**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **ý**                                         |   | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934**  |
|----------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                                               |   |                                                                                                |
| **For the quarterly period ended  March 31, 2004** |
|                                               |   |                                                                                                |
| **OR**                                             |
|                                               |   |                                                                                                |
| **o**                                              |   | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934** |

 

**For thetransition periodfrom            to         **

 

**CommissionFile Number: 0-24081**

 

**EVOLVING SYSTEMS, INC.**

(Exact name of registrantas specified in its charter)

** **

| **Delaware**                                                   |   | **84-1010843**                   |
|----------------------------------------------------------------|--------|----------------------------------|
| (State or other jurisdiction of incorporation or organization) |   | (IRS Employer Identification No) |
|                                                           |   |                             |
| **9777 Mount Pyramid Court, Suite 100  Englewood, Colorado**   |   | **80112**                        |
| (Address of principal executive offices)                       |   | (Zip Code)                       |
|                                                           |   |                             |
| **(303) 802-1000**                                        |
| (Registrant’s telephone number)                           |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days.  Yes ýNo o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes oNo ý

 

As of April 26, 2004 there were 15,897,923 sharesoutstanding of Registrant’s Common Stock (par value $0.001 per share).

 

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**March 31, 2004**

**Table of Contents**

** **
| **PART I**                                                                                                | **FINANCIAL INFORMATION** |   |
|-----------------------------------------------------------------------------------------------------------|---------------------------|--------|
|                                                                                                      |                      |
| Item  1. Financial Statements                                                                             |                      |
|                                                                                                      |                      |
| Consolidated  Balance Sheets (Unaudited) as of March 31, 2004 and December 31, 2003                       |                      |
|                                                                                                      |                      |
| Consolidated  Statements of Operations (Unaudited) for the Three Months Ended March 31,  2004 and 2003    |                      |
|                                                                                                      |                      |
| Consolidated Statements of  Cash Flows (Unaudited) for the Three Months Ended March 31, 2004 and 2003     |                      |
|                                                                                                      |                      |
| Notes to  Unaudited Consolidated Financial Statements                                                     |                      |
|                                                                                                      |                      |
| Item  2. Management’s Discussion and Analysis of Financial Condition  and Results of Operations |                      |
|                                                                                                      |                      |
| Item  3. Quantitative and Qualitative Market Risk Disclosures                                             |                      |
|                                                                                                      |                      |
| Item  4. Controls and Procedures                                                                          |                      |
|                                                                                                      |                      |
| **PART II**                                                                                               | **OTHER INFORMATION**     |   |
|                                                                                                      |                      |
| Item 1. Legal Proceedings                                                                                 |                      |
|                                                                                                      |                      |
| Item 2. Changes in Securities                                                                             |                      |
|                                                                                                      |                      |
| Item 3. Defaults on Senior  Securities                                                                    |                      |
|                                                                                                      |                      |
| Item 4. Submission of Matters to  a Vote of Security Holders                                              |                      |
|                                                                                                      |                      |
| Item 5. Other Information                                                                                 |                      |
|                                                                                                      |                      |
| Item 6. Exhibits and Reports on  Form 8-K                                                                 |                      |
|                                                                                                      |                      |
| Signatures                                                                                                |                      |

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

**EVOLVINGSYSTEMS, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(inthousands except share data)**

**(unaudited)**

 
|                                                                                                                                                                              |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| **ASSETS**                                                                                                                                                                        |   |                |   |                    |   |
| Current assets:                                                                                                                                                                   |   |                |   |                    |   |
| Cash and cash  equivalents                                                                                                                                                        |   | $                   | 21,281 |                    | $      | 17,999 |   |
| Current portion  of restricted cash                                                                                                                                               |   | 100                 |   | 100                     |   |
| Contract  receivables, net of allowance of $65 at March 31, 2004 and December 31, 2003                                                                                            |   | 5,042               |   | 9,292                   |   |
| Unbilled  work-in-progress                                                                                                                                                        |   | 76                  |   | 622                     |   |
| Prepaid and  other current assets                                                                                                                                                 |   | 1,100               |   | 868                     |   |
| Total current  assets                                                                                                                                                             |   | 27,599              |   | 28,881                  |   |
| Property and  equipment, net                                                                                                                                                      |   | 1,873               |   | 1,579                   |   |
| Intangible  assets, net                                                                                                                                                           |   | 3,626               |   | 3,845                   |   |
| Goodwill                                                                                                                                                                          |   | 6,955               |   | 6,996                   |   |
| Long-term  restricted cash                                                                                                                                                        |   | 400                 |   | 400                     |   |
| Total assets                                                                                                                                                                      |   | $                   | 40,453 |                    | $      | 41,701 |   |
|                                                                                                                                                                              |   |                |   |                    |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                    |   |                |   |                    |   |
| Current  liabilities:                                                                                                                                                             |   |                |   |                    |   |
| Current portion  of long-term obligations                                                                                                                                         |   | $                   | 29     |                    | $      | 29 |   |
| Accounts payable  and accrued liabilities                                                                                                                                         |   | 2,752               |   | 3,044                   |   |
| Unearned revenue                                                                                                                                                                  |   | 10,577              |   | 11,972                  |   |
| Total current  liabilities                                                                                                                                                        |   | 13,358              |   | 15,045                  |   |
| Long-term  obligations                                                                                                                                                            |   | 166                 |   | 183                     |   |
| Total  liabilities                                                                                                                                                                |   | 13,524              |   | 15,228                  |   |
| Commitments and  contingencies (Note 8)                                                                                                                                           |   |                |   |                    |   |
| Stockholders’  equity:                                                                                                                                                       |   |                |   |                    |   |
| Common stock,  $0.001 par value; 25,000,000 shares authorized; 15,885,423 and 15,778,540  shares issued and outstanding as of March 31, 2004 and December 31, 2003,  respectively |   | 16                  |   | 16                      |   |
| Accumulated  other comprehensive income                                                                                                                                           |   | 2                   |   | —                  |   |
| Additional paid-in  capital                                                                                                                                                       |   | 67,552              |   | 67,342                  |   |
| Accumulated  deficit                                                                                                                                                              |   | (40,641             | )      | (40,885                 | )      |
| Total  stockholders’ equity                                                                                                                                                  |   | 26,929              |   | 26,473                  |   |
| Total  liabilities and stockholders’ equity                                                                                                                                  |   | $                   | 40,453 |                    | $      | 41,701 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

1

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**EVOLVINGSYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(inthousands except per share data)**

