicon Valley
Bank.
    
    Incorporated by
reference to Exhibit
10.33 to the
Companys Quarterly
Report on Form 10-Q
for the quarter
ended March 31,
2005.10.3
    
    Amended and Restated Secured
Promissory Note dated April 14,
2005, in principal amount of $10.0
million, made by the Company,
Needham (Delaware) Corp., Provo
Prepaid (Delaware) Corp. and
Telemate.Net Software, Inc. in
favor of Silicon Valley Bank.
    
    Incorporated by
reference to Exhibit
10.34 to the
Companys Quarterly
Report on Form 10-Q
for the quarter
ended March 31,
2005.10.4
    
    Sublease dated July 1, 2005,
between the Company and Digital
Insurance, Inc.
    
    Incorporated by
reference to Exhibit
99.1 to the
Companys Current
Report on Form 8-K
filed on July 8,
2005.10.5
    
    Bill of Sale dated July 1, 2005,
executed by the Company in favor
of Digital Insurance, Inc.
    
    Incorporated by
reference to Exhibit
99.2 to the
Companys Current
Report on Form 8-K
filed on July 8,
2005.
 38




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##### Table of Contents



Exhibit No.
    
    Exhibit
    
    Method of Filing10.6
    
    Security Agreement entered into
on July 1, 2005, between the
Company and Digital Insurance,
Inc.
    
    Incorporated by reference to
Exhibit 99.3 to the Companys
Current Report on Form 8-K
filed on July 8, 2005.10.7
    
    Amendment to the 7.5%
Convertible Debentures dated as
of July 25, 2005 among the
Company, Mainfield Enterprises
Inc. and Heimdall Investments,
Ltd.
    
    Incorporated by reference to
Exhibit 99.1 to the Companys
Current Report on Form 8-K
filed on July 29, 2005.10.8
    
    Limited Waiver and Amendment to
Loan Documents dated July 25,
2005 between the Company and
Silicon Valley Bank.
    
    Incorporated by reference to
Exhibit 99.2 to the Companys
Current Report on Form 8-K
filed on July 29, 2005.10.9
    
    Limited Waiver and Amendment to
Loan Documents (Exim Program)
dated July 25, 2005 between the
Company and Silicon Valley
Bank.
    
    Incorporated by reference to
Exhibit 99.3 to the Companys
Current Report on Form 8-K
filed on July 29, 2005.31.1
    
    Rule 13a-14(a)/15d-14(a)
Certification by the Companys
Chief Executive Officer.
    
    Filed herewith.31.2
    
    Rule 13a-14(a)/15d-14(a)
Certification by the Companys
Chief Financial Officer.
    
    Filed herewith.32.1
    
    Section 1350 Certification by
the Companys Chief Executive
Officer.
    
    Filed herewith.32.2
    
    Section 1350 Certification by
the Companys Chief Financial
Officer.
    
    Filed herewith.
 39