##### **UnitedStates**

**Securities and Exchange Commission**

#### **Washington, D.C. 20549**

 

**FORM 10-QSB**

 

**ý****        QuarterlyReport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

 

#### **For the Quarter Ended December 31,2005**

 

**o****        TransitionReport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

 

#### **Commission File Number:06425**

 
| **Utah**                                                         | ** ** | **SENTO CORPORATION**                                             | ** ** | **87-0284979**                         |
|------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|----------------------------------------|
| (State or  other Jurisdiction of  Incorporation or Organization) |       | Exact Name  of Small Business Issuer as  Specified in its Charter |       | (I.R.S.  Employer  Identification No.) |

# ** **

**420 EastSouth Temple, Suite 400**

**Salt LakeCity, Utah 84111**

(Address of Principal ExecutiveOffices)

 

Issuer’s telephone number,including area code: **(801) 431-9200**

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes ý             No o

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act)

 

Yes o             No ý

 

State the number of shares outstanding ofeach of the issuer’s classes of common equity, as of the latest practicabledate:

 
| **Class**                           | ** ** | **Outstanding at January 31,  2006** |
|-------------------------------------|------------|-------------------------------------------|
| Common capital stock $.25 par value |       | 3,865,020                                 |

 

Transitional Small Business Disclosure Format (check one):

 

Yes o             No ý

 

 

----

 

**SENTOCORPORATION**

Quarterly Report on Form 10-QSB

Quarter ended December 31,2005

 

TABLE OF CONTENTS

 
| PART I.    | FINANCIAL INFORMATION                                           | 1  |
|------------|-----------------------------------------------------------------|----|
| Item 1.    | Financial Statements                                            | 1  |
|       | Condensed Consolidated Balance Sheets                           | 1  |
|       | Condensed Consolidated Statements of  Operations                | 2  |
|       | Condensed Consolidated Statements of Cash  Flows                | 3  |
|       | Supplemental Disclosures of Cash Flow  Information              | 4  |
|       | Notes to Condensed Consolidated Financial  Statements           | 5  |
| Item 2.    | Management’s Discussion and Analysis or  Plan of Operation | 13 |
|       | Overview                                                        | 13 |
|       | Application of Critical Accounting Policies                     | 15 |
|       | Operations Review                                               | 17 |
|       | Liquidity and Capital Resources                                 | 20 |
|       | Seasonality                                                     | 22 |
|       | Risks Related to Existing and Proposed  Operations              | 22 |
| Item 3.    | Controls and Procedures                                         | 25 |
| PART II.   | OTHER INFORMATION                                               | 26 |
| Item 2.    | Unregistered Sale of Equity Securities and  Use of Proceeds     | 26 |
| Item 6.    | Exhibits                                                        | 26 |
| SIGNATURES | 27                                                              |

 

# ****

# ** **

PART I. FINANCIAL INFORMATION

## Item 1.             Financial Statements

 

#### **SENTO CORPORATION**

**ANDSUBSIDIARIES**

### **Condensed Consolidated Balance Sheets**

 
| ** **                                                                                    | ** ** | **December 31,   2005** | ** ** | **March 31,    2005** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                                                                                    | ** ** | **(Unaudited)**              | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                    |       |                         |       |                       |       |
| ** **                                                                                    |       |                         |       |                       |       |
| Current assets:                                                                               |       |                         |       |                       |       |
| Cash and cash equivalents                                                                     |       | $                            | 3,549,885  |                       | $          | 5,698,195 |   |
| Accounts receivable, net                                                                      |       | 8,592,917                    |       | 4,326,315                  |       |
| Other current assets                                                                          |       | 811,622                      |       | 643,059                    |       |
| Total current assets                                                                          |       | 12,954,424                   |       | 10,667,569                 |       |
|                                                                                          |       |                         |       |                       |       |
| Property and equipment, net                                                                   |       | 4,582,438                    |       | 4,031,632                  |       |
| Intangible assets, net                                                                        |       | 2,040,796                    |       | 1,229,607                  |       |
| Other assets                                                                                  |       | 322,808                      |       | 296,775                    |       |
| Total Assets                                                                                  |       | $                            | 19,900,466 |                       | $          | 16,225,583 |   |
|                                                                                          |       |                         |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                |       |                         |       |                       |       |
| ** **                                                                                    |       |                         |       |                       |       |
| Current liabilities:                                                                          |       |                         |       |                       |       |
| Current portion of long-term debt and capital leases                                          |       | $                            | 1,453,943  |                       | $          | 745,699 |   |
| Accounts payable                                                                              |       | 3,206,635                    |       | 2,110,013                  |       |
| Accrued payroll and payroll taxes                                                             |       | 2,421,687                    |       | 1,559,676                  |       |
| Current portion of accrued contingent consideration from  business acquisition                |       | 792,157                      |       | —                     |       |
| Current deferred taxes                                                                        |       | 77,412                       |       | —                     |       |
| Current accrued building consolidation costs                                                  |       | 57,935                       |       | 118,793                    |       |
| Accrued liabilities and other                                                                 |       | 1,022,719                    |       | 635,834                    |       |
| Total current liabilities                                                                     |       | 9,032,488                    |       | 5,170,015                  |       |
|                                                                                          |       |                         |       |                       |       |
| Long-term debt and capital leases, net of current portion                                     |       | 1,142,103                    |       | 959,259                    |       |
| Accrued contingent consideration from business acquisition, net  of current portion           |       | 820,573                      |       | 907,898                    |       |
| Accrued building consolidation costs, net of current portion                                  |       | 125,154                      |       | —                     |       |
| Deferred taxes                                                                                |       | 232,235                      |       | —                     |       |
| Total Liabilities                                                                             |       | 11,352,553                   |       | 7,037,172                  |       |
|                                                                                          |       |                         |       |                       |       |
| Stockholders’ equity:                                                                    |       |                         |       |                       |       |
| Common stock                                                                                  |       | 983,306                      |       | 965,077                    |       |
| Additional paid-in capital                                                                    |       | 20,757,465                   |       | 20,662,508                 |       |
| Treasury stock                                                                                |       | (259,620                     | )          | (203,681                   | )          |
| Accumulated other comprehensive income (loss) – foreign currency  translation adjustment |       | (8,652                       | )          | 42,670                     |       |
| Accumulated deficit                                                                           |       | (12,924,586                  | )          | (12,278,163                | )          |
| Total stockholders’ equity                                                               |       | 8,547,913                    |       | 9,188,411                  |       |
| Total Liabilities and Stockholders’ Equity                                               |       | $                            | 19,900,466 |                       | $          | 16,225,583 |   |

 

*See accompanying notes to condensedconsolidated financial statements.*

 

1

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**SENTOCORPORATION**

**ANDSUBSIDIARIES**

 

### **Condensed Consolidated Statements of Operations**

**(Unaudited)**

 
| ** **                                                                                     | ** ** | **Three Months Ended**        | ** ** | **Nine Months Ended**         | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                                                                                     | ** ** | **December 31,****2005** | ** ** | **December 31,****2004** | ** ** | **Deceember 31,****2005** | ** ** | **December 31,****2004** | ** ** |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Revenue                                                                                        | ** ** | $                             | 15,154,851 |                          | 10,047,153 | ** ** | $ | 33,777,982 | ** ** | $ | 22,782,861 | ** ** |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Gross cost of sales                                                                            |       | 12,285,385                    |       | 8,025,613                     |       | 28,183,588 |   | 19,441,540 |   |
| Less: training incentive reimbursements                                                        |       | (196,000                      | )          | —                        |       | (196,000 | ) | — |   |
| Cost of sales                                                                                  |       | 12,089,385                    |       | 8,025,613                     |       | 27,987,588 |   | 19,441,540 |   |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Gross profit                                                                                   |       | 3,065,466                     |       | 2,021,540                     |       | 5,790,394 |   | 3,341,321 |   |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Product development                                                                            |       | 20,852                        |       | 61,765                        |       | 69,460 |   | 295,741 |   |
| Selling, general and administrative expenses                                                   |       | 2,228,827                     |       | 1,629,192                     |       | 5,823,037 |   | 3,367,296 |   |
| Provision for (recovery of) doubtful  account                                                  |       | —                        |       | 475,000                       |       | (181,593 | ) | 475,000 |   |
| Amortization of intangible assets                                                              |       | 90,893                        |       | 54,447                        |       | 227,516 |   | 54,447 |   |
| Restructuring charge                                                                           |       | —                        |       | —                        |       | 477,575 |   | — |   |
| Non-cash charge for valuation of warrants issued for services                                  |       | —                        |       | 53,057                        |       | — |   | 239,558 |   |
| Stock-based compensation (benefit)                                                             |       | 27,611                        |       | (68,947                       | )          | (41,041 | ) | (235,355 | ) |
| Operating income (loss)                                                                        |       | 697,283                       |       | (182,974                      | )          | (584,560 | ) | (855,366 | ) |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Other income (expense), net                                                                    |       | 8,843                         |       | (36,719                       | )          | (46,657 | ) | (73,886 | ) |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Income (loss) before income taxes                                                              |       | 706,126                       |       | (219,693                      | )          | (631,217 | ) | (929,252 | ) |
| Income tax benefit (expense)                                                                   |       | 2,455                         |       | (78,707                       | )          | (15,206 | ) | (78,707 | ) |
| Net income (loss)                                                                              |       | 708,581                       |       | (298,400                      | )          | (646,423 | ) | (1,007,959 | ) |
| Deemed dividend as a result of warrant modification                                            |       | —                        |       | —                        |       | — |   | (37,875 | ) |
| Net income (loss) attributable to common stockholders                                          |       | $                             | 708,581    |                          | $          | (298,400 | ) | $ | (646,423 | ) | $ | (1,045,834 | ) |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Basic net income (loss) per share                                                              |       | $                             | 0.19       |                          | $          | (0.08 | ) | $ | (0.17 | ) | $ | (0.28 | ) |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Diluted net income (loss) per share                                                            |       | $                             | 0.17       |                          | $          | (0.08 | ) | $ | (0.17 | ) | $ | (0.28 | ) |
|                                                                                           |       |                          |       |                          |       |   |   |   |   |
| Basic weighted average number of common and common equivalent shares  outstanding              |       | 3,827,068                     |       | 3,807,873                     |       | 3,805,957 |   | 3,722,628 |   |
| Diluted weighted average number of  common and common equivalent  shares outstanding |       | 4,117,669                     |       | 3,807,873                     |       | 3,805,957 |   | 3,722,628 |   |

 

*See accompanying notes to condensedconsolidated financial statements.*

 

2

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**SENTOCORPORATION**

**AND SUBSIDIARIES**

 