**(unaudited)**

 
|                                                        |   | **Three  Months Ended March 31,** |   |
|-------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                        |   | **2004**                          |   | **2003** |   |
| **REVENUE**                                                 |   |                              |   |   |   |
| License fees and  services                                  |   | $                                 | 3,219  |   | $ | 5,004 |   |
| Customer support                                            |   | 2,547                             |   | 3,587 |   |
| Total revenue                                               |   | 5,766                             |   | 8,591 |   |
|                                                        |   |                              |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                |   |                              |   |   |   |
| Costs of license  fees and services, excluding depreciation |   | 1,077                             |   | 1,893 |   |
| Costs of customer  support, excluding depreciation          |   | 1,874                             |   | 1,307 |   |
| Sales and  marketing                                        |   | 936                               |   | 705 |   |
| General and  administrative                                 |   | 935                               |   | 916 |   |
| Product  development                                        |   | 491                               |   | 276 |   |
| Depreciation                                                |   | 274                               |   | 330 |   |
| Restructuring  and other expenses                           |   | —                            |   | 118 |   |
| Total costs of  revenue and operating expenses              |   | 5,587                             |   | 5,545 |   |
|                                                        |   |                              |   |   |   |
| Income from  operations                                     |   | 179                               |   | 3,046 |   |
| Other income,  net                                          |   | 57                                |   | 47 |   |
| Income before  income taxes                                 |   | 236                               |   | 3,093 |   |
| Benefit from  income taxes                                  |   | 8                                 |   | — |   |
| Net income                                                  |   | $                                 | 244    |   | $ | 3,093 |   |
|                                                        |   |                              |   |   |   |
| **Basic  income per common share**                          |   | $                                 | 0.02   |   | $ | 0.23 |   |
|                                                        |   |                              |   |   |   |
| **Diluted  income per common share**                        |   | $                                 | 0.01   |   | $ | 0.21 |   |
|                                                        |   |                              |   |   |   |
| Weighted average  basic shares outstanding                  |   | 15,837                            |   | 13,437 |   |
| Weighted average  diluted shares outstanding                |   | 17,939                            |   | 14,456 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

2

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**EVOLVINGSYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
|                                                                               |   | **Three  Months Ended March 31,** |   |
|------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                               |   | **2004**                          |   | **2003** |   |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         |   |                              |   |   |   |
| Net income                                                                         |   | $                                 | 244    |   | $ | 3,093 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |   |                              |   |   |   |
| Depreciation                                                                       |   | 274                               |   | 330 |   |
| Amortization of  intangible assets                                                 |   | 219                               |   | — |   |
| Loss on  impairment and disposal of property and equipment                         |   | —                            |   | (4 | ) |
| Bad debt expense                                                                   |   | —                            |   | 8 |   |
| Change in  operating assets and liabilities:                                       |   |                              |   |   |   |
| Contract  receivables                                                              |   | 4,250                             |   | 8,657 |   |
| Unbilled  work-in-progress                                                         |   | 546                               |   | (408 | ) |
| Prepaid and  other assets                                                          |   | (230                              | )      | (25 | ) |
| Accounts payable  and accrued liabilities                                          |   | (293                              | )      | (253 | ) |
| Unearned revenue                                                                   |   | (1,395                            | )      | (3,213 | ) |
| Long-term  obligations                                                             |   | (10                               | )      | 101 |   |
| Net cash  provided by operating activities                                         |   | 3,605                             |   | 8,286 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |   |                              |   |   |   |
| Purchase of  property and equipment                                                |   | (568                              | )      | (49 | ) |
| Proceeds from  sale of property and equipment                                      |   | —                            |   | 7 |   |
| Cash acquired in  acquisition, net of cash paid                                    |   | 41                                |   | — |   |
| Net cash used in  investing activities                                             |   | (527                              | )      | (42 | ) |
|                                                                               |   |                              |   |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |   |                              |   |   |   |
| Capital lease  payments                                                            |   | (7                                | )      | (8 | ) |
| Proceeds from  the issuance of stock                                               |   | 210                               |   | 73 |   |
| Net cash  provided by financing activities                                         |   | 203                               |   | 65 |   |
|                                                                               |   |                              |   |   |   |
| **EFFECT  OF EXCHANGE RATES ON CASH**                                              |   | 1                                 |   | — |   |
|                                                                               |   |                              |   |   |   |
| Net increase in  cash and cash equivalents                                         |   | 3,282                             |   | 8,309 |   |
| Cash and cash  equivalents at beginning of period                                  |   | 17,999                            |   | 8,601 |   |
| Cash and cash  equivalents at end of period                                        |   | $                                 | 21,281 |   | $ | 16,910 |   |
|                                                                               |   |                              |   |   |   |
| Supplemental  disclosure of other cash and non-cash financing transactions:        |   |                              |   |   |   |
| Interest paid                                                                      |   | $                                 | 7      |   | $ | 5 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

3

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**EVOLVINGSYSTEMS, INC.**

 

**NOTES TO UNAUDITED****CONSOLIDATED FINANCIAL STATEMENTS**

 

**(1)****   Basisof Presentation**

 

*Interim Consolidated Financial Statements*.The accompanying consolidated financial statements of Evolving Systems, Inc.(“Evolving Systems”, the “Company”) have been prepared pursuant to the rulesand regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America(“GAAP”) have been condensed or omitted pursuant to such rules and regulations.However, management believes that the disclosures are adequate to make theinformation presented not misleading. The unaudited consolidated financialstatements included in this document have been prepared on the same basis asthe annual consolidated financial statements, and in management’s opinion,reflect all adjustments, which include only normal recurring adjustments,necessary for a fair presentation in accordance with GAAP. The results for thethree months ended March 31, 2004 are not necessarily indicative of the resultsthat the Company will have for any subsequent quarter or full fiscal year.  These consolidated financial statementsshould be read in conjunction with the audited consolidated financial statementsand the notes to those statements for the year ended December 31, 2003including the Company’s Annual Report on Form 10-K for the year ended December31, 2003.

 

*Use ofEstimates*. The preparation of financial statements inconformity with GAAP requires us to make estimates and assumptions that affectthe reported amounts of assets and liabilities, disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting period. Actual resultscould differ from those estimates.

 

*ForeignCurrency Translation*. The rupee is the functional currencyfor the Company’s Indian subsidiary. The Company translates asset and liabilityaccounts to the U.S. dollar based on the exchange rate as of the balancesheet date, while income statement and cash flow statement amounts aretranslated to the U.S. dollar at the average exchange rate for the period.Exchange gains or losses resulting from such translation are included as aseparate component of stockholders’ equity. Transaction gains and losses arerecognized in income during the period in which they occur. During the threemonths ended March 31, 2004, the Company recognized a net transaction loss ofapproximately $3,000.

 

*ComprehensiveIncome*. The Company applies SFAS No. 130, *Reporting Comprehensive Income* whichestablishes standards for reporting comprehensive income or loss and itscomponents in financial statements.  The Company’s comprehensive income iscomprised of its net income and foreign currency translation adjustment. For the quarter ended March 31, 2004, total comprehensive income was$246,000. For the quarter ended March 31, 2003, comprehensive income equalednet income as there was no foreign currency translation adjustment during theperiod.

 

*Principlesof Consolidation*.  Theconsolidated financial statements include the accounts of the Company and itssubsidiaries.  All significantintercompany transactions and balances have been eliminated.

 

**(2)  Earnings Per Common Share**

 

Basic earnings per commonshare (“EPS”) was computed by dividing net income by the weighted averagenumber of common shares outstanding during the period. Diluted EPS was computedusing the weighted average number of common shares plus all dilutive potentialcommon shares outstanding during the period unless the effect of the potentialcommon shares was anti-dilutive.

