##### **UnitedStatesSecurities and Exchange Commission**

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

#### ** **

**FORM 10-QSB**

 
| **ý** | **Quarterly Report pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934** |
|------------|----------------------------------------------------------------------------------------------|

 

#### **For the QuarterEnded December 31, 2004**

 
| **o** | **Transition report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**Commission File Number 06425**

 

**SENTO****CORPORATION**

Exact Name ofSmall Business Issuer as Specified in its Charter

** **

| **Utah**                                                         | ** ** | ** **                                                 | ** ** | **87-0284979**                        |
|------------------------------------------------------------------|------------|------------------------------------------------------------|------------|---------------------------------------|
| (State or other  Jurisdiction of  Incorporation or Organization) | ** ** |                                                       |       | (I.R.S. Employer  Identification No.) |
|                                                             | ** ** | ** **                                                 |       |                                  |
|                                                             | ** ** | **808  East Utah Valley Drive  American Fork, Utah 84003** |       |                                  |
|                                                             | ** ** | (Address of  Principal Executive Offices)                  |       |                                  |

# ** **

Issuer’s telephonenumber, including area code:  **(801) 772-1100**

 

Check whether theissuer (1) filed all 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 to suchfiling requirements for the past 90 days.

 

Yes ý   No o

 

State the numberof shares outstanding of each of the issuer’s classes of common equity, as ofthe latest practicable date:

 

| **Class**                             | ** ** | **Outstanding  at  January 31, 2004** |
|---------------------------------------|------------|---------------------------------------|
| Common capital  stock  $.25 par value |       | 3,858,617                             |

 

Transitional SmallBusiness Disclosure Format (check one):

 

Yes o   No ý

 

 

----

 

**SENTO****CORPORATION**

Quarterly Reporton Form 10-QSB

Quarter endedDecember 31, 2004

 

TABLE OF CONTENTS

 
| PART I                                                                    | - FINANCIAL INFORMATION |                                                                            |
|---------------------------------------------------------------------------|-------------------------|---------------------------------------------------------------------------------|
|                                                                      |                    |                                                                            |
| Item 1.                                                                   |                    | Financial Statements                                                            |   |
|                                                                      |                    |                                                                            |   |   |
| Condensed Consolidated Balance Sheets                                     |                    |
|                                                                      |                    |                                                                            |   |   |
| Condensed Consolidated Statements of Operations                           |                    |
|                                                                      |                    |                                                                            |   |   |
| Condensed Consolidated Statements of Cash Flows                           |                    |
|                                                                      |                    |                                                                            |   |   |
| Supplemental Disclosures of Cash Flow  Information                        |                    |
|                                                                      |                    |                                                                            |   |   |
| Notes to Condensed Consolidated Financial Statements                      |                    |
|                                                                      |                    |                                                                            |   |   |
| G.                                                                        |                    | INCOME  TAXES                                                                   |   |
|                                                                      |                    |                                                                            |   |   |
| Item 2. Management’s Discussion and Analysis  or Plan of Operations. |                    |
|                                                                      |                    |                                                                            |   |
| Overview                                                                  |                    |
|                                                                      |                    |                                                                            |   |   |
| Critical Accounting Policies                                              |                    |
|                                                                      |                    |                                                                            |   |   |
| Results of Operations                                                     |                    |
|                                                                      |                    |                                                                            |   |   |
| Liquidity and Capital Resources                                           |                    |
|                                                                      |                    |                                                                            |   |   |
| Seasonality                                                               |                    |                                                                            |   |
|                                                                      |                    |                                                                            |   |   |
| Risks Related to Existing and Proposed  Operations                        |                    |
|                                                                      |                    |                                                                            |   |   |
| Item 3. Controls and Procedures                                           |                    |
|                                                                      |                    |                                                                            |   |   |
| PART II.                                                                  | OTHER INFORMATION       |                                                                            |
|                                                                      |                    |                                                                            |   |   |
| Item 2.                                                                   |                    | Changes in Securities and Small Business Issuer Purchases of Equity  Securities |   |
|                                                                      |                    |                                                                            |   |   |
| Item 6.                                                                   |                    | Exhibits                                                                        |   |   |
|                                                                      |                    |                                                                            |   |   |
| SIGNATURES                                                                |                    |                                                                            |   |

 

i

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# **PART I  - FINANCIALINFORMATION**

## Item 1.  FinancialStatements

##  

#### **SENTO** CORPORATION

**ANDSUBSIDIARIES**

 

### **CondensedConsolidated Balance Sheets**

** **
|                                                                              | ** **                  | ** **  | **December 31, 2004** | ** **  | **March 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------|-----------------------------|-------------|-----------------------|-------------|--------------------|------------|
|                                                                              | ** **                  | ** **  | **(Unaudited)**       | ** **  | ** **         | ** ** |
|                                                                              | **ASSETS**                  | ** **  | ** **            | ** **  | ** **         | ** ** |
|                                                                              |                        |        |                  |        |               |       |
|                                                                              | Current assets:             |        |                  |        |               |       |
|                                                                              | Cash                        |        | $                     | 4,878,126   |               | $          | 6,567,811 |   |
|                                                                              | Accounts receivable, net    |        | 5,324,035             |        | 4,632,111          |       |
|                                                                              | Other current assets        |        | 721,885               |        | 456,182            |       |
|                                                                              | Total current  assets       |        | 10,924,046            |        | 11,656,104         |       |
|                                                                              |                        |        |                  |        |               |       |
|                                                                              | Property and equipment, net |        | 4,548,179             |        | 4,220,560          |       |
|                                                                              | Intangible assets, net      |        | 1,034,491             |        | —             |       |
|                                                                              | Other assets                |        | 328,492               |        | 132,896            |       |
|                                                                              | Total Assets                |        | $                     | 16,835,208  |               | $          | 16,009,560 |   |
|                                                                              |                        |        |                  |        |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                    |                        |        |                  |        |               |
|                                                                              |                        |        |                  |        |               |
| Current liabilities:                                                              |                        |        |                  |        |               |
| Current portion of long-term debt and capital leases                              |                        | $           | 776,201               |        | $                  | 728,357    |   |
| Accounts payable                                                                  |                        | 1,925,536   |                  | 1,334,409   |               |
| Accrued payroll and payroll taxes                                                 |                        | 1,490,376   |                  | 923,757     |               |
| Accrued liabilities and other                                                     |                        | 698,995     |                  | 1,470,447   |               |
| Total current liabilities                                                         |                        | 4,891,108   |                  | 4,456,970   |               |
|                                                                              |                        |        |                  |        |               |
| Long-term debt and capital leases, net of current portion                         |                        | 950,168     |                  | 656,324     |               |
| Accrued contingent consideration from business acquisition                        |                        | 655,590     |                  | —      |               |
| Total liabilities                                                                 |                        | 6,496,866   |                  | 5,113,294   |               |
|                                                                              |                        |        |                  |        |               |
| Stockholders’ equity:                                                        |                        |        |                  |        |               |
| Common stock                                                                      |                        | 964,592     |                  | 863,225     |               |
| Additional paid-in capital                                                        |                        | 20,770,257  |                  | 20,512,919  |               |
| Accumulated other comprehensive income - foreign currency translation  adjustment |                        | 91,330      |                  | —      |               |
| Accumulated deficit                                                               |                        | (11,487,837 | )                     | (10,479,878 | )                  |
| Total stockholders’ equity                                                   |                        | 10,338,342  |                  | 10,896,266  |               |
| Total Liabilities and Stockholders’ Equity                                   |                        | $           | 16,835,208            |        | $                  | 16,009,560 |   |
|                                                                                   |                             |             |                       |             |                    |            |  |  |

 

*Seeaccompanying notes.*

 

1

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**SENTO****CORPORATION**

**ANDSUBSIDIARIES**

 

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

**(Unaudited)**

 
| ** **                                                                                    | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                    | ** ** | **December  31,**       | ** ** | **December  31,**      | ** ** | **December  31,** | ** ** | **December  31,** | ** ** |
| ** **                                                                                    | ** ** | **2004**                | ** ** | **2003**               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Revenue                                                                                       |       | $                       | 10,047,153 |                   | $          | 5,200,254 |   | $ | 22,782,861 |   | $ | 13,439,919 |   |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Cost of sales                                                                                 |       | 8,025,613               |       | 4,191,801              |       | 19,441,540 |   | 11,887,233 |   |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Gross profit                                                                                  |       | 2,021,540               |       | 1,008,453              |       | 3,341,321 |   | 1,552,686 |   |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Product development                                                                           |       | 61,765                  |       | —                 |       | 295,741 |   | — |   |
| Selling, general and administrative expenses                                                  |       | 1,629,192               |       | 737,599                |       | 3,367,296 |   | 2,002,532 |   |
| Specific reserve for doubtful account                                                         |       | 475,000                 |       | —                 |       | 475,000 |   | — |   |
| Amortization of intangible assets                                                             |       | 54,447                  |       | —                 |       | 54,447 |   | — |   |
| Non-cash charge for valuation of warrants                                                     |       | 53,057                  |       | —                 |       | 239,558 |   | — |   |
| Stock-based compensation expense (benefit)                                                    |       | (68,947                 | )          | 275,189                |       | (235,355 | ) | 324,747 |   |
| Operating loss                                                                                |       | (182,974                | )          | (4,335                 | )          | (855,366 | ) | (774,593 | ) |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Non-cash charge for valuation of warrants and conversion of debentures                        |       | (3,111                  | )          | (48,233                | )          | (10,437 | ) | (150,779 | ) |
| Other expense, net                                                                            |       | (33,608                 | )          | (88,891                | )          | (63,449 | ) | (233,582 | ) |
| Net loss before income taxes                                                                  |       | (219,693                | )          | (141,459               | )          | (929,252 | ) | (1,158,954 | ) |
| Income taxes                                                                                  |       | 78,707                  |       | —                 |       | 78,707 |   | — |   |
| Net loss                                                                                      |       | (298,400                | )          | (141,459               | )          | (1,007,959 | ) | (1,158,954 | ) |
| Deemed divided as a result of warrant modification                                            |       | —                  |       | —                 |       | (37,875 | ) | — |   |
| Net loss attributable to common stockholders                                                  |       | $                       | (298,400   | )                      | $          | (141,459 | ) | $ | (1,045,834 | ) | $ | (1,158,954 | ) |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Basic and diluted net loss per share                                                          |       | $                       | (0.08      | )                      | $          | (0.06 | ) | $ | (0.28 | ) | $ | (0.51 | ) |
|                                                                                          |       |                    |       |                   |       |   |   |   |   |
| Basic and diluted weighted average number of common and common  equivalent shares outstanding |       | 3,807,873               |       | 2,372,232              |       | 3,722,628 |   | 2,258,541 |   |

