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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q [X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 [  ]
TRANSITION REPORT UNDER SECTION 13 OR 15(d)  For the transition period
from 
 to Commission file number 0-22190   VERSO TECHNOLOGIES, INC.  MINNESOTA
(State or Other Jurisdiction
of Incorporation or Organization)
    
    41-1484525
(I.R.S. Employer Identification No.)
 400 Galleria Parkway, Suite 300, Atlanta, GA 30339
(Address of Principal Executive Offices) (678) 589-3500
(Registrants Telephone Number, Including Area Code)   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [  ]. Indicated by check mark whether registrant is an accelerated filer (as defined
in Rule 12b-2 of the Exchange Act) Yes [X] No [  ]. Shares of the registrants common stock, par value $.01 per share, outstanding
as of November 9, 2004: 133,104,056.




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VERSO TECHNOLOGIES, INC.
FORM 10-Q INDEX Page No.Part I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of September 30, 2004 and
December 31, 2003
    
    
    2Condensed Consolidated Statements of Operations for the three months
and the nine months ended September 30, 2004 and 2003
    
    
    3Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2004 and 2003
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    32Item 4. Controls and Procedures
    
    
    32PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    33Item 6. Exhibits and Reports on Form 8-K
    
    
    33Signature Page
    
    
    34Exhibit Index
    
    
    35EX-31.1 SECTION 302 FOR CERTIFICATION OF CEOEX-31.2 SECTION 302 FOR CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
 1




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 September 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETS:Current assets:Cash and cash equivalents
    
    $
    10,865
    
    
    $
    7,654Restricted cash
    
    
    
    
    
    
    2,290Accounts receivable, net of allowance for doubtful accounts of
$1,294 and $1,995, respectively
    
    
    7,834
    
    
    
    13,620Inventories
    
    
    8,914
    
    
    
    8,727Other current assets
    
    
    1,487
    
    
    
    1,003Total current assets
    
    
    29,100
    
    
    
    33,294Property and equipment, net of accumulated depreciation and amortization
of $8,787 and $6,277, respectively
    
    
    5,365
    
    
    
    5,749Investment
    
    
    554
    
    
    
    673Other intangibles, net of accumulated amortization of $3,793 and $2,145,
respectively
    
    
    5,660
    
    
    
    7,308Goodwill
    
    
    15,998
    
    
    
    16,228Total assets
    
    $
    56,677
    
    
    $
    63,252LIABILITIES AND SHAREHOLDERS EQUITY:Current liabilities:Accounts payable
    
    $
    2,521
    
    
    $
    4,418Accrued compensation
    
    
    1,956
    
    
    
    1,564Accrued expenses
    
    
    3,022
    
    
    
    3,007Current portion of notes payable
    
    
    
    
    
    
    347Current portion of accrued costs of MCK acquisition
    
    
    434
    
    
    
    4,464Current portion of liabilities of discontinued operations
    
    
    759
    
    
    
    1,039Unearned revenue and customer deposits
    
    
    5,287
    
    
    
    5,718Total current liabilities
    
    
    13,979
    
    
    
    20,557Liabilities of discontinued operations, net of current portion
    
    
    744
    
    
    
    834Other long-term liabilities
    
    
    1,262
    
    
    
    1,637Notes payable, net of current portion
    
    
    2,696
    
    
    
    2,652Convertible subordinated debentures
    
    
    4,185
    
    
    
    3,979Total liabilities
    
    
    22,866
    
    
    
    29,659Shareholders 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;
133,104,056 and 122,781,117 shares issued and outstanding
    
    
    1,331
    
    
    
    1,228Additional paid-in capital
    
    
    322,926
    
    
    
    306,293Stock payable
    
    
    94
    
    
    
    130Accumulated deficit
    
    
    (290,482
    )
    
    
    (273,144
    )Deferred compensation
    
    
    (97
    )
    
    
    (1,012
    )Accumulated
other comprehensive income (loss) - foreign currency translation
    
    
    39
    
    
    
    98Total shareholders equity
    
    
    33,811
    
    
    
    33,593Total liabilities and shareholders equity
    
    $
    56,677
    
    
    $
    63,252
 The accompanying notes are an integral part of these condensed consolidated financial statements. 2




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VERSO TECHNOLOGIES, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except
share data)
 For the three months ended
    
    For the nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue:Products
    
    $
    6,207
    
    
    $
    9,573
    
    
    $
    22,927
    
    
    $
    26,697Services
    
    
    5,039
    
    
    
    5,741
    
    
    
    16,216
    
    
    
    17,473Total revenue
    
    
    11,246
    
    
    
    15,314
    
    
    
    39,143
    
    
    
    44,170Cost of revenue:Products:Product costs
    
    
    3,378
    
    
    
    3,671
    
    
    
    10,385
    
    
    
    10,198Amortization of intangibles
    
    
    351
    
    
    
    203
    
    
    
    1,243
    
    
    
    508Total cost of product
    
    
    3,729
    
    
    
    3,874
    
    
    
    11,628
    
    
    
    10,706Services
    
    
    3,027
    
    
    
    2,686
    
    
    
    9,376
    
    
    
    7,910Total cost of revenue
    
    
    6,756
    
    
    
    6,560
    
    
    
    21,004
    
    
    
    18,616Gross profit:Products
    
    
    2,478
    
    
    
    5,699
    
    
    
    11,299
    
    
    
    15,991Services
    
    
    2,012
    
    
    
    3,055
    
    
    
    6,840
    
    
    
    9,563Total gross profit
    
    
    4,490
    
    
    
    8,754
    
    
    
    18,139
    
    
    
    25,554Operating expenses:General and administrative
    
    
    3,982
    
    
    
    2,897
    
    
    
    11,266
    
    
    
    10,146Sales and marketing
    
    
    3,500
    
    
    
    2,402
    
    
    
    10,287
    
    
    
    6,493Research and development
    
    
    3,034
    
    
    
    2,382
    
    
    
    8,919
    
    
    
    6,661Depreciation and amortization of property and equipment
    
    
    831
    
    
    
    867
    
    
    
    2,420
    
    
    
    2,062Amortization of intangibles
    
    
    135
    
    
    
    60
    
    
    
    405
    
    
    
    180Amortization of deferred compensation, related to
sales, general and administrative
    
    
    90
    
    
    
    194
    
    
    
    346
    
    
    
    587Write-down of goodwill
    
    
    
    
    
    
    10,930
    
    
    
    
    
    
    
    10,930Reorganization costs
    
    
    
    
    
    
    93
    
    
    
    584
    
    
    
    207Reorganization costs - stock related
    
    
    
    
    
    
    139
    
    
    
    570
    
    
    
    219Total operating expenses
    
    
    11,572
    
    
    
    19,964
    
    
    
    34,797
    
    
    
    37,485Operating (loss) income
    
    
    (7,082
    )
    
    
    (11,210
    )
    
    
    (16,658
    )
    
    
    (11,931
    )Other income (expense), net:Other income
    
    
    72
    
    
    
    
    
    
    
    224
    
    
    
    18Equity in loss of investment
    
    
    (56
    )
    
    
    (9
    )
    
    
    (119
    )
    
    
    (61
    )Interest expense, net
    
    
    (255
    )
    
    
    (388
    )
    
    
    (785
    )
    
    
    (1,149
    )(239
    )
    
    
    (397
    )
    
    
    (680
    )
    
    
    (1,192
    )Loss before income taxes
    
    
    (7,321
    )
    
    
    (11,607
    )
    
    
    (17,338
    )
    
    
    (13,123
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (7,321
    )
    
    $
    (11,607
    )
    
    $
    (17,338
    )
    
    $
    (13,123
    )Net loss per
common share - basic and diluted
    
    $
    (0.05
    )
    
    $
    (0.12
    )
    
    $
    (0.13
    )
    
    $
    (0.14
    )Weighted
average shares outstanding - basic and diluted
    
    
    133,113,337
    
    
    
    96,507,282
    
    
    
    130,994,763
    
    
    
    92,361,308
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands, except share data)
 (Unaudited)
 For the nine months endedSeptember 30,2004
    
    2003Operating Activities:Continuing operations:Net loss
    
    $
    (17,338
    )
    
    $
    (13,123
    )Adjustments to reconcile net loss to net cash
(used in) provided by continuing operating activities:Equity in loss of investment
    
    
    119
    
    
    
    61Depreciation and amortization of property and equipment
    
    
    2,420
    
    
    
    2,062Amortization of intangibles
    
    
    1,648
    
    
    
    688Amortization of deferred compensation
    
    
    346
    
    
    
    587Write-down of goodwill
    
    
    
    
    
    
    10,930Provision for doubtful accounts
    
    
    651
    
    
    
    1,573Amortization of loan fees and discount on convertible subordinated debentures
    
    
    400
    
    
    
    415Reorganization costs-stock related
    
    
    570
    
    
    
    Other
    
    
    54
    
    
    
    (112
    )Changes in current operating assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    5,265
    
    
    
    (3,709
    )Inventories
    
    
    (187
    )
    
    
    2,547Other current assets
    
    
    (631
    )
    
    
    (155
    )Accounts payable
    
    
    (1,897
    )
    
    
    708Accrued compensation
    
    
    392
    
    
    
    552Accrued expenses
    
    
    (227
    )
    
    
    (2,591
    )Unearned revenue and customer deposits
    
    
    (431
    )
    
    
    316Net cash (used in) provided by continuing operating activities
    
    
    (8,846
    )
    
    
    749Discontinued
operations - payments of discontinued operations liabilities
    
    
    (370
    )
    
    
    (710
    )Net cash (used in) provided by operating activities
    
    
    (9,216
    )
    
    
    39Investing Activities:Purchases of property and equipment
    
    
    (2,047
    )
    
    
    (977
    )Purchased software development
    
    
    
    
    
    
    (481
    )Decrease in restricted cash
    
    
    2,290
    
    
    
    Payment of assumed liabilities and costs of acquisition of MCK Communications, Inc.
    