 

No reconciliation of theEPS numerators was necessary for the three months ended March 31, 2004 and2003, as net income was used as the numerator for each period.  The reconciliation of the EPS denominator isas follows (in thousands):

 
|                                                  |   | **Three  Months Ended March 31,** |   |
|-------------------------------------------------------|--------|-----------------------------------|--------|
|                                                  |   | **2004**                          |   | **2003** |   |
|                                                  |   |                              |   |   |   |
| Basic weighted  average common shares outstanding     |   | 15,837                            |   | 13,437 |   |
| Effect of  dilutive securities - options and warrants |   | 2,102                             |   | 1,019 |   |
| Diluted weighted  average common shares outstanding   |   | 17,939                            |   | 14,456 |   |

 

Options to purchase313,000 and 508,000 shares of common stock were excluded from the dilutivecommon stock calculation for the three months ended March 31, 2004 and 2003,respectively, because their exercise prices were greater than the average fairmarket value of the Company’s stock for the period.

 

4

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**(3)Stock-Based Compensation**

 

The Company has elected to follow Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” or APB No. 25,and related interpretations in accounting for its employee stock options.  Under APB No. 25, because the exercise priceof the Company’s employee stock options is generally equal to the market priceof the underlying stock on the date of the grant, no compensation expense isrecognized.  Statements of FinancialAccounting Standards No. 123, “Accounting for Disclosure of Stock-Based Compensation”or SFAS No. 123, establishes an alternative method of expense recognition forstock-based compensation awards to employees based on estimated fairvalues.  The Company elected not toadopt SFAS No. 123 for expense recognition purposes.

 

In accordance withthe interim disclosure provisions of Statements of Financial AccountingStandards, or SFAS No. 148, “Accounting for Stock Based Compensation Transitionand Disclosure-an Amendment of SFAS No. 123,” the pro forma effect on theCompany’s net income had compensation expense been recorded for the threemonths ended March 31, 2004 and 2003, respectively, as determined under thefair value method, as prescribed in SFAS No. 123, is shown below (in thousands,except per share data).

 
|                                                          |   | **Three  Months Ended March 31,** |   |
|---------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                          |   | **2004**                          |   | **2003** |   |
|                                                          |   |                              |   |   |   |
| Net income as  reported                                       |   | $                                 | 244    |   | $ | 3,093 |   |
| Stock based  compensation expense under the fair value method |   | (579                              | )      | (67 | ) |
| SFAS No. 123 Pro  forma                                       |   | $                                 | (335   | ) | $ | 3,026 |   |
| Net income per  common share as reported:                     |   |                              |   |   |   |
| Basic                                                         |   | $                                 | 0.02   |   | $ | 0.23 |   |
| Diluted                                                       |   | $                                 | 0.01   |   | $ | 0.21 |   |
| SFAS No. 123 Pro  forma                                       |   |                              |   |   |   |
| Basic                                                         |   | $                                 | (0.02  | ) | $ | 0.23 |   |
| Diluted                                                       |   | $                                 | (0.02  | ) | $ | 0.21 |   |

 

**(4) Concentration of Credit Risk**

 

For the three months endedMarch 31, 2004 and 2003, the Company recognized 76% (34%, 18%, 13% and 11%) and82% (27%, 21%, 19% and 15%), respectively, of total revenue from foursignificant customers (greater than 10%), all in the telecommunicationsindustry.

 

As of March 31, 2004, three significant customers(greater than 10%) accounted for approximately 81% (30%, 26% and 25%) ofcontract receivables.  At December 31,2003, three significant customers (greater than 10%) accounted forapproximately 75% (34%, 29% and 12%) of contract receivables.

 

**(5)Income Taxes**

 

As of March 31, 2004 andDecember 31, 2003, the Company continued to maintain a full valuation allowancedue to the uncertainties related to the Company’s ability to utilize itsdeferred tax asset.  The Company’sassessment of this valuation allowance was made using all available evidence,both positive and negative. In particular, the Company considered both itshistorical results and its projections of profitability for only the reasonablyforeseeable future periods.  TheCompany’s realization of its recorded net deferred tax assets is dependent onfuture taxable income and, therefore, the Company is not assured that suchbenefits will be realized.

 

**(6) Restructuring and Other Expenses**

 

In early 2002, managementimplemented a restructuring plan (the “Plan”) due to the downturn in thetelecommunications industry, the Company’s sharp decline in revenue, the FCC’sdelay in ruling on wireless number portability and other factors.  The Plan included workforce reductions,restructuring of the Company’s headquarters building lease, the closure of itssatellite field offices and the write down of certain fixed assets, all ofwhich were executed in 2002. At March 31, 2004 and December 31, 2003, theremaining accrual related to the closure of the satellite offices. Thefollowing summarizes the activity during the first quarter of 2004 related tothe Plan.

 

*Closureof satellite offices.* The Company closed all of its satellite field offices during 2002.  Because the costs to sublease or terminatethese lease commitments are based on estimates, the Company may incuradditional costs related to the satellite office closures.  As of March 31, 2004 approximately $119,000was included in accounts payable and accrued liabilities, and approximately$37,000 was included in long-term obligations, related to the closure of thesatellite offices.

 

5

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The following tablesummarizes the change in the accrual balance since December 31, 2003 (inthousands):

 
|                               |   | **Closure of  Satellite Offices** |   |
|------------------------------------|--------|-----------------------------------|--------|
| Accrual balance  December 31, 2003 |   | $                                 | 175    |   |
| 1st quarter cash  payments, net    |   | (19                               | )      |
| Accrual balance  March 31, 2004    |   | $                                 | 156    |   |

 

**(7)Segment Information**

 

In accordance with SFASNo. 131, “Disclosures about Segments of an Enterprise and Related Information,”the Company defines operating segments as components of an enterprise for whichseparate financial information is available. This information is reviewed regularly by the chief operatingdecision-maker, or decision-making group, to evaluate performance and to makeoperating decisions. The Company has identified its Chief Executive Officer andChief Financial Officer as its chief operating decision makers. These chiefoperating decision makers review the revenues by segment and review overallresults of operations.

 

The Company currentlyoperates its business as two operating segments based on revenue type: licensefees/services revenue and customer support revenue (as shown on theConsolidated Statements of Operations). License fees and services revenue represents the fees received from thelicense of software products and those services directly related to thedelivery of the licensed products as well as custom development, integrationservices and time and materials work. Customer supportrevenue includes recurring maintenance fees, fees for specified maintenanceupgrades, annual support fees and warranty maintenance.  Warranty maintenance revenues are withheldfrom the revenue on a project and are recognized ratably over the warrantyperiod. The Company provides products and services solely within theUnited States geographic area, although it does have a product developmentfacility in Bangalore, India.  Totalassets have not been specified because the information is not available to thechief operating decision-making group.

