##### Table of Contents



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, 2006
 OR
 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: 000-22190
 VERSO TECHNOLOGIES, INC.
  Minnesota
    
    41-1484525(State of incorporation)
    
    (I.R.S. EmployerIdentification No.)
 
 678.589.3500
 þ o
  o o þ
 o þ




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##### 



VERSO TECHNOLOGIES, INC.
FORM 10-Q
INDEX
 Page No.Part I. FINANCIAL INFORMATIONItem 1. Financial StatementsCondensed Consolidated Balance Sheets as of June 30, 2006 (unaudited) and December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005 (unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005 (unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements (unaudited)
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4. Controls and Procedures
    
    
    34PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    35Item 1A. Risk Factors
    
    
    35Item 5. Other Information
    
    
    35Item 6. Exhibits
    
    
    35Signature Page
    
    
    35Exhibit Index
    
    
    36EX-10.1 AGREEMENT OF SOFTWARE DEVELOPMENT DATED 5-10-06EX-10.2 AGREEMENT TO LOAN DOCUMENTS DATED 6-27-06EX-10.3 VERSO, VERSO VERILINK, LLP & CM SOLUTIONS CONTRACT DATED 7-18-06EX-10.4 MANUFACTURING AGREEMENT DATED 7-12-06EX-10.5 AMENDMENT TO NOTE DATED 7-12-06EX-10.6 AGREEMENT DATED 6-19-06EX-10.7 AMENDMENT NO 1 TO AGREEMENT DATED 8-25-03EX-10.8 AMENDMENT NO. 2 TO PRODUCT PURCHASE AGREEMENTEX-10.9 AMENDMENT NO. 3 TO PRODUCT PURCHASE AGREEMENTEX-10.10 AMENDMENT NO.4 PRODUCT PURCHASE AGREEMENTEX-10.11 AMENDMENT NO.5 PRODUCT PURCHASE AGREEMENTEX-10.12 AMENDMENT NO.6 PRODUCT PURCHASE AGREEMENTEX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
  2




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##### Table of Contents



VERSO TECHNOLOGIES, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 June 30,
    
    
    December 31,2006
    
    
    2005(Unaudited)ASSETS:Current assets:Cash and cash equivalents
    
    $
    1,324
    
    
    $
    1,079Restricted cash
    
    
    1,469
    
    
    
    1,656Accounts receivable, net
    
    
    8,749
    
    
    
    7,336Inventories
    
    
    11,161
    
    
    
    4,259Other current assets
    
    
    2,076
    
    
    
    1,954Current portion of note receivable
    
    
    574
    
    
    
    655Total current assets
    
    
    25,353
    
    
    
    16,939Property and equipment, net
    
    
    2,235
    
    
    
    2,305Investment
    
    
    638
    
    
    
    745Note receivable, net of current portion
    
    
    2,364
    
    
    
    2,736Other intangibles, net of accumulated amoritzation of $2,219 and $1,729, repectively
    
    
    2,465
    
    
    
    2,859Goodwill
    
    
    2,514
    
    
    
    2,514Total assets
    
    $
    35,569
    
    
    $
    28,098LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Line of credit
    
    $
    3,325
    
    
    $
    1,269Accounts payable
    
    
    3,205
    
    
    
    2,309Accrued compensation
    
    
    1,402
    
    
    
    1,111Accrued expenses
    
    
    3,865
    
    
    
    2,231Current portion of accrued loss on sublease
    
    
    462
    
    
    
    543Current portion of liabilities of discontinued operations
    
    
    703
    
    
    
    1,921Current portion of convertible debentures
    
    
    3,935
    
    
    
    3,262Unearned revenue and customer deposits
    
    
    2,979
    
    
    
    2,391Total current liabilities
    
    
    19,876
    
    
    
    15,037Accrued loss on sublease, net of current portion
    
    
    960
    
    
    
    1,150Liabilities of discontinued operations, net of current portion
    
    
    415
    
    
    
    610Other long-term liabilities
    
    
    
    
    
    
    50Notes payable, net of current portion
    
    
    2,824
    
    
    
    2,785Convertible debentures, net of current portion
    
    
    5,105
    
    
    
    5,627Total liabilities
    
    
    29,180
    
    
    
    25,259Shareholders equity:Preferred stock, no par value, 200,000 shares authorized;
164,766 shares issued and 8,766 outstanding
    
    
    2,784
    
    
    
    Common stock, $.01 par value, 60,000,000 shares authorized;
36,022,112 and 27,310,524 shares issued and outstanding
    
    
    360
    
    
    
    273Additional paid-in capital
    
    
    344,795
    
    
    
    334,650Stock payable
    
    
    
    
    
    
    67Accumulated deficit
    
    
    (341,289
    )
    
    
    (331,991
    )Accumulated other comprehensive income (loss)  foreign currency translation
    
    
    (261
    )
    
    
    (160
    )Total shareholders equity
    
    
    6,389
    
    
    
    2,839Total liabilities and shareholders equity
    
    $
    35,569
    
    
    $
    28,098
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VERSO TECHNOLOGIES, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
 For the three months ended
    
    
    For the six months endedJune 30, 2006
    
    
    June 30, 2005
    
    
    June 30, 2006
    
    
    June 30, 2005Revenue:Products
    
    $
    5,156
    
    
    $
    4,603
    
    
    $
    8,753
    
    
    $
    7,342Services
    
    
    3,225
    
    
    