### **CondensedConsolidated Statements of Cash Flow**s

**(Unaudited)**

 
| ** **                                                                           | ** ** | **Nine  Months Ended**      | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                           | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| Cash flows from operating activities:                                                |       |                        |       |   |   |
| Net loss                                                                             |       | $                           | (646,423   | ) | $ | (1,007,959 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities:     |       |                        |       |   |   |
|   Depreciation and amortization                                            |       | 1,587,435                   |       | 1,193,542 |   |
|   Non-cash interest expense related to warrants issued with  debt          |       | 10,705                      |       | 249,995 |   |
|   Stock-based compensation                                                 |       | (41,041                     | )          | (235,355 | ) |
|   Restructuring charge                                                     |       | 477,575                     |       | — |   |
|   Deferred taxes                                                           |       | (6,881                      | )          | — |   |
|   Changes in operating assets and liabilities:                             |       |                        |       |   |   |
| Accounts receivable                                                                  |       | (4,283,946                  | )          | 1,143,987 |   |
| Other assets                                                                         |       | (241,044                    | )          | (139,798 | ) |
| Accounts payable                                                                     |       | 1,096,622                   |       | (439,851 | ) |
| Accrued liabilities and other                                                        |       | 958,361                     |       | (473,211 | ) |
| Net cash provided by (used in) operating activities                                  |       | (1,088,637                  | )          | 291,350 |   |
| Cash flows used in investing activities:                                             |       |                        |       |   |   |
| Purchase of property and equipment                                                   |       | (1,987,022                  | )          | (1,104,911 | ) |
| Acquisition of business, including purchase of acquired  business’ secured debt |       | —                      |       | (872,221 | ) |
| Net cash used in investing activities                                                |       | (1,987,022                  | )          | (1,977,132 | ) |
|                                                                                 |       |                        |       |   |   |
| Cash flows from financing activities:                                                |       |                        |       |   |   |
| Principal payments of long-term debt, capital leases and credit  Line                |       | (1,119,617                  | )          | (725,923 | ) |
| Proceeds from issuance of long-term debt, capital leases and credit  line            |       | 2,000,000                   |       | 849,579 |   |
| Payment of accrued offering costs                                                    |       | —                      |       | (627,364 | ) |
| Repurchase of common stock                                                           |       | (55,939                     | )          | — |   |
| Proceeds from exercise of stock options, warrants and employee  stock purchases      |       | 154,227                     |       | 408,475 |   |
| Net cash provided by (used in) financing activities                                  |       | 978,671                     |       | (95,233 | ) |
| Effect of foreign currency translations                                              |       | (51,322                     | )          | 91,330 |   |
| Net decrease in cash and cash equivalents                                            |       | (2,148,310                  | )          | (1,689,685 | ) |
| Cash and cash equivalents at beginning of period                                     |       | 5,698,195                   |       | 6,567,811 |   |
| Cash and cash equivalents at end of period                                           |       | $                           | 3,549,885  |   | $ | 4,878,126 |   |

 

*See accompanying notes**to condensed consolidatedfinancial statements.*

 

3

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**SENTOCORPORATION**

**ANDSUBSIDIARIES**

 

### **Supplemental Disclosures of Cash Flow Information**

### **(Unaudited)**

 
| ** **                                                            | ** ** | **Nine  Months Ended**      | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                            | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|                                                                  |       |                        |       |   |   |
| Cash paid for:                                                        |       |                        |       |   |   |
| Interest                                                              |       | $                           | 123,252    |   | $ | 104,108 |   |
| Income taxes                                                          |       | —                      |       | — |   |
|                                                                  |       |                        |       |   |   |
| Non-cash  investing and financing activities:                         |       |                        |       |   |   |
| Equipment financed through long-term note                             |       | $                           | —     |   | $ | 157,136 |   |
|                                                                  |       |                        |       |   |   |
| Purchase Price Adjustments:                                           |       |                        |       |   |   |
| Intangible assets                                                     |       | $                           | 1,038,704  |   | $ | — |   |
| Contingent consideration for business acquisition                     |       | (722,176                    | )          | — |   |
| Deferred tax liability                                                |       | (316,528                    | )          | — |   |
|                                                                  |       | $                           | —     |   | $ | — |   |
|                                                                  |       |                        |       |   |   |
| Assets acquired and liabilities assumed through business acquisition: |       |                        |       |   |   |
| Receivables                                                           |       | $                           | —     |   | $ | 1,835,911 |   |
| Property and equipment                                                |       | —                      |       | 201,810 |   |
| Other assets, including $1,088,938 of intangibles                     |       | —                      |       | 1,413,296 |   |
| Total assets acquired                                                 |       | —                      |       | 3,451,017 |   |
| Less liabilities assumed:                                             |       |                        |       |   |   |
| Accounts payable                                                      |       | —                      |       | 1,030,978 |   |
| Accrued contingent consideration                                      |       | —                      |       | 655,590 |   |
| Long-term debt and capital lease obligations                          |       | —                      |       | 51,680 |   |
| Other liabilities, including $65,000 of accrued purchase liabilities  |       | —                      |       | 840,548 |   |
| Net cash paid                                                         |       | $                           | —     |   | $ | 872,221 |   |

 

*See accompanying notes**to condensed consolidatedfinancial statements.*

 

4

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#### **SENTO CORPORATION**

**ANDSUBSIDIARIES**

 

### **Notes to Condensed Consolidated Financial Statements**

**December 31,2005**

**(Unaudited)**

 

A.                                   BASISOF PRESENTATION

 

The accompanying unaudited condensedconsolidated financial statements of Sento Corporation (the “Company”) havebeen prepared in accordance with the instructions to Form 10-QSB and donot include all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements. In theopinion of management, all adjustments (consisting of normal recurring entries)considered necessary for a fair presentation have been included.

 

Operatingresults for the three- and nine-month periods ended December 31, 2005 arenot necessarily indicative of the results that may be expected for the fullfiscal year. The unaudited condensed consolidated financial statements shouldbe read in conjunction with the audited consolidated financial statements andfootnotes thereto included in the Company’s Annual Report on Form 10-KSBfor the year ended March 31, 2005.

 

The Company’soperations are carried out by its two wholly-owned subsidiaries, SentoTechnical Services Corporation, a Utah corporation, and Xtrasource Acquisition, Inc.,a Delaware corporation. The Company’s operations are located in Utah, Wyoming,North Carolina, New Mexico, the Netherlands and France. In addition, theCompany has contractual relations with a third-party service provider in India.

 

B.                                     SHAREBASED PAYMENT

 

Prior to October 1,2005, the Company accounted for its stock option plan and its employee stockpurchase plan using the intrinsic value method of accounting provided under APBOpinion No. 25, *Accounting for StockIssued to Employees*, (APB 25) and related interpretations, aspermitted by FASB Statement No. 123, *Accounting for Stock-BasedCompensation,* (SFAS123). Under this method no compensation expensewas recognized for issuances of stock pursuant to employee stock purchase plan,or for stock option grants, with the exception of options that were repriced inApril 2003 and accounted for under variable accounting. Accordingly,share-based compensation was included as a pro forma disclosure in thefinancial statement footnotes and continues to be presented as a pro formadisclosure for periods prior to the three-month period ended December 31,2005.

 

Effective October 1,2005, the Company adopted the fair value recognition provisions of FASBStatement No. 123 (R), *Share-Based Payment*,(SFAS 123R) using the modified-prospective transition method. Under thistransition method, compensation cost recognized during the three-month periodended December 31, 2005 includes: a) compensation costs for allshare-based payments granted through September 30, 2005, but for which thevesting period had not been completed as of September 30, 2005, based onthe grant date fair value estimated in accordance with the original provisionsof SFAS 123, and b) compensation cost for all share-based payments grantedsubsequent to September 30, 2005, based on the grant date fair valueestimated in accordance with the provisions of SFAS 123R. Under themodified-prospective transition method, results for prior periods are notrestated.

 

5

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As a result ofadopting SFAS 123R on October 1, 2005, the Company’s earnings beforeincome taxes, net earnings and earnings per share for the three-month periodended December 31, 2005 are different than what they would have been hadthe Company not adopted SFAS 123R as shown in the following table:

 
| ** **                                                                                                                                           | ** ** | **Income   Before   Income   Tax** | ** ** | **Net   Income** | ** ** | **Basic   Earnings   Per Share** | ** ** | **Diluted   Earnings   Per Share** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|------------------|------------|----------------------------------|------------|------------------------------------|------------|
| Earnings as  reported under SFAS 123R for the three-month period ended December 31,  2005                                                       |       | $                                  | 706,126    |             | $          | 708,581                          |       | $                                  | 0.19       |   | $ | 0.17 |   |
|                                                                                                                                                 |       |                               |       |             |       |                             |       |                               |       |
| Add back  share-based payment expense that would not have been recognized had the  Company not adopted SFAS 123R                                     |       | 27,611                             |       | 27,611           |       | 0.01                             |       | 0.01                               |       |
|                                                                                                                                                 |       |                               |       |             |       |                             |       |                               |       |
| Less  compensation costs relating to repriced options under variable accounting  that would have been expensed had the Company not adopted SFAS 123R |       | (519,128                           | )          | (519,128         | )          | (0.14                            | )          | (0.13                              | )          |
|                                                                                                                                                 |       |                               |       |             |       |                             |       |                               |       |
| Pro Forma  earnings for the three-months ended December 31, 2005 had the Company  not adopted SFAS 123R                                         |       | $                                  | 214,609    |             | $          | 217,064                          |       | $                                  | 0.06       |   | $ | 0.05 |   |

 

SFAS 123Rrequires that cash flows resulting from tax deductions in excess of thecompensation cost recognized for those options (excess tax benefits) to beclassified as financing cash flows. However, the Company has significant netoperating loss carry-forwards for tax purposes and has therefore not recognizedany excess tax benefits from the exercise of stock options.

 

Stock Options:

 

The Companygrants stock options to employees and non-employee directors under its OmnibusStock Incentive Plan. Vesting requirements for awards under this plan vary byindividual grants and are time-based. The majority of the options granted underthe plan have a contractual life of 10 years. However, some of the grants havea contractual life of 5 years. The fair value of each option award is estimatedas of the date of grant using a Black-Scholes option pricing model. Theweighted average assumptions for the nine-month periods ended December 31,2005 and 2004 are:

 

| ** **              | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0.0      | %          | 0.0      | %          |
| Expected Volatility     |       | 90.0     | %          | 75.0     | %          |
| Risk-free interest rate |       | 4.0      | %          | 3.7      | %          |
| Expected term           |       | 5 years  |       | 5 years  |       |

 

Expectedvolatility is based on historical volatility of the Company’s common stock. TheCompany uses historical data to estimate option exercises and employee terminationbehavior within the valuation model. The risk-free rate for the expected termof the option is based on the U.S. Treasury yield curve in effect at the timeof grant.

 

The followingsummary presents information regarding outstanding options as of December 31,2005 and changes during the nine-month period then ended with regard to alloptions:

 

6

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| ** **                            | ** ** | **Shares   under   Option** | ** ** | **Weighted  Average  Exercise   Price** | ** ** | **Weighted  Average  Remaining  Contract Term** | ** ** | **Aggregate  Intrinsic   Value** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|-------------------------------------------------|------------|----------------------------------|------------|
| Outstanding at March 31, 2005    |       | 402,619                     |       | $                                       | 4.48       |                                            |       |                             |       |   |
| Granted                               |       | 250,250                     |       | $                                       | 2.98       |                                            |       |                             |       |   |
| Exercised                             |       | (29,946                     | )          | $                                       | 2.37       |                                            |       |                             |       |   |
| Forfeited or expired                  |       | (11,617                     | )          | $                                       | 6.13       |                                            |       |                             |       |   |
| Outstanding at December 31, 2005 |       | 611,306                     |       | $                                       | 3.94       |                                            | 7.54       |                             | $          | 1,962,401 |   |
| Exercisable at December 31, 2005 |       | 555,219                     |       | $                                       | 4.09       |                                            | 7.45       |                             | $          | 1,699,260 |   |

 

The weightedaverage grant-date fair value of options granted during the nine-month periodsended December 31, 2005 and 2004 were $745,785 and $1,336,091 respectively.The total intrinsic value of options exercised during the nine-month periodsending December 31, 2005 and 2004 were $127,965 and $1,018,835respectively.