 

Revenue and costs ofrevenue information by segments are as follows (in thousands):

 

 

|                                    |   | **Three  Months Ended March 31,** |   |
|-----------------------------------------|--------|-----------------------------------|--------|
|                                    |   | **2004**                          |   | **2003** |   |
| Revenue                                 |   |                              |   |   |   |
| License fees and  services              |   | $                                 | 3,219  |   | $ | 5,004 |   |
| Customer support                        |   | 2,547                             |   | 3,587 |   |
|                                    |   | 5,766                             |   | 8,591 |   |
|                                    |   |                              |   |   |   |
| Segment profit,  excluding depreciation |   |                              |   |   |   |
| License fees and  services              |   | 2,142                             |   | 3,111 |   |
| Customer support                        |   | 673                               |   | 2,280 |   |
|                                    |   | 2,815                             |   | 5,391 |   |
|                                    |   |                              |   |   |   |
| Other operating  expenses               |   | 2,362                             |   | 1,897 |   |
| Depreciation                            |   | 274                               |   | 330 |   |
| Restructuring  and other                |   | —                            |   | 118 |   |
| Income from  operations                 |   | $                                 | 179    |   | $ | 3,046 |   |

 

**(8) Commitments and Contingencies**

 

As permitted under Delaware law, the Company hasagreements with its officers and directors under which it agrees to indemnifythem for certain events or occurrences while the officer or director is, orwas, serving at our request in this capacity. The term of the indemnification period is indefinite.  There is no limit on the amount of futurepayments the Company could be required to make under these indemnificationagreements; however, it maintains Directors and Officers insurance policies, aswell as an Employment Practices Liability Insurance Policy, that may enable itto recover a portion of any future amounts paid. As a result of the Company’s

 

6

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insurance policy coverage, it believes the estimated fair value ofthese indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for theseagreements as of March 31, 2004.

 

The Company enters into standard indemnification termswith its customers, as discussed below, in the ordinary course of business.Because the Company subcontracts some of the development of deliverables underits customer contracts, it could be required to indemnify its customers forwork performed by its subcontractors. Depending upon the nature of the customerindemnification, the potential amount of future payments the Company could berequired to make under these indemnification agreements may be unlimited. TheCompany may be able to recover damages from a subcontractor if theindemnification to its customers results from the subcontractor’s failure toperform. To the extent the Company is unable to recover damages from itssubcontractors, it could be required to reimburse the indemnified party for thefull amount. The Company has never incurred costs to defend lawsuits or settleclaims relating to indemnification arising out of its subcontractors’ failureto perform.

 

The Company enters into standard indemnification termswith its customers in the ordinary course of business under which it agrees toindemnify its customers for certain claims arising out of our performance underits contracts.  As these representguarantees of its own performance, no liability has been recognized as of March31, 2004.

 

**(9)  Business Combination**

 

On November 3, 2003, the Company acquired all of theoutstanding shares of privately-held CMS Communications, Inc. (“CMS”) ofColumbus, Ohio in exchange for 732,773 shares of Evolving Systems, Inc. commonstock.  The acquisition was accountedfor using the purchase method of accounting and accordingly, the assetsacquired and liabilities assumed were recorded at their respective fair valuesas of the acquisition date.  The resultsof CMS’ operations have been included in the consolidated financial statementssince the purchase date.

 

CMS is a provider of network management operationssupport software for major telecommunications carriers.  In addition to adding complementary productsand sharing many common customers, CMS brings a workforce that is familiar withcomplex tier one telecommunications solutions. The Company believes that CMS’s network management products will fit theCompany’s solutions business model and provide it with additional opportunitieswith their tier one customers.

 

The aggregate purchase price of approximately $11.2million includes the issuance of 732,773 shares of Evolving Systems, Inc.common stock in exchange for all outstanding shares of CMS.  The fair value of Evolving Systems, Inc.’scommon stock was determined using an average price of approximately $14.98 inaccordance with EITF 99-12, “Determination of the Measurement Date for theMarket Price of Acquirer Securities Issued in a Purchase Business Combination,”which was the average closing price a few days before and after the mergeragreement.

 

**ProForma Financial Information**

 

The financial information inthe table below summarizes the combined results of operations of EvolvingSystems and CMS, on a pro forma basis, as though the companies had beencombined as of the beginning of the period presented below.  This pro forma financial information ispresented for informational purposes only and is not necessarily indicative ofthe results of operations that would have been achieved had the acquisitionactually taken place as of the beginning of the period presented below.  The following amounts are in thousands,except per share amounts.

 

|                                         |   | **Three  Months Ended  March 31,  2003** |   |
|----------------------------------------------|--------|------------------------------------------|--------|
| Revenues                                     |   | $                                        | 9,573  |   |
| Net income  (loss)                           |   | $                                        | 3,104  |   |
|                                         |   |                                     |   |
| Weighted average  basic shares outstanding   |   | 14,170                                   |   |
| Weighted average  diluted shares outstanding |   | 15,189                                   |   |
|                                         |   |                                     |   |
| Basic income per  share                      |   | $                                        | 0.22   |   |
| Diluted income  per share                    |   | $                                        | 0.20   |   |

 

7

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#### **(10) Goodwill**

#### ** **

During 2003, the Companyacquired goodwill and intangible assets as a result of its acquisition ofCMS.  Amortization ofidentifiable intangibles is expensed as “costs of license fees and services,excluding depreciation” and “costs of customer support, excludingdepreciation”. As of March 31, 2004goodwill was $7.0 million and in accordance with SFAS 142, will not beamortized but will be subject to an annual impairment test to make sure thatthe carrying amount of the goodwill is not impaired.  The goodwill will be assessed on an annual basis for impairmentat the reporting unit level by applying a fair-value-based test. Goodwill wasreduced by $41,000 during the three months ended March 31, 2004, due primarilyto the return of the cash escrow account.

 

#### ** **(11) Recent AccountingPronouncements

#### ** **

In December 2003, the FASB issued Interpretation No.46 (revised December 2003), “Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51” (“FIN 46R”). FIN 46R requires a company toconsolidate a variable interest entity, as defined, when the company willabsorb a majority of the variable interest entity’s expected losses, receive amajority of the variable interest entity’s expected residual returns, or both.FIN 46R also requires certain disclosures relating to consolidated variable interestentities and unconsolidated variable interest entities in which a company has asignificant variable interest. The provisions of FIN 46R are required forcompanies that have interests in variable interest entities or potentialvariable interest entities commonly referred to as special-purpose entities forperiods ending after December 15, 2003. The provisions of FIN 46R are requiredto be applied for periods ending after March 15, 2004 for all other types ofentities. The adoption of FIN 46R did not have a material impact on theCompany’s results of operations or financial condition.

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

 

# OVERVIEW

 

*ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contains forward-looking statements that have been made pursuant tothe provisions of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are basedon current expectations, estimates, and projections about Evolving Systems’industry, management’s beliefs, and certain assumptions made bymanagement.  Forward-looking statementsinclude our expectations regarding product, services, and maintenance revenue,annual savings associated with the organizational changes effected in prioryears, and short- and long-term cash needs. In some cases, words such as “anticipates”, expects”, “intends”,“plans”, “believes”, “estimates”, variations of these words, and similarexpressions are intended to identify forward-looking statements.  The statements are not guarantees of futureperformance and are subject to certain risks, uncertainties, and assumptionsthat are difficult to predict; therefore, actual results may differ materiallyfrom those expressed or forecasted in any forward-looking statements.  Risk and uncertainties of our businessinclude those set forth in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2003 under “Risk Factors” on pages 8 through 13 as wellas additional risks described in this Form 10-Q.  Unless required by law, we undertake no obligation to updatepublicly any forward-looking statements, whether as a result of newinformation, future events, or otherwise. However, readers should carefully review the risk factors set forth inother reports or documents the Company files from time to time with theSecurities and Exchange Commission, particularly the Quarterly Reports on Form10-Q and any Current Reports on Form 8-K.*