 

*Seeaccompanying notes.*

 

2

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**SENTO****CORPORATION**

**ANDSUBSIDIARIES**

 

### **Condensed Consolidated Statements of Cash Flows**

**(Unaudited)**

 
| ** **                                                                           | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                           | ** ** | **December 31,**      | ** ** | **December 31,** | ** ** |
| ** **                                                                           | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                                |       |                  |       |   |   |
| Net loss                                                                             |       | $                     | (1,007,959 | ) | $ | (1,158,954 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities:     |       |                  |       |   |   |
| Depreciation and amortization                                                        |       | 1,193,542             |       | 1,202,424 |   |
| Accretion of debt for warrant and revaluation of warrants issued for  services       |       | 249,995               |       | 150,779 |   |
| Stock-based compensation                                                             |       | (235,355              | )          | 324,747 |   |
| Changes in operating assets and liabilities:                                         |       |                  |       |   |   |
| Accounts receivable                                                                  |       | 1,143,987             |       | (312,559 | ) |
| Other assets                                                                         |       | (139,798              | )          | (190,585 | ) |
| Accounts payable                                                                     |       | (439,851              | )          | (120,396 | ) |
| Accrued liabilities and other                                                        |       | (473,211              | )          | 403,519 |   |
| Net cash provided by operating activities                                            |       | 291,350               |       | 298,975 |   |
| Cash flows used in investing activities:                                             |       |                  |       |   |   |
| Purchase of property and equipment                                                   |       | (1,104,911            | )          | (904,185 | ) |
| Acquisition of business, including purchase of acquired business’  secured debt |       | (872,221              | )          | — |   |
| Net cash used in investing activities                                                |       | (1,977,132            | )          | (904,185 | ) |
| Cash flows from financing activities:                                                |       |                  |       |   |   |
| Principal payments on long-term debt and debentures                                  |       | (725,923              | )          | (1,555,794 | ) |
| Net borrowings under line of credit                                                  |       | —                |       | 300,669 |   |
| Issuance of long-term debt and debentures                                            |       | 849,579               |       | 621,563 |   |
| Payment of accrued offering costs                                                    |       | (627,364              | )          | — |   |
| Proceeds from stock options and warrants exercised                                   |       | 332,363               |       | 31,371 |   |
| Proceeds from stock issued through employee stock purchase plan                      |       | 76,112                |       | 26,435 |   |
| Net cash used in financing activities                                                |       | (95,233               | )          | (575,756 | ) |
| Effect of foreign currency translations                                              |       | 91,330                |       | — |   |
| Net decrease in cash                                                                 |       | (1,689,685            | )          | (1,180,966 | ) |
| Cash at beginning of period                                                          |       | 6,567,811             |       | 2,583,337 |   |
| Cash at end of period                                                                |       | $                     | 4,878,126  |   | $ | 1,402,371 |   |

 

*See accompanying notes.*

 

3

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**SENTO****CORPORATION**

**ANDSUBSIDIARIES**

 

### **Supplemental Disclosures of Cash FlowInformation**

**(Unaudited)**

 
| ** **                                                               | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **December 31,**      | ** ** | **December 31,** | ** ** |
| ** **                                                               | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                                                     |       |                  |       |   |   |
| Cash paid for:                                                           |       |                  |       |   |   |
| Interest                                                                 |       | $                     | 104,108    |   | $ | 181,164 |   |
| Income taxes                                                             |       | —                |       | — |   |
|                                                                     |       |                  |       |   |   |
| Non-cash investing and financing activities:                             |       |                  |       |   |   |
|                                                                     |       |                  |       |   |   |
| Value of  warrants issued with long-term debt and convertible debentures |       | $                     | —     |   | $ | 179,841 |   |
| Value of warrants issued to placement agent                              |       | —                |       | 36,031 |   |
| Conversion of debentures (including accrued interest of $7,483)          |       | —                |       | 476,774 |   |
| Equipment financed through long-term note                                |       | 157,136               |       | 23,790 |   |
|                                                                     |       |                  |       |   |   |
| 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.*

 

4

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#### **SENTO**CORPORATION

**ANDSUBSIDIARIES**

 

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

**December31, 2004**

**(Unaudited)**

 

A.                                   BASISOF PRESENTATION

 

The accompanying unaudited condensed consolidated financial statements have beenprepared in accordance with the instructions to Form 10-QSBand do not include all of the information and footnotes required by generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring entries) considered necessary for a fairpresentation have been included.

 

Operating resultsfor the three and nine-month periods ended December 31, 2004 are notnecessarily indicative of the results that may be expected for the full fiscalyear.  The unauditedcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and footnotes thereto included inthe Company’s Annual Report on Form 10-KSB/A for theyear ended March 31, 2004.

 

The Company’soperations are carried out by its two wholly-owned subsidiaries, Sento Technical Services Corporation, a Utah corporationand Xtrasource Acquisitions Inc., a Delawarecorporation.  The Company’s operationsare located in Utah, Wyoming, North Carolina, the Netherlands and France.

 

The Company hasadopted the footnote disclosure provisions of Statement of Financial AccountingStandards No. 123, *Accounting for StockBased-Compensation*(SFAS 123).  SFAS 123 encouragesentities to adopt a fair value based method of accounting for stock options orsimilar equity instruments.  However, italso allows an entity to continue measuring compensation cost for stock-basedcompensation using the intrinsic-value method of accounting prescribed byAccounting Principles Board Opinion No. 25, *Accounting for StockIssued to Employees*(APB 25). The Company has elected to continue to apply the provisions of APB 25and provide pro forma footnote disclosures required by SFAS123, which has been determined as if the Company had accounted for its employeestock options under the fair value method.

 

The fair value ofeach option grant is estimated on the date of grant using the Black Scholes option-pricing model with the followingweighted-average assumptions: expected dividend yield of zero percent,risk-free interest rate of 3.6 percent, expected life of 5 years, and expectedstock-price volatility of 74 percent.

 

The Companyapplies APB 25 in accounting for options issued under the SentoCorporation 1999 Omnibus Stock Incentive Plan. Had the Company determined compensation cost based on the fair value atthe grant date for its stock options under SFAS 123,the Company’s loss would have been changed to the pro forma amounts indicatedbelow for the three and nine-month periods ended December 31, 2004 and 2003:

 

Periodsended December 31, 2004:

 
| ** **                                    | ** ** | ** **  | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|-----------------------------------------------|------------|-------------|------------|------------------|------------|-----------------|------------|
| Net loss  attributable to common stockholders |       | As reported |       | $                | (298,400   | )               | $          | (1,045,834 | ) |
|                                          |       | Pro forma   |       | $                | (395,205   | )               | $          | (1,405,659 | ) |
| Basic and  diluted loss per share             |       | As reported |       | $                | (0.08      | )               | $          | (0.28 | ) |
|                                          |       | Pro forma   |       | $                | (0.10      | )               | $          | (0.38 | ) |

 

5

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Periods ended December31, 2003:

 
| ** **                                    | ** ** | ** **  | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|-----------------------------------------------|------------|-------------|------------|------------------|------------|-----------------|------------|
| Net loss  attributable to common stockholders |       | As reported |       | $                | (141,459   | )               | $          | (1,158,954 | ) |
|                                          |       | Pro forma   |       | $                | (249,089   | )               | $          | (1,479,979 | ) |
| Basic and  diluted loss per share             |       | As reported |       | $                | (0.06      | )               | $          | (0.51 | ) |
|                                          |       | Pro forma   |       | $                | (0.11      | )               | $          | (0.66 | ) |

 

The full impact ofcalculating compensation cost for stock options under SFAS123 may not be representative of the effects on reported net loss for futureperiods.

 

B.                                     LONG-TERMDEBT AND CAPITAL LEASES

 

On May 11, 2004, the Company refinanced its line of credit and existingterm loans with a bank, wherein the line of credit was renewed and the threeexisting term loans were combined into one term loan.  The line of credit was increased from amaximum of $2,500,000 to $3,000,000 (subject to a limit of 80% of eligibleaccounts receivable), has an interest rate equal to the bank’s prime rate (5.25%at December 31, 2004) plus 1%, has a two-year term, and provides for annualextension subject to the approval of the bank. The line of credit terms also contain an annual commitment fee of0.75%.  The new term loan for $750,000includes the repayment of the three existing term loans plus $316,140 inadditional equipment financing.  Theterms of this loan include a 1.0% commitment fee, an interest rate of 7.4%,monthly payments of $23,260 including interest, and a term of three years.