 

The followingtable provides pro-forma net earnings and earnings per share had the Company appliedthe fair value method of SFAS 123 during the nine-month periods ended December 31,2005 and 2004 until the time of the adoption of SFAS 123R on October 1,2005:

 
| ** **                                                                        | ** ** | **Nine Months  Ended  December 31,  2005** | ** ** | **Nine Months  Ended  December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Net loss attributable to common  stockholders:                                    |       | $                                               | (646,423   | )                                               | $          | (1,045,834 | ) |
| Deduct  stock-based compensation expense determined under fair value basis method |       | $                                               | (1,111,276 | )                                               | $          | (359,825 | ) |
| Pro forma net loss                                                                |       | $                                               | (1,757,699 | )                                               | $          | (1,405,659 | ) |
| Reported basic loss per share                                                     |       | $                                               | (0.17      | )                                               | $          | (0.28 | ) |
| Pro forma basic loss per share                                                    |       | $                                               | (0.46      | )                                               | $          | (0.38 | ) |
| Reported diluted loss per share                                                   |       | $                                               | (0.17      | )                                               | $          | (0.28 | ) |
| Pro forma diluted loss per share                                                  |       | $                                               | (0.46      | )                                               | $          | (0.38 | ) |

 

Employee Stock Purchase Plan:

 

The Companyhas an Employee Stock Purchase Plan which permits employees to invest by meansof periodic payroll deductions in the Company’s common stock during six-monthcontribution periods. Through November 30, 2005, employees participatingin the Employee Stock Purchase Plan could purchase shares at 85% of the lowerof the market price of the Company’s common stock on the beginning and endingdates of the contribution periods. Effective December 1, 2005, theEmployee Stock Purchase Plan was amended to only allow shares to be purchasedat 85% of market price of the Company’s common stock at the end of thecontribution period.

 

During thenine-month periods ended December 31, 2005 and 2004, 36,257 and 22,565shares of the Company’s common stock were purchased by plan participants. Compensationexpense relating to the Company’s Employee Stock Purchase Plan of $6,094 isincluded in the accompanying statements of operations for the three- andnine-month periods ended December 31, 2005.

 

C.                                     LONG-TERMDEBT AND CAPITAL LEASES

 

Effective March 31,2005, the Company renewed its line of credit with a bank that allows theCompany to borrow up to****$3,000,000 or80% of eligible accounts receivable. The line of credit accrues interest at 1%over of the bank’s prime rate (7.25% as of December 31, 2005) and matureson March 31, 2007. As of December 31, 2005, the Company had a$500,000 outstanding balance against the line.

 

Effective March 31, 2005, the Company also entered into a termdebt agreement with a bank for equipment financing. The loan allows for minimumdraws of $100,000 per draw with a maximum of

 

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$1,000,000 to be drawn through March 31,2006. The Company is required to make interest only payments equal to 1.5% overthe bank’s prime rate during the draw-down period. At the end of the draw-downperiod, the Company will be required to pay monthly installments of principaland interest over 36 months. During the nine months ended December 31,2005, the Company had drawn the entire $1,000,000 which was all outstanding.

 

D.                                    COMMONSTOCK

 

Ninemonths ended December 31, 2005

 

During the nine months ended December 31,2005, options to purchase 29,946 shares of the Company’s common stock wereexercised, 36,257 shares of common stock were purchased by employees under theCompany’s Employee Stock Purchase Plan, and warrants to purchase 6,250 sharesof common stock were exercised resulting in $154,227 of net proceeds to theCompany.

 

On April 23,2003, the Company’s Board of Directors approved an employee stock option exchangeprogram (the “Exchange Program”), pursuant to which the Company granted optionsto purchase 313,592 shares of the Company’s common stock at an exercise priceof $1.60 per share in exchange for the cancellation of options to purchase377,342 shares of the Company’s common stock at exercise prices in excess of$2.00 per share. The new options issued under the Exchange Program were subjectto variable plan accounting in accordance with Financial Accounting StandardsBoard Interpretation No. 44, *Accounting for CertainTransactions Involving Stock Compensation*. Under variable planaccounting, the Company was required to recognize compensation expense(benefit) in its consolidated statements of operations for any change in theintrinsic value of the options. The intrinsic value of the repriced options isbased on the market price of the underlying vested and unexercised shares ofcommon stock and is calculated as the difference between the fair market valueof the common stock and $1.60 (the market price at April 23, 2003, whichwas the effective date of the exchange). This compensation adjustment wasrecorded on a quarterly basis until the adoption of Statement of FinancialAccounting Standards No. 123R, *Share-Based Payment*(SFAS 123R) on October 1, 2005.

 

During the sixmonths ended September 30, 2005, the Company recorded $68,652 ofstock-based compensation benefit for these options since the value of theCompany’s common stock decreased between March 31, 2005 and September 30,2005. Effective October 1, 2005, due to the Company’s adoption of SFAS123R, the variable****accountingtreatment for the options repriced under the Exchange Program is no longerrequired.  From April 2003 throughSeptember 2005 the Company has recorded a cumulative net expense of $1,147,000from marking these options to market.

 

During thethree months ended December 31, 2005, the Company recorded $27,611 ofshare based payment expense under the provisions of SFAS 123R.

 

On February 28,2005, the Company’s Board of Directors approved a stock repurchase planauthorizing the Company to repurchase up to 10% of its then outstanding commonstock over a one-year period. The purchase price, amount of shares perpurchase, and the specific purchase dates are subject to approval by theCompany’s Board of Directors and compliance with rules and regulations ofthe Securities and Exchange Commission. During the nine months ended December 31,2005, the Company repurchased 16,938 shares of common stock at a cost of$55,939. As of December 31, 2005, a total of 76,737 shares had beenrepurchased under the stock buy-back plan and are accounted for as treasurystock in the accompanying financial statements.

 

Ninemonths ended December 31, 2004

 

During the nine months ended December 31,2004, options to purchase 166,815 shares of the Company’s common stock wereexercised and 22,565 shares of common stock were purchased by the Company’semployees under the Company’s Employee Stock Purchase Plan.

 

During the nine months ended December 31,2004, warrants to purchase 204,250 shares of common stock were exercised undercashless provisions of the underlying warrant agreements resulting in theCompany issuing 167,853 shares of common stock. In addition, during the sameperiod warrants to purchase 50,000 shares of common stock were exercised at atotal price of $88,125.

 

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During thenine months ended December 31, 2004, the Company recorded $235,355 ofstock-based compensation benefit from marking to market the options repricedunder the Exchange Program.

 

In January 2004,the Company entered into a consulting agreement with terms that required theCompany to issue the consultant warrants to purchase 5,000 shares of commonstock each month.  As of December 31,2005 warrants to purchase 60,000 shares of common stock were outstanding underthis agreement, of which warrants to purchase 45,000 shares were issued duringthe nine months ended December 31, 2004. The warrants vest 25% every threemonths from the date of issuance, have a term of three and one-half years, andhave an exercise price of $3.00 per share. On October 31, 2004, theCompany terminated the consulting agreement. Accordingly, subsequent to October 31,2004 no further warrants have been issued under the agreement. The value ofthese warrants, as determined using the Black-Scholes valuation model, wererecognized during the performance period as opposed to the vesting schedule sincethe period of performance has ended.

 

Effective May 21, 2004, the Company’sboard of directors modified certain warrants to extend the expiration date fromMay 31, 2004 to August 31, 2004. The value of this warrantmodification, as determined using the Black-Scholes valuation model, was$37,875 (which is the difference between the value of the original warrantsimmediately prior to the modification and the value of the extended warrants). Inconnection with this modification, the warrant holders did not provide anyadditional stated or unstated rights, privileges, or agreements to the Company.Accordingly, this transaction has been reflected as a “deemed dividend as aresult of warrant modification” on the accompanying statement of operations andin determining net loss attributable to common stockholders. On August 31,2004, the subject warrants expired unexercised.

 

E.                                      INCOME(LOSS) PER SHARE

 

Income (loss) per share is computed inaccordance with Statement of Financial Accounting Standards No. 128, *Earnings Per Share*. Basic income (loss) per share iscomputed by dividing net income (loss) by the weighted average number of sharesof common stock outstanding for the period. Diluted income (loss) per sharereflects the potential dilution that could occur from shares of common stockissuable through stock options, warrants and other convertible securities, ifdilutive. Options and warrants to purchase 290,601 shares of common stock havebeen included in the calculation of diluted common stock outstanding for thethree-month period ended December 31, 2005. Options and warrants topurchase 143,679 shares of common stock have not been included in thecalculation of diluted common stock outstanding for the nine-month period endedDecember 31, 2005, because to do so would be anti-dilutive. Options andwarrants to purchase 224,007 and 304,972 shares of common stock, respectively,have not been included in the calculation of diluted common stock outstandingfor the three and nine months ended December 31, 2004, because to do sowould be anti-dilutive.

 

F.                                      FACILITIESCONSOLIDATION

 

InJanuary 2005, the Company approved a plan to consolidate its Utah contactcenter facilities from three locations into one “super center” by July 2005.The Company completed this plan and ceased using the second of the centers thatwas to be abandoned under the plan in June 2005. Costs incurred withclosing this facility, including the impairment of leasehold improvements andthe accrual of future lease obligations, have been recorded as a restructuringcharge in the Company’s condensed consolidated statement of operations for thenine months ended December 31, 2005. In addition, management determinedthat it was not economically feasible to open its contact center in GreenRiver, Wyoming, which has been and is currently idle. Therefore, the cost offuture lease payments for the Green River facility has also been included inthe restructuring charge in the accompanying condensed consolidated statementof operations for the nine months ended December 31, 2005. The followingsummarizes the costs recorded as a restructuring charge during the nine monthsended December 31, 2005:

 

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| Discounted  value of future facilities lease obligations |   | $       | 329,831 |   |
|----------------------------------------------------------|--------|---------|---------|--------|
| Impairment of leasehold improvements                     |   | 122,744 |    |
| Moving costs and other                                   |   | 25,000  |    |
|                                                     |   | $       | 477,575 |   |

 

The following is a reconciliation ofaccrued restructuring expense for the nine months ended December 31, 2005:

 
| Accrued restructuring expenses at March 31, 2005                   |   | $        | 118,793 |   |
|-------------------------------------------------------------------------|--------|----------|---------|--------|
| Accrual of future facilities lease  obligations, moving and other costs |   | 354,831  |    |
| Accretion of discount on future rent of  abandoned Green River facility |   | 4,050    |    |
| Costs paid during period                                                |   | (294,585 | )       |
| Accrued restructuring expenses at December 31,  2005               |   | 183,089  |    |
| Less current  portion of accrued restructuring expenses                 |   | (57,935  | )       |
| Long-term accrued restructuring expenses                                |   | $        | 125,154 |   |

 

G.                                  BUSINESSACQUISITION

 

In October 2004 the Company, through its wholly-owned subsidiary, Xtrasource Acquisition, Inc. (“Acquisition”), acquired substantially all of the assets of Xtrasource, Inc. (“Xtrasource”), a non-affiliated, privately-held Delaware corporation with approximately $10 million in annual sales. Acquisition agreed to pay the owners of Xtrasource a quarterly contingent earnout of 30% of earnings before interest, taxes, depreciation and amortization (“Earnout”) for the quarterly periods between the closing and September 30, 2009 (with a maximum aggregate cap of $6.5 million). Earnout payments are subject to various reduction and offset rights including, but not limited to, reductions for debt payments (to secured and unsecured creditors) and working capital deficiencies. The accrued contingent consideration represents the Company’s estimate of the Earnout liability. This estimate is based on the Company’s forecasts of earnings attributable to the Xtrasource operations through September 2009. During the quarter ended December 31, 2005, the purchase price of the acquired business has been adjusted in accordance with purchase price true-up provisions of Statement of Financial Accounting Standards No. 141, *Business Combinations,* after considering on-going operations during the first 12 months of post-acquisition activity. The true-up increased the estimated deferred consideration by approximately $722,000 and increased deferred tax liabilities by approximately $317,000. The offset to these increases was an increase in intangible assets of $1,039,000. The actual amounts eventually paid for the Earnout could differ materially from management’s estimate. Going forward, all true-ups to the Earnout liability will be recognized in the Company’s operating results.