    
    (4,063
    )
    
    
    9,915Acquisition of certain assets of Clarent Corporation, net of cash acquired
    
    
    
    
    
    
    (1,122
    )Net cash (used in) provided by investing activities
    
    
    (3,820
    )
    
    
    7,335Financing Activities:Net repayments under line of credit
    
    
    
    
    
    
    (800
    )Payments of notes payable
    
    
    (350
    )
    
    
    (2,550
    )Shareholder note repayments
    
    
    
    
    
    
    1,771Proceeds from private placement, net
    
    
    16,474
    
    
    
    Proceeds from issuances of common stock in connection with the
exercise of options, net
    
    
    128
    
    
    
    2,744Net cash provided by financing activities
    
    
    16,252
    
    
    
    1,165Effect of exchange rate changes on cash
    
    
    (5
    )
    
    
    (52
    )Increase (decrease) in cash and cash equivalents
    
    
    3,211
    
    
    
    8,487Cash and cash equivalents at beginning of period
    
    
    7,654
    
    
    
    1,294Cash and cash equivalents at end of period
    
    $
    10,865
    
    
    $
    9,781Supplemental disclosure of cash flow information:Cash payments (receipts) during the periods for:Interest
    
    $
    272
    
    
    $
    611Income taxes
    
    $
    (80
    )
    
    $
    136Non-cash investing and financing activitiesCommon stock consideration for acquisitions:MCK
Communications, Inc. - issuance of 18,278,423 shares of common stock
    
    $
    
    
    
    $
    24,130Compensatory options fully-vested and/or
extended in reorganization
    
    $
    570
    
    
    $
    264Issuance of common stock in litigation settlement
    
    
    
    
    
    
    264Issuance of warrants in exchange for services
    
    
    
    
    
    
    119Issuance of common stock in exchange for services
    
    
    133
    
    
    
    Assets acquired and liablities assumed in conjunction with business acquisitions:Fair value of assets acquired, excluding cash and restricted cash
    
    
    
    
    
    
    10,966Liabilities assumed
    
    
    
    
    
    
    986Notes payable for acquisition of certain assets of Clarent Corporation
    
    $
    
    
    
    $
    9,800
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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VERSO TECHNOLOGIES, INC AND SUBSIDIARIES. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS September 30, 2004 (Unaudited)  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 operations include three
separate business segments, the Carrier Solutions Group, which includes
the Companys Clarent softswitching division and the Companys subsidiary
NACT Telecommunications, Inc. (NACT), the Enterprise Solutions Group,
which includes the Companys Clarent Netperformer division and the
Companys subsidiaries Telemate.Net Software, Inc. (Telemate.Net) and
MCK Communications, Inc. (MCK) and the Advanced Applications Services
Group, which includes the Companys technical applications support group
which was previously included as part of the Enterprise Solutions Group.
The Carrier Solutions Group includes domestic and international sales of
hardware and software, integration, applications and technical training
and support. The Enterprise Solutions Group offers hardware-based
solutions (which include software) for companies seeking to build private,
packet-based voice and data networks. Additionally, the Enterprise
Solutions 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 Companys Carrier Solution Group and Enterprise Solution
Group segments. The Company acquired MCK in September 2003 and
substantially all the business assets of Clarent Corporation (Clarent)
in February 2003. These acquisitions were both accounted for as purchases
(see Note 2).The condensed consolidated financial statements include the accounts of
Verso Technologies, Inc. and its wholly-owned subsidiaries, MCK,
Telemate.Net, NACT, and Clarent Canada Ltd.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, 2003.2.
    
    MERGERS AND ACQUISITIONSMCK Communications, Inc.On September 26, 2003, to increase capital and to enhance the Companys
ability to provide technology that allows enterprises the ability to
migrate to next-generation environments, the Company acquired all of the
outstanding capital stock of MCK by means of a merger. The acquisition
cost was approximately $25.0 million, consisting of 18,278,423 shares of
the Companys common stock with a fair value of $24.1 million and
acquisition costs of approximately $900,000. 5




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  2.
    
    MERGERS AND ACQUISITIONS, ContinuedMCK Communications, Inc.  ContinuedThe acquisition was treated as a purchase for accounting purposes, and
accordingly, the assets and liabilities were recorded at their fair value
at the date of the acquisition.The Company prepared an allocation of the purchase price based on the
estimated fair values of the acquired assets and liabilities. The Company
anticipates the fair value assessments and allocation of the purchase
price to be finalized in 2004. Intangible assets relating to channels of
distribution, strategic licenses and current technology total $3.6 million
and are being amortized over three years.In April 2003, the Company negotiated the original agreement to acquire
MCK in which the MCK stockholders would be entitled to receive
approximately 20.0 million shares of the Companys common stock which was
valued at $13.0 million, based on the volume weighted average closing
price per share of the Companys common stock as reported on the Nasdaq
SmallCap Market for the twenty trading day period beginning March 19, 2003
and ending April 15, 2003. As part of the original agreement, the Company
was to receive $7.5 million in cash. The terms of the agreement were
amended on June 13, 2003. Under the amended terms, MCK stockholders were
entitled to receive approximately 18.3 million shares of the Companys
common stock and the cash MCK was required to have at the closing of the
merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued
in the merger was reduced by the amendment, the amendment changed the
measurement date for valuing such shares. As a result of the increase in
the price of the Companys common stock prior to June 13, 2003, the
revised valuation for the shares of the Companys common stock to be
issued in the merger increased to $24.1 million. As a result of this
increase in value, the goodwill recorded in the merger was impaired upon
closing the merger. The Company completed an impairment analysis in
accordance with Statement of Financial Accounting Standards (SFAS) No.
142, Goodwill and Other Intangible Assets (SFAS No. 142). Based upon
this analysis, the Company recorded a write-off of approximately $10.9
million during the quarter ended September 30, 2003.Clarent CorporationOn February 12, 2003, to enhance the Companys position in the
next-generation networking and technology market, the Company acquired
substantially all the business assets and certain related liabilities of
Clarent. The purchase consideration was approximately $10.8 million,
consisting of $9.3 million in discounted seller notes issued by the
Company and acquisition costs of approximately $1.5 million. At the
closing of the acquisition, the Company issued three promissory notes to
Clarent: a $5.0 million secured note due February 13, 2004, which bore
interest at 10% per annum and a $1.8 million non-interest bearing
unsecured note due February 13, 2004, which was discounted at 6.25% per
annum, both of which were paid in full at September 30, 2004; and a $3.0
million secured note due February 12, 2008, which bears interest at 5% per
annum, discounted at 7.5% per annum. The unamortized discount totaled
approximately $304,000 at September 30, 2004. The assets the Company
purchased from Clarent secure the secured notes.The acquisition was treated as a purchase for accounting purposes, and
accordingly, the assets and liabilities were recorded at their fair value
at the date of the acquisition. Gross intangible assets acquired totaling
$821,000 primarily consist of current technology and are being amortized
over three years. 6




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  2.
    
    MERGERS AND ACQUISITIONS, ContinuedClarent Corporation  ContinuedThe preliminary allocations of the costs of acquisitions of MCK and the
net assets of Clarent, as adjusted, are as follows (in thousands): MCK
    
    ClarentCash
    
    $
    10,575
    
    
    $
    571Restricted cash
    
    
    2,015
    
    
    
    115Accounts receivable
    
    
    1,175
    
    
    
    2,717Inventories
    
    
    423
    
    
    
    5,465Other current assets
    
    
    453
    
    
    
    613Property and equipment
    
    
    365
    
    
    
    1,650Other intangilbes
    
    
    3,600
    
    
    
    821Goodwill (1)
    
    
    14,243
    
    
    
    Accounts payable
    
    
    (508
    )
    
    
    (103
    )Accrued compensation
    
    
    (195
    )
    
    
    (198
    )Current portion of accrued costs of MCK purchase
    
    
    (5,810
    )
    
    
    Accrued expenses
    
    
    (782
    )
    
    
    (331
    )Deferred revenue
    
    
    (524
    )
    
    
    (480
    )Cost of acquisition
    
    $
    25,030
    
    
    $
    10,840
  (1)
    
    Prior to MCK goodwill write-down of $10.9 million  Pro Forma Effect of MCK and Clarent Transactions  The results of MCK have been included in the Companys consolidated
results beginning October 1, 2003 and the results of Clarent have been
included in the Companys consolidated results subsequent to February 12,
2003. The write-down of goodwill in 2003 for MCK of $10.9 million is
included in the results for the quarter ended and nine months ended
September 30, 2003. The following unaudited pro forma information
presents the results of continuing operations of the Company for the three
months and nine months ended September 30, 2003, as if the acquisition of
MCK and Clarent had taken place on January 1, 2003, (in thousands, except
per share amounts): September 30, 2003Three months
    
    Nine monthsended
    
    endedRevenues
    
    $
    18,366
    
    
    $
    54,997Net loss
    
    $
    (16,390
    )
    
    $
    (24,582
    )Net loss per common share  basic and diluted
    
    $
    (0.14
    )
    
    $
    (0.22
    )Weighted average shares outstanding
- basic and diluted
    
    
    113,778,392
    
    
    
    110,304,933
 7




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  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 an immediate
distribution channel into 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
Shanghai Tangsheng, 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, 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 nine months ended September 30, 2004 and 2003 (in thousands) are as
follows: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Operating results:Revenues
    
    $
    
    
    
    $
    152
    
    
    $
    534
    
    
    $
    812Operating loss
    
    $
    (110
    )
    
    $
    (18
    )
    
    $
    (233
    )
    
    $
    (134
    )Net loss
    
    $
    (110
    )
    
    $
    (18
    )
    
    $
    (233
    )
    
    $
    (121
    )
 8




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  4.
    
    DISCONTINUED OPERATIONSFollowing the acquisition of NACT in July 2001, the Company determined
that its value added reseller business and associated consulting practice
(legacy VAR business) was not strategic to the Companys ongoing
objectives and discontinued capital and human resource investment in its
legacy VAR business. Accordingly, the Company elected to report its legacy
VAR business as discontinued operations by early adoption of SFAS No. 144,
Accounting for the Impairment of Disposal of Long-Lived Assets (SFAS
No. 144). There were no results of discontinued operations for the three
and nine months ended September 30, 2004 and 2003, respectively.The liabilities of discontinued operations included in the accompanying
condensed consolidated balance sheet (in thousands) are as follows: September 30,
    
    December 31,2004
    
    2003Accrued restructuring costs
    
    $
    1,242
    
    
    $
    1,472Other current liabilities
    
    
    261
    
    
    
    401Liabilities of discontinued operations
    
    $
    1,503
    
    
    $
    1,873
  Accrued restructuring costs relate primarily to several leases for
buildings and equipment that are no longer being utilized in continuing
operations. The accrual is for all remaining payments due on these
leases, less estimated amounts to be paid by any sublessors. The accrual
for one of the leases with total payments remaining through January 31,
2010 of $2.1 million is offset by sublease receipts totaling approximately
$970,000 through the end of the Companys lease term and assumes an amount
of $240,000 for the extension of one of the subleases through the end of
the Companys lease term.The activity in the restructuring accrual for discontinued operations was
as follows: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Balance beginning of period
    
    $
    1,609
    
    
    $
    2,342
    
    
    $
    1,873
    
    
    $
    3,131Lease payments, net of sublease receipts
    
    
    (80
    )
    
    
    (119
    )
    
    
    (247
    )
    
    
    (583
    )Other payments
    
    
    (26
    )
    
    
    (66
    )
    
    
    (123
    )
    
    
    (391
    )Balance end of period
    
    $
    1,503
    
    
    $
    2,157
    
    
    $
    1,503
    
    
    $
    2,157
 9




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  5.
    