    3,910
    
    
    
    6,416
    
    
    
    7,778Total revenue
    
    
    8,381
    
    
    
    8,513
    
    
    
    15,169
    
    
    
    15,120Cost of revenue:Products:Product costs
    
    
    2,671
    
    
    
    2,299
    
    
    
    4,328
    
    
    
    3,683Amortization of intangibles
    
    
    175
    
    
    
    147
    
    
    
    369
    
    
    
    215Total cost of product
    
    
    2,846
    
    
    
    2,446
    
    
    
    4,697
    
    
    
    3,898Services
    
    
    2,188
    
    
    
    2,355
    
    
    
    4,284
    
    
    
    4,690Total cost of revenue
    
    
    5,034
    
    
    
    4,801
    
    
    
    8,981
    
    
    
    8,588Gross profit:Products
    
    
    2,310
    
    
    
    2,157
    
    
    
    4,056
    
    
    
    3,444Services
    
    
    1,037
    
    
    
    1,555
    
    
    
    2,132
    
    
    
    3,088Total gross profit
    
    
    3,347
    
    
    
    3,712
    
    
    
    6,188
    
    
    
    6,532Operating expenses:General and administrative
    
    
    2,211
    
    
    
    2,366
    
    
    
    4,644
    
    
    
    4,844Sales and marketing
    
    
    1,801
    
    
    
    2,109
    
    
    
    3,574
    
    
    
    4,320Research and development
    
    
    1,994
    
    
    
    1,737
    
    
    
    3,773
    
    
    
    3,421Depreciation and amortization
    
    
    402
    
    
    
    580
    
    
    
    866
    
    
    
    1,240Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    124Reorganization costs  loss on sublease
    
    
    
    
    
    
    2,550
    
    
    
    
    
    
    
    2,550Total operating expenses
    
    
    6,408
    
    
    
    9,342
    
    
    
    12,857
    
    
    
    16,499Operating loss from continuing operations
    
    
    (3,061
    )
    
    
    (5,630
    )
    
    
    (6,669
    )
    
    
    (9,967
    )Other income (expense), net:Other income
    
    
    
    
    
    
    (24
    )
    
    
    2
    
    
    
    (18
    )Equity in loss of investment
    
    
    (41
    )
    
    
    (23
    )
    
    
    (107
    )
    
    
    (51
    )Interest expense, net, including $931, $482, $1,836 and $844
of amortization of loan fees and discount on convertible
debentures in each period, respectively
    
    
    (1,257
    )
    
    
    (723
    )
    
    
    (2,524
    )
    
    
    (1,297
    )(1,298
    )
    
    
    (770
    )
    
    
    (2,629
    )
    
    
    (1,366
    )Loss from continuing operations before income taxes
    
    
    (4,359
    )
    
    
    (6,400
    )
    
    
    (9,298
    )
    
    
    (11,333
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss from continuing operations
    
    
    (4,359
    )
    
    
    (6,400
    )
    
    
    (9,298
    )
    
    
    (11,333
    )Loss from discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (566
    )Net loss
    
    $
    (4,359
    )
    
    $
    (6,400
    )
    
    $
    (9,298
    )
    
    $
    (11,899
    )Net loss per common share  basic and diluted:Loss from continuing operations
    
    $
    (0.13
    )
    
    $
    (0.24
    )
    
    $
    (0.29
    )
    
    $
    (0.43
    )Loss from discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.02
    )$
    (0.13
    )
    
    $
    (0.24
    )
    
    $
    (0.29
    )
    
    $
    (0.45
    )Weighted average shares outstanding  basic and diluted
    
    
    33,591,796
    
    
    
    26,888,110
    
    
    
    31,772,906
    
    
    
    26,783,927
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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 endedJune 30, 2006
    
    
    June 30, 2005Operating Activities:Continuing operations:Net loss from continuing operations
    
    $
    (9,298
    )
    
    $
    (11,333
    )Adjustments to reconcile net loss from continuing operations to net
cash (used in) provided by continuing operating activities:Equity in loss of investment
    
    
    107
    
    
    
    52Stock based compensation
    
    
    159
    
    
    
    Depreciation and amortization
    
    
    1,235
    
    
    
    1,455Provision for doubtful accounts
    
    
    124
    
    
    
    75Amortization of loan fees and discount on convertible subordinated
debentures
    
    
    1,836
    
    
    
    844Reorganization costs-loss on sublease
    
    
    
    
    
    
    2,550Other
    
    
    (98
    )
    
    
    (5
    )Changes in current operating assets and liabilities, net of effects of
acquisitions:Accounts receivable
    
    
    (1,537
    )
    
    
    (264
    )Inventories
    
    
    (968
    )
    
    
    1,135Other current assets
    
    
    (157
    )
    
    
    146Accounts payable
    
    
    896
    
    
    
    (377
    )Accrued compensation
    
    
    (59
    )
    
    
    (249
    )Accrued expenses
    
    
    1,075
    
    
    
    (177
    )Unearned revenue and customer deposits
    
    
    391
    
    
    
    (459
    )Net cash used in continuing operating activities
    
    
    (6,294
    )
    
    
    (6,607
    )Discontinued operations:Loss from discontinued operations
    
    
    
    
    
    
    (566
    )Adjustment to reconcile loss from discontinued operations to net cash used in
discontinued operating activities
    