 

The acquiredassets consist of call center operations with facilities in the United States,the Netherlands and France. Assets acquired also include intangible assetsconsisting primarily of the Xtrasource assigned customer contracts and relatedcustomer base. These intangible assets are being amortized over the expecteduseful life of five years. As of December 31, 2005 and March 31,2005, the Company’s intangible assets consist entirely of the intangible assetsacquired through this transaction. The carrying value of intangible assets(after purchase price adjustments) at December 31, 2005 totaled$2,404,906, net of $364,110 of accumulated amortization. The carrying value ofintangible assets at March 31, 2005 totaled $1,229,607, net of $136,594 ofaccumulated amortization.

 

H.                                    INCOME TAXES

 

Even thoughthe Company had a consolidated net loss for the nine months ended December 31,2005, the Company’s operations are located in different tax jurisdictions andmay require the payment of income taxes in specific jurisdictions. Income taxexpense (benefit) for the three- and nine-month periods ended December 31,2005 consists of the provision for income taxes on the Company’s European operationsnet of amortization of the Company’s deferred tax liabilities. The Company hasnet operating loss carry-forwards for U.S. income tax purposes sufficient tooffset taxable U.S. income generated during the three months ended December 31,2005.

 

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I.                                         GEOGRAPHICINFORMATION

 

The following geographic area data includes net revenue and long-lived assets based on physical location:

 
| ** **          | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|---------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **          | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue:**        |       |                                      |       |                                     |       |   |   |   |   |
| United  States      |       | $                                         | 12,571,000 |                                     | $          | 7,865,000 |   | $ | 26,882,000 |   | $ | 20,601,000 |   |
| Europe              |       | 2,584,000                                 |       | 2,182,000                                |       | 6,896,000 |   | 2,182,000 |   |
| Consolidated  total |       | $                                         | 15,155,000 |                                     | $          | 10,047,000 |   | $ | 33,778,000 |   | $ | 22,783,000 |   |
|                     |            |                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |

 
| ** **             | ** ** | **December 31, 2005** | ** ** | **March 31,   2005** | ** ** |
|------------------------|------------|----------------------------|------------|---------------------------|------------|
|                   |       |                       |       |                      |       |
| **Long-lived assets:** | ** ** | ** **                 | ** ** | ** **                | ** ** |
| United  States         |       | $                          | 5,835,000  |                      | $          | 4,246,000 |   |
| Europe                 |       | 1,111,000                  |       | 1,312,000                 |       |
| Consolidated  total    |       | $                          | 6,946,000  |                      | $          | 5,558,000 |   |

 

J.                                        NEWMEXICO EXPANSION

 

On September 20, 2005 (and in subsequent amendments), the Company entered into a five-year lease agreement with Centurion SW, LLC, an unrelated third party, commencing November 1, 2005, for approximately 45,000 square feet in the Compass Bank Plaza at 505 Marquette Avenue, N.W., Albuquerque, New Mexico. Under the terms of the lease, the Company will pay a base rent of approximately $9,000 a month for January 2006, with the monthly payment obligation increasing to approximately $32,000 for February 2006, $45,000 for March 2006 and approximately $60,000 per month by the end of the five-year lease term, plus any incremental increase in operating expenses. The Company has two options to extend the lease for an additional five years, plus any incremental increase in operating expenses. The lease also provides the Company the right to obtain additional space in the building under the same terms and conditions on a prorated basis for the remainder of the lease term. The Company began contact center operations in this facility during November 2005.

 

K.                                    SEASONALITY

 

The Company’soperating results have historically been affected by the seasonal variancesexperienced by some of its significant clients. Historically, the third andfourth quarters have been favorably affected by a significant increase inservice requests experienced from the Company’s support of certain clients’products and/or services. The Company anticipates that it will continue to haveseasonal variances.

 

L                                         JOBTRAINING INCENTIVE REIMBURSEMENT

 

In October 2005,Sento applied for and was awarded by the State of New Mexico job trainingreimbursements under the State’s Job Training Incentive Program (JTIP) of up to$1.1 million for training wages to be incurred for 314 positions in the Company’sAlbuquerque contact center. Based on the Company’s significant growth in thequarter, it amended that original request in December and was awarded upto an additional $431,000 of JTIP funding for another 131 positions. TheCompany also applied for and was awarded up to $862,000 of JTIP funding for anadditional 243 positions anticipated to be hired between January and April 2006as the ramp up of Albuquerque continues. All of these awards are based on areimbursement of between 50% and 55% of the wages associated with the completedtraining hours. The majority of the employees are contact and technical supportagents who, among other 

 

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requirements, must each complete 640 traininghours before the Company can submit for reimbursement of their wages. Based onthe start dates of the first group of Albuquerque employees and projectedcompletion of their training hours, the Company expects to receive its firstcash payment from this program in April 2006. These cash payments shouldcontinue during the first two quarters of fiscal 2007. The Company has accruedand will continue to accrue for the anticipated JTIP funds it expects toreceive from the State of New Mexico once the training hours have beencompleted. The accrual is recognized as an offset to cost of sales in thecondensed consolidated statements of operations. The JTIP funds have alreadybeen appropriated and reserved by the State of New Mexico for the Company. Oncethe employees complete the training hours, the Company can file the appropriatestatutory claims requests to obtain the JTIP funds. These awards are one-timeevents that will be recognized during the training period for the employeescovered.

 

M.                                 SUBSEQUENTEVENTS

 

On January 26, 2006, the Companyexecuted an amendment to loan documents, including an amended and restated schedule toour loan and security agreement. This amendment calls for an additional$1,500,000 term loan with the bank to be used for the purchase of property andequipment. The loan can be drawn upon in minimum increments of $100,000 throughMarch 31, 2006 (“Availability End Date”). The loan accrues interest at1.5% over the bank’s prime rate. The company pays interest only on this loanuntil the Availability End Date at which time the Company will be required tomake principal and interest payments. The principal is to be repaid in equalmonthly installments over 36 months from the Availability End Date. The Companyalso has the option to fix the interest rate to 4.5% over the yield on UnitedStates Treasury Notes with a three year maturity as of the Availability EndDate.

 

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## Item 2.             Management’sDiscussion and Analysis or Plan of Operation.

 

**Forward-Looking Statements**

 

*Thestatements contained in this Quarterly Report on Form 10-QSB that are notpurely historical are “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. All forward-looking statementsinvolve various risks and uncertainties. Forward-looking statements containedin this Report include statements regarding our plans to develop and deliverintegrated information technology services, market opportunities andacceptance, expectations, goals, revenues, financial performance, strategies,mission and intentions for the future. Such forward-looking statements areincluded under “Management’s Discussion and Analysis or Plan of Operation” andencompass our beliefs, expectations, hopes or intentions regarding futureevents. Words such as “expects,” “intends,” “believes,” “anticipates,” “should,”and “likely” also identify forward-looking statements. All forward-lookingstatements included in this Report are made as of the date hereof, based on informationavailable to us as of such date, and we assume no obligation – and specificallydisclaim any obligation - to update any forward-looking statement. It isimportant to note that such statements may not prove to be accurate and thatour actual results and future events will vary, and may vary materially, fromthose anticipated in such statements. Among the factors that could cause actualresults to differ materially from our expectations are those described under “Management’sDiscussion and Analysis or Plan of Operation-Risks Related to Existing andProposed Operations.” All subsequent written and oral forward-lookingstatements attributable to Sento or persons acting on our behalf are expresslyqualified in their entirety by this section and other factors includedelsewhere in this Report. **[Unless otherwiseindicated “we,” “us,” “our,” and “the Company” refer to Sento Corporation andits subsidiaries.]***

 

### **Overview**

 

The followingManagement’s Discussion and Analysis or Plan of Operation (“MD&A”) is intendedto help the reader understand Sento Corporation (“Sento,” “we” or “us”) ouroperations and business environment. MD&A is provided as a supplement to(and should be read in conjunction with) our financial statements andaccompanying notes. Our MD&A includes the following sections:

 

Our Business – a general description of ourbusiness and the industry in which we operate.

 

Significant Events – a discussion of eventsthat have had a significant impact on our accompanying consolidated financialstatements.

 

Application of Critical Accounting Policies –a discussion of accounting policies that require critical judgments andestimates.

 

Operations Review – an analysis of ourCompany’s consolidated results of operations.

 

Liquidity and Capital Resources – an analysisof our cash flows, sources and uses of cash.

 

Seasonality – a discussion on how seasonalityaffects our business.

 

Risks Related to Existing and ProposedOperations – a description of certain risks and uncertainties that could causeour actual results to differ materially from our historical results or ourcurrent expectations or projections.

 

**Our Business**

 

We are aglobal provider of custom solutions that leverage “Right Channeling,” amethodology for ensuring that companies make informed choices for multi-channelcommunication that support their business goals and customer expectations. Weoffer call and contact center solutions for customer acquisition, customerservice, service intervention and technical support. We use modern customercontact centers, coupled with our state-of-the-art proprietary software systemsand other non-proprietary 

 

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technology, to provide domestic andinternational support services and technology solutions to our primary targetmarkets consisting of: (1) small to mid-sized companies or divisions oflarge companies that outsource customer and technical support; and/or (2) companieswhich may or may not outsource but are interested in deploying our RightChanneling and other unique offerings. We conduct our principalbusiness operations through our wholly-owned subsidiaries, Sento TechnicalServices Corporation and Xtrasource Acquisition, Inc.