 

The Company alsohas a commitment from the bank for a term loan of up to $1,500,000 for futureequipment financing.  The Company maytake advances on this loan in a minimum amount of $100,000 through March 31,2005. The underlying term loans have a term of three years, require monthlyprincipal and interest payments, have a fixed interest rate determined at thedate of the advance based on the three-year U.S. Treasury Bond rate plus 4.5%,and have a commitment fee of 1%.  Duringthe nine months ended December 31, 2004, the Company was advanced $533,439under this term loan.

 

During the ninemonths ended December 31, 2004, the Company purchased $157,136 of softwareunder a note payable.  The note calls forquarterly payments of $13,773 through April 2007.

 

C.                                     COMMONSTOCK

 

Nine months endedDecember 31, 2004

 

During the ninemonths ended December 31, 2004, options to purchase 166,815 shares of commonstock were exercised and 22,565 shares of common stock were purchased byemployees under the Company’s Employee Stock Purchase Plan.

 

During the ninemonths ended December 31, 2004, warrants to purchase 204,250 shares of commonstock were exercised under cashless provisions of the underlying warrantagreements, resulting in the Company issuing 167,853 shares of commonstock.  In addition, during the sameperiod warrants to purchase 50,000 shares of common stock were exercised at atotal price of $88,125.

 

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 options to purchase 377,342 shares of theCompany’s common stock at exercise prices in excess of $2.00 per share.  The new options issued under the ExchangeProgram are subject to variable plan accounting in accordance with FASB Interpretation No. 44, *Accountingfor Certain Transactions Involving Stock Compensation* (“Interpretation44”).  Under variable plan accounting,the Company is required to recognize compensation expense (benefit) in itsconsolidated statements of operations for any change in the intrinsic value ofthe options.  The intrinsic value of the repriced options is based on the market price of theCompany’s common stock and is calculated as the difference between the fairmarket value of the common stock and $1.60 (the market price at April 23, 2003,which was the effective date of the exchange). This compensation adjustment must be recorded on a quarterly basis untilthe new options issued under the

 

6

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Exchange Program areexercised, forfeited or expire unexercised. During the nine months ended December 31, 2004, the Company recorded$235,355 of stock-based compensation benefit for these options since the valueof the Company’s common stock decreased between March 31, 2004 and December 31,2004.

 

The impact of thenew options issued under the Exchange Program on the Company’s consolidatedfinancial statements will depend on quarterly fluctuations in the price of theCompany’s common stock and the dates of exercises, forfeitures or cancellationsof the new options.  Moreover, becausethe precise amount of compensation expense will depend on the market price ofthe Company’s common stock at the end of each quarterly period, the Companywill not be able to forecast in advance the amount of compensation expense(benefit) related to these options that it will incur in any futureperiod.  As of December 31, 2004, optionsto purchase 119,639 shares of common stock remained outstanding under theExchange 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 31,2004 warrants to purchase 60,000 shares of common stock were outstanding underthis agreement, of which, warrants to purchase 45,000 shares of common stockwere issued during the nine months ended December 31, 2004. The warrants vest25% every three months from the date of issuance, have a term of three andone-half years, and have an exercise price of $3.00 per share.  During the nine months ended December 31,2004, the Company recorded $239,558 of expense for the value of these warrantsissued during the nine-month period.  Nofurther warrants will be issued under this agreement as the agreement has beenterminated.

 

Effective May 21,2004, the Company’s board of directors modified certain warrants to extend theexpiration date from May 31, 2004 to August 31, 2004.  The value of this warrant modification, asdetermined 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 extendedwarrants).  In connection with thismodification, the warrant holders did not provide any additional stated orunstated rights, privileges, or agreements to the Company. Accordingly, thistransaction has been reflected as a “deemed dividend as a result of warrantmodification” on the accompanying statement of operations and in determiningnet loss attributable to common stockholders. All of these warrants have since expired.

 

Nine months endedDecember 31, 2003

 

During the ninemonths ended December 31, 2003, options to purchase 19,564 shares of commonstock were exercised and 18,231 shares of common stock were purchased byemployees under the Company’s Employee Stock Purchase Plan.

 

Additionalpaid-in-capital increased $215,872 relating to the warrants issued inconjunction with convertible debentures. In addition, debentures with a face value of $467,774, together withassociated accrued interest of $7,483, were converted into 271,563 shares ofthe Company’s common stock.

 

During the ninemonths ended December 31, 2003, the Company recorded $324,747 of stock-basedcompensation for options under the above-mentioned Exchange Program.

 

D.                                    LOSSPER SHARE

 

Loss per share iscomputed in accordance with Financial Accounting Standards Board Standard 128, *Earnings Per Share*.  Basic loss per share is computed by dividingnet loss by the weighted average number of shares of common stock outstandingfor the period.  Diluted income or lossper share reflects the potential dilution that could occur from shares ofcommon stock issuable through stock options, warrantsand other convertible securities, if dilutive. Options and warrants to purchase 224,007 and 304,972 shares of commonstock, respectively, have not been included in the calculation of dilutedcommon stock outstanding for the three and nine-months periods ended December31, 2004, because to do so would be anti-dilutive.  Options and warrants to purchase 355,718 and192,809 shares of common stock, respectively, have not been included in thecalculation of diluted common stock outstanding for the three and nine-monthperiods ended December 31, 2003, because to do so would be anti-dilutive.  Shares

 

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issuablepursuant to convertible debentures (293,889 shares as of December 31, 2003)have not been included in the calculations of diluted common stock outstandingfor the three and nine-month periods ended December 31, 2003, as to do so wouldbe anti-dilutive.

 

The followingtables set forth the computation of basic and diluted loss per share for thethree and nine-month periods ended December 31, 2004 and December 31, 2003:

 
| ** **                                                                     | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                     | ** ** | **December 31, 2004**  | ** ** | **December 31, 2003** | ** ** |
|                                                                           |       |                   |       |   |   |
| Net loss  attributable to common stockholders                                  |       | $                      | (298,400   | ) | $ | (141,459 | ) |
| Denominator for  basic and diluted net loss per share -weighted average shares |       | 3,807,873              |       | 2,372,232 |   |
|                                                                           |       |                   |       |   |   |
| Basic and  diluted net loss per share                                          |       | $                      | (0.08      | ) | $ | (0.06 | ) |

 
| ** **                                                                     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                     | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|                                                                           |       |                  |       |   |   |
| Net loss  attributable to common stockholders                                  |       | $                     | (1,045,834 | ) | $ | (1,158,954 | ) |
| Denominator for  basic and diluted net loss per share -weighted average shares |       | 3,722,628             |       | 2,258,541 |   |
|                                                                           |       |                  |       |   |   |
| Basic and  diluted net loss per share                                          |       | $                     | (0.28      | ) | $ | (0.51 | ) |

 

E.                                      BUSINESSACQUISITION

 

Effective October1, 2004, the Company, through its wholly-owned subsidiary, XtrasourceAcquisition, Inc. (“Acquisition”), acquired substantially all of the assets of Xtrasource, Inc. (“Xtrasource”),a non-affiliated, privately-held Delaware corporation with approximately $10million in annual sales.  Acquisitionagreed to pay the former owners of Xtrasource aquarterly contingent earnout of 30% of earningsbefore interest, taxes, depreciation and amortization (“Earnout”)for the quarterly periods between the closing and September 30, 2009 (with amaximum aggregate cap of $6.5 million).  Earnout payments are subject to various reduction and offsetrights including, but not limited to, reductions for debt payments (to securedand unsecured creditors) and working capital deficiencies.  Acquisition has granted the former owners of Xtrasource a line of credit of no more than $200,000 toenable Xtrasource to pay costs and expensesassociated with closing its Brazilian subsidiary, which Acquisition did notacquire (nor assume its liabilities), and for ordinary course expenses relatedto the transaction.  Amounts drawn on theline of credit will be deducted from Earnoutpayments.  The Company’s consolidatedoperating results contain the operating results of the acquired business fromOctober 1, 2004 through December 31, 2004.

 

The acquiredassets consist of call center operations with facilities in the United States,the Netherlands and France that offer integrated customer solutions, includinghelp desk, technical assistance, and live web chat.  The purchase of Xtrasourceprovides the Company with a larger geographic footprint and additional languageskills to enhance customer service.  Thepurchase also allows the Company to broaden its product offerings.  The purchase was accounted for as follows:

 

8

 
| Assets acquired:                                                      |   |      |      |
|-----------------------------------------------------------------------|--------|-----------|-----------|
| Receivables, net                                                      |   | $         | 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 |      |
| 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   |   |

 

The intangibleassets acquired consist primarily of the Xtrasourceassigned customer contracts and customer base. These intangible assets are being amortized over the expected usefullife of five years.  As of December 31,2004, the Company’s intangible assets consist entirely of the intangible assetsacquired through this transaction.  Thecarrying value of intangible assets at December 31, 2004 totaled $1,034,491,net of $54,447 of accumulated amortization.

 

The accruedcontingent consideration represents the Company’s estimate of the Earnout liability. This estimate is based on the Company’s forecasts of Xtrasource’searnings through September 2009.  Theactual amounts eventually paid for the Earnout coulddiffer materially from management’s estimate.