    
    (1,510
    )
    
    
    (405
    )Net cash used in discontinued operating activities
    
    
    (1,510
    )
    
    
    (971
    )Net cash used in operating activities
    
    
    (7,804
    )
    
    
    (7,578
    )Investing Activities:Continuing operations:Net cash (used in) provided by investing activities for continuing
operations Purchases of property and equipment
    
    
    (197
    )
    
    
    (397
    )Purchase of WSECI
    
    
    
    
    
    
    (244
    )Purchase of Verilink
    
    
    
    
    
    
    Decrease (increase) in restricted cash
    
    
    187
    
    
    
    (1,620
    )Net cash provided by (used in) investing activities for continuing
operations
    
    
    (10
    )
    
    
    (2,261
    )Discontinued operations:Proceeds from notes receivable from Citel
    
    
    550
    
    
    
    Proceeds from sale of discontinued operations
    
    
    
    
    
    
    4,015Net cash provided by investing activities for discontinued operations
    
    
    550
    
    
    
    4,015Net cash provided by investing activities
    
    
    540
    
    
    
    1,754Financing Activities:Proceeds from the issuance of stock
    
    
    24
    
    
    
    42Borrowings on line of credit
    
    
    2,056
    
    
    
    Payments on long-term debt
    
    
    (1,350
    )
    
    
    Proceeds from convertible debentures, net
    
    
    
    
    
    
    12,757Proceeds from private placement, net
    
    
    6,762
    
    
    
    Net cash provided by financing activities
    
    
    7,492
    
    
    
    12,799Effect of exchange rate changes on cash
    
    
    17
    
    
    
    (16
    )(Decrease) increase in cash and cash equivalents
    
    
    245
    
    
    
    6,959Cash and cash equivalents at beginning of period
    
    
    1,079
    
    
    
    4,234Cash and cash equivalents at end of period
    
    $
    1,324
    
    
    $
    11,193Supplemental disclosure of cash flow information:Cash payments (receipts) during the periods for:Interest
    
    $
    392
    
    
    $
    363Income taxes
    
    $
    4
    
    
    $
    (38
    )Non-cash investing and financing activitiesStock consideration for acquisitions:WSECI  issuance of 65,379 and 190,000 shares of common stock
    
    $
    95
    
    
    $
    331Verilink  issuance of 2,900,000 shares of common stock
    
    
    2,784
    
    
    
    Verilink  issuance of 8765.7122 shares of Class C preferred stock
    
    
    2,784
    
    
    
    Issuance of note receivable in disposition of MCK
    
    
    
    
    
    
    3,500Issuance of warrants in conjunction with convertible debentures
    
    
    
    
    
    
    5,084Issuance of common stock in exchange for services
    
    
    123
    
    
    
    694Assets acquired and liabilities assumed in conjunction with business
acquisitions:Fair value of assets acquired, excluding cash and restricted cash
    
    
    7,339
    
    
    
    1,084Liabilities assumed
    
    $
    (1,434
    )
    
    $
    
  5




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. BASIS OF PRESENTATION
        6




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##### Table of Contents



2. MERGERS AND ACQUISITIONS
 Business Assets of Verilink
   Value of common stock issued
    
    $
    2,784Value of Series C preferred stock issued
    
    
    2,784Direct transaction costs
    
    
    338Total purchase consideration
    
    $
    5,906
  7




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##### Table of Contents



PurchasePriceAllocationTangible assets:Inventories
    
    $
    5,934Property & equipment, net
    
    
    500Collection fee receivable
    
    
    767Other assets
    
    
    138Liabilities assumed
    
    
    (1,433
    )Total estimated purchase price allocation
    
    $
    5,906
 Pro Forma Financial Information in thousands, except per share amounts
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Revenue
    
    $
    12,628
    
    
    $
    22,424
    
    
    $
    26,572
    
    
    $
    42,861Net loss
    
    $
    (6,230
    )
    
    $
    (6,739
    )
    
    $
    (16,158
    )
    
    $
    (14,374
    )Earnings (loss) per
share, basic and
diluted
    
    $
    (0.17
    )
    
    $
    (0.23
    )
    
    $
    (0.47
    )
    
    $
    (0.49
    )
 WSECI, Inc.
    8




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##### Table of Contents



WSECIProperty and equipment
    
    $
    52Accounts receivable
    
    
    93Other intangibles
    
    
    1,458Cost of acquisition
    
    $
    1,603
  3. EQUITY INVESTMENT
    Three months ended
    
    Six months endedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Operating results:Revenues
    
    $
    708
    
    
    $
    195
    
    
    $
    708
    
    
    $
    664Operating loss
    
    $
    (80
    )
    
    $
    (44
    )
    
    $
    (210
    )
    
    $
    (100
    )Net loss
    
    $
    (80
    )
    
    $
    (44
    )
    
    $
    (210
    )
    
    $
    (100
    )
 4. DISCONTINUED OPERATIONS
   9




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Three months ended June 30,
    
    
    Six months ended June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    212Gross loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (27
    )Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (566
    )Loss from discontinued operations
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (566
    )
   June 30,
    
    
    December 31,2006
    
    
    2005Notes receivable
    
    $
    2,938
    
    
    $
    3,391Liabilities of discontinued operations:Accrued rent
    
    $
    428
    
    
    $
    1,707Other current liabilities
    
    
    690
    
    
    