 

**SignificantEvents**

 

***Xtrasource Acquisition***

 

Effective October 1, 2004, through our wholly owned subsidiary Xtrasource Acquisition, Inc., we acquired substantially all of the assets of Xtrasource, Inc.****(Xtrasource), a non-affiliated, privately-held Delaware corporation with approximately $10 million in annual sales. We have agreed to pay the owners of Xtrasource a quarterly contingent earnout of 30% of earnings before interest, taxes, depreciation and amortization from the acquired Xtrasource operations (Earnout) for the quarterly periods between the closing and September 30, 2009 (with a maximum cap of $6.5 million). Earnout payments are subject to various reductions and offset rights including reductions for debt payments (to secured and unsecured creditors) and net working capital adjustment. We granted the owners of Xtrasource a line of credit of no more than $200,000 to enable Xtrasource to pay costs and expenses associated with closing its Brazilian subsidiary, which we did not acquire (and for which we did not assume its liabilities), and for ordinary expenses related to the transaction. Amounts drawn on the line of credit will be deducted from Earnout payments. Our consolidated operating results contain the operating results of the acquired business for the periods beginning on or after October 1, 2004.

 

Because of better than expected performance of the acquired Xtrasource operations during the first year since the acquisition, we have increased our estimate of the Earnout by $722,000 and recorded this adjustment as a true-up of the purchase price as permitted under purchase accounting rules. This adjustment brings the total accrued contingent consideration for the purchase to $1,613,000. In conjunction with this true-up we also recognized a deferred foreign tax liability of $317,000 related to non-deductible amortization in our European tax jurisdictions. This deferred consideration true-up and related deferred foreign tax liability resulted in a corresponding increase in our intangible assets, which resulted in increased amortization expense during our quarter ended December 31, 2005. Going forward, all true-ups to the Earnout liability will be recognized in our operating results.

 

***Facilities Consolidation***

 

OnJanuary 27, 2005, we announced our intention to consolidate our Utah callcenter operations from three centers into a single combined center. Wecompleted this move during June 2005. We believe this consolidation willenable us to increase our efficiencies and reduce the cost of providing ourservices over the long-term. During the quarter ended June 30, 2005, weincurred moving costs of approximately $25,000 and a write-down of unneededproperty and equipment of $123,000. In addition, we accrued rent expense forthe remaining lease term on the vacated Utah centers (approximately $62,000)during the three months ended June 30, 2005. The above costs areidentified as restructuring charges in our statement of operations for the ninemonths ended December 31, 2005. In addition, we reviewed the viability ofthe future utilization of our Green River, Wyoming facility that is currentlynot in use. Based on our review, we determined that it would not beeconomically feasible to reopen this facility in the future and therefore haveincluded the future costs associated with this facility ($268,000) in ourrestructuring accrual during the three-month period ended June 30, 2005. Therestructuring charges discussed above had a negative impact on our operatingresults during the nine months ended December 31, 2005.

 

***Job Training Incentive Reimbursement***

 

In October, weapplied for and were awarded job training reimbursements from the State of NewMexico’s Job Training Incentive Program (JTIP) of up to $1.1 million fortraining wages to be incurred for 314 positions in our Albuquerque contactcenter. Based on our significant growth in the quarter, we amended thatoriginal request in December and were awarded up to an additional $431,000of JTIP funding for another 131 positions. We also applied for and were awardedup to $862,000 of JTIP funding for an additional 243 positions anticipated tobe hired between January and April 2006 as the ramp up of our 

 

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Albuquerque operations continues. All ofthese awards are based on a reimbursement of between 50% and 55% of theemployees’ training wages. The majority of the employees are contact andtechnical support agents who, among other requirements, must each complete 640training hours before we can submit for reimbursement of their wages. Based onthe start dates of the first group of Albuquerque employees and projectedcompletion of their training hours, we expect to receive our first cash paymentfrom this program in April 2006. These cash payments should continueduring the first two quarters of fiscal 2007.

 

Under GAAP, weaccrued $196,000 of JTIP funds during the three- and nine-month periods ended December 31,2005. The accrual is recognized as an offset to cost of sales in the condensedconsolidated statements of operations. The JTIP funds have already beenappropriated and reserved by the State of New Mexico for us. Once our employeescomplete the training hours, we can file the appropriate statutory claimsrequests to obtain the funds. These awards are one-time events that will berecognized over the periods that we incur the related training costs. We expectthat most of these costs will be incurred during the nine months ending September 30,2006. The JTIP funds help reduce actual training costs as well as partiallyoffset the impact of lower margin training revenue as we continue to ramp-upour Albuquerque site.

 

### **Applicationof Critical Accounting Policies**

 

Management discussed with our Audit Committeethe development, selection and disclosure of our critical accounting policiesand estimates and the application of these policies and estimates.

 

***Basis of Presentation andConsolidation***

 

Our consolidated financial statements areprepared in accordance with generally accepted accounting principles in theUnited States (“GAAP”). Our significant accounting policies are described inNote 2 to our Consolidated Financial Statements included in our Annual Reporton Form 10-KSB for the year ended March 31, 2005. Included withinthese policies are our “critical accounting policies.” Critical accountingpolicies are those policies that are most important to the preparation of ourconsolidated financial statements and require management’s subjective andcomplex judgments due to the need to make estimates about the effect of mattersthat are inherently uncertain. Our critical accounting policies relate torevenue recognition, credit risk and stock-based compensation. The applicationof these accounting policies involves the exercise of judgment and the use ofassumptions as to future uncertainties, and as a result, actual results coulddiffer materially from these estimates. The development and selection of thesecritical accounting policies have been discussed, and are reviewed each year,with the Audit Committee of our Board of Directors.

 

***Revenue Recognition***

 

Revenue is recognized when persuasiveevidence of an arrangement exists, delivery of services has occurred, the feeis fixed or determinable, and collection of the resulting receivable isreasonably assured. We generate revenue by delivering customer support and/ortechnical assistance to users of our clients’ products and/or services byproviding communications utilizing live chat, Web collaboration, email andtelephone interactions. We recognize revenues as services are provided,according to the terms of the underlying agreement with our clients whichspecify how the client will be charged, generally based on a monthly, hourly,per minute or per-contact rate. We also provide licenses to a limited number ofour clients for the use of our customer contact software tools that we host. Inthese arrangements, we charge our client a monthly fee based on the number ofthe clients. Revenue under those arrangements is recognized as the service isprovided.

 

Revenues generated from professional andconsulting services are recognized as the service is provided, based on timeand materials incurred at contractually agreed upon rates.

 

***Credit Risk***

 

We have established an allowance for doubtfulaccounts to reserve for uncollectible accounts receivable. Each quarter wereview the receivables on an account-by-account basis and determine theprobability of collection. Management judgment is exercised in determining theprobability of collection.

 

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Factors we consider in making this judgment are the age of thereceivable, the financial resources of our clients, previous client history andrecent client communications. Our credit losses have generally been within ourexpectations; however, we have experienced exceptions from time to time. Duringfiscal 2005, we established a specific reserve of $475,000 for a financiallydistressed client. During the three months ended September 30,2005, this customer was able to acquire additional funding and paid us $181,593against their receivable and gave us a note for $400,000 that matures in fiscal2007 for the remaining balance. We have fully reserved the note and willrecognize the repayment upon payment from the customer. There can be no assurancethat our future credit losses will be within our expectations. Additionally,our revenues and accounts receivable are concentrated in relatively fewcustomers. A significant change in the liquidity or financial position of anyone of these customers or a further deterioration in the economic environment,in general, could have an adverse impact on the collectibility of our accountsreceivable and our future operating results.

 

***Stock–Based Compensation***

 

In December 2004,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 123R, *Share-Based Payment*(SFAS 123R), which requires the measurement of all share-based payments toemployees, including grants of employee stock options, using a fair-value-basedmethod and the recording of such expense in the consolidated statements ofoperations. Pro forma disclosures currently permitted under Statement of FinancialAccounting Standards No. 123, *Accountingfor Stock Based Compensation* (SFAS 123) are no longer analternative to financial statement recognition under SFAS 123R.

 

Under theprovisions of SFAS 123R, the variable accounting treatment of certain of ouroptions that were repriced in April 2003 is no longer required. Since therepricing and through September 2005, we were required to record anexpense or benefit from “marking-to-market” exercisable and outstandingrepriced options. We have recorded a cumulative net expense of $1,147,000 from April 2003through September 2005 from marking these options to market. Thiscumulative charge is mainly due to net increases in the price of our commonstock from the $1.60 market value per share on the date of the re-pricing. Webelieve the elimination of the variable accounting treatment of these optionsunder the provisions of SFAS 123R will benefit us in future periods due to theexpected continuation of price volatility of our common stock. Therefore, weelected to adopt the provisions of SFAS 123R for the reporting period beginningOctober 1, 2005.

 

We took stepsin September 2005 to reduce the cost exposure of implementing SFAS 123R,including accelerating the vesting of all outstanding stock options withexercise prices above the fair market value as of September 30, 2005 (“under-water”options). We used the modified prospective method of adopting the provisions ofSFAS 123R. Under this method, the unamortized value of non-vested awardsgranted prior to the adoption of SFAS 123R is required to be expensed in ourconsolidated statement of operations over the remaining vesting period. Byaccelerating the vesting of our outstanding under-water options prior to theadoption of SFAS 123R, we were able to reduce the amount of future expense thatotherwise would have been required to recognize on these options after adoptingSFAS 123R. Options granted after the adoption of SFAS 123R are expensed overtheir vesting period.

 

For the threeand six month periods that ended September 30, 2005 and 2004, we appliedthe provisions of SFAS 123. SFAS 123 encourages entities to adopt afair-value-based method of accounting for stock options or similar equityinstruments. However, it also allows an entity to continue measuringcompensation cost for stock based compensation using the intrinsic-value methodof accounting prescribed by Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(APB 25). We elected to continue to apply the provisions of APB 25 and providepro forma disclosures required by SFAS 123 in the footnotes to the consolidatedfinancial statements. We use the Black Scholes option-pricing model todetermine the amount of additional pro forma expense related to these optionsas presented in our disclosures. Under generally accepted accountingprinciples, had we adopted a fair-value-based method of accounting for stockoptions, the pro forma expense for these options would have been recorded asexpense in our statements of operations and could have materially affected ouroperating results.