    INVENTORIESInventories consist primarily of purchased electronic components, and are
stated at the lower of cost or market. Cost is determined by using the
first-in, first-out method.Inventories as of September 30, 2004 and December 31, 2003, are comprised
of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    5,980
    
    
    $
    5,610Work in process
    
    
    280
    
    
    
    1,028Finished goods
    
    
    2,654
    
    
    
    2,089Total inventories
    
    $
    8,914
    
    
    $
    8,727
  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 purchased software development, channels of distribution,
strategic licenses, current technology and customer relationship.
Purchased software development is amortized on a straight-line basis over
an estimated useful life of three years once the projects are placed in
service. The channels of distribution, strategic licenses and current
technology are amortized on a straight-line basis over their 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
SFAS No. 142.Goodwill and other intangible assets consist of the following (in
thousands): September 30,
    
    December 31,AmortizationPeriod in months
    
    2004
    
    2003Intangibles subject to amortization:Purchased software development
    
    36 months
    
    $
    2,629
    
    
    $
    2,629Channels of distribution
    
    36 months
    
    
    900
    
    
    
    900Strategic licenses
    
    36 months
    
    
    1,800
    
    
    
    1,800Current technology
    
    36 months
    
    
    1,721
    
    
    
    1,721Customer relationship
    
    120 months
    
    
    2,403
    
    
    
    2,403Weighted average months
    
    57 months
    
    
    9,453
    
    
    
    9,453Accumulated amortization:Purchased software development
    
    
    
    
    (1,801
    )
    
    
    (1,438
    )Channels of distribution
    
    
    
    
    (300
    )
    
    
    (75
    )Strategic licenses
    
    
    
    
    (600
    )
    
    
    (150
    )Current technology
    
    
    
    
    (672
    )
    
    
    (242
    )Customer relationship
    
    
    
    
    (420
    )
    
    
    (240
    )Net intangibles subject to amortization
    
    
    
    
    5,660
    
    
    
    7,308Goodwill
    
    
    
    
    15,998
    
    
    
    16,228Total goodwill and other intangibles
    
    
    
    $
    21,658
    
    
    $
    23,536
 10




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  7.
    
    LOAN FACILITY WITH SILICON VALLEY BANKIn February 2003, the Company amended its original credit agreement (the
Original Credit Agreement) with its primary lender, Silicon Valley Bank
(Silicon), to increase the Companys credit line with Silicon from $5.0
million to $10.0 million, subject to borrowing availability. The Company
also entered into certain additional arrangements with Silicon including
an export-import (EX-IM) facility that will provide for working capital
based on the Companys international accounts receivable and inventory
related to export sales. The Company and Silicon further amended the
credit facility in connection with the acquisition of MCK and the
acquisition of substantially all of the business assets along with certain
related liabilities of Clarent (as amended, the Amended Credit
Agreement). 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 2.0% above
Silicons Base Rate, with a minimum Base Rate of 4.25% (6.75% at September
30, 2004). 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. The Amended Credit Agreement
included a loan fee of $170,000 and .375% per annum on unused available
borrowings. In February 2004, the Company and Silicon further amended the
credit facility. Under the terms of the Amended Credit Agreement, the
Company must maintain a minimum tangible net worth 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. Interest
payments are due monthly, and the Amended Credit Agreement originally
expired in August 2004, but at the Companys request, Silicon further
amended the credit facility to extend the term to January 2005. The
Company paid an amendment fee of $51,000 which is being amortized to
interest expense over the term of the amendment. The Company requested
this extension versus a renewal to give the Company time to determine how
best to size its line of credit to cover its expected borrowing base in
2005 and give the Company maximum financing flexibility. In addition, the
Company was not in compliance with the minimum tangible net worth covenant
as of September 30, 2004, and Silicon waived such non-compliance and
amended the covenants to eliminate the minimum tangible net worth covenant
and add a minimum cash and excess availability covenant.Pursuant to the loan commitment letter with Silicon, on February 12, 2003,
the Company issued to Silicon a warrant to purchase 350,000 shares of the
Companys common stock at an exercise price of $0.44 per share. The fair
value of the warrant issued totaled approximately $119,000, using the
Black-Scholes option pricing method based on the following
weighted-average assumptions: expected volatility  104%; expected life 
five years; risk-free interest rate  3.0%; and expected dividend yield 
0%. The loan fees and fair value of the warrants issued are being
amortized to interest expense over the term of the Amended Credit
Agreement.The Company had no borrowings under the Amended Credit Agreement as of
September 30, 2004. The availability under the Amended Credit Agreement
at September 30, 2004 was $6.5 million. The Company has outstanding
letters of credit in the amount of $1.6 million at September 30, 2004,
which reduces borrowing capacity under the Amended Credit Agreement.8.
    
    OTHER COMPREHENSIVE LOSSComprehensive loss for the three and nine months ended September 30, 2004
and 2003 is shown in the following table (in thousands): Three months ended September 30,
    
    Nine months ended September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (7,321
    )
    
    $
    (11,607
    )
    
    $
    (17,338
    )
    
    $
    (13,123
    )Other comprehensive loss:Foreign currency translation
    
    
    52
    
    
    
    (36
    )
    
    
    (59
    )
    
    
    (63
    )Comprehensive loss
    
    $
    (7,269
    )
    
    $
    (11,643
    )
    
    $
    (17,397
    )
    
    $
    (13,186
    )
 11




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATIONThe Company reports information for three segments, the Carrier Solutions
Group, the Enterprise Solutions Group and the Advanced Applications
Services Group. Previously the Company reported two segments, the Carrier
Solutions Group and the Enterprise Solutions Group. In 2004, the Company
changed its internal reporting and decision-making for the Enterprise
Solutions Group and segregated the activity of the Advanced Applications
Services Group. Management evaluates the business segment performance
based on contributions before unallocated items. Inter-segment sales and
transfers are not significant. Carrier
Solutions
Group:
    
    The Companys Carrier Solutions Group consists of the operations of
the Companys Clarent softswitching division and the Companys
subsidiary, NACT. The Companys Carrier Solutions Group includes
hardware and software, integration, applications and technical
training and support.Enterprise
Solutions
Group:
    
    The Companys Enterprise Solutions Group consists of the operations
of the Companys Clarent Netperformer division, the Companys
subsidiary Telemate.Net and the Companys subsidiary MCK. The
Enterprise Solutions Group offers hardware-based solutions (which
include software) for companies seeking to build private,
packet-based voice and data networks. Additionally, the Enterprise
Group offers software-based solutions for Internet access and usage
management that include call accounting and usage reporting for
Internet protocol network devices, as well as customer support.Advanced
Applications
Services
Group:
    
    The Companys 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 Companys Carrier Solution Group and Enterprise
Solutions Group segments.
 12




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATION, ContinuedSummarized financial information concerning the Companys reportable
segments is shown in the following table (in thousands): Carrier
    
    Enterprise
    
    ApplicationsSolutions
    
    Solutions
    
    ServicesGroup
    
    Group
    
    Group
    
    TotalFor the Three Months Ended September 30, 2004Revenue
    
    $
    3,879
    
    
    $
    4,541
    
    
    $
    2,826
    
    
    $
    11,246Contribution before unallocated items
    
    
    (1,432
    )
    
    
    866
    
    
    
    657
    
    
    
    91For the Three Months Ended September 30, 2003Revenue
    
    $
    7,575
    
    
    $
    4,468
    
    
    $
    3,271
    
    
    $
    15,314Contribution before unallocated items
    
    
    979
    
    
    
    2,574
    
    
    

    1,407
    
    
    
    4,960At September 30, 2004Goodwill
    
    $
    10,170
    
    
    $
    4,375
    
    
    $
    1,453
    
    
    $
    15,998Total Assets
    
    
    22,354
    
    
    
    14,574
    
    
    
    4,203
    
    
    
    41,131At December 31, 2003Goodwill
    
    $
    10,170
    
    
    $
    4,605
    
    
    $
    1,453
    
    
    $
    16,228Total Assets
    
    
    28,279
    
    
    
    16,545
    
    
    
    4,382
    
    
    
    49,206
  The following table reconciles the contribution before unallocated items
to the loss before income taxes (in thousands): Three Months EndedSeptember 30,2004
    
    2003Contribution before unallocated items, per above
    
    $
    91
    
    
    $
    4,960Corporate general and administrative expenses
    
    
    (2,462
    )
    
    
    (1,485
    )Sales and marketing
    
    
    (3,500
    )
    
    
    (2,402
    )Corporate research and development
    
    
    (155
    )
    
    
    Depreciation and amortization of property and equipment
    
    
    (831
    )
    
    
    (867
    )Amortization of intangibles
    
    
    (135
    )
    
    
    (60
    )Amortization of deferred compensation, related to
sales, general and administrative
    
    
    (90
    )
    
    
    (194
    )Write-down of goodwill
    
    
    
    
    
    
    (10,930
    )Reorganization costs
    
    
    
    
    
    
    (93
    )Reorganization costs-stock related
    
    
    
    
    
    
    (139
    )Other
    
    
    (239
    )
    
    
    (397
    )Loss before income taxes
    
    $
    (7,321
    )
    
    $
    (11,607
    )
 13




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##### Table of Contents



VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATION, Continued Carrier
    
    Enterprise
    
    ApplicationsSolutions
    
    Solutions
    
    ServicesGroup
    
    Group
    
    Group
    
    TotalFor the Nine Months Ended September 30, 2004Revenue
    
    $
    16,082
    
    
    $
    13,808
    
    
    $
    9,253
    
    
    $
    39,143Contribution before unallocated items
    
    
    (74
    )
    
    
    2,468
    
    
    
    2,458
    
    
    
    4,852For the Nine Months Ended September 30, 2003Revenue
    
    $
    23,427
    
    
    $
    11,108
    
    
    $
    9,635
    
    
    $
    44,170Contribution before unallocated items
    
    
    4,509
    
    
    
    5,297
    
    
    
    4,029
    
    
    
    13,835
  The following table reconciles the contribution before unallocated items
to the loss before income taxes (in thousands): Nine Months EndedSeptember 30,2004
    
    2003Contribution before unallocated items, per above
    
    $
    4,852
    
    
    $
    13,835Corporate general and administrative expenses
    
    
    (6,588
    )
    
    
    (5,088
    )Sales and marketing
    
    
    (10,287
    )
    
    
    (6,493
    )Corporate research and development
    
    
    (310
    )
    
    
    Depreciation and amortization of property and equipment
    
    
    (2,420
    )
    
    
    (2,062
    )Amortization of intangibles
    
    
    (405
    )
    
    
    (180
    )Amortization of deferred compensation, related to
sales, general and administrative
    
    
    (346
    )
    
    
    (587
    )Write-down of goodwill
    
    
    
    
    
    
    (10,930
    )Reorganization costs
    
    
    (584
    )
    
    
    (207
    )Reorganization costs-stock related
    
    
    (570
    )
    
    
    (219
    )Other
    
    
    (680
    )
    
    
    (1,192
    )Loss before income taxes
    
    $
    (17,338
    )
    
    $
    (13,123
    )
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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  9.
    