    824Liabilities of discontinued operations
    
    $
    1,118
    
    
    $
    2,531
     10




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Three months ended June 30,
    
    
    Six months ended June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Balance beginning of period
    
    $
    2,322
    
    
    $
    3,504
    
    
    $
    2,531
    
    
    $
    3,013Lease payments, net of sublease receipts
    
    
    (1,119
    )
    
    
    (124
    )
    
    
    (1,279
    )
    
    
    (343
    )Other payments
    
    
    (13
    )
    
    
    (9
    )
    
    
    (51
    )
    
    
    (120
    )Estimated costs of disposal of discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000Legal and other costs of disposal
    
    
    (72
    )
    
    
    (130
    )
    
    
    (83
    )
    
    
    (309
    )Balance end of period
    
    $
    1,118
    
    
    $
    3,241
    
    
    $
    1,118
    
    
    $
    3,241
 5. INVENTORIES
  June 30,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    8,102
    
    
    $
    3,026Work in process
    
    
    82
    
    
    
    5Finished goods
    
    
    2,977
    
    
    
    1,228Total inventories
    
    $
    11,161
    
    
    $
    4,259
  6. GOODWILL AND OTHER INTANGIBLES
  11




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Amortization
    
    
    June 30,
    
    
    December 31,Period in months
    
    
    2006
    
    
    2005Intangibles subject to amortization:Current technology
    
    36 months
    
    $
    2,279
    
    
    $
    2,185Customer relationship
    
    120 months
    
    
    2,403
    
    
    
    2,403Weighted average months
    
    80 months
    
    
    4,682
    
    
    
    4,588Accumulated amortization:Current technology
    
    
    
    
    
    
    (1,376
    )
    
    
    (1,008
    )Customer relationship
    
    
    
    
    
    
    (841
    )
    
    
    (721
    )Net intangibles subject to amortization
    
    
    
    
    
    
    2,465
    
    
    
    2,859Goodwill
    
    
    
    
    
    
    2,514
    
    
    
    2,514Total goodwill and other intangibles
    
    
    
    
    
    $
    4,979
    
    
    $
    5,373
 7. LOAN FACILITY WITH SILICON VALLEY BANK
   8. CONVERTIBLE DEBENTURES
 Senior Unsecured Convertible Debentures
  12




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As filed
    
    AdjustedMarch 31, 2005:Convertible debentures
    
    $
    9,171
    
    
    $
    5,607Total liabilities
    
    
    28,322
    
    
    
    24,783Total shareholders equity
    
    
    12,404
    
    
    
    15,959June 30, 2005:Convertible debentures
    
    $
    9,440
    
    
    $
    6,006Total liabilities
    
    
    30,202
    
    
    
    26,768Total shareholders equity
    
    
    6,044
    
    
    
    9,519
   Convertible Subordinated Debentures
   9. OTHER COMPREHENSIVE LOSS
  Three months ended June 30,
    
    
    Six months ended June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net loss
    
    $
    (4,359
    )
    
    $
    (6,400
    )
    
    $
    (9,298
    )
    
    $
    (11,899
    )Other comprehensive loss:Foreign currency translation
    
    
    (78
    )
    
    
    (36
    )
    
    
    (101
    )
    
    
    (227
    )Comprehensive loss
    
    $
    (4,437
    )
    
    $
    (6,436
    )
    
    $
    (9,399
    )
    
    $
    (12,126
    )
 13




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##### Table of Contents



10. SEGMENT INFORMATION
  Technologies Group:
    
    Consists of the operations of the
Companys softswitch, I-Master and
NetPerformer divisions; and the
Companys Telemate.Net and Verilink
subsidiaries. The Technologies
Group includes international and
domestic sales of hardware and
software, integration, applications
and technical training and support.
The Technologies Group offers
hardware and software
based-solutions for companies
seeking to build private,
packet-based voice and data
networks. Additionally, the
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
Technologies Group added the product
suite from the Verilink business
asset acquisition that provide
access, multiplexing and transport
of voice and data services that
extend legacy networks as well as
next generation converged access
solutions, which deliver voice, data
and video to business customers.Advanced ApplicationsServices Group:
    
    Consists of the Companys technical
applications support group, which
was previously included as part of
the Enterprise Solutions Group.
Includes outsourced technical
application services and application
installation and training services
to outside customers, as well as
customers of the Companys
Technologies Group.
  AdvancedTechnologies
    
    ApplicationGroup
    
    Services Group
    
    TotalFor the Three Months Ended June 30, 2006Revenue
    
    $
    6,657
    
    
    $
    1,724
    
    
    $
    8,381(Loss) before unallocated items
    
    
    (1,067
    )
    
    
    (1
    )
    
    
    (1,068
    )At June 30, 2006Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    22,629
    
    
    
    3,676
    
    
    
    26,305For the Months Ended June 30, 2005Revenue
    
    $
    5,984
    
    
    $
    2,529
    
    
    $
    8,513(Loss) contribution before unallocated items
    
    
    (1,247
    )
    
    
    544
    
    
    
    (703
    )At December 31, 2005Goodwill
    
    
    1,061
    
    
    
    1,453
    
    
    
    2,514Total assets
    
    
    14,437
    
    
    
    3,655
    
    
    
    18,092
  14




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##### Table of Contents



Three months ended June 30,2006
    
    
    2005Loss before unallocated items, per above
    
    $
    (1,068
    )
    