 

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### **OperationsReview**

 

***Analysis of ConsolidatedStatements of Operations***

 
| ** **                                                     | ** ** | **Three Months Ended December 31,** | ** ** | **Nine Months Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                 | ** ** | **2004**                                | ** ** | **%   Change** | ** ** | **2005** | ** ** | **2004** | ** ** | **%   Change** | ** ** |
| Revenue                                                        | ** ** | $                                        | 15,154,851 | ** **                              | $          | 10,047,153 |   | 51 | % | $ | 33,777,982 |   | $ | 22,782,861 |   | 48 | % |
|                                                           |       |                                     |       |                                    |       |   |   |   |   |   |   |   |   |
| Cost of  sales                                                 |       | 12,089,385                               |       | 8,025,613                               |       | 51 | % | 27,987,588 |   | 19,441,540 |   | 44 | % |
|                                                           |       |                                     |       |                                    |       |   |   |   |   |   |   |   |   |
| Gross margin                                                   |       | 3,065,466                                |       | 2,021,540                               |       | 51 | % | 5,790,394 |   | 3,341,321 |   | 73 | % |
|                                                           |       |                                     |       |                                    |       |   |   |   |   |   |   |   |   |
| Product  development                                           |       | 20,852                                   |       | 61,765                                  |       | (66 | )% | 69,460 |   | 295,741 |   | (77 | )% |
| Selling,  general and administrative expenses                  |       | 2,228,827                                |       | 1,629,192                               |       | 37 | % | 5,823,037 |   | 3,367,296 |   | 73 | % |
| Provision  for (recovery of) doubtful account                  |       | —                                   |       | 475,000                                 |       |   | * | (181,593 | ) | 475,000 |   |   | * |
| Amortization  of intangible assets                             |       | 90,893                                   |       | 54,447                                  |       | 67 | % | 227,516 |   | 54,447 |   | 318 | % |
| Restructuring  charge                                          |       | —                                   |       | —                                  |       |   | * | 477,575 |   | — |   |   | * |
| Non-cash  charge for valuation of warrants issued for services |       | —                                   |       | 53,057                                  |       |   | * | — |   | 239,558 |   |   | * |
| Stock-based  compensation (benefit)                            |       | 27,611                                   |       | (68,947                                 | )          |   | * | (41,041 | ) | (235,355 | ) | 83 | % |
| Operating  income (loss)                                       |       | 697,283                                  |       | (182,974                                | )          |   | * | (584,560 | ) | (855,366 | ) | 32 | % |
|                                                           |       |                                     |       |                                    |       |   |   |   |   |   |   |   |   |
| Other income  (expense), net                                   |       | 8,843                                    |       | (36,719                                 | )          |   | * | (46,657 | ) | (73,886 | ) |   | * |
|                                                           |       |                                     |       |                                    |       |   |   |   |   |   |   |   |   |
| Income  (loss) before income taxes                             |       | 706,126                                  |       | (219,693                                | )          |   | * | (631,217 | ) | (929,252 | ) |   | * |
| Income tax  (provision) benefit                                |       | 2,455                                    |       | (78,707                                 | )          |   | * | (15,206 | ) | (78,707 | ) |   | * |
| Net income  (loss)                                             |       | 708,581                                  |       | (298,400                                | )          |   | * | (646,423 | ) | (1,007,959 | ) |   | * |
| Deemed  dividend as a result of warrant modification           |       | —                                   |       | —                                  |       |   | * | — |   | (37,875 | ) |   | * |
| Net income  (loss) attributable to common stockholders         |       | $                                        | 708,581    |                                    | $          | (298,400 | ) |   | * | $ | (646,423 | ) | $ | (1,045,834 | ) |   | * |

 

----

*                             Calculationis not meaningful

 

Note - Referto the above Analysis of Consolidated Statements of Income while reading theoperations review discussion below.

 

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***Revenues***

 

Revenueincreased by $5,108,000 during the three months ended December 31, 2005when compared to the same three-month period in 2004. Of this increase,$2,755,000 was attributable to new customers, while $2,353,000 was attributableto a net increase in business volume from existing customers. A significantamount of the increase in revenue was generated through our new customercontact center in Albuquerque, New Mexico. This contact center was openedduring the three-month period ended December 31, 2005.

 

Revenueincreased by $10,995,000 during the nine-month period ended December 31,2005 when compared to the same nine-month period in 2004. Of this increase,$3,411,000 was attributable to new customers, $2,720,000 was attributable to anet increase in business volume from existing customers and $4,864,000 isattributable to the acquired Xtrasource business (a full nine months of revenuefrom the acquired business is included in the nine-month period ended December 31,2005 while only three months of revenue from the acquired business is includedin the nine-month period ended December 31, 2004).

 

***Cost of Sales***

 

Our cost ofsales increased by $4,064,000 during the three months ended December 31,2005 when compared to the same three-month period in 2004. The increase incosts was driven principally by the increase in revenue discussed above. Thecost of sales as a percentage of revenue was 79.8% for the quarter ended December 31,2005 versus 79.9% for the same period in 2004. Included in our cost of sales forthe three months ended December 31, 2005 are the costs of training over500 new employees in our New Mexico center that was opened in November 2005.During the three-month period ended December 31, 2005, we offset $196,000(1.3% of revenue) of these training costs through the accrual of JTIP fundswhich have been set aside for us by the State of New Mexico for thereimbursement of training costs.

 

Our cost ofsales increased by $8,546,000 during the nine months ended December 31,2005 when compared to the same three-month period in 2004. This increase incosts was driven primarily by the increase in revenue volume. The cost of salesas a percentage of revenue was 82.9% for the nine months ended December 31,2005 versus 85.3% for the same period in 2004. The costs of sales for the ninemonths ended December 31, 2005 was also reduced by the $196,000 accrual ofJTIP funds discussed above.

 

***Operating Expenses***

 

**Product Development.** Our productdevelopment cost decreased $41,000 when compared to the same three-month periodin 2004. During the three months ended December 31, 2004, we were workingon two significant projects related to enhancements of our Right-Channelingtechnology and the development of our proprietary business intelligence system.These projects were completed during fiscal 2005. We began a new project infiscal 2006 related to our customer interaction technology, which to this pointhas required less development costs than the projects worked on during fiscal2005. We anticipate that we will continue to incur product development costs aswe continue to enhance our technology.

 

Our productdevelopment costs decreased $226,000 during the nine months ended December 31,2005 when compared to the same nine-month period in 2004. Again, this decreaseis reflective of lower development costs associated with our customerinteraction technology than the development costs associated with the twoprojects that were worked on during fiscal 2005.

 

**Selling,General and Administrative Expenses.** Our selling,general and administrative expenses increased $600,000 during the three monthsended December 31, 2005 when compared to the same three-month period in2004. This increase was mainly due to sales commissions earned on theadditional revenue and a planned increase in sales and marketing activities todrive increases in our revenues. While total selling, general andadministrative expenses increased, these costs as a percentage of revenuedecreased during the three months ended December 2005 when compared to thesame three-month period in 2004. As a percentage of revenue, selling generaland administrative expenses were 14.7% of revenue during the three months endedDecember 31, 2005 and 16.2% of revenue during the three months ended December 31,2004.

 

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The increasein selling, general and administrative expenses of $2,456,000 during the ninemonths ended December 31, 2005 when compared to the same nine-month periodin 2004 is attributable to the increased commissions, selling and marketingefforts discussed above and expenses associated with the acquired Xtrasourceoperations. The selling, general and administrative costs during the ninemonths ended December 31, 2004 only have three months of activity from theacquired Xtrasource business while the nine months ended December 31, 2005have a full nine months of activity from the acquired Xtrasource business.

 

**Collectionof fully-reserved doubtful account.** During thequarter ended December 31, 2004, we determined it was necessary tospecifically reserve for a receivable due from a financially distressedcustomer. This customer was able to acquire additional funding during ourcurrent fiscal year. As a result of that funding they paid us $181,593 in September 2005against the receivable and gave us a note for $400,000 that matures in fiscal2007. The $181,593 has been included in our statement of operations for thenine months ended December 31, 2005. The note receivable, which is fullyreserved, will not be recognized in income until paid.

 

**Amortization of intangible assets.** EffectiveOctober 1, 2004, we acquired substantially all of the assets andoperations of Xtrasource. We allocated the purchase price over the assetsacquired, including an allocation of $1,366,000 to intangible assets whichprimarily represents the acquired customer base and the related assignedcontracts. Due to better-than-expected operating results from the acquiredbusiness, we adjusted the purchase price of the acquisition during thisquarter, which resulted in an increase in accrued contingent consideration of$722,000 and a deferred tax liability of $317,000. The increase in the accruedcontingent consideration and the deferred tax liability had the effect ofincreasing our intangible assets by $1,039,000. We have determined that theexpected life of these intangible assets is five years and accordingly, werecorded an expense of $91,000 and $228,000, respectively, during the three andnine months ended December 31, 2005. The amortization during the three andnine months ended December 31, 2005 includes one month of additionalamortization recognized subsequent to the purchase price adjustment. Theamortization expense during the three and nine months ended December 31,2004 represent only three months of amortization as the acquisition waseffective October 1, 2004 and was based on the originally recordedintangible asset value prior to any subsequent purchase price adjustments.

 

**Restructuring charge.** In January 2005 weapproved a plan to consolidate our three Utah contact centers into asingle combined center.We believe that this consolidation will improve our utilization of resourcesand thereby increase our productivity and profitability. We stopped using oneof these facilities in March 2005 and one in June 2005. In addition,we determined that it was not economically viable to reopen our center in GreenRiver, Wyoming that has been and is currently idle. Therefore, we recorded$478,000 of restructuring charges relating to the Utah facility closed in June 2005and the Green River, Wyoming facility. The charges include accrued facilitiesand relocation costs as well as an impairment of approximately $123,000 ofleasehold improvements that were located in the abandoned Utah facility.

 

**Non-cash charge for valuation of warrantsissued for services.** During the three and nine months ended December 31,2004, we issued warrants to purchase common stock to a non-employee forconsulting services. Pursuant to Emerging Issues Task Force (EITF) 96-18, *Accounting for Equity Instruments that are Issued toOther than Employees for Acquiring or in Conjunction with Selling Goods orServices*, we accounted for these arrangements based on the fairvalue of the warrants issued. The fair value of these warrants was measuredeach quarter as the related services were provided and the underlying warrantsvested. We use the Black Scholes pricing model to determine the value of thesewarrants. The resulting quarterly change in value of these warrants was chargedto income. We charged expenses totaling $54,000 and $240,000, respectively, toour statements of operations during the three- and nine-month periods ended December 31,2004. Our arrangement with this consultant was terminated in October 2004.We did not incur any similar charges during the three- and nine-month periodsended December 31, 2005.

 

**Stock-Based Compensation.** During the threemonths ended December 31, 2005, we recognized $28,000 of expense relatedto share-based payments under the provisions of Financial Accounting Standards No. 123R,*Share-Based Payment* (SFAS 123R). Weadopted SFAS 123R on October 1, 2005 using the modified prospective methodoutlined in SFAS 123R. Under the modified prospective method there is norestatement of prior-period financial statements. However, pursuant to SFAS123R, the 

 

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unamortized pro forma expense on unvestedawards issued prior to the adoption of SFAS 123R must be charged to thestatement of operations over the remaining vesting period of the awards alongwith fair value of awards issued subsequent to the adoption of SFAS 123R.

 

In April 2003,our Board of Directors approved an employee stock option exchange program. Underthis program, options to purchase 377,342 shares of common stock with exerciseprices above $2.00 per share were cancelled in exchange for options to purchase313,592 shares of common stock at an exercise price equal to the then currentmarket price of $1.60. This exchange program was considered to be an effective “repricing”of stock options, which required us to adjust the amount of compensationexpense we recognized each quarter until the stock options were exercised,forfeited or expired. The cumulative amount of this charge was calculated bymultiplying the exercisable number of options as of the applicable measurement date by the difference betweenthe market price of the stock on suchdate and the exercise price of $1.60, less any amounts previouslyrecognized. This accounting treatment for the repriced options is notapplicable for periods after the adoption of SFAS 123R.