    SEGMENT INFORMATION, ContinuedThe following table reconciles the segment total assets to the Companys
total assets: September 30,
    
    December 31,2004
    
    2003Total assets before unallocated items, per above
    
    $
    41,131
    
    
    $
    49,206Corporate assets:Cash and cash equivalents
    
    
    10,801
    
    
    
    7,654Restricted cash
    
    
    
    
    
    
    2,290Other current assets
    
    
    743
    
    
    
    144Property and equipment, net
    
    
    3,448
    
    
    
    3,285Investment
    
    
    554
    
    
    
    673$
    56,677
    
    
    $
    63,252
  The Company conducts research and development in Canada. International
sales of the Companys products and services originate only from the
United States. The geographic distribution of the Companys revenues and
contribution before unallocated items (in thousands) are as follows: Canada
    
    United States
    
    TotalFor the Three Months Ended September 30, 2004Revenue
    
    $
    
    
    
    $
    11,246
    
    
    $
    11,246Contribution before unallocated items
    
    
    (1,242
    )
    
    
    1,333
    
    
    
    91For the Three Months Ended September 30, 2003Revenue
    
    $
    
    
    
    $
    15,314
    
    
    $
    15,314Contribution before unallocated items
    
    
    (745
    )
    
    
    5,705
    
    
    
    4,960For the Nine Months Ended September 30, 2004Revenue
    
    $
    
    
    
    $
    39,143
    
    
    $
    39,143Contribution before unallocated items
    
    
    (3,998
    )
    
    
    8,850
    
    
    
    4,852For the Nine Months Ended September 30, 2003Revenue
    
    $
    
    
    
    $
    44,170
    
    
    $
    44,170Contribution before unallocated items
    
    
    (2,113
    )
    
    
    15,948
    
    
    
    13,835At September 30, 2004Total assets
    
    $
    1,053
    
    
    $
    55,624
    
    
    $
    56,677At December 31, 2003Total assets
    
    $
    1,514
    
    
    $
    61,738
    
    
    $
    63,252
 15




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  10.
    
    REORGANIZATION COSTSIn 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 nine months ended September 30, 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.In the first and third quarters of 2003, the Company initiated a
reorganization to accommodate the acquisition of the assets of Clarent and
made an effort to consolidate functions and improve operational
efficiencies and eliminated 25 positions held by employees. As a result
of these actions, the Company recorded reorganization costs of $232,000
and $426,000, respectively during the three and nine months ended
September 30, 2003. The reorganization costs consist of severance costs
of $93,000 and $207,000, respectively, and non-cash stock compensation of
$139,000 and 219,000, respectively, for the three and nine months ended
September 30, 2003.11.
    
    PRIVATE PLACEMENTOn February 24, 2004, the Company completed a private placement of
securities pursuant to which it issued 9.8 million shares of its common
stock and warrants to purchase 2.5 million shares of its common stock for
an aggregate purchase price of $17.7 million, or $1.80 per share. The
warrants issued in connection with the private placement are exercisable
for a period of seven years at an exercise price of $2.30 per share. The
Company received approximately $16.5 million, net of expenses, from the
private placement of these securities.12.
    
    STOCK OPTIONS AND WARRANTSThe Company has a stock option plan for employees, 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 September 30, 2004 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
    
    September 30, 2004
    
    Exercise Price
    
    September 30, 2004
    
    Exercise Price$0.19-$0.50
    
    
    3,342,552
    
    
    $
    0.42
    
    
    
    2,751,177
    
    
    $
    0.42$0.51-$1.00
    
    
    741,432
    
    
    $
    0.65

    
    
    
    636,308
    
    
    $
    0.64$1.01-$1.50
    
    
    1,408,349
    
    
    $
    1.28
    
    
    
    871,639
    
    
    $
    1.32$1.51-$2.13
    
    
    1,012,230
    
    
    $
    1.72
    
    
    
    167,730
    
    
    $
    1.76$2.14-$2.14
    
    
    4,573,619
    
    
    $
    2.14
    
    
    
    4,136,119
    
    
    $
    2.14$2.15-$3.05
    
    
    290,815
    
    
    $
    2.74
    
    
    
    282,726
    
    
    $
    2.75$3.06-$4.00
    
    
    1,745,859
    
    
    $
    3.49
    
    
    
    1,096,984
    
    
    $
    3.46$4.01-$5.00
    
    
    1,374,935
    
    
    $
    4.24
    
    
    
    1,344,560
    
    
    $
    4.24$5.01-$18.00
    
    
    683,075
    
    
    $
    6.77
    
    
    
    683,075
    
    
    $
    6.77Total
    
    
    15,172,866
    
    
    $
    2.15
    
    
    
    11,970,318
    
    
    $
    2.24
  Options and warrants issued to employees generally terminate ten years
from the date of grant. Termination dates on the options and warrants
listed above range from October 1, 2004 to September 27, 2014. 16




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VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of stock options and warrants granted to employees
as of September 30, 2004, and the changes during the nine months ended
September 30, 2004 is presented below: Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseOptions
    
    PricesOutstanding at
beginning of the period
    
    
    14,727,764
    
    
    $
    2.13Granted
    
    
    1,115,730
    
    
    
    1.67Exercised
    
    
    (382,359
    )
    
    
    0.54Forfeited
    
    
    (288,269
    )
    
    
    1.39Expired
    
    
    
    
    
    
    Outstanding at end of period
    
    
    15,172,866
    
    
    $
    2.15Exercisable at end of period
    
    
    11,970,318
    
    
    $
    2.24
  A summary of warrants issued primarily in connection with financing is as
follows: Number of
    
    Weighted AverageExercise Price
    
    Outstanding Warrants
    
    Exercise Price
    
    Expiration Date$0.01
    
    
    37,532
    
    
    $
    0.01
    
    
    September 2005-October 2006$1.50-$1.82
    
    
    1,244,106
    
    
    $
    1.63
    
    
    August 2005-January 2006$2.30-$3.09
    
    
    2,462,861
    
    
    $
    2.30
    
    
    February 2005-February 2011$3.80-$5.51
    
    
    2,122,469
    
    
    $
    4.98
    
    
    July 2005-October 2006$5.62-$5.65
    
    
    4,534,839
    
    
    $
    5.65
    
    
    February 2005-September 2005$6.00
    
    
    150,000
    
    
    $
    6.00
    
    
    October 2006Total
    
    
    10,551,807
    
    
    $
    4.25
  All warrants are vested.The exercise price and number of outstanding warrants for certain warrants
previously issued have been adjusted according to their antidilution
provisions. 17




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##### Table of Contents



VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  12.
    
    STOCK OPTIONS AND WARRANTS, ContinuedA summary of the status of warrants issued primarily in connection with
financing as of September 30, 2004, and the changes during the nine months
ended September 30, 2004 is presented below: Number of
    
    WeightedShares of
    
    AverageUnderlying
    
    ExerciseWarrants
    
    PricesOutstanding at beginning of period
    
    
    8,010,196
    
    
    $
    4.90Granted
    
    
    2,457,525
    
    
    
    2.30Exercised
    
    
    
    
    
    
    Expired
    
    
    (25,000
    )
    
    
    5.00Effects of anti-dilutive provisions
    
    
    109,086Outstanding and exercisable at end of period
    
    
    10,551,807
    
    
    $
    4.25
  If the Company had used the fair value-based method of accounting for its
stock option and incentive plans and charged compensation cost against
income, over the vesting period, based on the fair value of options at the
date of grant, then the pro-forma net loss and net loss per common share
would have been as follows (in thousands, except for per share amounts): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (7,321
    )
    
    $
    (11,607
    )
    
    $
    (17,338
    )
    
    $
    (13,123
    )Add: Stock-based compensation
expense included in net loss
    
    
    90
    
    
    
    194
    
    
    
    346
    
    
    
    587Less: Total stock-based employee
compensation expense determined
under fair value based method
for all awards
    
    
    (714
    )
    
    
    (844
    )
    
    
    (1,944
    )
    
    
    (2,450
    )Pro forma net loss
    
    $
    (7,945
    )
    
    $
    (12,257
    )
    
    $
    (18,936
    )
    
    $
    (14,986
    )Net loss per common shareAs reported
    
    $
    (0.05
    )
    
    $
    (0.12
    )
    
    $
    (0.13
    )
    
    $
    (0.14
    )Pro forma
    
    
    (0.06
    )
    
    
    (0.13
    )
    
    
    (0.14
    )
    
    
    (0.16
    )
 18




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##### Table of Contents



VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) September 30, 2004 (Unaudited)  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 and nine
months ended September 30, 2004 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 nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Shares issuable under stock options
    
    
    2,343,657
    
    
    
    7,061,632
    
    
    
    3,216,048
    
    
    
    4,768,705Shares issuable pursuant to warrants
to purchase common stock
    
    
    37,187
    
    
    
    7,674,188
    
    
    
    39,978
    
    
    
    7,685,7052,380,844
    
    
    
    14,735,820
    
    
    
    3,256,026
    
    
    
    12,454,410
  14.
    
    LITIGATION Except for the pending matters described in Note 17 to the Companys
audited consolidated financial statements included in the Companys Annual
Report on Form 10-K for the year ended December 31, 2003, 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 17 to the Companys audited consolidated financial
statements included in the Companys Annual Report on Form 10-K for the year
ended December 31, 2003 during the nine months ended September 30, 2004. 19




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##### Table of Contents



ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this Quarterly Report on Form 10-Q and in future
filings by the Company with the SEC and in the Companys written and oral
statements that are not statements of historical facts are forward-looking
statements within the meaning of the Private Securities Litigation Reform Act
of 1995. The words believe, expect, anticipate, intend, will and
similar expressions are examples of words that identify forward-looking
statements. Forward-looking statements include, without limitation, statements
regarding our future financial position, business strategy and expected cost
savings. These forward-looking statements are based on our current beliefs, as
well as assumptions we have made based upon information currently available to
us. Each forward-looking statement reflects our current view of future events
and is subject to risks, uncertainties and other factors that could cause
actual results to differ materially from any results expressed or implied by
our forward-looking statements. Important factors that could cause actual
results to differ materially from the results expressed or implied by any
forward-looking statements include: - the volatility of the price of the Companys common stock; - the Companys ability to fund future growth; - the Companys ability to be profitable; - the Companys ability to attract and retain qualified personnel; - general 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 obligation to indemnify certain customers; - the Companys exposure to risks inherent in international operations; - the Companys dependence on contract manufacturers and suppliers; - the Companys ability to integrate the operations of the businesses recently
acquired by the Company; - the Companys dependence on a small number of customers for revenue with
respect to certain of the Companys products; - the Companys ability to develop and maintain relationships with key vendors; - new regulation and legislation; - general economic and business conditions; and - other risks and uncertainties disclosed in the Companys Annual Report on
Form 10-K for the year ended December 31, 2003 and in the Companys other
filings with the SEC. All subsequent forward-looking statements relating to the matters
described in this document and attributable to us or to persons acting on our
behalf are expressly qualified in their entirety by such factors. We have no
obligation to publicly update or revise these forward-looking statements to
reflect new information, future events, or otherwise, except as required by
applicable Federal securities laws, and we caution you not to place undue
reliance on these forward-looking statements. 20