    $
    (703
    )Corporate general and administrative expenses
    
    
    (1,506
    )
    
    
    (1,747
    )Corporate research and development
    
    
    (85
    )
    
    
    (50
    )Depreciation and amortization
    
    
    (402
    )
    
    
    (580
    )Reorganization costs
    
    
    
    
    
    
    Reorganization costs  loss on sublease
    
    
    
    
    
    
    (2,550
    )Other
    
    
    (1,298
    )
    
    
    (770
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (4,359
    )
    
    $
    (6,400
    )
  AdvancedTechnologies
    
    ApplicationGroup
    
    Services Group
    
    TotalFor the Six Months Ended June 30, 2006Revenue
    
    $
    11,538
    
    
    $
    3,631
    
    
    $
    15,169(Loss) contribution before unallocated items
    
    
    (2,644
    )
    
    
    200
    
    
    
    (2,444
    )For the Six Months Ended June 30, 2005Revenue
    
    $
    10,056
    
    
    $
    5,064
    
    
    $
    15,120(Loss) contribution before unallocated items
    
    
    (3,521
    )
    
    
    1,135
    
    
    
    (2,386
    )
  Six months ended June 30,2006
    
    
    2005Loss before unallocated items, per above
    
    $
    (2,444
    )
    
    $
    (2,386
    )Corporate general and administrative expenses
    
    
    (3,248
    )
    
    
    (3,560
    )Corporate research and development
    
    
    (111
    )
    
    
    (107
    )Depreciation and amortization
    
    
    (866
    )
    
    
    (1,240
    )Reorganization costs
    
    
    
    
    
    
    (124
    )Reorganization costs  loss on sublease
    
    
    
    
    
    
    (2,550
    )Other
    
    
    (2,629
    )
    
    
    (1,366
    )Income taxes
    
    
    
    
    
    
    Loss from continuing operations
    
    $
    (9,298
    )
    
    $
    (11,333
    )
 15




---



##### Table of Contents



June 30,
    
    
    December 31,2006
    
    
    2005Total assets before unallocated items, per above
    
    $
    26,305
    
    
    $
    18,092Corporate assets:Cash and cash
equivalents
    
    
    1,324
    
    
    
    706Restricted cash
    
    
    1,469
    
    
    
    1,656Current portion of
notes receivable
    
    
    574
    
    
    
    655Other current
assets
    
    
    1,457
    
    
    
    1,594Property and
equipment, net
    
    
    1,438
    
    
    
    1,914Investment
    
    
    638
    
    
    
    745Notes receivable,
net of current portion
    
    
    2,364
    
    
    
    2,736$
    35,569
    
    
    $
    28,098
  Canada
    
    United States
    
    TotalFor the Three Months ended June 30, 2006Revenue
    
    $
    
    
    
    $
    8,381
    
    
    $
    8,381(Loss) contribution before unallocated Items
    
    
    (1,281
    )
    
    
    213
    
    
    
    (1,068
    )For the Three Months ended June 30, 2005Revenue
    
    $
    
    
    
    $
    8,513
    
    
    $
    8,513Loss before unallocated Items
    
    
    (1,160
    )
    
    
    457
    
    
    
    (703
    )For the Six Months ended June 30, 2006Revenue
    
    $
    
    
    
    $
    15,169
    
    
    $
    15,169(Loss) contribution before unallocated Items
    
    
    (2,575
    )
    
    
    131
    
    
    
    (2,444
    )For the Six Months ended June 30, 2005Revenue
    
    $
    
    
    
    $
    15,120
    
    
    $
    15,120Loss before unallocated Items
    
    
    (2,352
    )
    
    
    46
    
    
    
    (2,306
    )At June 30, 2006Total Assets
    
    
    407
    
    
    
    35,162
    
    
    
    35,569At December 31, 2005Total Assets
    
    
    715
    
    
    
    27,383
    
    
    
    28,098
 11. REORGANIZATION COSTS
  16




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12. STOCK OPTIONS AND WARRANTS
  Options and Warrants Outstanding
    
    
    Options and Warrants ExercisableRange of
    
    Outstanding at
    
    
    Weighted Average
    
    
    Exercisable at
    
    
    Weighted AverageExercise Prices
    
    June 30, 2006
    
    
    Exercise Price
    
    
    June 30, 2006
    
    
    Exercise Price$0.95-$1.45
    
    
    589,449
    
    
    $
    1.41
    
    
    
    549,699
    
    
    $
    1.41$1.45-$2.50
    
    
    754,245
    
    
    $
    2.21
    
    
    
    598,495
    
    
    $
    2.17$2.51-$5.00
    
    
    223,150
    
    
    $
    3.27
    
    
    
    182,650
    
    
    $
    3.22$5.01-$7.50
    
    
    149,911
    
    
    $
    6.48
    
    
    
    99,911
    
    
    $
    6.59$7.51-$90.00
    
    
    1,317,043
    
    
    $
    13.60
    
    
    
    1,316,168
    
    
    $
    13.59Total
    
    
    3,033,798
    
    
    $
    7.28
    
    
    
    2,746,923
    
    
    $
    7.72
   Number ofShares of
    
    
    WeightedUnderlying
    
    
    AverageOptions
    
    
    Exercise PricesOutstanding at beginning of period
    
    
    3,201,096
    
    
    $
    8.23Granted
    
    
    110,000
    
    
    