 

Evolving Systems, Inc. (“we”, “our”, “us”) is aprovider of mission critical and cost-effective software solutions to tier onetelecommunications companies. We maintain long-standing relationships with manyof the largest wireline and wireless telecommunications providers in the UnitedStates. Our customers rely on us to develop, deploy, enhance, maintain andintegrate complex, highly reliable software solutions for a range of OperationsSupport Systems (OSS) and Network Support Systems (NSS). Our customers includefour of the largest wireline carriers in North America, representingapproximately 90 percent of U.S. access lines, and four wireless carriers,representing more than 20 percent of U.S. wireless subscribers. We offersoftware products and solutions that enable our customers to comply withgovernment-mandated requirements regarding local number portability (LNP) forwireline, and wireless number portability (WNP). We also offer inventory andassignment software which supports carriers compliance with the governmentphone number conservation mandates. In addition, we offer a variety of networkassurance and fulfillment solutions that were added to our portfolio when weacquired CMS Communications Inc., (“CMS”) in November 2003. We are uniquelypositioned as a provider of both OSS, NSS and comprehensive systems integrationcapabilities because these complementary competencies enable us to address andimplement solutions across a customer’s infrastructure.

 

Founded in 1985, we initially focused on providingcustom software development and professional services to a limited number oftelecommunications companies. In 1996, concurrent with the passage of theTelecommunications Act of 1996 (the Telecom Act), we made a strategic decisionto add software products to our established professional services offerings.Since that time we have built and acquired a strong product portfolio thatincludes, but is not limited to, LNP OSS software that enables carriers to meetFederal

 

8

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Communications Commission (FCC) requirements that consumers bepermitted to retain their phone numbers when changing service providers; numberinventory and conservation software that addresses FCC mandates to extend thelife of the North American Numbering Plan; and a solution for collectingtraffic data off of network elements which supports both service assurancerequirements and network planning activities. Number portability is mandatedand implemented for U.S. wireline carriers today and was implemented by allU.S. wireless carriers for top-tier markets on November 24, 2003, with allremaining markets scheduled for implementation on May 24, 2004.  Number conservation, or number pooling, hasbeen mandatory for all U.S. carriers since November 2002, and is implementedfor both U.S. wireline and wireless carriers today.

 

Historically, we have helped our customers integrateour products into their existing OSS environments. In 2002, we initiated arestructuring plan, which, in addition to significant operational costreductions and greater leverage of offshore development, included thereengineering of our business model to a solutions strategy.  The solutions business model reflects a morebalanced mix of services and products, as well as integration and productenhancements for our customer’s back office to meet the specific requirementsof each customer. Solutions which include our intellectual property andextensions, enhancements and integration are typically licensed to ourcustomers and supported by us. We branded the integration and developmentmethodology that supports our new business strategy **ServiceXpress**TM.

 

***ServiceXpress* Strategy**

 

Our ***ServiceXpress*** strategy is a solutions model that focuseson providing our customers with high quality solutions that meet their specificneeds, as quickly as feasible, at the lowest possible price. We work with ourcustomers using our domain knowledge to identify precisely what they want. Weminimize the cost and maximize the speed of delivery by using low-cost offshoredevelopment, incorporating our products and ***ServiceXpress*** tools into the solution,as well as third party products and tools. We also provide efficient lifecyclesupport. We achieve high quality by following our ***ServiceXpress*** methodology that defines arepeatable process for developing, delivering and supporting high qualitysolutions. Most of our solutions are provided for a fixed price which allowsour customers to benefit from the savings we achieve while providing us withwhat we think is a fair margin. We strive to be a premier low-cost provider ofhigh-quality, mission-critical software solutions for wireline and wirelesstelecommunications carriers.

 

After we deliver a solution to a customer, we pursuefollow-on business that includes software development services, software enhancementsto our products and related integration, as well as customer support andmaintenance services. Because the solutions we provide usually performfunctions that are required for the operation of our customer’s business, weexpect follow-on revenue to occur for several years after an initial sale.

 

While providing support and maintenance services, wemay also become aware of new opportunities with our customers. This allows usto expand our product portfolio and ***ServiceXpress*** tools to solve our customers’needs, generally in their back office systems environment.  Our ***ServiceXpress*** strategy is currently used insupport of most of our customer engagements.

 

**CriticalAccounting Policies**

 

Management’s Discussion and Analysis of FinancialCondition and Results of Operations is based on our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America, or GAAP. We review theaccounting policies we use in reporting our financial results on a regularbasis. The preparation of our consolidated financial statements requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenue and expenses, and related disclosure of contingent assetsand liabilities. In many cases, the accounting treatment of a particulartransaction is specifically dictated by GAAP and does not require our judgmentin its application.  Our seniormanagement has reviewed these critical accounting policies and relateddisclosures with our Audit Committee. We have identified the policies below as critical to our businessoperations and the understanding of our results of operations.

 

•                  Revenue recognition

 

•                  Allowance for doubtful accounts

 

•                  Income taxes

 

•                  Goodwill and intangible assets

 

**RevenueRecognition**

 

Customer support revenue is typically recognizedratably over the service contract period as noted in our Annual Report on 

 

9

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Form 10-K for the year ended December 31, 2003.  Occasionally, customer support revenue maybe recognized differently. If customer support is sold in a contract thatcontains multiple elements and fair value of each of the elements does not exist,Statements of Position, or SOP 97-2, “Software Revenue Recognition”, requiresthat all revenue from the arrangement must be deferred until the earlier ofwhen (1) such evidence does exist for each element, (2) all elements have beendelivered, or (3) the evidence of fair value exists for the undeliveredelements.

 

For a detailed discussion on the application of theseaccounting policies, see “Item 7: Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in our Annual Report on Form10-K for the year ended December 31, 2003.

 

**RecentDevelopments**

 

**Customer Support**

 

During the first quarter of 2004, we did not recordrevenue related to an arrangement because the customer purchased services,specified licensed software upgrades and customer support.  Since fair value of the undeliveredspecified licensed software upgrades does not exist, all of the revenue relatedto this contract will be deferred until the specified licensed softwareupgrades are delivered and accepted.  Weexpect this to occur in the first quarter of 2005. The costs associated withthis contract will be expensed as incurred.

 

**Offshore Development**

 

In February 2004, we formed Evolving Systems NetworksIndia Private Limited, a wholly owned subsidiary of Evolving Systems (EvolvingSystems India).  For several years,offshore development, through subcontractors, has been a key aspect of ourlow-cost, accelerated-deployment strategy. With the formation of Evolving Systems India we expect to have morecontrol and flexibility and lower costs than our previous outsourceddevelopment approach using offshore third party contractors. For the threemonths ended March 31, 2004, we incurred costs of approximately $100,000 tostart up the office and to recruit and train employees. All of these costs wereexpensed as product development. During the second and third quarters while wetransition our development work from our third-party subcontractor to ourIndian development team, we expect to have expenses associated with ourthird-party subcontractor as well expenses to train employees in our Indianoffice. In the late third quarter and in subsequent quarters we expect torealize cost savings after we complete the transition of work from ourthird-party subcontractor.