 

F.                                      GEOGRAPHICINFORMATION

 

The followinggeographic area data includes net revenue and long-lived assets based onphysical location:

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------|------------|------------------------|------------|-----------------------|------------|
| ** **          | ** ** | **December 31,**       | ** ** | **December 31,**      | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **          | ** ** | **2004**               | ** ** | **2003**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:            |       |                   |       |                  |       |   |   |   |   |
| United States       |       | $                      | 7,865,000  |                  | $          | 5,200,000 |   | $ | 20,601,000 |   | $ | 13,440,000 |   |
| Europe              |       | 2,182,000              |       | —                |       | 2,182,000 |   | — |   |
| Consolidated  total |       | $                      | 10,047,000 |                  | $          | 5,200,000 |   | $ | 22,783,000 |   | $ | 13,440,000 |   |
|                |       |                   |       |                  |       |   |   |   |   |
| Long-lived  assets: |       |                   |       |                  |       |   |   |   |   |
| United States       |       | $                      | 4,775,000  |                  | $          | 4,353,000 |   | $ | 4,775,000 |   | $ | 4,353,000 |   |
| Europe              |       | 1,136,000              |       | —                |       | 1,136,000 |   | — |   |
| Consolidated  total |       | $                      | 5,911,000  |                  | $          | 4,353,000 |   | $ | 5,911,000 |   | $ | 4,353,000 |   |

 

## G.                                     INCOME TAXES

##  

Income tax expensefor the three and nine-month periods ended December 31, 2004 consists of theprovision for income taxes on the Company’s European operations that wereacquired through the Xtrasource acquisition.  Even though the Company had a consolidatednet loss for the three and nine months ended December 31, 2004, the Company’soperations are located in different tax jurisdictions and may require thepayment of income taxes in specific jurisdictions when operations in thosejurisdictions are profitable.

 

H.                                    RECENTLYISSUED ACCOUNTING PRONOUNCEMENTS

 

InDecember 2004, the FASB issued SFAS 123R which requires the measurement of allshare-based payments to employees, including grants of employee stock options,using a fair-value-based method and the recording of such expense in theconsolidated statements of operations. The Company is required to adopt theaccounting provisions of SFAS 123R for reportingperiods beginning after December 15, 2005. The Company’s pro 

 

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forma disclosurespreviously permitted under SFAS 123 no longerwill be an alternative to financial statement recognition under SFAS 123R.  Although the Company has not yet determinedwhether the adoption of SFAS 123R will result inamounts that are similar to the current pro forma disclosures under SFAS 123, management is evaluating the requirementsunder SFAS 123R and expects the adoption couldhave a significant impact on Company’s consolidated statements of operationsand net income/loss per share.

 

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## Item 2.  Management’s Discussion andAnalysis or Plan of Operations.

##  

**Forward-LookingStatements**

 

*The statements contained in this Quarterly Reporton Form 10-QSB that are not purely historical are “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended.  All forward-looking statementsinvolve various risks and uncertainties. Forward-looking statements contained in this Report include statementsregarding our plans to develop and deliver integrated information technologyservices, market opportunities and acceptance, expectations, goals, revenues,financial performance, strategies, mission and intentions for the future.  Such forward-looking statements are includedunder “Management’s Discussion and Analysis or Plan of Operations” andencompass Sento’s beliefs, expectations, hopes orintentions regarding future events. Words such as “expects,” “believes,” “anticipates,” “should,” and “likely”also identify forward-looking statements. All forward-looking statementsincluded in this Report are made as of the date hereof, based on informationavailable to us as of such date, and we assume no obligation to update anyforward-looking statement.  It isimportant to note that such statements may not prove to be accurate and that ouractual results and future events could differ materially from those anticipatedin such statements.  Among the factorsthat could cause actual results to differ materially from our expectations arethose described under “Management’s Discussion and Analysis or Plan ofOperations---Risks Related to Existing and Proposed Operations.”  All subsequent written and oralforward-looking statements attributable to Sento orpersons acting on our behalf are expressly qualified in their entirety by thissection and other factors included elsewhere in this Report.*

 

### **Overview**

### ** **

SentoCorporation (“**Sento***,*” “**we**,” “**us**” or the “**Company**”)is a right-channeling solutions leader, delivering a successful customerservice and technical support experience through multi-channel interactions,contact center management expertise and professional services focused onbusiness process management.  Through Sento’s Customer Choice Platformtm,an integrated suite of multi-channel CRM technologies, customers are given achoice of self-service and assisted-service options - via web, e-mail, chat,and phone - for increased customer satisfaction with dramatic cost savings to Sento’s clients.  Ourprofessional services are provided across telephony and internet supportchannels by enhancing and customizing integrated technology solutions for ourclients.  Sentoprovides multi-channel support in 18 languages. We are primarily focused on the following vertical markets: e-commerce,insurance, consumer electronics and peripherals, computers and peripherals,software, and health care.  We conductour business operations through Sento and ourwholly-owned subsidiaries, Sento Technical ServicesCorporation and Xtrasource Acquisitions Inc.

 

We believe that a significant issue currently facingour company relates to the variable pricing of a number of our outstandingemployee stock options.  In April 2003,we repriced the majority of the then outstandingemployee stock options to the then current market price of $1.60 pershare.  This repricingwas done to give our employees incentive to grow revenues and improveprofitability, with the objective of increasing stockholder value.  We believe this repricingcontributed in a large part to our improved operating results during the fiscalyear ended March 31, 2004.  Underaccounting principles generally accepted in the United States (“GAAP”), weare required to “mark to market” these employee options, by adjusting thenon-cash compensation expense we record on these stock options on a quarterlybasis until they are exercised, forfeited or expire. This non-cash expense iscalculated by multiplying the number of currently exercisable options by theamount that the current market price of our common stock is above the exerciseprice of $1.60 per share, less any amounts previously recorded as expense forvested shares.  Thus, in a period ofincreasing stock prices we may record a significant amount of non-cashcompensation expense.  Conversely, if ourstock price falls in a future period, we may subsequently reverse a portion ofthe expense previously recognized with respect to stock options that remainoutstanding.  These periodic adjustmentsof our non-cash compensation expense may result in significant volatility inthe results of our operations.  Duringthe three and nine months ended December 31, 2004, we recognized non-cashcompensation benefits of $68,974 and $235,355, respectively.  During the three and nine months endedDecember 31, 2003, we recognized non-cash compensation expense of $275,189 and$324,747, respectively.  These non-cashbenefits and expense charges reflect adjustments to the value of the optionsdue to the changes in market price of our common stock above the exercise priceof $1.60 per share.  See Note C to our unaudited condensed consolidated financial statements.

 

Because the actual amount of compensation expense wewill recognize with respect to outstanding stock options will depend on themarket price of our common stock at the end of each quarterly period and thetiming of

 

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exercise, forfeiture orexpiration of outstanding options, we are not able to forecast the amount ofnon-cash compensation expense related to these stock options that we may incurin any future period.

 

Pursuant toa consulting agreement with Remsen Funding Corporation of New York (“Remsen”), we  agreed to issue toRemsen, as partial consideration for consulting services, a warrant to purchase5,000 shares of our common stock each month during the term of theagreement.  Through October 31, 2004, weissued to Remsen warrants to purchase 60,000 shares of common stock.  The warrants permit the holder to acquireshares of common stock at an exercise price of $3.00 per share at any time priorto the date that is three and one-half years after the date of issuance.  Each warrant vests with respect to 25% of theshares subject thereto on the first day of each calendar quarter following itsissuance.  The warrants also include anet exercise provision and anti-dilution provisions pursuant to which theexercise price and number of shares issuable  thereunder will be adjusted proportionately in the event ofa stock split, stock dividend, recapitalization or similar transaction.  We also have granted the warrant holderpiggyback registration rights with respect to any registration (other than onForm S-4 or Form S-8) that permits the registration of secondary sales.  This agreement was terminated October 31,2004.

 

We haverecognized expense based on the fair value of the warrants over the periodwhich the consulting services were provided.

 

Effective May 21, 2004, our board of directorsmodified certain warrants to extend the expiration date from May 31, 2004 toAugust 31, 2004.  The value of thiswarrant modification, as determined using the Black-Scholesvaluation model, was $37,875 (which is the difference between the value of theoriginal warrants immediately prior to the modification and the value of theextended warrants).  In connection withthis modification, the warrant holders did not provide to us any additionalstated or unstated rights, privileges, or agreements. Accordingly, thistransaction has been reflected as a “deemed dividend as a result of warrantmodification” on our accompanying statement of operations and in determiningnet loss attributable to common stockholders.

 

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 previous owners of Xtrasource a quarterly contingent earnout of 30% of earnings before interest, taxes, depreciation and amortization (the “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 reduction and offset rights including, but not limited to, reductions for debt payments (to secured and unsecured creditors) and working capital deficiencies.  We granted the previous 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 (nor assumed its liabilities), and for ordinary course 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 from October 1, 2004 through December 31, 2004.

 

On January 27,2005, we announced our intentions to consolidate our Utah call centeroperations from three centers into one primary super-center.  We anticipate this move to happen over ourtwo fiscal quarters ending March 31 and June 30, 2005.  We believe we will be able to increase ourefficiencies through this initiative and reduce the cost of providing ourservices over the long-term.  However, weanticipate that we will incur moving costs of approximately $100,000 and theprobable write-down of property and equipment that will not be needed after themove of approximately $300,000.  Inaddition, we anticipate that we will accrue rent expense for the remaining leaseterm on the vacated centers (approximately $230,000) once we cease use of thosecenters.  The anticipated chargesdiscussed above will have a negative impact on our operations during thequarters ending March 31, and June 30, 2005.

 

### **CriticalAccounting Policies**

### ** **

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, 2004, asamended. Those financial statements were prepared in accordance with accountingprinciples generally accepted in the United States.  Included within these policies are our “criticalaccounting policies.”  Criticalaccounting policies are those policies that are most important to thepreparation of our condensed consolidated financial statements and requiremanagement’s subjective and complex judgments due to the need to make estimatesabout the effect of matters that

 

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are inherently uncertain.  Our critical accounting policies relate torevenue recognition, credit risk and stock-based compensation.  The application of these accounting policiesinvolves the exercise of judgment and the use of assumptions as to futureuncertainties, and as a result, actual results will differ, and could differmaterially, from such estimates.

 

The development and selection of these criticalaccounting policies have been discussed, and are reviewed each quarter, withthe Audit Committee of our Board of Directors.