    3.50Exercised
    
    
    (4,060
    )
    
    
    1.75Forfeited
    
    
    (273,238
    )
    
    
    16.90Expired
    
    
    
    
    
    
    Outstanding at end of period
    
    
    3,033,798
    
    
    $
    7.28Exercisable at end of period
    
    
    2,746,923
    
    
    $
    7.72
   Number of
    
    
    Weighted AverageExercise Price
    
    Outstanding Warrants
    
    
    Exercise Price
    
    
    Expiration Date$0.05
    
    
    5,000
    
    
    $
    0.05
    
    
    October 2006$1.56
    
    
    5,614,692
    
    
    $
    1.56
    
    
    August 2011$2.16-$2.17
    
    
    800,000
    
    
    $
    2.17
    
    
    July 2007-February 2011$2.91
    
    
    2,462,400
    
    
    $
    2.19
    
    
    February 2010$6.82
    
    
    491,505
    
    
    $
    6.82
    
    
    February 2011$26.25-$30.00
    
    
    50,000
    
    
    $
    28.50
    
    
    October 2006Total
    
    
    9,423,597
    
    
    $
    3.59
 17




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##### Table of Contents



Number ofShares of
    
    
    WeightedUnderlying
    
    
    AverageWarrants
    
    
    Exercise PricesOutstanding at beginning of period
    
    
    4,107,192
    
    
    $
    3.82Granted
    
    
    5,614,692
    
    
    
    1.56Exercised
    
    
    
    
    
    
    Expired
    
    
    (298,287
    )
    
    
    6.74Outstanding at end of period
    
    
    9,423,597
    
    
    $
    2.38Exercisable at end of period
    
    
    3,808,905
    
    
    $
    3.59
      Six Months EndedJune 30, 2006Risk-free interest rate
    
    5.0%Expected life
    
    4 yearsExpected volatility
    
    106.00%Expected dividend yield
    
    0.0%
 18




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##### Table of Contents



Three Months
    
    Six MonthsEnded
    
    EndedJune 30, 2005
    
    June 30, 2005Net loss, as reported
    
    $
    (6,400
    )
    
    $
    (11,899
    )Add: Stock-based compensation expense included in net loss
    
    
    
    
    
    
    7Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards
    
    
    (187
    )
    
    
    91Pro forma net loss
    
    $
    (6,587
    )
    
    $
    (11,801
    )Net loss per common shareAs reported
    
    $
    (0.24
    )
    
    $
    (0.43
    )Pro forma
    
    $
    (0.24
    )
    
    $
    (0.44
    )
 13. NET LOSS PER SHARE
  For the three months ended
    
    
    For the six months endedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Shares issuable upon conversion of preferred stock
    
    
    478,022
    
    
    
    
    
    
    
    240,332Shares issuable under stock options
    
    
    1,428
    
    
    
    7,391
    
    
    
    5,319
    
    
    
    23,852Shares issuable pursuant to warrants
to purchase common stock
    
    
    4,779
    
    
    
    7,247
    
    
    
    4,808
    
    
    
    7,304484,229
    
    
    
    14,638
    
    
    
    250,459
    
    
    
    31,156
 14. PRIVATE PLACEMENT
  15.
    
    PREFERRED AND COMMON STOCK ISSUED IN CONNECTION WITH ACQUISITION OF BUSINESS ASSETS OF
VERILINK
  19




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16. LITIGATION
  
 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 risks associated with acquisitions;-
    
    the Companys ability to be profitable;-
    
    the Companys ability to attract and retain qualified personnel;-
    
    general economic conditions of the telecommunications market;
 20




---



##### Table of Contents



-
    
    the Companys research and development expenditures-
    
    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 and emerging markets;-
    
    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, 2006, Compared to Three Months Ended June 30, 2005
  Continuing Operations
   22




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##### Table of Contents



23




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##### Table of Contents



Business Unit Performance
 Packet-based
    
    
    AdvancedTechnologies
    
    
    Applications(Dollars in thousands)
    
    Group
    
    
    Services Group
    
    
    ConsolidatedFor the Three Months Ended June 30,
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    $
    6,657
    
    
    $
    5,984
    
    
    $
    1,724
    
    
    $
    2,529
    
    
    $
    8,381
    
    
    $
    8,513Gross profit
    
    
    3,151
    
    
    
    2,935
    
    
    
    195
    
    
    
    777
    
    
    
    3,346
    
    
    
    3,712Gross margin
    
    
    47
    %
    
    
    49
    %
    
    
    11
    %
    
    
    31
    %
    
    
    40
    %
    
    
    44
    %General and administrative
    
    
    595
    
    
    
    513
    
    
    
    110
    
    
    
    208
    
    
    
    705
    
    
    
    721Sales and marketing
    
    
    1,715
    
    
    
    2,024
    
    
    
    86
    
    
    
    85
    
    
    
    1,801
    
    
    
    2,109Research and development
    
    
    1,908
    
    
    
    1,687
    
    
    
    
    
    
    
    
    
    
    
    1,908
    
    
    
    1,687(Loss) contribution before
unallocated items
    
    $
    (1,067
    )
    
    $
    (1,289
    )
    
    $
    (1
    )
    
    $
    484
    
    
    
    (1,068
    )
    
    
    (805
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,506
    
    
    