 

**Results of Operations**

 

The following table presentsthe Company’s Consolidated Statements of Operations reflected as a percentageof total revenue.

 
|                                                        |   | **Three  Months Ended March 31,** |   |
|-------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                        |   | **2004**                          |   | **2003** |   |
| **REVENUE**                                                 |   |                              |   |   |   |
| License fees and  services                                  |   | 56                                | %      | 58 | % |
| Customer support                                            |   | 44                                | %      | 42 | % |
| Total revenue                                               |   | 100                               | %      | 100 | % |
|                                                        |   |                              |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                |   |                              |   |   |   |
| Costs of license  fees and services, excluding depreciation |   | 19                                | %      | 22 | % |
| Costs of  customer support, excluding depreciation          |   | 33                                | %      | 15 | % |
| Sales and  marketing                                        |   | 16                                | %      | 8 | % |
| General and  administrative                                 |   | 16                                | %      | 11 | % |
| Product  development                                        |   | 8                                 | %      | 3 | % |
| Depreciation                                                |   | 5                                 | %      | 4 | % |
| Restructuring  and other expenses                           |   | —                            |   | 1 | % |
| Total costs of  revenue and operating expenses              |   | 97                                | %      | 64 | % |
|                                                        |   |                              |   |   |   |
| Income from  operations                                     |   | 3                                 | %      | 36 | % |
| Other income,  net                                          |   | 1                                 | %      | — |   |
| Income before  income taxes                                 |   | 4                                 | %      | 36 | % |
| Provision for  income taxes                                 |   | —                            |   | — |   |
| Net income                                                  |   | 4                                 | %      | 36 | % |

 

10

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**Thethree months ended March 31, 2004 compared to the three months ended March 31,2003**

 

**Revenue**

 

Revenue is comprised of license fees/services andcustomer support.  License fees andservices revenue represent the fees we receive from the license of our softwareproducts and those services directly related to the delivery of the licensed productas well as custom development, integration services and time and materialswork.  Customer support revenue includes recurringmaintenance fees, specified maintenance upgrades, annual support fees andwarranty maintenance.  Warrantymaintenance revenues are withheld from a project and are recognized ratablyover the warranty period.  Totalrevenues were $5.8 million and $8.6 million for the three months endedMarch 31, 2004 and 2003, respectively. The following table presents theCompany’s revenue by core product (in thousands).

 

 

|                               |   | **Three Months  Ended March 31,** |   |
|------------------------------------|--------|-----------------------------------|--------|
|                               |   | **2004**                          |   | **2003** |   |
| Number  portability                |   | $                                 | 2,858  |   | $ | 5,560 |   |
| Number inventory  and assignment   |   | 1,908                             |   | 2,407 |   |
| Network  assurance and fulfillment |   | 665                               |   | — |   |
| Custom                             |   | 335                               |   | 624 |   |
|                               |   | $                                 | 5,766  |   | $ | 8,591 |   |

 

 

**License Fees and Services**

 

License fees and servicesrevenue decreased 36% to $3.2 million for the three months ended March 31,2004, from $5.0 million for the three months ended March 31, 2003.  The decrease in license fees and servicesrevenue is mainly due to not having a contract in 2004 similar to a large LNPproject that was completed during the three months ended March 31, 2003 ofapproximately $1.6 million.  Because themarket for core LNP software is mature, large core LNP license sales have declinedbut we continue to make smaller sales of LNP software enhancements andfeatures.

 

**Customer Support**

 

Customer support revenuedecreased 29% to $2.5 million for the three months ended March 31, 2004, from$3.6 million for the three months ended March 31, 2003.  The decrease in customer support revenue forthe three months ended March 31, 2004 is primarily due to the aforementioneddeferral of revenue related to a large LNP arrangement, as well as pricingpressures from customers, partially offset by network assurance and fulfillmentsupport on products acquired in the CMS acquisition.

 

**Costs ofRevenue, Excluding Depreciation**

 

Costs of revenue, excluding depreciation, consistprimarily of personnel costs, offshore development subcontractor costs,facilities costs, the costs of third-party software and all other direct costsassociated with this personnel. Total costs of revenue, excluding depreciation,were $3.0 million and $3.2 million for the three months ended March31, 2004 and 2003, respectively.

 

**Costs of License Fees and Services, Excluding Depreciation**

 

Costs of license fees and services, excludingdepreciation, were $1.1 million and $1.9 million for the three monthsended March 31, 2004 and 2003, respectively. The decrease of $816,000, or 43%, was due to a reduction of labor hoursspent on license related software and services, as a result of fewer licenseprojects.  As a percentage of licensefees and services revenue, costs of license fees and services, excludingdepreciation, decreased to 33% for the three months ended March 31, 2004 from38% for the three months ended March 31, 2003. The decrease as a percentage of license fees and services revenues wasdue to the aforementioned decrease in costs, which was partially offset by thedecrease in license and services revenues.

 

**Costs of Customer Support, Excluding Depreciation**

 

Costs of customer support, excluding depreciation,were $1.9 million and $1.3 million for the three months ended March31, 2004 and 2003, respectively. The increase of $567,000, or 43%, is due toamortization of intangibles related to our acquisition of CMS in November 2003and increased hours worked on customer support projects to support theadditional product (“TDMS”) acquired from CMS. As a percentage of customer support revenue, costs of customer support,excluding depreciation, increased to 74% for the three months ended March 31,2004 from 36% for the three months ended March 31, 2003.  The increase as a percentage of customersupport revenue is due to the aforementioned increased costs as well asdecreased revenues in the first quarter of 2004 compared to 2003.

 

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**Salesand Marketing**

 

Sales and marketing expenses primarily consist ofcompensation costs, including bonuses and commissions, travel expenses, advertisingand occupancy expenses.  Sales andmarketing expenses were $936,000 and $705,000 for the three months ended March31, 2004 and 2003, respectively. The increase of $231,000, or 33%, is due toincreased employee-related costs and travel expenses related to our acquisitionof CMS in November 2003.  As apercentage of total revenue, sales and marketing expenses increased to 16% forthe three months ended March 31, 2004 from 8% for the three months ended March31, 2003.  The increase as a percentageof revenue is due to the aforementioned increase in expenses and decreasedrevenues in the first quarter of 2004 compared to 2003.

 

**Generaland Administrative**

 

General and administrative expenses consistprincipally of employee related costs and professional fees for the followingdepartments; facilities, finance, legal, human resources, and executivemanagement.  General and administrativeexpenses were $935,000 and $916,000 for the three months ended March 31, 2004and 2003, respectively.  The increase of$19,000, or 2%, is due to increased salary expense and professional fees,partially offset by decreased bonus expense. As a percentage of total revenue, general and administrative expensesincreased to 16% for the three months ended March 31, 2004 from 11% for thethree months ended March 31, 2003.  Theincrease as a percentage of revenue is mainly due to decreased revenues in thefirst quarter of 2004 compared to 2003.

 

**ProductDevelopment**

 

Product development expenses consist primarily ofemployee related costs, offshore development subcontractor expenses and coststo start up our offshore Indian facility. Product development expenses were $491,000 and $276,000 for the threemonths ended March 31, 2004 and 2003, respectively. The increase of $215,000,or 78%, is due to our continued work on development of our ***ServiceXpress*** toolkit, new features relatedto our traffic data management system, and costs related to the start up of ournewly formed Bangalore, India subsidiary. As a percentage of revenue, product development expenses increased to 8%for the three months ended March 31, 2004 from 3% for the three months endedMarch 31, 2003.  The increase as apercentage of revenue is due to the increased hours worked and decreasedrevenues in the first quarter of 2004 compared to 2003.