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##### Table of Contents



Overview Following the acquisition of NACT in 2001, the Company began selling
products to the carrier market and focusing its strategic direction on
developing and marketing next-generation communications products. The
Companys current business was built on acquisitions made by the Company by
leveraging the economic downturn in the telecommunications area. In the second
half of 2001, the Company acquired NACT and Telemate.Net; Telemate.Net products
are sold to enterprise customers. Both of these companies sold products almost
exclusively in domestic markets. In the first quarter of 2003, the Company
acquired substantially all of the operating assets of Clarent, which provided
the Company with patented VoIP technologies for both the carrier and enterprise
markets (primarily serving international markets) and significantly increased
the Companys market share in the worldwide softswitch market. At the end of
the third quarter of 2003, the Company acquired MCK and added MCKs integrated
access routers and distributed telephony devices products to the Companys
enterprise segment. For the nine months ended September 30, 2004, 76% of the
Companys consolidated revenues are attributable to the businesses acquired in
these four acquisitions and 47% of the Companys consolidated revenues are
attributable to the businesses acquired by the Company in 2003. The Companys strategy through 2003 was to add next-generation
communications products to its suite of products through strategic acquisitions
and to leverage these operations through cost reductions to enhance cash flow.
With the acquisition of substantially all of the operating assets of Clarent,
the Company enhanced its strategy to move growth toward international markets.
International revenue increased to 33% of the Companys consolidated revenues
for the nine months ended September 30, 2004 versus 8% of the Companys
consolidated revenues for the full year 2002. As the acquisition of
substantially all of the operating assets of Clarent was funded primarily by
short-term seller financing, generating cash flow during 2003 was extremely
important to the Company. As such, the Company leveraged its combined
operations, reducing sales, general and administrative costs (as compared to
costs prior to the acquisition), while preserving the research and development
expenditures, which are necessary for the Companys long-term growth and
viability. Through 2003, the Companys focus had been on completing strategic
acquisitions, integrating these acquisitions and enhancing cash flow through
cost containment, especially in the areas of sales and marketing. In 2004, the
Company has significantly increased its expenditures for sales and marketing to
focus on long-term sustainable revenue growth. In the first quarter of 2004,
the Company completed a private placement and raised approximately $16.5
million, net of expenses, to fund the expanded sales and marketing programs.
The Company expects that these additional expenditures will significantly
increase the operating loss in 2004 as compared to 2003, excluding the
write-down of goodwill in 2003. General 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 three separate business segments, the Carrier Solutions Group, which
includes the Companys Clarent softswitching division and the Companys
subsidiary NACT, the Enterprise Solutions Group, which includes the Companys
Clarent Netperformer division and the Companys subsidiaries Telemate.Net and
MCK, and the Advanced Applications Services Group, which includes the Companys
technical application support group which was previously included as part of
the Enterprise Solutions Group. The Carrier Solutions Group includes domestic
and international sales of hardware and software, integration, applications and
technical training and support. The Enterprise Solutions Group offers
hardware-based solutions (which include software) for companies seeking to
build private, packet-based voice and data networks. Additionally, the
Enterprise Solutions 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 customers of the Companys Carrier Solution Group and Enterprise
Solution Group segments, as well as outsourced technical application customers
and includes application installation and training services. The Company
acquired MCK in September 2003 and substantially all the business assets of
Clarent in February 2003. The consolidated financial statements include the accounts of Verso
Technologies, Inc. and its wholly-owned subsidiaries, MCK, Telemate.Net, NACT
and Clarent Canada Ltd. The Company believes that the foregoing events significantly affect the
comparability of the Companys results of operations from year to year. You
should read the following discussion of the Companys results of operations and
financial condition in conjunction with the Companys audited consolidated
financial statements and notes thereto included in the Companys Annual Report
on Form 10-K for the year ended December 31, 2003. 21




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##### Table of Contents



Results of Operations Three Months Ended September 30, 2004, compared to Three Months Ended September 30, 2003 For the three months ended September 30, 2004, the Companys net loss
totaled $7.3 million, or $.05 per share, compared with a net loss of $11.6
million, or $.12 per share, for the same period in 2003. The 2003 results
include a write-down of goodwill of $10.9 million or $.11 per share. Total revenue was $11.2 million in the three months ended September 30,
2004, reflecting a 27% decrease from the same period in 2003. Products revenue
decreased from $9.6 million in the three months ended September 30, 2003, to
$6.2 million in the three months ended September 30, 2004. In 2003, the
Company began redirecting its focus for NACT products sales away from its
historic market, primarily emerging domestic carriers (which market was
consolidating), towards carriers in the international market. During the three
months ended September 30, 2003, the Companys Carrier Solutions Group had a
large sale of software to two customers; this did not occur in the three months
ended September 30, 2004. Services revenue was $5.0 million for the three
months ended September 30, 2004, reflecting a 12% decrease from the same period
in 2003. Gross profit was 40% of revenue in the three months ended September
30, 2004, compared with 57% of revenue for the same period in 2003. The
decrease in gross profit dollars resulted primarily from the decrease in
revenues. The decrease in gross profit percentage is due to a decline in
revenues across all product lines in relation to fixed departmental costs
(primarily personnel and related costs) related to the production and support
departments and the increase in amortization of intangibles related to the MCK
and Clarent acquisitions. Total operating expenses incurred for the three months ended September 30,
2004, were $11.6 million, a decrease of $8.4 million compared to the same
period in 2003. The decrease is primarily attributable to the following items:
the 2003 results included a write-down of goodwill of $10.9 million and
reorganization costs of $232,000, decreases in depreciation expense of $36,000
and amortization of deferred compensation of $104,000 offset by increases in
general and administrative expenses of $1.1 million, sales and marketing
expenses of $1.1 million, research and development expenses of $652,000 and
amortization of intangibles of $75,000. The increase in general and administrative expenses resulted from an
increase in expenses related to the acquisition of MCK in September 2003 as
well as an increase in professional fees related to the implementation of
Section 404 of the Sarbanes-Oxley Act of 2002 during the nine months ended
September 30, 2004. The increase in sales and marketing and research and development expenses
resulted from the Companys intention to expand its sales and marketing
programs in 2004 and the addition of personnel and related costs related to the
acquisition of MCK in September 2003. The decrease in depreciation expense is primarily related to fully
depreciated assets offset by the increases related to the purchase of furniture
and equipment of approximately $2.0 million and $504,000 during the first nine
months of 2004 and the last three months of 2003, respectively. Capital
expenditures are primarily depreciated on a straight-line basis over their
estimated useful lives of three years. The increase in intangible amortization is related to the amortization of
the channels of distribution related to the acquisition of MCK in September
2003. The $104,000 decrease in amortization of deferred compensation primarily
related to the termination of certain options and full vesting of other options
outstanding since the Companys acquisitions of Telemate.Net in November 2001
and Cereus Technology Partners, Inc. (Cereus) in September 2000. The
deferred compensation represents the intrinsic value of the Telemate.Net and
Cereus unvested options outstanding at the date of the acquisitions of
Telemate.Net and Cereus and is amortized over the remaining vesting period of
the options. The write-down of goodwill relates to the acquisition of MCK. In April
2003, the Company negotiated the original agreement to purchase MCK in which
the MCK stockholders would be entitled to receive approximately 20.0 million
shares of the Companys common stock which was valued at $13.0 million, based
on the volume weighted average closing price per share of the Companys common
stock as reported on the Nasdaq SmallCap Market for the twenty trading day
period beginning March 19, 2003 and ending April 15, 2003. As part of the
original agreement, the Company was to receive $7.5 million in cash. The terms
of the agreement were amended on June 13, 2003. Under the amended terms, MCK
stockholders were entitled to receive approximately 18.3 million shares of the
Companys common stock and the cash MCK was required to have at the closing of
the merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued in the
merger was reduced by the amendment, the amendment changed the measurement date
for valuing such shares. As a result of the increase in the price of the
Companys common stock, prior to June 13, 2003, the revised valuation for the
shares of the Companys common stock to be issued in the merger increased to
$24.1 million. As a 22




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##### Table of Contents



result of this increase in value, the goodwill recorded in the merger was
impaired upon closing the merger. The Company completed an impairment analysis
in accordance with SFAS No. 142. Based upon this analysis, the Company
recorded a write-off of approximately $10.9 million during the quarter ended
September 30, 2003. In the third quarter of 2003, the Company initiated a reorganization as a
part of its effort to consolidate functions and improve operational
efficiencies and eliminated 11 employee positions. As a result of these
actions, the Company recorded reorganization costs of $232,000 during the three
months ended September 30, 2003. The reorganization costs consist of severance
costs and non-cash stock compensation expense related primarily to the
acceleration of vesting of options. As a percent of revenue, operating expenses were 103% during the three
months ended September 30, 2004 as compared to 130% for the same period in
2003. Excluding the write-down of goodwill, operating expenses as a percent of
revenue would have been 59% during the three months ended September 30, 2003. Other income was $72,000 during the three months ended September 30, 2004
compared with zero for the same period in 2003. Equity in loss of investment was $56,000 during the three months ended
September 30, 2004, compared to $9,000 for the same period in 2003. This
amount represents the Companys portion of BeTrues income or losses. 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. Net interest expense was $255,000 during the three months ended September
30, 2004, a decrease of $133,000 compared to the same period in 2003. The
decrease was attributable to payments made on the Companys notes payable for
the acquisition of assets from Clarent. Business Unit Performance Carrier
    
    Enterprise
    
    AdvancedSolutions
    
    Solutions
    
    ApplicationsDollars in thousands
    
    Group
    
    Group
    
    Services Group
    
    ConsolidatedFor the Three MonthsEnded September 30,
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    3,879
    
    
    $
    7,575
    
    
    $
    4,541
    
    
    $
    4,468
    
    
    $
    2,826
    
    
    $
    3,271
    
    
    $
    11,246
    
    
    $
    15,314Gross profit
    
    
    1,234
    
    
    
    3,823
    
    
    
    2,325
    
    
    
    3,317
    
    
    
    931
    
    
    
    1,614
    
    
    
    4,490
    
    
    
    8,754Gross margin
    
    
    32
    %
    
    
    50
    %
    
    
    51
    %
    
    
    74
    %
    
    
    33
    %
    
    
    49
    %
    
    
    40
    %
    
    
    57
    %General and administrative
    
    
    839
    
    
    
    988
    
    
    
    407
    
    
    
    217
    
    
    
    274
    
    
    
    207
    
    
    
    1,520
    
    
    
    1,412Research and development
    
    
    1,827
    
    
    
    1,856
    
    
    
    1,052
    
    
    
    526
    
    
    
    
    
    
    
    
    
    
    
    2,879
    
    
    
    2,382Contribution before unallocated items
    
    $
    (1,432
    )
    
    $
    979
    
    
    $
    866
    
    
    $
    2,574
    
    
    $
    657
    
    
    $
    1,407
    
    
    $
    91
    
    
    $
    4,960Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,462
    
    
    
    1,485Sales and marketing
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,500
    
    
    
    2,402Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    155
    
    
    
    Depreciation and amortization of
property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    831
    
    
    
    867Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    135
    
    
    
    60Amortization of deferred compensation,
related to sales, general and
administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    90
    
    
    
    194Write-down of goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,930Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    93Reorganization costs-stock related
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    139Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,082
    )
    