    1,645Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    85
    
    
    
    50Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    402
    
    
    
    580Reorganization costs  loss on sublease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,550Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,061
    )
    
    
    (5,630
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,298
    )
    
    
    (770
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (4,359
    )
    
    $
    (6,400
    )
 Technologies Group
    Advanced Applications Services Group
   24




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Discontinued Operations
  Six Months Ended June 30, 2006, Compared to Six Months Ended June 30, 2005
  Continuing Operations
           25




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##### Table of Contents



Business Unit Performance
 AdvancedTechnologies
    
    
    Applications(Dollars in thousands)
    
    Group
    
    
    Services Group
    
    
    ConsolidatedFor the Six Months Ended June 30,
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    $
    11,538
    
    
    $
    10,056
    
    
    $
    3,631
    
    
    $
    5,064
    
    
    $
    15,169
    
    
    $
    15,120Gross profit
    
    
    5,591
    
    
    
    4,970
    
    
    
    597
    
    
    
    1,604
    
    
    
    6,188
    
    
    
    6,532Gross margin
    
    
    48
    %
    
    
    49
    %
    
    
    16
    %
    
    
    32
    %
    
    
    41
    %
    
    
    43
    %General and administrative
    
    
    1,160
    
    
    
    1,074
    
    
    
    236
    
    
    
    420
    
    
    
    1,396
    
    
    
    1,494Sales and marketing
    
    
    3,413
    
    
    
    4,146
    
    
    
    161
    
    
    
    174
    
    
    
    3,574
    
    
    
    4,320Research and development
    
    
    3,662
    
    
    
    3,314
    
    
    
    
    
    
    
    
    
    
    
    3,662
    
    
    
    3,314(Loss) contribution before
unallocated items
    
    $
    (2,644
    )
    
    $
    (3,564
    )
    
    $
    200
    
    
    $
    1,010
    
    
    
    (2,444
    )
    
    
    (2,596
    )Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,248
    
    
    
    3,350Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    111
    
    
    
    107Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    866
    
    
    
    1,240Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    124Reorganization costs  loss on
sublease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,550Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,669
    )
    
    
    (9,967
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,629
    )
    
    
    (1,366
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (9,298
    )
    
    $
    (11,333
    )
 Technologies Group
    Advanced Applications Services Group
  26




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##### Table of Contents



Discontinued Operations
   For the Six Months ended June 30,2006
    
    
    2005Revenue
    
    $
    
    
    
    $
    212Gross loss
    
    
    
    
    
    
    (27
    )Operating loss
    
    
    
    
    
    
    (566
    )Loss from discontinued operations
    
    $
    
    
    
    $
    (566
    )
  Critical Accounting Policies
  Revenue Recognition
  27




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Allowance for Doubtful Accounts
  Inventory Obsolescence
  28




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##### Table of Contents



Liabilities of Discontinued Operations
    Deferred Tax Asset Valuation Allowance
  Litigation and Related Contingencies
  Goodwill, Intangible Assets and Long-Lived Assets
   29




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Liquidity and Capital Resources
 Summary
       30




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Cash Flow
      Contractual Obligations and Commercial Commitments
  31




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##### Table of Contents



Less than
    
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    
    1 year
    
    
    1-3 years
    
    
    4-5 years
    
    
    5 yearsLine of credit
    
    $
    3,325
    
    
    $
    3,325
    
    
    $
    
    
    
    $
    
    
    
    $
    Additional payments for the acquisition of
Encore Group
    
    
    131
    
    
    
    131
    
    
    
    
    
    
    
    
    
    
    
    Notes payable for the purchase of Clarent
    
    
    3,000
    
    
    
    
    
    
    
    3,000
    
    
    
    
    
    
    
    Convertible subordinated debentures
    
    
    900
    
    
    
    900
    
    
    
    
    
    
    
    
    
    
    
    Senior unsecured convertible debentures
    
    
    13,500
    
    
    
    3,093
    
    
    
    10,407
    
    
    
    
    
    
    
    Operating leases:Continuing operations
    
    
    6,315
    
    
    
    2,003
    
    
    
    1,814
    
    
    
    2,498
    
    
    
    Discontinued operations
    
    
    1,374
    
    
    
    374
    
    
    
    381
    
    
    
    619
    
    
    
    Total contractual cash obligations
    
    $
    28,545
    
    
    $
    9,826
    
    
    $
    15,602
    
    
    $
    3,117
    
    
    $
    
   Sources of Cash
    32




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##### Table of Contents



,
    
 Item 3: Quantitative and Qualitative Disclosures About Market Risk
 Market Risk
  Interest Rate Risks
  33




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##### Table of Contents



Foreign Currency Risks
  
 Item 4: Controls and Procedures
   34




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##### Table of Contents



PART II  OTHER INFORMATION
 
 Item 1. Legal Proceedings
  
 Item 1A. Risk Factors
   The Companys dependence on contract manufacturers and suppliers and contract software
developers could result in product delivery delays.
  
 Item 5. Other Information
  35




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##### Table of Contents



Item 6. Exhibits
  
 SIGNATURE
  VERSO TECHNOLOGIES, INC.Date: August 18, 2006
    
    
    
    By:
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer(duly authorized signatory and Principal
Financial and Accounting Officer)
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EXHIBIT INDEX
 Exhibit No.
    