 

During theperiod between the commencement of our fiscal 2006 year and our adoption ofSFAS 123R, we recognized $69,000 of benefit in our statement of operationsrelating to the repricing of the options described above. We recognized $69,000and $235,000 of benefit, respectively, during the three- and nine-month periodsending December 31, 2004 relating to the repricing of these options. Althoughwe recognized benefits during these periods for the repriced options, werecognized a cumulative net expense of $1,147,000 for the repriced options fromthe date of the repricing until the adoption of SFAS 123R. This cumulativeexpense was mainly due to the net increase in our stock price from the date ofthe repricing until the adoption of SFAS 123R. Due to the volatility in theprice of our common stock and our improved profitability, we felt that theearly adoption of SFAS 123R would minimize the impact of our stock price on ouroperating results. Had we not adopted SFAS 123R, we would have had to recognize$491,000 of additional expense during the three months ended December 31,2005 as a result in a net increase in the price of our common stock during thethree-month period.

 

***Income tax expense***

 

Our operationsare located in different tax jurisdictions and may require the payment ofincome taxes in specific jurisdictions. Income tax benefit (expense) for thethree and nine-month periods ended December 31, 2005 consists of a benefitof $7,000 for the amortization the deferred tax liability that was accrued aspart of the purchase price adjustment for the Xtrasource acquisition, net ofincome tax expense of $5,000 for the three months ended December 31, 2005and $22,000 for the nine months ended December 31, 2005. The income taxexpense amounts noted above relate primarily to our European operations. Webelieve we have sufficient net operating loss carry-forwards to offset any federaland state income tax expense that would have otherwise been charged to our U.S.operations for the three and nine months ended December 31, 2005.

 

### **Liquidity and Capital Resources**

 

We believe that we have sufficientcapital resources to continue our current level of operations for theforeseeable future. However, we have experienced significant growth during thenine months ended December 31, 2005. If this growth continues, we may needto acquire additional debt and/or equity financing to provide funding forfacilities build-outs and working capital requirements. Currently, we have anoperating credit line with a bank that allows us to borrow up to $3,000,000 andis based on 80% of eligible accounts receivable. As of December 31, 2005we had $500,000 outstanding on this line of credit. The line of credit accruesinterest at 1% over the bank’s prime rate (7.25% at December 31, 2005). Therewere no balances outstanding on the credit line as of March 31, 2005.

 

On January 26, 2006, we executed anamendment to loan documents, including an amended and restated schedule toour loan and security agreement. This amendment calls for an additional$1,500,000 term loan with the bank to be used for the purchase of property andequipment. The loan can be drawn upon in minimum increments of $100,000 throughMarch 31, 2006 (“Availability End Date”). The loan accrues interest at1.5% over the bank’s prime rate. We pay interest only on this loan until theAvailability End Date at which time we will be required to make principal andinterest payments. The principal is to be repaid in equal monthly installmentsover 36 months from the Availability End Date. We also have the 

 

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optionto fix the interest rate to 4.5% over the yield on United States Treasury Noteswith a three year maturity as of the Availability End Date.

 

The following is a summarization of ourconsolidated statements of cash flows and a discussion of significant itemswithin the statements:

 
| ** **                                                                                                 | ** ** | **Nine Months Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities:**                                                                 |       |                                    |       |   |   |
| Net loss                                                                                                   | ** ** | $                                       | (646,423   | ) | $ | (1,007,959 | ) |
| Add back  depreciation and amortization                                                                    |       | 1,587,435                               |       | 1,193,542 |   |
| (Increase)  decrease in receivables                                                                        |       | (4,283,946                              | )          | 1,143,987 |   |
| Increase  (decrease) in accounts payable                                                                   |       | 1,096,622                               |       | (439,851 | ) |
| Other                                                                                                      |       | 1,157,675                               |       | (598,369 | ) |
| Net cash  provided by (used in) operating activities                                                       |       | (1,088,637                              | )          | 291,350 |   |
|                                                                                                       |       |                                    |       |   |   |
| **Cash  flows used in investing activities:**                                                              |       |                                    |       |   |   |
| Purchase of  property and equipment                                                                        |       | (1,987,022                              | )          | (1,104,911 | ) |
| Acquisition  of business (Xtrasource), including the purchase of the acquired business’  secured debt |       | —                                  |       | (872,221 | ) |
| Net cash  used by investing activities                                                                     |       | (1,987,022                              | )          | (1,977,132 | ) |
|                                                                                                       |       |                                    |       |   |   |
| **Cash  flows from financing activities:**                                                                 |       |                                    |       |   |   |
| Principal  payments of long-term debt, capital leases and credit line                                      |       | (1,119,617                              | )          | (725,923 | ) |
| Proceeds  from issuance of long-term debt, capital leases and credit line                                  |       | 2,000,000                               |       | 849,579 |   |
| Payment of  accrued offering costs                                                                         |       | —                                  |       | (627,364 | ) |
| Repurchase  of common stock                                                                                |       | (55,939                                 | )          | — |   |
| Proceeds  from exercise of stock options, warrants and employee stock purchases                            |       | 154,227                                 |       | 408,475 |   |
| Net cash  provided by (used in) financing activities                                                       |       | 978,671                                 |       | (95,233 | ) |
| Effect of  foreign currency translations                                                                   |       | (51,322                                 | )          | 91,330 |   |
| Net decrease  in cash                                                                                      |       | (2,148,310                              | )          | (1,689,685 | ) |
| Cash and  cash equivalents at the beginning of period                                                      |       | 5,698,195                               |       | 6,567,811 |   |
| **Cash and  cash equivalents at the end of period**                                                        | ** ** | $                                       | 3,549,885  |   | $ | 4,878,126 |   |

 

Cash flowsfrom operating activities decreased by $1,380,000 during the nine months ended December 31,2005 when compared to the same period in 2004. The key component of thisdecrease was an increase in receivables during the nine-months ended December 2005of $4,284,000, while receivables decreased by $1,144,000 during the samenine-month period in 2004. Our record growth during the three months ended December 31,2005 (an increase in revenues of $5,108,000 over the same three-month period in2004 and an increase in revenues of $5,292,000 over the three-month periodended September 30, 2005), was the primary cause for this increase. Theeffect of the increase in receivables was partially offset by an increase inpayables during the same nine-month period. The increase in payables isprincipally attributable to our increased business volume as indicated by theincrease in revenue during the nine months ended December 31, 2005.

 

We spent$1,987,000 on property and equipment during the nine months ended December 31,2005. This represents an 80% increase from purchases during the same nine-monthperiod in 2004. The majority of these purchases were necessary to open thecontact center in Albuquerque, New Mexico in October 2005. We receivedproceeds of $1,500,000 from borrowings under long-term debt, capital leases andnet borrowings under our credit line during the nine months ended December 31,2005. This represents a 77% increase from similar borrowings during the samenine-month period in 2004. With the exception of $500,000 that was outstandingon our credit line as of December, 31, 2005, these borrowings were used to helpfinance property and equipment purchases.

 

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We also spent$872,000 on the acquisition of the Xtrasource assets and $627,000 on thepayment of accrued offering costs during the nine months ended December 31,2004. The amount spent on the Xtrasource acquisition includes the purchase ofXtrasource’s secured debt. The amount spent on offering costs during the ninemonths ended December 31, 2004 relates to equity financing that was fundedon March 30, 2004.

 

### **Seasonality**

 

Our operating results have historicallybeen affected by the seasonal variances experienced by some of our significantclients. Historically, our third and fourth quarters have been favorablyaffected by a significant increase in service requests we experienced from oursupport of certain clients’ products and/or services. Going forward, weanticipate that we will continue to have seasonal variances.

 

### **Risks Related to Existing and Proposed Operations**

 

There are anumber of factors that may affect our operating results, including the risksand uncertainties identified in the following paragraphs. In addition to otherinformation set forth in this Report, readers should review and carefullyconsider the following factors.

 

***Weare experiencing revenue growth and our future operations will require skilledmanagement of growth******.***

 

Our currentand future revenue growth must be considered in light of the risks, expenses,delays, problems and difficulties frequently encountered in the establishmentof a new business concept, the development and commercialization of productsbased on new technologies, and the competitive environment in which we willoperate.  As our operations expand, our success will depend on our abilityto manage continued growth, including integration of our executive officers,directors and consultants into an effective management and technical team; toformulate strategic alliances, joint ventures, or other collaborativearrangements with third parties; to commercialize and market our proposedproducts and services; and to monitor and manage these relationships on along-term basis.  If our management is unable to integrate these resourcesand manage growth effectively, the quality of our products and services, our abilityto retain key personnel, and the results of our operations could be materiallyand adversely affected.

 

***Managingthe utilization level of our resources is necessary in order to achieve ourdesired profitability.***

 

Our businessstrategy requires us to efficiently utilize personnel and physical facilitiesin an effort to increase our profitability. As we expand our operations, we maynot always be able to manage the level of personnel and facilities to reach ourdesired levels of utilization, which may affect our profitability. Also, if welose existing clients, we may have excess personnel and physical facilitiesthat would have an adverse effect on our business operations and ourprofitability.

 

***Ifwe do not keep up with the rapid technological change experienced by thecustomer contact service industry, our products and services may becomeobsolete and we may lose clients.***

 

The customercontact service industry is characterized by rapid technological change,alterations in customer requirements and preferences, and the emergence of newindustry standards and practices. Our operating results and financial conditionwill depend, in part, on our ability to develop solutions that keep pace withcontinuing changes in information technology, evolving industry standards, andchanging client requirements. There can be no assurance that we will besuccessful in adequately addressing these developments on a timely basis orthat, if these developments are addressed, we will be successful in themarketplace. In addition, products or technologies developed by others couldrender our services non-competitive or obsolete. Our failure to address thesedevelopments could have a material negative effect on our business andfinancial condition.

 

***Wemay be unable to attract, train and retain key management, technical andmarketing personnel.***

 

Our successwill depend, in large part, on our ability to attract, retain and train highlyqualified technical, managerial and marketing personnel with the expertiserequired to successfully conduct our 

 

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operations. We have entered into employmentagreements with certain of our key managerial personnel; however, thoseagreements are subject to termination under various circumstances and we havenot entered into employment agreements with any of our key technical personnelother than our Chief Technology Officer. If we lose any key personnel or areunable to attract, retain, train or motivate qualified personnel, our businessoperations and financial condition may be materially and adversely affected.

 

***Wehave a history of losses and may continue to experience losses******.***

 

We experiencednet losses in four of our last six fiscal years and during our most recent ninemonths ended December 31, 2005. We had an accumulated deficit of$(12,925,000) as of December 31, 2005. We cannot provide any assurancesthat we will be able to maintain profitable operations. We may incur losses infuture periods, particularly if we lose clients, are unable to attract andretain new clients or do not properly utilize our resources. We cannot ensurethat we will be able to maintain consistently profitable operations.

 

***Implementationof our growth plans will be dependent on our ability to market and sell ourservices to new and existing clients.***

 

Our growthplans are dependent upon our ability to attract and retain new clients and togenerate additional business from existing clients. Our efforts to market andsell our services will be affected by fluctuations in technology and industrystandards, changes in customer requirements and preferences, increasedcompetition and general economic conditions, among other factors. Many of thesefactors are beyond our control. If we are incorrect in our assessment of thefeasibility of our growth plans, if we are not effective in our efforts tomarket and sell our services or if circumstances change in a way that we didnot foresee or anticipate, we may not grow as planned or our growth strategymay have an adverse effect on business operations and our profitability.