    
    (11,210
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (239
    )
    
    
    (397
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (7,321
    )
    
    $
    (11,607
    )
 23




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##### Table of Contents



Carrier Solutions Group Total revenue from the Companys Carrier Solutions Group revenue was $3.9
million in the three months ended September 30, 2004, a 49% decrease from the
same period in 2003. In 2003, the Company began redirecting its focus for NACT
product sales away from its historic market, primarily emerging domestic
carriers (which market was consolidating) towards carriers in the international
market. At the same time, the Company reduced its sales and marketing
expenditures for NACT, in a broad cost reduction initiative required to enable
the Clarent acquisition. During the three months ended September 30, 2003, the
Companys Carrier Solutions Group had a large sale of software to two
customers; this did not occur in the three months ended September 30, 2004. In
addition, during the three months ended September 30, 2004, the Company has
concentrated on larger international deals that require a longer time period to
close. Gross profit decreased by $2.6 million in the three months ended September
30, 2004, and was 32% percent of revenue, compared to 50% in the same period in
2003. The decrease in gross profit dollars is attributable to the decrease in
revenue. The decrease in gross margin is due to a decline in revenues in
relation to fixed departmental costs (primarily personnel and related costs)
related to the production and support departments. Allocated operating expenses incurred in the Carrier Solutions Group for
the three months ended September 30, 2004, were $2.7 million, a decrease of
$178,000 compared to the same period in 2003. The decrease in general and
administrative expenses is attributable to a reduction in bad debt expense.
The decrease in research and development expenses during the three months ended
September 30, 2004, reflects decreased personnel costs. As a percent of
revenue, operating expenses for the Carrier Solutions Group were 69% during the
three months ended September 30, 2004, up from 38% during the same period in
2003. Enterprise Solutions Group Total revenue for the Companys Enterprise Solutions Group was $4.5
million in the three months ended September 30, 2004, a 2% increase from the
same period in 2003. The increase in revenue is related to the Companys
acquisition of MCK in September 2003 offset by a decline in revenues across all
other product lines. Gross profit decreased by $992,000 in the three months ended September 30,
2004, and was 51% percent of revenue, compared with 74% of revenue in the same
period in 2003. The decrease in gross profit dollars is attributable to the
decline in revenue across all product lines, excluding the acquisition of MCK
in September 2003, as well as the increase in amortization of intangibles
related to MCK technology. The decrease in gross margin is due to a decline in
revenues in relation to fixed departmental costs (primarily personnel and
related costs) related to the production and support departments and the
addition of MCK which has lower margins. Allocated operating expenses incurred in Enterprise Solutions Group for
the three months ended September 30, 2004, were $1.5 million, an increase of
$716,000 compared to the same period in 2003. The increases in general and
administrative expenses and research and development expenses relate to the
acquisition of MCK in September 2003. As a percent of revenue, allocated
operating expenses for Enterprise Solutions Group were 32% during the three
months ended September 30, 2004, up from 17% during the same period in 2003.
The increase is primarily attributable to the increase in research and
development expenses as a percentage of revenue related to the acquisition of
MCK in September 2003. Advanced Applications Services Group Total revenue for the Companys Advanced Applications Services Group was
$2.8 million in the three months ended September 30, 2004, a 14% decrease from
the same period in 2003. The decrease in revenue is related to a decrease in
installation services, rebillable travel and outsourced services for
hospitality related customers. Gross profit decreased by $683,000 in the three months ended September 30,
2004, and was 33% of revenue, compared with 49% of revenue in the same period
in 2003. The decrease in gross profit dollars and gross margin is due to
increased personnel and related costs related to the Advanced Applications
Services Groups performance of consulting work to assist a large customer in
its conversion to a new software platform and the under-utilization of the
installation group. Allocated operating expenses incurred in Advanced Applications Services
Group for the three months ended September 30, 2004, were $274,000, an increase
of $67,000 compared to the same period in 2003. The increase in general and
administrative expenses primarily relate to an increase in personnel and
related costs. 24




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##### Table of Contents



Nine Months Ended September 30, 2004, compared to Nine Months Ended September 30, 2003 For the nine months ended September 30, 2004, the Companys net loss
totaled $17.3 million, or $.13 per share, compared with a net loss of $13.1
million, or $.14 per share, for the same period in 2003. The 2004 results
included $584,000 of reorganization costs and $570,000 of stock-related
reorganization costs. The 2003 results include a write-down of goodwill of
$10.9 million or $.12 per share and $207,000 of reorganization costs and
$219,000 of stock-related reorganization costs. Total revenue was $39.1 million in the nine months ended September 30,
2004, reflecting a 11% decrease from the same period in 2003. Products revenue
decreased from $26.7 million in the nine months ended September 30, 2003, to
$22.9 million in the nine months ended September 30, 2004. Services revenue
was $16.2 million for the nine months ended September 30, 2004, reflecting a 7%
decrease from the same period in 2003. Gross profit decreased for the nine
months ended September 30, 2004, and was 46% of revenue in 2004, compared with
58% of revenue in 2003. The decrease in gross profit dollars resulted from the
decrease in revenues, increased service costs and increased amortization of
intangibles related to the acquisition of MCK in September 2003. The decrease
in gross profit percentage is due to the increase in amortization of
intangibles and reduced margins on services revenues in all the segments of the
business. Total operating expenses incurred for the nine months ended September 30,
2004, were $34.8 million, a decrease of $2.7 million compared to the same
period of 2003. The decrease is primarily attributable to the following items:
the 2003 results included a write-down of goodwill of $10.9 million and a
decrease in amortization of deferred compensation of $241,000 offset by
increases in general and administrative expenses of $1.1 million, sales and
marketing expenses of $3.8 million, research and development expenses of $2.3
million, depreciation expenses of $358,000, amortization of intangibles of
$225,000 and reorganization costs of $728,000. The increase in general and administrative, sales and marketing and
research and development expenses resulted from the addition of personnel and
related costs related to the acquisitions of MCK in September 2003 and
substantially all of the business assets of Clarent in February 2003. The increase in depreciation expense is primarily related to the fixed
assets recorded in connection with the acquisition of MCK and substantially all
the business assets of Clarent, as well as, the increases related to the
purchase of furniture and equipment of approximately $2.0 million and $504,000
during the first nine months of 2004 and the last three months of 2003,
respectively, offset by decreases related to fully depreciated assets. Capital
expenditures are primarily depreciated on a straight-line basis over their
estimated useful lives of three years. The increase in intangible amortization is related to the amortization of
the channels of distribution related to the acquisition of MCK in September
2003. The $241,000 decrease in amortization of deferred compensation primarily
related to the termination of certain options and full vesting of other options
outstanding since the Companys acquisitions of Telamate.Net in November 2001
and Cereus Technology in September 2000. The deferred compensation represents
the intrinsic value of the Telemate.Net and Cereus unvested options outstanding
at the date of the acquisitions of Telemate.Net and Cereus and is amortized
over the remaining vesting period of the options The write-down of goodwill relates to the acquisition of MCK. In April
2003, the Company negotiated the original agreement to purchase MCK in which
the MCK stockholders would be entitled to receive approximately 20.0 million
shares of the Companys common stock which was valued at $13.0 million, based
on the volume weighted average closing price per share of the Companys common
stock as reported on the Nasdaq SmallCap Market for the twenty trading day
period beginning March 19, 2003 and ending April 15, 2003. As part of the
original agreement, the Company was to receive $7.5 million in cash. The terms
of the agreement were amended on June 13, 2003. Under the amended terms, MCK
stockholders were entitled to receive approximately 18.3 million shares of the
Companys common stock and the cash MCK was required to have at the closing of
the merger was reduced from $7.5 million to approximately $6.4 million.
Although the number of shares of the Companys common stock to be issued in the
merger was reduced by the amendment, the amendment changed the measurement date
for valuing such shares. As a result of the increase in the price of the
Companys common stock, prior to June 13, 2003, the revised valuation for the
shares of the Companys common stock to be issued in the merger increased to
$24.1 million. As a result of this increase in value, the goodwill recorded in
the merger was impaired upon closing the merger. The Company completed an
impairment analysis in accordance with SFAS No. 142. Based upon this analysis,
the Company recorded a write-off of approximately $10.9 million during the nine
months ended September 30, 2003. The $377,000 increase in reorganization costs and $351,000 increase in
stock related reorganization costs is related to the termination of a senior
executive in the first quarter of 2004. As a result of these actions, the
Company recorded total reorganization costs of $1.2 million during the nine
months ended September 30, 2004. In the nine months ended September 30, 2003,
the Company initiated a reorganization to accommodate the acquisition of the
assets of Clarent and made an effort to 25




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##### Table of Contents



consolidate functions and improve operational efficiencies and eliminated
25 positions held by employees. As a result of these actions, the Company
recorded reorganization costs of $426,000 during the nine months ended
September 30, 2003. The reorganization costs consist of severance costs of
$207,000, and non-cash stock compensation of $219,000 for the nine months ended
September 30, 2003. As a percent of revenue, operating expenses were 89% during the nine
months ended September 30, 2004, up from 85% for the same period in 2003.
Excluding the write-down of goodwill, operating expenses as a percent of
revenue would have been 60% during the nine months ended September 30, 2003. Other income was $224,000 during the nine months ended September 30, 2004,
compared with $18,000 for the same period in 2003. Equity in loss of investment was $119,000 during the nine months ended
September 30, 2004, compared to $61,000 for the same period in 2003. This
amount represents the Companys portion of BeTrues income or losses. 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. Net interest expense was $785,000 during the nine months ended September
30, 2004, a decrease of $364,000 compared to the same period in 2003. The
decrease was attributable to payments made on the Companys notes payable for
the acquisition of assets from Clarent. Business Unit Performance Carrier
    
    Enterprise
    
    AdvancedSolutions
    
    Solutions
    
    ApplicationsDollars in thousands
    
    Group
    
    Group
    
    Services Group
    
    ConsolidatedFor the Three MonthsEnded September 30,
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    16,082
    
    
    $
    23,427
    
    
    $
    13,808
    
    
    $
    11,108
    
    
    $
    9,253
    
    
    $
    9,635
    
    
    $
    39,143
    
    
    $
    44,170Gross profit
    
    
    7,742
    
    
    
    13,316
    
    
    
    7,166
    
    
    
    7,604
    
    
    
    3,231
    
    
    
    4,634
    
    
    
    18,139
    
    
    
    25,554Gross margin
    
    
    48
    %
    
    
    57
    %
    
    
    52
    %
    
    
    68
    %
    
    
    35
    %
    
    
    48
    %
    
    
    46
    %
    
    
    58
    %General and administrative
    
    
    2,521
    
    
    
    3,748
    
    
    
    1,384
    
    
    
    705
    
    
    
    773
    
    
    
    605
    
    
    
    4,678
    
    
    
    5,058Research and development
    
    
    5,295
    
    
    
    5,059
    
    
    
    3,314
    
    
    
    1,602
    
    
    
    
    
    
    
    
    
    
    
    8,609
    
    
    
    6,661Contribution before
unallocated items
    
    $
    (74
    )
    