 

*Revenue Recognition.* Revenue is recognized whenpersuasive evidence of an arrangement exists, delivery of services hasoccurred, the fee is fixed or determinable, and collection of the resultingreceivable is reasonably assured.  Wegenerate revenue by delivering technical assistance to users of our clients’products through the use of live chat, Web collaboration, e-mailand telephone interactions.  We recognizerevenues as services are provided, according to the terms of the underlyingagreement with our clients which specify how the client will be charged,generally based on a monthly, hourly, per-minute or per-call rate.  We also provide licenses to a limited numberof our clients for the use of our customer contact software tools that wehost.  In these arrangements, we chargeour client a monthly fee based on the number of users.  Revenue under those arrangements isrecognized as the service is provided.

 

Revenuesgenerated from professional and consulting services are recognized as theservice is provided, based on time and materials incurred at contractuallyagreed upon rates.

 

*CreditRisk.* We have established an allowance for doubtfulaccounts to reserve for uncollectible accounts receivable.  Each quarter we review the receivables on anaccount-by-account basis and determine the probability of collection.  Management judgment is used in determiningthe probability of collection. Factors we consider in making this judgment arethe age of the receivable, the financial resources of our clients, previousclient history and recent client communications.  With the exception of a specific reserve of$475,000 for amounts due from a financially distressed customer that werecorded in December 2004, our credit losses have generally been within ourexpectations.  However, there can be noassurance that our future credit losses will be within our expectations.  In addition, our revenues and accountsreceivable are concentrated in a relatively few number of customers.  A significant change in the liquidity orfinancial position of any one of these customers or a further deterioration inthe economic environment, in general, could have an adverse impact on the collectability of our accounts receivable and our futureoperating results.

 

*Stock –BasedCompensation.* Statement of Financial AccountingStandards No. 123, *Accounting for Stock BasedCompensation* (SFAS 123), encouragesentities to adopt a fair value based method of accounting for stock options orsimilar equity instruments.  However, italso allows an entity to continue measuring compensation cost for stock based compensationusing the intrinsic-value method of accounting prescribed by AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees* (APB 25). We have elected to continue to apply the provisions of APB 25 andprovide pro forma disclosures required by SFAS 123 inthe footnotes to the consolidated financial statements.  We use the Black Scholesoption-pricing model to determine the amount of additional pro forma expenserelated to these options as presented in our disclosures.  Had we adopted a fair value based method ofaccounting for stock options, the pro forma expense for these options in ourdisclosures would be recorded as expense in our statements of operations andcould materially affect our operating results.

 

In December 2004, the FASBissued SFAS 123R which requires the measurementof all share-based payments to employees, including grants of employee stockoptions, using a fair-value-based method and the recording of such expense inthe consolidated statements of operations. We are required to adopt theaccounting provisions of SFAS 123R for reportingperiods beginning after December 15, 2005. Our pro forma disclosures previously permitted under SFAS 123no longer will be an alternative to financial statement recognition under SFAS 123R.  Althoughwe have not yet determined whether the adoption of SFAS 123Rwill result in amounts that are similar to the current pro forma disclosuresunder SFAS 123, we are evaluating therequirements under SFAS 123R and expects theadoption could have a significant impact on our consolidated statements ofoperations and net income/loss per share.

 

In April 2003, we repricedcertain of our outstanding employee stock options. We account for stock optionsthat were repriced in accordance with FASB Interpretation No. 44 *Accountingfor Certain Transactions Involving Stock Compensation* (“Interpretation 44”), which requires that we adjust thecompensation expense we record on these stock options based on the market priceof our underlying common stock until the options are exercised,

 

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forfeited or expire.  This adjustment to compensation expense isdone quarterly and can fluctuate significantly due to the volatility of themarket price of our common stock.

 

We also issue equity-based incentive compensation tonon-employees from time to time. Pursuant to Emerging Issues Task Force (EITF)96-18, *Accounting for Equity Instruments that are Issuedto Other than Employees for Acquiring or in Conjunction with Selling Goods orServices*, we account for these arrangements based on the fair valueof the equity instrument issued.  Thefair value of these instruments is remeasured eachquarter as the related goods or services are provided and the underlyingsecurities vest.  We use the Black Scholes pricing model to determine the value of theseinstruments.  The resulting quarterlychange in value of these instruments is either charged or credited to incomeand can also fluctuate significantly based on the change in value of theunderlying common stock.

 

### **Results ofOperations**

### ** **

**Three months ended December 31,2004 compared to three months ended December 31, 2003**

 

*Revenues.*  Our revenues increased 93%, or $4,847,000,from $5,200,000 for the three months ended December 31, 2003 to $10,047,000 forthe three months ended December 31, 2004. The primary reasons for the increase was $2,616,000 of revenue generatedfrom the operations we acquired from Xtrasource and a43% increase in business primarily from existing customers.

 

*Cost ofSales.*  Our costof sales increased $3,834,000, or 91%, from $4,192,000 for the three monthsended December 31, 2003 to $8,026,000 for the three months ended December 31,2004.  This increase in cost of sales wasprimarily a result of increased business as discussed in the revenue sectionabove.  Our gross profit as a percentageof sales increased slightly from 19% for the three months ended December 31,2003 to 20% for the three months ended December 31, 2004.  Efficiencies we realized from better utilizationof our capacity were adversely impacted by upfront training and labor costs ofapproximately $127,000, associated with the increase in business as customerservice agents are trained for the specific requirements of each new customer.

 

*ProductDevelopment*.  Wespent $62,000 in product development during the three months ended December 31,2004.  We believe that this productdevelopment is necessary for anticipated new business and to enhance ourproduct offerings.  We incurred nosignificant product development costs during the three months ended December31, 2003.

 

*Selling,General and Administrative Expenses.*  Our selling, general and administrativeexpenses increased by 121%, or $891,000, from $738,000 for the three monthsended December 31, 2003 to $1,629,000 for the three months ended December 31,2004.  This increase was primarily due tothe acquisition of Xtrasource and an increase incosts we incurred to respond to the 43% increase in business from our existingoperations.  However, as a percentage ofrevenue, our selling, general and administrative expenses remained consistentat 16% of revenue during the three months ended December 31, 2004, whencompared to 15% of revenue during the three months ended December 31, 2003.

 

*Stock-BasedCompensation.* In April 2003, our Board of Directors approved an employee stock optionexchange program.  Under this program,options to purchase 377,342 shares of common stock with exercise prices above$2.00 per share were exchanged for options to purchase 313,592 shares of commonstock at an exercise price equal to the then current market price of$1.60.  This exchange program wasconsidered to be an effective “repricing” of stockoptions, which requires us to adjust the amount of compensation expense werecognize each quarter until the stock options are exercised, forfeited orexpire (see Note C to our unaudited condensedconsolidated financial statements).  Thecumulative amount of this charge is calculated by multiplying the exercisablenumber of options as of the applicablemeasurement date by the difference between the market price of the stockon such date and the exerciseprice of $1.60, less any amounts previously recognized.

 

During the three months ended December 31, 2004 werecorded a non-cash stock-based compensation benefitof $69,000, a $344,000 change from $275,000****ofnon-cash stock-based compensation expense that we recorded during the threemonths ended December 31, 2003.  Thisincrease was primarily a result of changes in vested and unexercised optionsunder the exchange program and fluctuations in the market value of our commonstock.

 

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The market value of our common stock has fluctuatedfrom $1.60 at April 23, 2003, the date of the exchange program approval, to$12.35 as of March 31, 2004, and to $4.90 as of December 31, 2004. Due to theprice volatility of our common stock and the inability to predict when and howmany stock options will be exercised or cancelled, we cannot project the impactof options under this exchange program on future quarters.

 

*Specificreserve for doubtful account.*  In December, 2004, we determined it wasnecessary to record a one-time charge of $475,000 to increase our bad debtreserves for a financially distressed client. The client incurred difficulties obtaining financing needed to fund anaggressive growth strategy causing us to believe that it is likely the clientwill not be able to pay its obligation. We recorded no such reserve during the three months ended December 31,2003.  We accrue provisions for bad debtsduring the ordinary course of business when events or circumstances indicatethat a receivable may not be collectible. These general provisions are included in selling, general andadministrative expenses for the three months ended December 31, 2004 and 2003.

 

*Amortizationof intangible assets.* Effective October 1, 2004, we acquired substantially all of the assetsand operations of Xtrasource.  We allocated the purchase price over theassets acquired, including an allocation of $1,089,000 to intangible assetswhich primarily represent the acquired customer base and the related assignedcontracts.  We have determined that theexpected life of these intangible assets is five years and accordingly, werecorded an expense of $54,000 for the amortization of these intangibles duringthe three months ended December 31, 2004. There was no comparable expense during the three months ended December31, 2003.

 

*Non-CashCharge for Valuation of Warrants*.  This expense relates to recognized chargesfor the value of warrants issued to consultants.  We recognize these costs over the period theconsulting services are provided.  Thiscost was $53,000 for the three months ended December 31, 2004.  There were no warrants issued to or earned byconsultants during the three months ended December 31, 2003.

 

*Non-CashCharge for Valuation of Warrants and Conversion of Debentures (non-operating).*  This expense relates to the amortization ofdebt discount created by allocating a portion of the proceeds received inconjunction with convertible debentures and notes payable financings towarrants issued with the debt.  Weamortize these costs over the life of the corresponding debt.  This cost decreased $45,000, or 94%, from$48,000 for the three months ended December 31, 2003 to $3,000 for the threemonths ended December 31, 2004.  Themajority of the costs recorded during the three months ended December 31, 2003related to the amortization of the debt discount associated with warrantsissued in conjunction with convertible debentures.  All of these debentures were converted tocommon stock during our fiscal year ended March 31, 2004 with all unamortizeddebt discount associated with these debentures being expensed at the time ofconversion.  The costs recorded duringthe three months ended December 31, 2004 relate to warrants that were issuedwith our bank financing and are being amortized over the life of the associateddebt.