 

**Restructuringand Other Expense**

 

Restructuring and other expenses of $118,000 wererecorded for the three months ended March 31, 2003, in accordance with theCompany’s restructuring plan, as follows:

 

•                  *Work forcereductions.*  All work forcereductions related to our restructuring plan were completed in 2002. During thethree months ended March 31, 2003, we recorded a benefit of $13,000 related tothe adjustment of our liability.  AtMarch 31, 2004 there was no remaining liability related to these workforcereductions.

 

•                  *Closure ofsatellite offices.*  We closedall of our satellite field offices during the six months ended June 30,2002.  Estimated costs to sublease orterminate the lease commitments of $131,000 were recorded in the three monthsended March 31, 2003; the 2003 expense is related to an adjustment of ourestimate of our office closure liability due to lower than expected subleaseincome.  At March 31, 2004,approximately $119,000 was included in accounts payable and accruedliabilities, and approximately $37,000 was included in long-term obligationsrelated to these office closures, which will be paid over the remaining leaseterms, ranging from 7 months to 25 months.

 

**OtherIncome, Net**

 

Other income, net, was$57,000 and $47,000 for the three months ended March 31, 2004 and 2003,respectively.  The increase is due tohigher interest income as a result of increased cash balances for the threemonths ended March 31, 2004 compared to the comparable period in 2003.

 

**Income Taxes**

 

There was an income tax benefit of $8,000 for thethree months ended March 31, 2004, due to a refund that was collected on aprior year amended tax return, partially offset by the estimated current taxexpense.

 

**Liquidityand Capital Resources**

 

We have historically financed operations through cashflows from operations and equity transactions. At March 31, 2004, our principal source of liquidity was $21.3 millionin cash and cash equivalents, representing 53% of total assets.  Working capital at March 31, 2004 was $14.2million compared to $13.8 million at December 31, 2003.

 

During the three months ended March 31, 2004 our cashand cash equivalents increased to $21.3 million from $18.0 million at December31, 2003.  This increase is primarily aresult of approximately $3.6 million in cash provided by operations for thethree months

 

12

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ended March 31, 2004.  The cashgenerated from operating activities is mainly due to collections of ourcontract receivables.  The cash flowgenerated from the collection of contract receivables was partially offset by adecrease in our unearned revenue balance due to recognition of revenue on ourannual customer support agreements and delivery of licensed software and services.  Cash used by investing activities of$527,000 was primarily due to capital expenditures for internal hardware thatimproved performance and reliability of our product development environment.Cash provided by financing activities of $203,000 included proceeds related tothe exercise of approximately 100,000 stock options.

 

We believe that our current cash and cash equivalents,together with anticipated cash flows from operations will be sufficient to meetour working capital and capital expenditure requirements for at least the nexttwelve months. In making this assessment we considered the following:

 

•                  Our cash andcash equivalents balance at March 31, 2004 of $21.3 million.

 

•                  Ourprofitability in the last seven quarters and anticipated profitability duringthe remainder of 2004.

 

•                  Our currentexpense run rate.

 

•                  Our backlog ofapproximately $11.0 million, including $1.6 million in license fees andservices and $9.4 million in customer support at March 31, 2004.

 

Notwithstanding these assessments, we may requireadditional funds to support our business objectives through equity or debtfinancing. Specifically, additional funds may be needed to support our growththrough merger and acquisition. There can be no assurance that additionalfinancing will be available at all or that if available, such financing will beobtainable on terms favorable to us and would not be dilutive.

 

**FactorsThat Might Affect Operating Results**

 

These results should be read in conjunction with therisk factors defined in the Company’s Annual Report on Form 10-K for the yearended December 31, 2003. Statements contained in this Quarterly Report withrespect to future revenue and expenses are “forward-looking statements” withinthe meaning of Section 21E of the Securities Exchange Act of 1934, as amended.Actual results may differ. Among the factors that could cause actual results todiffer are those described below and in more detail in our Annual Report onForm 10-K.

 

Our operating results have fluctuated significantly inthe past and are likely to continue to fluctuate significantly in the future.Fluctuations in operating results may cause volatility in the price of ourcommon stock. These quarterly fluctuations may result from a number of factors,including:

 

•                  *Reliance onfew customers.*  A significantportion of our revenue and contracts receivable has been and is expected tocontinue to be derived from a small number of customers. Accordingly, the lossof any significant customer, delays in collections, delivery or acceptance ofany of our products or delays in the performance of services could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

•                  *Adversetrends in the telecommunications industry.*  Due to a major downturn in the telecommunications industry whichbegan in the second half of 2000 (and continues to the present), many of thecompanies in the telecommunications industry have declared bankruptcy, delayedpayments to their suppliers or delayed additional purchases.

 

•                  *Maturemarket for number portability products.*  The market for our number portability products is mature andthere can be no assurances that we will successfully identify new productopportunities or will achieve market acceptance of new products brought to themarket.  If our products do not performsatisfactorily, or if we have delays in product development, our business,financial condition and results of operations could be materially harmed.

 

•                  *QuarterlyFluctuations in Revenue as a Result of Revenue Recognition Rules.   *Manyof our contracts are for large, complex projects where software and servicesare provided over a period of many months. Recently, our customers have been requesting more customization of oursoftware and services to their exact needs. As a result, revenue recognition under our contracts may vary dependingupon the particular software revenue recognition rule that applies.  For example, we recently entered into acontract which contains customer support, services and software releases.Because of the applicability of certain accounting rules, we are required todefer the revenue under that contract until the software is accepted by thecustomer; the expenses incurred, however, must be accounted for as they occur.  This accounting treatment will have asignificant impact on our quarterly results of operation.

 

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•                  *Integrationof future acquisitions.* The integration of future acquisitions maypresent risks and we may be unable to achieve the product, financial orstrategic goals intended at the time of any acquisition. The risks we mayencounter in such transactions include:

 

•                  we may havedifficulty assimilating the operations and personnel of the acquired company;

 

•                  we may havedifficulty effectively integrating the acquired technologies or products withour current products and technologies;

 

•                  we may havedifficulty in maintaining controls, procedures and policies during thetransition and integration;

 

•                  customers of theacquired company may decide not to renew their contracts with the combinedentity and other ongoing business may be disrupted by transition andintegration issues;

 

•                  the financialand strategic goals for the acquired and combined businesses may not beachieved;

 

•                  due diligenceprocesses may fail to identify significant issues with product quality,intellectual property ownership, product architecture, legal and financialcontingencies, and product development;

 

•                  significant exitcharges may be sustained if products acquired in business combinations areunsuccessful;

 

•                  acquisitionsrequire considerable time and commitment of management, which can distractmanagement from day-to   day operationsand result in additional costs which reduce profits;

 

•                  we do not know ifwe will be able to identify and purchase assets and/or companies that willcomplement our business;

 

•                  we do not knowif we will be able to finance future acquisitions;

 

•                  certainmanagement and other employees of an acquired entity may be critical to thesuccess of the acquired company, and we do not know if we will be successful inretaining these individuals in the combined companies;

 

•                  we may incurimpairment charges in the future related to our goodwill and intangible assetsif we do not achieve our expected cash flows or growth rates;

 

•                  the price of ourstock may go down as stockholders receiving stock in connection with thetransaction, elect to sell their shares, or the marketplace does not favorablyview the transaction.