    Exhibit
    
    Method of Filing2.1
    
    Securities Purchase
Agreement dated as of June
15, 2006 among the Company,
Winslow Asset Group, LLC
and Winslow Asset Holdings,
LLC. (The schedules to the
Securities Purchase
Agreement have been omitted
from this Quarterly Report
pursuant to Item 601(b)(2)
of Regulation S-K, and the
Company agrees to furnish
copies of such omitted
schedules supplementally to
the Securities and Exchange
Commission upon request.)
    
    Incorporated by reference
to Exhibit 2.1 to the
Companys Current Report on
Form 8-K filed on June 21,
2006.3.1
    
    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.
    
    Incorporated by reference
to Exhibit 3.4 to the
Companys Quarterly Report
on Form 10-Q for the
quarter ended June 30,
2005.3.5
    
    Articles of Amendment to
the Companys Articles of
Incorporation, effective as
of October 11, 2005.
    
    Incorporated by reference
to Exhibit 3.1 to the
Companys Current Report on
Form 8-K filed October 7,
2005.3.6
    
    The Companys Amended and
Restated Bylaws, adopted
October 24, 2005.
    
    Incorporated by reference
to Exhibit 3.1 to the
Companys Current Report on
Form 8-K filed October 7,
2005.3.7
    
    Statement of Rights of
Series C Preferred Stock of
the Company effective June
16, 2005.
    
    Incorporated by reference
to Exhibit 3.1 to the
Companys Current Report on
Form 8-K filed on June 21,
2006.4.1
    
    Registration Rights
Agreement dated March 20,
2006, between the
Registrant and Joseph Noel.
    
    Incorporated by reference
to Exhibit 4.4 to the
Registrants Registration
Statement on Form S-3 (No.
333-133373).4.2
    
    Registration Rights
Agreement dated March 20,
2006, between the
Registrant and J.P. Turner
& Company, L.L.C.
    
    Incorporated by reference
to Exhibit 4.5 to the
Registrants Registration
Statement on Form S-3 (No.
333-133373).
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Exhibit No.
    
    Exhibit
    
    Method of Filing4.3
    
    Registration Rights
Agreement dated March 20,
2006, between the
Registrant and Croft &
Bender.
    
    Incorporated by reference
to Exhibit 4.6 to the
Registrants Registration
Statement on Form S-3 (No.
333-133373).4.4
    
    Registration Rights
Agreement dated as of June
16, 2006 between the
Company and Winslow Asset
Group, LLC.
    
    Incorporated by reference
to Exhibit 4.1 to the
Companys Current Report on
Form 8-K filed on June 21,
2006.10.1
    
    Agreement of Software
Development dated as of May
10, 2006, between the
Company and Elitecore
Technologies Limited.
    
    Filed herewith.10.2
    
    Amendment to Loan Documents
dated as of June 27, 2006
among the Company, certain
of its subsidiaries and
Silicon Valley Bank.
    
    Filed herewith.10.3
    
    Contract entered into on
July 17, 2006, among the
Company, Verso Verilink,
LLC and CM Solutions, Inc.
    
    Filed herewith.10.4
    
    Manufacturing Agreement
dated as of July 12, 2006
between the Company and CM
Solutions Corporation.
    
    Filed herewith.10.5
    
    Amendment to Note dated as
of June 30, 2006 among the
Company, CITEL
Technologies, Inc. and
CITEL Technologies Limited.
    
    Filed herewith.10.6
    
    Agreement dated as of June
19, 2003 between Telesector
Resources Group, Inc.,
d/b/a Verizon Services
Group, and XEL
Communications Inc., which
agreement has been assumed
by Verso Verilink, LLC.
    
    Filed herewith.10.7
    
    Amendment No. 1 to
Agreement dated as of
August 25, 2003 between
Telesector Resources Group,
Inc., d/b/a Verizon
Services Group and XEL
Communications, Inc., which
amendment has been assumed
by Verso Verilink, LLC.
    
    Filed herewith.10.8
    
    Amendment No. 2 to Product
Purchase Agreement dated as
of December 12, 2003
between Telesector
Resources Group, Inc.,
d/b/a Verizon Services
Group and XEL
Communications, Inc., which
amendment has been assumed
by Verso Verilink, Inc.
    
    Filed herewith.10.9
    
    Amendment No. 3 to Product
Purchase Agreement dated as
of February 18, 2004
between Telesector
Resources Group, Inc.,
d/b/a Verizon Services
Group and XEL
Communications, Inc., which
amendment has been assumed
by Verso Verilink, Inc.
    
    Filed herewith.
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Exhibit No.
    
    Exhibit
    
    Method of Filing10.10
    
    Amendment No. 4 to Contract
No. C0302362 dated as of
November 10, 2004 between
Telesector Resources Group,
Inc., d/b/a Verizon
Services Group, and
Verilink Corporation, which
amendment has been assumed
by Verso Verilink, Inc.
    
    Filed herewith.10.11
    
    Amendment No. 5 to Product
Purchase Agreement dated as
of March 4, 2005 between
Telesector Resources Group,
Inc., d/b/a Verizon
Services Group, and
Verilink Corporation, which
amendment has been assumed
by Verso Verilink, Inc.
    
    Filed herewith.10.12
    
    Amendment No. 6 to Product
Purchase Agreement dated as
of July 27, 2006, between
Verso Verilink, LLC and
Verizon Services Corp.
    
    Filed herewith.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.
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