    $
    4,509
    
    
    $
    2,468
    
    
    $
    5,297
    
    
    $
    2,458
    
    
    $
    4,029
    
    
    $
    4,852
    
    
    $
    13,835Unallocated items:Corporate general and administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,588
    
    
    
    5,088Sales and marketing
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,287
    
    
    
    6,493Corporate research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    310
    
    
    
    Depreciation and amortization of
property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,420
    
    
    
    2,062Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    405
    
    
    
    180Amortization of deferred compensation,
related to sales, general and
administrative
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    346
    
    
    
    587Write-down of goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,930Reorganization costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    584
    
    
    
    207Reorganization costs-stock related
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    570
    
    
    
    219Operating loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,658
    )
    
    
    (11,931
    )Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (680
    )
    
    
    (1,192
    )Loss before income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (17,338
    )
    
    $
    (13,123
    )
 26




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##### Table of Contents



Carrier Solutions Group Total revenue from the Companys Carrier Solutions Group revenue was $16.1
million in the nine months ended September 30, 2004, a 31% decrease from the
same period in 2003. In 2003, the Company began redirecting its focus for NACT
product sales away from its historic market, primarily emerging domestic
carriers (which market was consolidating), towards carriers in the
international market. Gross profit decreased by $5.6 million in the nine months ended September
30, 2004, and was 48% percent of revenue, compared to 57% in the same period in
2003. The decrease in gross profit dollars is attributable to the decrease in
revenue. The decrease in gross margin is due to a decline in revenues in
relation to fixed departmental costs (primarily personnel and related costs)
related to the production and support departments and the increase in
amortization of intangibles related to the Clarent acquisition. Allocated operating expenses incurred in the Carrier Solutions Group for
the nine months ended September 30, 2004, were $7.8 million, a decrease of
$991,000 compared to the same period in 2003. The decrease in general and
administrative expenses is attributable to a reduction in bad debt expense,
personnel costs and facility expenses. The increase in research and
development expenses reflects increases related to increased personnel costs.
As a percent of revenue, operating expenses for the Carrier Solutions Group
were 49% during the nine months ended September 30, 2004, up from 38% during
the same period in 2003. Enterprise Solutions Group Total revenue for the Companys Enterprise Solutions Group was $13.8
million in the nine months ended September 30, 2004, a 24% increase from the
same period in 2003. The increase in revenue is primarily related to the
Companys acquisition of MCK in September 2003. Gross profit decreased by $438,000 in the nine months ended September 30,
2004, and was 52% percent of revenue, compared with 68% of revenue in the same
period in 2003. The decrease in gross profit dollars is attributable to the
decline in revenue across all product lines, excluding the acquisition of MCK
in September 2003, as well as the increase in amortization of intangibles
related to MCK technology. The decrease in gross margin is related to the
increase in amortization of intangibles related to MCK technology, inventory
obsolescence adjustments and the mix of business, particularly the addition of
MCK which has lower margins. Allocated operating expenses incurred in Enterprise Solutions Group for
the nine months ended September 30, 2004, were $4.7 million, an increase of
$2.4 million compared to the same period in 2003. The increases in general and
administrative expenses and research and development expenses relate to the
acquisition of MCK in September 2003 and Clarents Netperformer division in
February 2003. As a percent of revenue, allocated operating expenses for
Enterprise Solutions Group were 34% during the nine months ended September 30,
2004, up from 21% during the same period in 2003. The increase is primarily
attributable to the increase in research and development expenses as a
percentage of revenue related to the acquisitions of MCK in September 2003 and
Clarents Netperformer division in February 2003. Advanced Applications Services Group Total revenue for the Companys Advanced Applications Services Group was
$9.3 million in the nine months ended September 30, 2004, a 4% decrease from
the same period in 2003. The decrease in revenue is related to a decrease in
installation services, rebillable travel and outsourced services for
hospitality related customers. Gross profit decreased by $1.4 million in the nine months ended September
30, 2004, and was 35% of revenue, compared with 48% of revenue in the same
period in 2003. The decrease in gross profit dollars and gross margin is due
to increased personnel and related costs related to the Advanced Applications
Services Groups performance of consulting work to assist a large customer in
its conversion to a new software platform. Allocated operating expenses incurred in Advanced Applications Services
Group for the nine months ended September 30, 2004, were $773,000, an increase
of $168,000 compared to the same period in 2003. The increase in general and
administrative expenses primarily relate to an increase in personnel and
related costs. 27




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##### Table of Contents



Critical Accounting Policies The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
of America requires management to make judgments, assumptions and estimates
that affect the amounts reported in the consolidated financial statements and
accompanying notes. Factors that could affect the Companys future operating
results and cause actual results to vary from expectations include, but are not
limited to, lower than anticipated growth from existing customers, an inability
to attract new customers, an inability to successfully integrate acquisitions
and technology changes, or a decline in the financial stability of the
Companys customers. Negative developments in these or other risk factors
could have a material adverse affect on the Companys financial position and
results of operations. A summary of the Companys critical accounting policies follows: Allowance for Doubtful Accounts The Company is required to estimate the collectibility of its trade
receivables. Considerable judgment is required in assessing the ultimate
realization of these receivables, including the creditworthiness of each
customer. The evaluation is based on credit information and collection history
concerning the customer up and through the determination date. The Company
determines the allowance for doubtful accounts based on a specific review of
outstanding customer balances and a general reserve based upon aging of
customer accounts and write-off history. Significant changes in required
reserves have been recorded in recent periods and may occur in the future due
to the current telecommunications and general economic environments and updates
to customer credit information and collection activity. Inventory Obsolescence The Company is required to state its inventories at the lower of cost or
market. In assessing the ultimate realization of inventories, the Company
makes judgments as to future demand requirements and compares that with the
current and committed inventory levels. The Company has recorded changes in
net realizable values in recent periods due to the impact of current and future
technology trends and changes in strategic direction, such as discontinuances
of product lines, as well as, changes in market conditions due to changes in
demand requirements. Estimates of the future demand for inventory are based on
sales projections or historical usage for different products, as well as
estimates of inventory required to fulfill maintenance requirements for
products previously sold. It is possible that changes in the net realizable
value of inventory may continue to occur in the future due to the current
market conditions. Restructuring Accruals- Discontinued Operations During 2001, the Company initiated certain restructuring plans. In
conjunction with these restructuring plans, the Company established a
restructuring reserve account for the estimated costs related to the plans.
These costs primarily related to facilities closings, severance costs and other
businesses exiting costs. For the facilities closings cost, a reserve was
established for all remaining lease payments due on buildings and equipment
that were no longer being utilized in continuing operations, less assumptions
for sub-leases. The accrual for one of the leases with total payments
remaining through January 31, 2010 of $2.1 million is offset by sublease
receipts totaling $980,000 through the end of the lease term and assumes an
amount of $240,000 for the extension of one of the subleases through the end of
the lease term. As of September 30, 2004, the Company had a remaining reserve
balance of approximately $1.2 million, which is included in liabilities of
discontinued operations. The Company currently believes that this remaining
estimated balance is appropriate to cover future obligations associated with
the restructurings; however, changes in these estimates could occur based on
changes in the financial condition of the subleases. Deferred Tax Asset Valuation Allowance The Company currently has significant deferred tax assets, which are
subject to periodic recoverability assessment. Realization of the Companys
deferred tax assets is principally dependant upon achievement of projected
future taxable income. The Companys judgments regarding future profitability
may change due to market conditions, its ability to continue to successfully
execute its strategic plan and other factors. These changes, if any, may
require possible material adjustments to these deferred tax asset balances.
Due to the uncertainty of the Companys ability to recognize the entire tax
benefit, the Company established an offsetting provision for the tax assets. Litigation and Related Contingencies The Company is subject to proceedings, lawsuits and other claims related
to labor, product and other matters. The Company is required to assess the
likelihood of any adverse judgments or outcomes to these matters, as well as,
potential ranges of probable losses. A determination of the amount of reserves
required, if any, for these contingencies is made by the Company 28




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##### Table of Contents



with assistance of its legal counsel after careful analysis of each
individual issue based upon the then-current facts and circumstances. The
required reserves may change in the future due to new developments in each
matter or changes in approach such as a change in settlement strategy in
dealing with these matters. Goodwill, Intangible Assets and Long-Lived Assets Goodwill represents the excess of costs over the fair value of net assets
of businesses acquired. Goodwill and intangible assets acquired in a purchase
business combination and determined to have an indefinite useful life are not
amortized, but instead are tested for impairment at least annually in
accordance with provisions of SFAS No. 142. Significant estimates are made
with respect to the impairment testing. SFAS No. 142 also requires that
intangible assets with estimable useful lives be amortized over their
respective estimated useful lives to their estimated residual values, and
reviewed for impairment in accordance with SFAS No. 144. In accordance with SFAS No. 144, long-lived assets, such as property,
plant and equipment and purchased assets subject to amortization, are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable. Recoverability of assets
to be held and used is measured by a comparison of the carrying amount of an
asset to estimated undiscounted future cash flows expected to be generated by
the asset. If the carrying amount of an asset exceeds its estimated future
cash flows, an impairment charge is recognized by the amount by which the
carrying amount of the asset exceeds the fair value of the asset. Significant
estimates are made with respect to recoverability and fair value assessments. Liquidity and Capital Resources Summary Liquidity is the measurement of the Companys ability to have adequate
cash or access to cash at all times in order to meet financial obligations when
due, as well as to fund corporate expansion and other activities. For the last
three years, the Company has met its liquidity requirements through a
combination of cash provided by debt from third party lenders, issuances of
debt and equity securities and purchases of other businesses. At September 30, 2004, the Company had a positive working capital position
(excess of current assets over current liabilities) of $15.1 million compared
to a positive working capital position of $12.7 million at December 31, 2003.
The Companys cash and cash equivalents totaled $10.9 million at September 30,
2004, and $7.7 million at December 31, 2003. Total long-term debt, net of
discount, was $6.9 million at September 30, 2004 and $6.6 million at December
31, 2003. At September 30, 2004 and December 31, 2003, the Company had no
borrowings under its $10.0 million Amended Credit Agreement with Silicon. The
Companys borrowing availability under the Amended Credit Agreement at
September 30, 2004 was $6.5 million. The Company has outstanding stand-by
letters of credit in the amount of $1.6 million at September 30, 2004, which
reduce borrowing capacity under the Amended Credit Agreement. On February 12, 2003, in connection with the Companys acquisition of the
assets of Clarent, the Company amended its existing Original Credit Agreement
with Silicon, and entered into certain additional credit agreements. The
amendments and additional agreements increased the Companys asset-based
revolving credit line from $5.0 million to $10.0 million, included an EX-IM
facility that provides for working capital based on the Companys international
accounts receivable and inventory related to export sales and extended the term
of the Original Credit Agreement for 18 months (through August 13, 2004). In
April 2003 and February 2004, the Company and Silicon further amended the
credit facility to increase the EX-IM facility and to modify certain financial
covenants related to the timing of the closing of the acquisition of the assets
of Clarent, among other things. Under the terms of the Amended Credit
Agreement, the Company must maintain a minimum tangible net worth 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. In August
2004, at the Companys request, Silicon further amended the credit facility to
extend the term to January 2005. The Company requested an extension instead of
a renewal of the credit facility to give the Company time to determine how best
to structure its line of credit to cover its expected borrowing base in 2005.
In addition, the Company was not in compliance with the minimum tangible net
worth covenant as of September 30, 2004, and Silicon waived such non-compliance
and amended the covenants to eliminate the minimum tangible net worth covenant
and add a minimum cash and excess availability covenant. On February 12, 2003, the Company acquired substantially all the business
assets and assumed certain related liabilities of Clarent for $9.8 million in
notes. At September 30, 2004, a $3.0 million secured note due February 12,
2008, which bears interest at 5% per annum, remains outstanding. The assets
the Company purchased from Clarent secure the note, second to the Banks. 29