 

•                  *RisksAssociated with Offshore Development.*  We are currently in the process of staffing our Indian subsidiaryto provide software development services and maintenance services.  Any failure by us to transition the workcurrently being performed by our Indian subcontractor to our subsidiary or tootherwise manage our offshore development process could negatively impact ourability to satisfy our customer contracts.

 

Other factors that might affect operating results:

 

•                  the size of newcontracts and when they are signed; our rate of progress under our contracts;

•                  the timing ofcustomer and market acceptance of our products and service offerings;

•                  actual oranticipated changes in government laws and regulations related to thetelecommunications market;

•                  judicial oradministrative actions about these laws or regulations;

•                  the nature andpace of enforcement of the Telecommunications Act of 1996;

•                  productlifecycles;

•                  the mix ofproducts and services sold;

•                  changes indemand for our products and services;

•                  the timing ofthird-party contractors’ delivery of software and hardware;

•                  budgeting cyclesof our customers;

•                  changes in therenewal rate of support agreements;

•                  level and timingof expenses for product development and sales, general and administrativeexpenses;

•                  competition byexisting and emerging competitors in the telecommunications software markets;

 

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•                  our success indeveloping and selling new products, controlling cost, attracting and retainingqualified personnel and expanding our sales and customer focused programs;

•                  software defectsand other product quality problems;

•                  changes in ourstrategy;

•                  the extent ofindustry consolidation; and

•                  general economicconditions.

 

Our expense levels are based in significant part onour expectations regarding future revenue. Our revenue is difficult to forecastas the market for our products and services is rapidly evolving, and our salescycle and the size and timing of significant contracts vary substantially amongcustomers. Accordingly, we may be unable to adjust spending in a timely mannerto compensate for any unexpected shortfall in revenue. Any significantshortfall from anticipated levels of demand for our products and services couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

Based on all of the foregoing, we believe it ispossible for future revenue, expenses and operating results to varysignificantly from quarter to quarter. As a result, quarter-to-quarter comparisonsof operating results are not necessarily meaningful or indicative of futureperformance. Furthermore, we believe that it is possible that in any givenquarter, including the current quarter, our operating results could differ fromthe expectations of public market analysts or investors. In such event, or inthe event that adverse conditions prevail, or are perceived to prevail, withrespect to our business or generally, the market price of our common stockwould likely go down.

 

ITEM  3.  QUANTITATIVE AND QUALITATIVE MARKET RISKDISCLOSURES

 

**Foreign Exchange Risk**

 

Our international business in India is subject torisks, including, but not limited to, unique economic conditions, changes inpolitical climate, differing tax structures, other regulations andrestrictions, and foreign exchange rate volatility.  Accordingly, our future results could be adversely impacted bychanges in these or other factors.

 

**Interest Rate Risk**

 

In the ordinary course of business we are exposed tothe risk of changes in interest rates. Our cash balances are subject to interest rate fluctuations and as such,interest income amounts may fluctuate from current levels.

 

For additional information about Evolving Systems’risk factors see Evolving Systems’ Annual Report on Form 10-K for the yearended December 31, 2003.

 

ITEM 4.    CONTROLS AND PROCEDURES 

 

(a) Evaluation of disclosure controls and procedures. As of March 31, 2004, the end of the period covered by this report, we evaluated, under the supervision of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms.

 

(b) Changes in internal controls. During the period covered by this report, there were no significant changes in our internal controls or in other factors that could significantly affect our internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

##### **PART II**. OTHER INFORMATION

##### ** **

ITEM 1. LEGAL PROCEEDINGS

 

From time to time we are involved in various legalproceedings arising in the normal course of business operations.   We are currently not aware of any legal proceedingsthat would have a material effect on our business, financial condition orresults of operations.

 

15

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ITEM 2. CHANGES IN SECURITIES

 

None

 

ITEM 3. DEFAULTS ON SENIOR SECURITIES

 

None

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

None

 

ITEM 5. OTHER INFORMATION

 

None

 

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                  Exhibits

 

Exhibit 31.1 - Certification pursuant to Section 302of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 - Certification pursuant to Section 302of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 - Certification pursuant to Section 906of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 - Certification pursuant to Section 906of the Sarbanes-Oxley Act of 2002

 

(b)                                 Reportson Form 8-K

 

On January 9, 2004, wefurnished a Current Report on Form 8-K listing the executive officers of theCompany effective January 1, 2004.

 

On January 21, 2004, wefiled a Current Report on Form 8-K updating our Management’s Discussion andAnalysis of Financial Condition and the Financial Statements and FinancialStatement Schedule from our Annual Report on Form 10-K for the fiscal yearended December 31, 2002, which was originally filed on March 28,2003. This update was due to the changes in segment reporting and relatedchanges in revenue and related costs of revenue classifications beginning withthe Company’s Form 10-Q for the quarterly period ended March 31, 2003.

 

On February 4, 2004, wefurnished a Current Report on Form 8-K announcing our bookings for the fourthquarter of 2003 and reaffirming our 2003 guidance.

 

On March 8, 2004, wefurnished a Current Report on Form 8-K announcing that:

 

•                  On February 23, 2004, Thaddeus Dupperwas named Vice-President of Sales and Business Development.

 

•                  On March 4, 2004, Donald R. Dixonresigned from the Board of Directors and on March 5, 2004, Robert J. Loarieresigned from the Board of Directors. Both Mr. Dixon and Mr. Loariejoined the Board in 1996. During 2003, the firms which they represented distributedtheir shares in the Company. The Board of Directors has filled the positionvacated by Mr. Dixon (see below) and is currently seeking to fill thevacancy resulting from Mr. Loarie’s resignation.

 

•                  On March 4, 2004, the Companyappointed David J. Nicol to the Board of Directors, to serve until the 2006Annual Meeting of Stockholders and until his successor is elected and hasqualified, or until his earlier death, resignation or removal.

 

•                  Effective March 12, 2004,Patrick Shane Furlong, Vice President, Principal—Consulting Practice, hasresigned from the Company.

 

OnMarch 8, 2004, we furnished a Current Report on Form 8-K announcing ourfinancial results for the calendar year 2003 and fourth quarter of 2003.

 

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On March 19, 2004, we furnished a Current Report onForm 8-K that Steve B. Warnecke, a member of the Board of Directors of theCompany entered into an agreement to sell up to 18,366 common shares of theCompany owned by Mr. Warnecke over a period commencing March 15, 2004 andending March 15, 2005.

 

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###### **SIGNATURES**

###### ** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Date: May 10, 2004 | /s/ BRIAN R. ERVINE                                                                 |   |
|--------------------|-------------------------------------------------------------------------------------|--------|
|               | Brian R. Ervine                                                                     |
|               | Senior Vice President, Chief  Financial Officer, Treasurer and  Assistant Secretary |
|               | (Principal Financial and Accounting Officer)                                        |

 

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