 

***Our revenues and quarterly results can bevolatile, which makes evaluating our business difficult.***

 

Individualclient revenue transactions can constitute a substantial percentage of ourquarterly revenue, and some revenue transactions may generate a substantialportion of the operating profits for a quarter. Our revenues also are afunction of the number of support requests we receive, and the time we spend onsuch requests. Thus, if we receive fewer support requests than anticipated orthe time spent in resolving inquiries is greater than anticipated, our revenuesmay fluctuate. Further, delays in the receipt of customer orders can causesignificant fluctuations in revenues from quarter to quarter.

 

For the reasons identified above, we believethat period-to-period comparisons of our revenues and operating results may notbe meaningful and should not be considered an indication of future performance.

 

***Severalkey clients represent a significant portion of our revenues, and the loss of akey client could affect our revenues and profitability.***

 

Three clientsaccounted for approximately 56% of our revenues for the nine months ended December 31,2005. These three clients accounted for approximately 29%, 15% and 12%,respectively, during the nine-month period.

 

Some of ourclients can generally cancel their contracts on short notice. It can take asignificant amount of time to develop and obtain new clients and retrainemployees to replace revenue from a lost client. Thus, the loss of any of ourkey clients could have a significant effect on our revenues and profitability. Inaddition, our future revenue growth is dependent upon our ability to attractand retain new clients.

 

***Weare subject to credit risks and may be unable to collect our accountsreceivable balances.***

 

We provideunsecured credit terms to our clients. Based on credit evaluations and otherinformation gathered by our personnel, we establish credit terms for eachclient; however, there can be no assurance that our future credit losses willbe consistent with our expectations. A significant change in the 

 

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liquidity or financial condition of one ormore key clients, or a larger number of smaller clients, or further deteriorationin the economic environment, in general, could have an adverse impact on thecollectibility of our accounts receivable and our future operating results.

 

***Marketvolatility and fluctuations in our stock price and trading volume may causesudden decreases in the value of an investment in our common stock.***

 

The market price of our common stock hashistorically been, and we expect it to continue to be, volatile. This price hasranged between $1.35 and $17.89 during the 33 months ended December 31,2005. The market for our common stock has, from time-to-time, experiencedextreme price and volume fluctuations, which have often appeared to beunrelated to our operating performance. Our stock price also has been affectedby our own public announcements regarding such things as quarterly earnings,changes in clients, obtaining financing and corporate partnerships. Consequently,events both within and beyond our control may cause shares of our common stockto lose their value rapidly.

 

***We are susceptible to business and politicalrisks from international operations that could result in reduced revenues orearnings.***

 

We operate businesses or have contractualrelationships in the Netherlands, France and India and are considering thepossibility of expanding into other countries. Additionally, there isincreasing demand for offshore customer care outsourcing capacity from NorthAmerican companies. Expansion of our existing international operations andentry into additional countries will require management attention and financialresources. In addition, there are certain risks inherent in conducting businessinternationally including: exposure to currency fluctuations, longer paymentcycles, greater difficulties in accounts receivable collection, difficulties incomplying with a variety of foreign laws, unexpected changes in legal orregulatory requirements, difficulties in staffing and managing foreignoperations, political instability and potentially adverse tax consequences. Tothe extent we do not manage our international operations successfully, ourbusiness could be adversely affected and our revenues and/or earnings could bereduced.

 

***Volatileeconomic conditions have affected and will likely continue to affect ouroperations and financial results.***

 

Volatile economicconditions have adversely affected our operations and financial results. Incertain sectors serviced by us in recent years, economic slowdowns have causedus to lose some clients and also resulted in increased pricing pressures andlower call volumes from some existing clients. Slower economic conditions maylimit our ability to attract new clients or retain existing clients. The slowereconomy may also result in excess capacity to service call volumes. Asubstantial percentage of our expenses are attributable to labor costsassociated with staffing Customer Contact Solutions Centers, which we may notbe able to significantly reduce on short notice in order to compensate forunexpected shortfalls in call volumes. We cannot forecast future fluctuations ineconomic conditions, and our operations and financial results may be materiallyand adversely affected by economic volatility.

 

***Ifcompanies reduce their reliance on outsourced services, our revenues andfinancial condition may be adversely affected.***

 

Our businessdepends in large part on the trend within the IT industry to outsource certainservices. We cannot provide any assurance that this trend will continue orthat, if the trend continues, it will continue at the same rate of growth. Thefailure of this trend to continue could have a material adverse effect on ourbusiness, financial condition, and results of operations.

 

***Competitivepressures could harm our financial performance.***

 

The market forcustomer contact services is highly fragmented and very competitive. In certainsegments of the industry, however, the customer contact services industry hasbegun to experience a degree of consolidation, and the development of majorcustomer contact center companies has resulted in an additional level of competitionfrom service providers that have greater name recognition, larger installedcustomer bases, and significantly greater financial, technical, and marketingresources than we have. Large established enterprise software companies mayleverage their existing relationships and capabilities to offer 

 

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customer service applications. In otherinstances, many large companies provide their own in-house customer caresupport and customer training. Also, a number of existing companies haveexperienced rapid internal growth, and several of these companies have beenactive in acquiring smaller regional customer contact services companies andare becoming major competitors with a measurable share of this rapidly expandingmarket. If our competitors provide more efficient or less expensive services,we may lose market share and revenues.

 

***Afailure of our computers, telecommunications equipment or software systemscould interrupt our ability to provide our services******.***

 

Our businessdepends to a large extent on computers, telecommunications equipment andsoftware systems (both equipment and systems maintained by us and equipment andsystems maintained by third parties). A natural disaster, human error,equipment malfunction or inadequacy or multiple other events could result in aprolonged interruption in our ability to provide support services to clients ortheir customers. The temporary or permanent loss of computer or telephoneequipment or systems, through casualty, operating malfunctions or otherwise,could have a material adverse effect on our operations, property or financialcondition, and business interruption insurance may not be adequate tocompensate for all losses that may be incurred.

 

***Werely on two third-party software companies for our chat, email applications andCRM case logging*.**

 

We contractwith a third-party software company to provide chat and email tools used withour CRM software, reporting and management services. Additionally, we use athird-party software company to do our CRM case logging for some of our majorclients. If either of these software companies fails in their business efforts,we may lose our access to these software tools. Our failure to obtain adequatereplacement software tools would cause us to experience service delays,interruptions or cancellations.

 

***Provisions of our Articles of Incorporation,Bylaws and Shareholder Rights Plan could impair or delay shareholders’ abilityto replace or remove our management and could discourage takeover transactionsthat shareholders might consider to be in their best interests.***

 

Our Articles of Incorporation and Bylaws, theUtah Revised Business Corporation Act, and the Utah Control Shares AcquisitionAct each contain certain provisions that may have the effect of inhibiting anon-negotiated merger or other business combination. Our Articles ofIncorporation grant to our Board of Directors the authority, without furtheraction by our shareholders, to fix the rights and preferences of, and issue sharesof preferred stock. Our recently adopted Bylaws provide advancenotice requirements that may limit the opportunity for our shareholders toadvance nominees for election to our Board of Directors or submit matters fromthe floor at our meetings of our shareholders. In addition, our Board ofDirectors has adopted a Shareholder Rights Plan which imposes constraints ontransactions which could result in a change of control of Sento. These provisions may deterhostile takeovers or delay or prevent changes in control of Sento or changes inour management, including transactions in which shareholders might otherwisereceive a premium for their shares over the then-current market prices. Inaddition, these provisions may limit the ability of our shareholders to approvetransactions that they may deem to be in their best interests.

 

***We have never declared a dividend on ourcommon stock and we do not anticipate paying dividends in the foreseeablefuture.***

 

No dividends have ever been declared or paidon our common stock. We intend to retain any future earnings for use in ourbusiness and do not anticipate paying any dividends on our common stock in theforeseeable future.

 

## Item 3.             Controls andProcedures

 

An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”) of the effectiveness of our disclosure controls and procedures, as of December 31, 2005. Based on that evaluation, our management, including our CEO and CFO, concluded that our disclosure controls and procedures are 

 

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effective to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported as specified in the SEC’s rules and forms. Our management, including our CEO and CFO, also supervised and participated in an evaluation of any changes in internal controls as of the end of the period covered by this Report and that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. Based on that evaluation, our executive management, including our CEO and our CFO, concluded that there had been no changes to our internal controls that would have had a material affect over the financial reporting for the quarter ending December 31, 2005.

 

# **PART II.**                                                 OTHER INFORMATION

# ** **

## Item 2.             Unregistered Sale ofEquity Securities and Use of Proceeds

 

There were no sales of unregistered securities during the nine monthsended December 31, 2005. However, during the nine months ended December 31,2005, we purchased the following shares of our common stock:

 

| **Period**                      | ** ** | **Total   number of shares purchased** | ** ** | **Average   price paid   per share** | ** ** | **Total number of   shares purchased as   part of publicly   announced plan (1)** | ** ** | **Maximum number   of shares that may   yet be purchased  under the plan (2),(3)** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| Month ended April 30, 2005 |       | 16,938                                 |       | $                                    | 3.30       |                                                                              | 76,737     |                                                                               | 309,293    |   |
| Total                           |       | 16,938                                 |       | $                                    | 3.30       |                                                                              | 76,737     |                                                                               | 309,293    |   |

 

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(1)                                  OnFebruary 28, 2005, we announced the commencement of the stock repurchaseplan.

(2)                                  OurBoard of Directors has approved the repurchase of up to 386,030 shares of ourcommon stock, representing ten percent of the number of shares of common stockoutstanding at the time the repurchase plan was approved.

(3)                                  Thestock repurchase plan expires on February 28, 2006.

 

## Item 6.             Exhibits

 

Exhibit 10.1Amendment to Loan Documents and Third Amended and Restated Schedule toLoan and Security Agreement with Silicon Valley Bank

Exhibit 10.2 Amendment one to leaseagreement with Centurion Southwest, LLC

Exhibit 10.3 Amendment two to leaseagreement with Centurion Southwest, LLC

Exhibit 10.4 First amendment to leaseagreement with Bay Pacific Corporation

Exhibit 10.5 Second amendment to leaseagreement with Bay Pacific Corporation

Exhibit 10.6 Amendment four to leaseagreement with AP Southeast Portfolio Partners, L.P.

Exhibit 10.7 Master lease and schedule 1with Tetra Financial Group LLC

Exhibit 10.8 Master lease agreement andschedules with Dell Financial Services

Exhibits 31.1 and 32.1 – Certifications ofthe Company’s Chief Executive Officer

Exhibits 31.2 and 32.2 – Certifications ofthe Company’s Chief Financial Officer

 

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## SIGNATURES

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this Quarterly Report on Form 10-QSB to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 

 
|                         | SENTO CORPORATION |
|------------------------------|-------------------|
|                         | (Registrant)      |
|                         |              |   |
|                         | By:               | /s/ PATRICK F. O’ NEAL |   |
|                         |              | Patrick F. O’ Neal |
|                         |              | President and Chief Executive Officer |
|                         |              | (Principal executive officer) |
|                         |              |   |
|                         | By:               | /s/ ANTHONY J. SANSONE |   |
|                         |              | Anthony J. Sansone |
|                         |              | Senior Vice President, Chief Financial  Officer and |
|                         |              | Secretary |
|                         |              | (Principal financial and accounting  officer) |
|                         |              |   |
| Dated February 13, 2006 |              |   |
|                              |                   |  |  |  |

 

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