 

*Otherincome (expense), net.** *Other expense, net, was $34,000for the three months ended December 31, 2004, a $55,000 change from otherexpense of $89,000 for the three months ended December 31, 2003.  The most significant reason for this changewas a decrease in net interest expense as a result of a significant improvementin our cash position and the conversion of debentures.

 

*Incometax expense.* Income tax expense for the three month period ended December 31, 2004consists of the provision for income taxes for our European operations thatwere acquired through the Xtrasourceacquisition.  Even though we had aconsolidated net loss for the three months ended December 31, 2004, ouroperations are located in different tax jurisdictions and may require thepayment of income taxes in specific jurisdictions when operations in thosejurisdictions are profitable.

 

**Nine months ended December 31,2004 compared to Nine months ended December 31, 2003**

 

*Revenues.*  Our revenues increased 70%, or $9,343,000,from $13,440,000 for the nine months ended December 31, 2003 to $22,783,000 forthe nine months ended December 31, 2004. The primary reasons for the increase were increased business fromexisting customers and $2,616,000 of revenue generated from the operations weacquired from Xtrasource.

 

*Cost ofSales.*  Our costof sales increased $7,555,000, or 64%, from $11,887,000 for the nine monthsended December 31, 2003 to $19,442,000 for the nine months ended December 31,2004.  This increase in cost of

 

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sales was primarily a result of increasedbusiness as discussed in the revenue section above.  Our gross profit as a percentage of salesincreased from 12% for the nine months ended December 31, 2003 to 15% for thenine months ended December 31, 2004. This increase was principally a result of better utilization of ourcapacity.  However, the efficiencies werealized from better utilization of our capacity were adversely impacted byupfront training and labor costs of approximately $261,000, associated with theincrease in business volume as customer service agents are trained for thespecific requirements of each new customer.

 

*ProductDevelopment*.  Wespent $296,000 in product development during the nine months ended December 31,2004.  We believe that this productdevelopment is necessary for anticipated new business and to enhance ourproduct offerings.  We incurred nosignificant product development costs during the nine months ended December 31,2003.

 

*Selling,General and Administrative Expenses.*  Our selling, general and administrativeexpenses increased by 68%, or $1,364,000, from $2,003,000 for the nine monthsended December 31, 2003 to $3,367,000 for the nine months ended December 31,2004.  This increase was primarily due tothe acquisition of Xtrasource and an increase incosts we incurred to respond to the increase in business from our existingoperations.  However, as a percentage ofrevenue, our selling, general and administrative expenses remained consistentat 15% of revenue during the nine months ended December 31, 2004 and 2003.

 

*Stock-BasedCompensation.* In April 2003, our Board of Directors approved an employee stock optionexchange program.  Under this program,options to purchase 377,342 shares of common stock with exercise prices above$2.00 per share were exchanged for options to purchase 313,592 shares of commonstock at an exercise price equal to the then current market price of$1.60.  This exchange program wasconsidered to be an effective “repricing” of stockoptions, which requires us to adjust the amount of compensation expense werecognize each quarter until the stock options are exercised, forfeited orexpire (see Note C to our unaudited condensedconsolidated financial statements).  Thecumulative amount of this charge is calculated by multiplying the exercisablenumber of options as of the applicablemeasurement date by the difference between the market price of stock on such date and the exercise price of$1.60, less any amounts previously recognized.

 

During the nine months ended December 31, 2004 werecorded a non-cash stock-based compensation benefitof $235,000, a $560,000 change from $325,000****ofnon-cash stock-based compensation expense that we recorded during the ninemonths ended December 31, 2003.  Thisincrease was primarily a result of changes in vested and unexercised optionsunder the exchange program and fluctuations in the market value of our commonstock.

 

The market value of our common stock has fluctuatedfrom $1.60 at April 23, 2003, the date of the exchange program approval, to$12.35 as of March 31, 2004, and to $4.90 as of December 31, 2004. Due to theprice volatility of our common stock and the inability to predict when and howmany stock options will be exercised or cancelled, we cannot project the impactof options under this exchange program on future quarters.

 

*Specificreserve for doubtful account.*  In December, 2004, we determined it wasnecessary to record a one-time charge of $475,000 to increase our bad debtreserves for a financially distressed client. The client incurred difficulties obtaining financing needed to fund anaggressive growth strategy causing us to believe that it is likely the clientwill not be able to pay its obligation. We recorded no such reserve during the nine months ended December 31,2003.  We accrue provisions for bad debtsduring the ordinary course of business when events or circumstances indicatethat a receivable may not be collectible. These provisions are included in selling, general and administrativeexpenses for the nine months ended December 31, 2004 and 2003.

 

*Amortizationof intangible assets.* Effective October 1, 2004, we acquired substantially all of the assetsand operations of Xtrasource.  We allocated the purchase price over theassets acquired, including an allocation of $1,089,000 to intangible assetswhich primarily represent the acquired customer base and the related assignedcontracts.  We have determined that theexpected life of these intangible assets is five years and accordingly, werecorded an expense of $54,000 for the amortization of these intangibles duringthe nine months ended December 31, 2004. There was no comparable expense during the nine months ended December31, 2003.

 

*Non-CashCharge for Valuation of Warrants*.  This expense relates to recognized chargesfor the value of warrants issued to consultants.  We recognize these costs over the period theconsulting services are provided.  This

 

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cost was $240,000 for the ninemonths ended December 31, 2004.  Therewere no warrants issued to or earned by consultants during the nine monthsended December 31, 2003.

 

*Non-CashCharge for Valuation of Warrants and Conversion of Debentures (non-operating).*  This expense relates to the amortization ofdebt discount created by allocating a portion of the proceeds received inconjunction with convertible debentures and notes payable financings towarrants issued with the debt.  Weamortize these costs over the life of the corresponding debt.  This cost decreased $141,000, or 93%, from$151,000 for the nine months ended December 31, 2003 to $10,000 for the ninemonths ended December 31, 2004.  Themajority of the costs recorded during the nine months ended December 31, 2003related to the amortization of the debt discount associated with warrantsissued in conjunction with convertible debentures.  All of these debentures were converted tocommon stock during our fiscal year ended March 31, 2004 with all unamortizeddebt discount associated with these debentures being expensed at the time of conversion.  The costs recorded during the nine monthsended December 31, 2004 relate to warrants that were issued with our bankfinancing and are being amortized over the life of the associated debt.

 

*Otherincome (expense), net.** *Other expense, net, was $63,000for the nine months ended December 31, 2004, a $171,000 change from otherexpense of $234,000 for the nine months ended December 31, 2003.  The most significant reason for this changewas a decrease in net interest expense as a result of a significant improvementin our cash position and the conversion of debentures.

 

*Incometax expense.* Income tax expense for the nine month period ended December 31, 2004consists of the provision for income taxes for our European operations thatwere acquired through the Xtrasourceacquisition.  Even though we had aconsolidated net loss for the six months ended December 31, 2004, ouroperations are located in different tax jurisdictions and may require thepayment of income taxes in specific jurisdictions when operations in thosejurisdictions are profitable.

 

### **Liquidity andCapital Resources**

### ** **

Our workingcapital decreased $1,166,000, or 16%, from $7,199,000 at March 31, 2004 to$6,033,000 at December 31, 2004.  Ourchange in working capital was primarily the result of a decrease in cashbalances of $1,690,000 from $6,568,000 as of March 31, 2004 to $4,878,000 as ofDecember 31, 2004.  The decrease in cashwas mainly due to amounts paid for the purchase of the assets and operations ofXtrasource, along with the associated transactioncosts and the purchase of property and equipment.

 

During the ninemonths ended December 31, 2004, we generated $291,000 of cash from operations.We used $1,105,000 of cash for investing in property, used $872,000 of cash forthe acquisition of the assets and operations of Xtrasource,and used $95,000 of cash from financing activities during the nine months endedDecember 31, 2004.  We also benefitedfrom $91,000 of positive foreign currency translations during the nine monthsended December 31, 2004.  The primaryreason for the change in the amount of cash generated from operating activitieswas the timing of cash receipts and payments on working capital balances, suchas accounts receivable, accounts payable and accrued liabilities.  Excluding the effects of the Xtrasource acquisition, the net decrease in receivablesfrom March 31, 2004 to December 31, 2004 was $1,144,000. Because our businesshas historically been seasonal with a significant increase in business in thethird and fourth quarters of our fiscal year, accounts receivable havegenerally been higher at March 31 and decreased in the first and second fiscalquarters as the receivables were collected. Excluding the effects of the Xtrasourceacquisition, there was a net decrease in payables and accrued liabilities fromMarch 31, 2004 to December 31, 2004, also primarily due to decreased businessvolume caused by the seasonality of our business.  The net decrease in accounts payable andaccrued liabilities partially offset the increased cash flow from thecollection of receivables.  Included inour cash flow from financing activities is $627,000 in  payments of offering costs relating to ourMarch 2004 private placement that were accrued and unpaid at March 31, 2004.

 

On May 11, 2004, we refinanced our line of credit and existing term loanswith a bank, wherein the line of credit was renewed and the existing three termloans were combined into one term loan. The agreement also allows us to draw on an additional term loan for upto $1,500,000 of equipment financing. The line of credit was increased from a maximum of $2,500,000 to$3,000,000 (subject to a limit of 80% of eligible accounts receivable), has aninterest rate equal to the sum of the bank’s prime rate (5.25% at December 31, 2004)plus 1%, and provides for annual extensions subject to approval of the bank.  The line of credit terms also contain anannual commitment fee of 0.75%.