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##### Table of Contents



Cash Flow Cash used in the Companys continuing operations in the nine months ended
September 30, 2004 totaled approximately $8.8 million compared with cash
provided by continuing operations of $749,000 in the same period in 2003. The
cash used in continuing operations during the nine months ended September 30,
2004 resulted primarily from cash used by continuing operations of $11.1
million (net loss from continuing operations of $17.3 million reduced by
non-cash charges totaling $6.2 million, including depreciation and amortization
of $4.8 million, stock-related reorganization costs of $570,000, provision for
doubtful accounts of $651,000 and equity in loss of investment of $119,000)
which was offset by changes in current operating assets and liabilities of
approximately $2.3 million. Cash used in the Companys discontinued operations in the nine months
ended September 30, 2004 totaled $370,000 compared with cash used in
discontinued operations of $710,000 in the same period in 2003. The Company used cash in investing activities in the nine months ended
September 30, 2004 of approximately $3.8 million, compared to cash provided by
investing activities of $7.3 million in the same period of 2003. In the nine
months ended September 30, 2004, the Company used $4.1 million in cash related
to the payment of accrued liabilities assumed in the acquisition of MCK as
compared to the $9.9 million in cash, net of acquisition costs, the Company
received related to the acquisition of MCK in the same period of 2003. During
the nine months ended September 30, 2004, restricted cash decreased by $2.3
million. The Company spent $2.0 million and $977,000 on capital expenditures
in the nine months ended September 30, 2004 and 2003, respectively. Cash provided by financing activities totaled approximately $16.3 million
in the nine months ended September 30, 2004 compared to $1.2 million in the
same period of 2003. For the nine months ended September 30, 2004, the Company
received proceeds from a private placement, net of associated fees of $16.5
million, received proceeds from the issuance of the Companys common stock
related to the exercise of stock options of $128,000 and paid $350,000 on the
notes payable for the purchase of the assets of Clarent in 2003. For the nine
months ended September 30, 2003, the Company borrowed $800,000 under the
Companys credit agreement with Silicon, received proceeds from the issuance of
the Companys common stock related to the exercise of stock options of $2.7
million, received $1.8 million in payments of notes receivables from
shareholders and paid $2.5 million on the notes payable for the purchase of the
assets of Clarent in 2003. Contractual Obligations and Commercial Commitments The following summarizes the Companys future contractual obligations at
September 30, 2004 (in thousands): 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
    
    
    631
    
    
    
    355
    
    
    
    276
    
    
    
    
    
    
    
    Notes payable for the purchase of Clarent
    
    
    3,000
    
    
    
    
    
    
    
    
    
    
    
    3,000
    
    
    
    Accrued costs of MCK acquisition
    
    
    3,492
    
    
    
    1,287
    
    
    
    2,205
    
    
    
    
    
    
    
    Convertible subordinated debentures
    
    
    4,500
    
    
    
    
    
    
    
    4,500
    
    
    
    
    
    
    
    Operating leases:Continuing operations
    
    
    15,661
    
    
    
    2,986
    
    
    
    4,722
    
    
    
    7,309
    
    
    
    644Discontinued operations
    
    
    2,120
    
    
    
    471
    
    
    
    744
    
    
    
    774
    
    
    
    131Total contractual cash obligations
    
    $
    29,404
    
    
    $
    5,099
    
    
    $
    12,447
    
    
    $
    11,083
    
    
    $
    775
 Note, this table excludes interest expense and sublease rentals and
assumes that leases are not renewed. The Company has outstanding stand-by
letters of credit in the amount of $1.6 million at September 30, 2004. Sources of Cash For the remainder of 2004, the Company expects that its primary sources of
cash will be from cash on hand. The Company expects that its current
operations will not generate positive income from operations before interest,
taxes, depreciation, amortization of intangibles and amortization of deferred
compensation for 2004. The Company is currently 30




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working on several initiatives to significantly reduce the cash used in continuing operations and to ensure
that is has sufficient liquidity to cover its needs for the next twelve months. The Amended Credit Agreement with Silicon, however, is subject to certain
financial covenants (including a minimum tangible net worth covenant) and
limitations on the Companys ability to access funds under the Amended Credit
Agreement. If the Company is in violation of the Amended Credit Agreement, or
does not have sufficient eligible accounts receivable and inventories to
support the level of borrowings it may need, then the Company may be unable to
draw on the Amended Credit Agreement to the extent necessary. To the extent
the Company does not have borrowing availability under the Amended Credit
Agreement, the Company may be required to obtain additional sources of capital,
sell assets, obtain an amendment to the Amended Credit Agreement or otherwise
restructure its outstanding indebtedness. Additional borrowings other than
pursuant to the Amended Credit Agreement must be approved by Silicon and may
have to be approved by the holders of the Clarent secured note due in 2008. If
the Company is unable to obtain additional capital, sell assets, obtain an
amendment to the Amended Credit Agreement or otherwise restructure its
outstanding indebtedness, then the Company may not be able to meet its
obligations. The Amended Credit Agreement, if not extended or replaced,
expires January 12, 2005. The Companys short-term cash needs are for working capital, including
cash operating losses, capital expenditures, remaining unpaid transaction costs
and assumed liabilities related to the acquisition of MCK and payments related
to discontinued operations. At September 30, 2004, accrued costs of MCK
acquisition and other long-term liabilities include $1.4 million in lease
payments related to lease obligations for excess space at the date of
acquisition. The Company expects to pay out approximately $501,000 related to
these obligations in the next twelve months. At September 30, 2004,
liabilities of discontinued operations included $1.2 million in lease payments
related to discontinued operations. The Company expects to pay out
approximately $191,000 related to discontinued operations in the next twelve
months. The Companys long-term cash needs are related to the costs of growing its
current business as well as prospective businesses to be acquired, including
capital expenditures and working capital. The Company expects to meet these
cash needs through cash from operations, if any, cash on hand, borrowings under
the Amended Credit Agreement or other debt facilities, if available, as well as
through possible issuances of equity or debt securities. If sufficient
borrowing capacity under a working capital line of credit is unavailable (or if
the Company is unable to restructure its existing Amended Credit Agreement in
the event that the Company requires additional borrowing capacity), or if the
Company is otherwise unable to obtain additional capital or sell assets, then
the Company may not be able to meet its obligations and growth plans. 31




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ITEM 3: QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk The Company is exposed to various market risks, including changes in interest
rates and foreign currency exchange rates. Market risk is the potential loss
arising from adverse changes in market rates and prices, such as interest rates
and foreign currency exchange rates. The Company does not enter into
derivatives or other financial instruments for trading or speculative purposes.
The Company has also not entered into financial instruments to manage and
reduce the impact of changes in interest rates and foreign currency exchange
rates although the Company may enter into such transactions in the future. Interest Rate Risks The Companys notes payable and convertible subordinated debentures at
September 30, 2004, carry interest rates, which are fixed. The Companys line
of credit with Silicon carries interest rates, which vary with the prime rate.
Accordingly, if the Company has any indebtedness outstanding under its line of
credit with Silicon, then any increases in Silicons prime rate will reduce the
Companys earnings. At September 30, 2004, the Company did not have any
indebtedness outstanding under its line of credit with Silicon. Foreign Currency Risks Products sold outside of the United States of America are transacted in U.S.
dollars and, therefore, the Company is not exposed to foreign currency exchange
risk. Transactions with Clarent Canada Ltd., MCKs subsidiary, MCK
Telecommunications, Inc. and NACTs subsidiary, NACT, Ltd. present foreign
currency exchange risk. The principal transactions are personnel and related
costs. The intercompany balance is denominated in U.S. dollars and changes in
foreign currency rates would result in foreign currency gains and losses.
Using the intercompany balance at September 30, 2004, a 10% strengthening of
the U.S. dollar against the Canadian dollar and the British pound would result
in a foreign currency transaction loss of approximately $101,000. To date,
foreign exchange gains and losses have not been significant. 
 ITEM 4: CONTROLS AND PROCEDURES The Companys Chief Executive Officer and Chief Financial Officer have
evaluated the effectiveness of the Companys disclosure controls and procedures
(as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the
period covered by this report, as required by paragraph (b) of Rules 13(a)-15
or 15(d)-15 of the Exchange Act. Based on such evaluation, such officers have
concluded that, as of the end of the period covered by this report, the
Companys disclosure controls and procedures are effective in alerting them on
a timely basis to material information relating to the Company (including its
consolidated subsidiaries) required to be included in the Companys periodic
filings under the Exchange Act. 32




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PART II  OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS Except for the pending matters described in Note 17 to the Companys
Consolidated Financial Statements included in the Companys Annual Report on
Form 10-K for the year ended December 31, 2003,
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. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits  3.1
    
    Amendment to the Companys Bylaws adopted November 3, 2004.*3.2
    
    The Companys Bylaws, as amended.*31.1
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Executive Officer.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Financial Officer.32.1
    
    Section 1350 Certification by the Companys Chief Executive Officer.32.2
    
    Section 1350 Certification by the Companys Chief Financial Officer.* Incorporated
by reference to the Companys Current Report on Form 8-K filed on November 9, 2004.  (b)
    
    Reports on Form 8-K.During the quarter ended September 30, 2004, the Company filed with
the SEC a Current Report on Form 8-K filed on August 3, 2004,
reporting under Item 12 of such report information regarding the
Companys results of operations and financial condition for the
second quarter 2004. 33




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934 the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. VERSO TECHNOLOGIES, INC.Date: November 9, 2004
    
    /s/ Juliet M. ReisingExecutive Vice President and Chief Financial Officer(duly authorized signatory andPrincipal Financial and Accounting Officer)
 34




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EXHIBIT INDEX 3.1
    
    Amendment to the Companys Bylaws adopted November 3, 2004.*3.2
    
    The Companys Bylaws, as amended.*31.1
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Executive Officer.31.2
    
    Rule 13a-14(a)/15d-14(a) Certification by the Companys Chief Financial Officer.32.1
    
    Section 1350 Certification by the Companys Chief Executive Officer.32.2
    
    Section 1350 Certification by the Companys Chief Financial Officer.* Incorporated by reference to the Companys Current Report on Form 8-K filed on November 9, 2004.