 

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Thenew term loan for $750,000 includes the repayment of the three existing termloans plus $316,140 in additional equipment financing.  The terms of this loan include a 1.0%commitment fee, an interest rate of 7.4%, monthly payments of $23,260 includinginterest, and a term of three years.  Wealso have a commitment from the bank for a term loan of up to $1,500,000 forfuture equipment financing.  During thenine months ended December 31, 2004, we were advanced $533,439 under this loan.  We may take advances on this loan in aminimum amount of $100,000 through March 31, 2005.  The underlying term loans will have a term ofthree years, require monthly principal and interest payments, will have a fixedinterest rate determined at the date of the advance based on the three-yearU.S. Treasury Bond rate plus 4.5%.

 

### **Seasonality**

### ** **

Our operatingresults have historically been affected by the seasonal variances experiencedby some of our significant clients. Historically, our third and fourth quarters have been favorably affectedby a significant increase in service requests we experienced from our supportof certain clients’ products.  Goingforward, we anticipate that we will continue to have seasonal variances.

 

### **RisksRelated to Existing and Proposed Operations**

### ** **

There are a numberof factors that may affect our operating results, including the risks anduncertainties identified in the following paragraphs.  In addition to other information set forth inthis Report, readers should review and carefully consider the followingfactors.

 

***Volatile economic conditions have affected and will likelycontinue to affect our operations and financial results.***

 

Volatile economicconditions have adversely affected our operations and financial results.  The slowing economy in recent years caused usto lose some clients and also resulted in increased pricing pressures and lowercall volumes from some existing clients. Slower economic conditions may limit our ability to attract new clientsor retain existing clients.  Thesefactors contributed to the decline in our revenues and the net losses weexperienced during most of fiscal 2002, 2003 and 2004.  The slower economy also resulted in excesscapacity 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 in economic conditions, and ouroperations and financial results may be materially and adversely affected byeconomic volatility.

 

***We repriced our employee stockoptions and may have significant volatility in our earnings if our stock priceincreases or decreases.***

 

In April 2003, we repriced certain employee and director stock options in aneffort to provide an adequate incentive to assist in the retention andmotivation of our employees and directors. Current accounting rules require us to adjust the amount of compensationexpense we recognize in our financial statements for changes in the stock priceuntil the stock options are exercised, forfeited or expire.  If our stock price is volatile, our futurestock compensation charges may affect our profitability, either positively ornegatively.

 

***Several key clients represent a significant portion of ourrevenues, and the loss of a key client could affect our revenues andprofitability.***

 

Two clientsaccounted for approximately 45% of our revenues for the three months endedDecember 31, 2004.  These two clients accounted for approximately 32% and 13%,respectively, of our revenues for the three months ended December 31,2004.  For the nine months ended December31, 2004, two clients accounted for approximately 46% of our revenues.  These two clients accounted for 27% and 19%,respectively, of our revenues for the nine months ended December 31, 2004.  A key client, who accounted for 28% ofrevenues in fiscal 2002, cancelled its contract with us early in fiscal2003.  The loss of this client had asignificant negative impact on our revenue and profitability in fiscal 2003 andfor the first nine months of fiscal 2004, until this business was replaced.

 

Our clients can generally cancel their contracts on short notice.  It can take a significant amount of time todevelop and obtain newclients and retrain employees to replace revenue from a lost client.  Thus, the loss of any of our key clientscould have a significant effect on our revenues and profitability.  In addition, our future revenue

 

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growth is dependent upon our ability to attract and retain new clients.  While we are actively pursuing new clients,we have no guarantee that we will be successful.

 

***If our clients are not successful, the amount of businessthat they outsource and the prices that they are willing to pay for suchservices may be diminished and could reduce our revenues.***

 

Our revenues are dependent on the success of ourclients.  If our clients are notsuccessful, the amount of business that they outsource may be diminished.  Thus, although we may have signed contracts,many of which contain minimum revenue commitments, to provide services to ourclients, there can be no assurance that the level of revenues to be receivedfrom such contracts will meet expectations. In addition, several clients, particularly in the communications andtechnology industries, have experienced substantial price competition.  As a result, we may face increasing pricepressure from such clients, which could negatively affect our operatingperformance.

 

***We have a history of losses and may continue to experiencelosses****.*

 

We experienced net losses in four of our last fivefiscal years.  For the nine months ended December 31,2004 and 2003, we had net losses of $(1,008,000) and $(1,159,000),respectively, and we had an accumulated deficit of $(11,488,000) as of December 31,2004.  We may continue to incur netlosses if we lose clients, are unable to attract and retain new clients or donot fully utilize our resources.  Wecannot ensure that we will be able to achieve or maintain consistent profitableoperations.

 

***We may be unable to attract, train and retain keymanagement, technical and marketing personnel.***

 

Our success will depend, in large part, on our abilityto attract, retain and train highly qualified technical, managerial andmarketing personnel with the expertise required to successfully conduct ouroperations.  We have not entered intoemployment agreements that obligate any of our key managerial or technicalpersonnel to remain with us for any specified period of time. If we lose anykey personnel or are unable to attract, retain, train or motivate qualifiedpersonnel, our business operations and financial condition may be materiallyand adversely affected.

 

***A failure of our computers, telecommunications equipment orsoftware systems could interrupt our ability to provide our services****.*

 

Our business depends to a large extent on computers,telecommunications equipment and software systems (both equipment and systemsmaintained by us and equipment and systems maintained by third parties).  A natural disaster, human error, equipmentmalfunction or inadequacy or multiple other events could result in a prolongedinterruption in our ability to provide support services to clients or theircustomers.  The temporary or permanentloss of computer or telephone equipment or systems, through casualty, operatingmalfunctions or otherwise, could have a material adverse effect on ouroperations, property or financial condition, and business interruptioninsurance may not be adequate to compensate for all losses that may beincurred.

 

***We rely on third-party software companies for our chat ande-mail applications*.**

 

We contract with third-party software companies toprovide chat and e-mail tools used with our CRM software, reporting andmanagement services.  If one of thesesoftware companies fails in its business efforts, we may lose our access tothese software tools.  Our failure toobtain adequate replacement software tools could cause us to experience servicedelays, interruptions or cancellations.

 

***We are subject to collections risks and may be unable tocollect our accounts receivable balances.***

 

We provide unsecured credit terms to our clients.  Based on credit evaluations and otherinformation gathered by our management, we establish credit terms for eachclient; however, there can be no assurance that our future credit losses willbe consistent with management’s expectations. During December 2004, we recorded a specific reserve of $475,000for amounts due from a financially distressed client.  We can give no assurance that other clientswill not experience similar problems in the future.  A significant change in the liquidity orfinancial condition of one or more key clients, or a larger number of smallerclients, or further deterioration in the economic 

 

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environment,in general, could have an adverse impact on the collectabilityof our accounts receivable and our future operating results.

 

***Managing the utilization level of our resources is necessaryin order to achieve our desired profitability.***

 

Our business strategy requires us to fully utilizeexcess personnel and physical facilities in an effort to increase ourprofits.  As we expand our operations, wemay not always be able to manage the level of personnel and facilities to reachour desired levels of utilization, which may affect our profitability.  Also, if we lose existing clients, we mayhave excess personnel and physical facilities that would have an adverse effecton our business operations and our profitability.

 

***Implementation of our growth plans will be dependent on ourability to market and sell our services to new and existing clients.***

 

Our growth plans are dependent upon our ability toattract and retain new clients and to generate additional business fromexisting clients.  Our efforts to marketand sell our services will be affected by fluctuations in technology andindustry standards, changes in customer requirements and preferences, andgeneral economic conditions, among other factors.  Many of these factors are beyond ourcontrol.  If we are incorrect in ourassessment of the feasibility of our growth plans, if we are not effective inour efforts to market and sell our services or if circumstances change in a waythat we did not foresee or anticipate, we may not grow as planned or our growthstrategy may have an adverse effect on business operations and ourprofitability.

 

***Competitive pressures could harm our financial performance.***

 

The market for customer contact services is highlyfragmented and very competitive.  Incertain segments of the industry, however, the customer contact servicesindustry has begun to experience a degree of consolidation, and the developmentof major customer contact center companies has resulted in an additional levelof competition from service providers that have greater name recognition,larger installed customer bases, and significantly greater financial,technical, and marketing resources than we have.  Large established enterprise softwarecompanies may leverage their existing relationships and capabilities to offercustomer service applications.  In otherinstances, many large companies provide their own in-house customer caresupport and customer training.  Also, anumber of existing companies have experienced rapid internal growth, andseveral of these companies have been active in acquiring smaller regionalcustomer contact services companies and are becoming major competitors with ameasurable share of this rapidly expanding market.  If our competitors provide more efficient orless expensive services, we may lose market share and revenues.

 

***A delay in market acceptance of our products and servicescould negatively impact our business and revenues.***

 

The customer contact services market is extremelycompetitive.  We were a relatively earlyentrant in the customer self-services and chat markets; however, we havestruggled in our efforts to market and sell our products and services and havebeen slow to develop certain business operations.  Further delays in the development of ourproducts and services would allow our competitors additional time to improvetheir service or product offerings, and also provide time for new competitorsto develop e-business customer service applications and solicit prospectiveclients within our target markets.  Thiswould increase competition that could result in additional pricing pressures,and we may lose market share and revenues.

 

***If we do not keep up with the rapid technological changeexperienced by the customer contact service market, our products and servicesmay become obsolete and we may lose clients.****.*

 

The customer contact service industry is characterizedby rapid technological change, alterations in customer requirements andpreferences, and the emergence of new industry 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 canbe no assurance that we will be successful in adequately addressing thesedevelopments on a timely basis or that, if these developments are addressed, wewill be successful in the marketplace. In addition, products or technologies developed by others could renderour services non-competitive or obsolete. Our failure to address these developments could have a material negativeeffect on our business and financial condition.

 

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***If companies reduce their reliance on outsourced services,our revenues and financial condition may be adversely affected.***

 

Ourbusiness depends in large part on the trend within the IT industry to outsourcecertain services.  We cannot provide anyassurance that this trend will continue or that, if the trend continues, itwill continue at the same rate of growth. The failure of this trend to continue could have a material adverseeffect on our business, financial condition, and results of operations.

 

***Market volatility and fluctuations in our stock price andtrading volume may cause sudden decreases in the value of an investment in ourcommon stock.***

 

Themarket price of our common stock has historically been, and we expect it tocontinue to be, volatile.  This price hasranged between $1.94 and $17.89 in the eighteen-month period ended December 31,2004.   The market for our common stockhas, from time-to-time, experienced extreme price and volume fluctuations,which have often appeared to be unrelated to our operating performance.  Our stock price also has been affected by ourown public announcements regarding such things as quarterly earnings, changesin clients, obtaining financing, acquisitions and corporate partnerships.  Consequently, events both within and beyondour control may cause shares of our common stock to lose their value rapidly.

 

***Our revenues and quarterly results can be volatile, whichmakes evaluating our business difficult.***

 

Individual clientrevenue transactions can constitute a substantial percentage of our quarterlyrevenue, and some revenue transactions may generate a substantial portion ofthe operating profits for a quarter.  Ourrevenues are also a function of the number of support requests we receive, andthe time we spend on such requests. Thus, if we receive fewer support requests than anticipated or the timespent in resolving inquiries is greater than anticipated, our revenues maydecline.  Further, delays in the receiptof orders can cause significant fluctuation in revenues from quarter toquarter.

 

Because our staffing and other operating expenses arebased on anticipated revenue levels, and a high percentage of our expenses arefixed, the volatility in our revenues can cause significant variations inoperating results from quarter to quarter and we may not be able to achieve orsustain profitability on a quarterly basis. In addition, we may expend significant resources pursuing potentialsales that will not be consummated. Furthermore, we may choose to reduce prices or to increase spending inresponse to competition or to pursue new market opportunities, which mayadversely affect our operating results.

 

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

 

***Shares eligible for future sale maycause the market price for our common stock to drop significantly, even if ourbusiness is doing well.***

 

Wecannot predict the effect, if any, that future salesof our common stock or the availability of shares for future sale will have onthe market price of our common stock from time to time.  We have entered into registration rightsagreements which contemplate that substantially all of our outstanding sharesof common stock will become freely tradable in the public market.  Other shares of our common stock issued inthe future, including shares issued upon exercise of outstanding options andwarrants, may become available for resale in the public market from time totime, and the market price of shares of our common stock could dropsignificantly if the holders of these shares sell them or are perceived by themarket as intending to sell them.  Inaddition, sales of a substantial number of shares of our common stock in ashort period of time could adversely affect the market price of our shares.

 

***Wemay have difficulties integrating the Xtrasourceacquisition.***

 

Wehave closed an asset purchase agreement with Xtrasource,pursuant to which we acquired substantially all of the assets of Xtrasource.  We mayexperience difficulties in post-acquisition integration and operation of theacquired assets, including retaining existing clients of Xtrasource.  The integration of Xtrasourcewill require significant management time and resources.  The diversion of management time and ourlimited resources could have a material adverse effect on our results ofoperations or financial condition.

 

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***Provisions of our Articles of Incorporation and Bylaws couldimpair or delay stockholders’ ability to replace or remove our management andcould discourage takeover transactions that stockholders might consider to bein their best interests.***

 

OurArticles of Incorporation and Bylaws, the Utah Revised Business CorporationAct, and the Utah Control Shares Acquisition Act each contain certainprovisions that may have the effect of inhibiting a non-negotiated merger orother business combination.  Our Articlesof Incorporation grant to our Board of Directors the authority, without furtheraction by our shareholders, to fix the rights and preferences of, and issueshares of preferred stock.  Theseprovisions may deter hostile takeovers or delay or prevent changes in controlof us or changes in our management, including transactions in whichshareholders might otherwise receive a premium for their shares over thethen-current market prices.  In addition,these provisions may limit the ability of shareholders to approve transactionsthat 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.***

 

Nodividends have ever been declared or paid on our common stock.  We intend to retain any future earnings foruse in our business and do not anticipate paying any dividends on our commonstock in the foreseeable future.

 

***We are susceptible to businessand political risks from international operations that could result in reducedrevenues or earnings.***

 

Weoperate businesses in the Netherlands and France along with an outsourcing arrangement  with acompany in India. In connection with its strategy, we plan to capture morerevenue relating to these operations. Additionally, there is increasing demand for offshore customermanagement outsourcing capacity from North American companies.  Expansion of our existing internationaloperations will require management attention and financial resources. Inaddition, 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 andmanaging foreign operations, political instability and potentially adverse taxconsequences. To the extent that we do not manage our international operationssuccessfully, our business could be adversely affected and its revenues and/orearnings could be reduced.

 

Inaddition, there has been political discussion and debate related to worldwidecompetitive sourcing, particularly from the United States to offshorelocations. There is proposed federal and state legislation currently pendingrelated to this issue. It is too early to determine if there would be anyimpact; however, future legislation, if enacted, could have an adverse effecton our results of operations and financial condition.

 

***Our operating results areimpacted by the Euro to US dollar exchange rate.***

 

Weserve some of our customer management clients using contact center capacity inEurope. The revenue and costs associated with these operations are typicallypriced in Euros, which represents a foreign exchange exposure to us. As theU.S. dollar weakened during 2003 and the first nine months of 2004, theoperating results of these contact centers, once translated into U.S. dollars,increased in comparison to prior years. As the Euro exchange rate continues tochange, our operating results will be impacted.

 

## Item 3.   Controls and Procedures

##  

An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer of the effectiveness of our disclosure controls and procedures, as of December 31, 2004. Based on that evaluation, our management, including our CEO and CFO, concluded that our disclosure controls and procedures are 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 Chief Executive Officer and Chief Financial Officer, 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 

 

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are reasonably likely to materially affect, our internal controls over financial reporting.  Based on that evaluation, our executive management, including our Chief Executive Officer and our Chief Financial Officer, 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, 2004.

 

# **PART II.**                                                 OTHERINFORMATION

 

## Item 2.             Changes in Securities and SmallBusiness Issuer Purchases of Equity Securities

##  

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 Sento issuing 167,853 shares of common stock.  In addition, warrants to purchase 50,000shares of common stock were exercised at a total price of $88,125.

 

Thesecurities issued were restricted securities taken for investment. Certificatesfor the securities issued bore a restrictive legend conspicuously on their faceand stop-transfer instructions were noted respecting such certificates on ourtransfer records, except in circumstances in which we received a writtenopinion from legal counsel to the holders of such securities to the effect thatdue to the tacking of holding periods of previously held debentures (given inexchange for the recently issued debentures) such common share certificatesissued on debenture conversion did not need to bear a restrictive legend. Eachof the foregoing transactions was effected in relianceon the exemption from registration provided in Section 4(2) of theSecurities Act of 1933 and Rule 506 of Regulation D adopted thereunder as transactions not involving any publicoffering.

 

Item 4.             Submissionof Matters to Vote of Security Holders

 

On October 20,2004, we held our annual meeting of shareholders (the “Annual Meeting”).  At the Annual Meeting, four matters weresubmitted to shareholders for consideration and approval.  Those matters, together with the votingresults for each matter, are described in the following paragraphs.

 

1.               Fivedirectors were elected to serve until our 2005 Annual Meeting ofShareholders.  The directors elected,together with votes received are: Patrick F. O’Neal 2,683,319 votes; Kim A.Cooper 2,859,538 votes; Eric Olafson 2,862,216 votes;Phillip J. Windley 2,863,891 votes; and C. LloydMahaffey 2,863,216 votes.

 

2.               Ourshareholders approved a proposal to ratify an amendment to the Sento Corporation 1999 Omnibus Stock Incentive Plan toincrease the number of shares of common stock available for issuance under theplan from 875,000 to 1,025,000.  Withrespect to this proposal, there were 563,975 shares voted in favor of theproposal, 245,082 shares voted against the proposal, 2,563 shares abstainedfrom the proposal and 2,067,296 shares were un-voted.

 

3.               Ourshareholders approved a proposal to ratify an amendment to the Sento Corporation Amended 1996 Employee Stock Purchase Planto increase the number of shares of common stock available for issuance underthe plan from 125,000 to 175,000.  Withrespect to this proposal, there were 760,301 shares voted in favor of theproposal, 45,157 shares voted against the proposal, 6,162 shares abstained fromthe proposal and 2,067,296 shares were un-voted.

 

4.               Ourshareholders approved a proposal to ratify the appointment of Ernst & YoungLLP as our independent auditors for the fiscal yearending March 31, 2005.  With respectto this proposal, there were 2,865,013 shares voted in favor of the proposal,8,543 shares voted against the proposal, and 5,360 shares abstained.

 

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Item 6.             Exhibits

 

Exhibits31.1 and 32.1 – Certifications of the Company’s Chief Executive Officer

Exhibits31.2 and 32.2 – Certifications of the Company’s Chief Financial Officer

 

 

## SIGNATURES

##  

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly 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 |
|   |               | Chief Financial  Officer and Secretary |
|   |               | (Principal  financial and accounting officer) |
|        |                    |  |  |  |

 

DatedFebruary 14, 2005.

 

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