**UNITED STATES****SECURITIES AND EXCHANGECOMMISSION****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  September 30, 2004**                                                                                                           |
|                                                                                                                                                             |
| **OR**                                                                                                                                                           |
| ** **                                                                                                                                                       |
| o                                                                                                                                                                | ** ** | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934** |
|                                                                                                                                                             |
| **For the transition period from             to           ** |
|                                                                                                                                                             |
| **Commission File Number: 0-24081**                                                                                                                              |

 

**EVOLVING SYSTEMS, INC.**(Exact name of registrant as specified in itscharter)

** **

| **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)

 

                Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes ý  No o

 

                Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).  Yes o  No ý

 

                Asof November 3, 2004 there were 15,976,059 shares outstanding of Registrant’sCommon Stock (par value $0.001 per share).

 

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**September 30, 2004**

**Table of Contents**

 

 
| **PART I**              | **FINANCIAL INFORMATION**                                                                                                |   |
|-------------------------|--------------------------------------------------------------------------------------------------------------------------|--------|
|                    |                                                                                                                     |   |
| Item 1.                 | Financial Statements                                                                                                     |   |
|                    |                                                                                                                     |   |
|                    | Consolidated Balance  Sheets (Unaudited) as of September 30, 2004 and December 31, 2003                        |   |
|                    |                                                                                                                     |   |
|                    | Consolidated  Statements of Operations (Unaudited) for the Three and Nine Months Ended  September 30, 2004 and 2003 |   |
|                    |                                                                                                                     |   |
|                    | Consolidated  Statements of Cash Flows (Unaudited) for the Nine Months Ended  September 30, 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                                                                                        |   |
|                    |                                                                                                                     |   |
| Signature               |                                                                                                                     |

 

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PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

**EVOLVING SYSTEMS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **2004**          | ** ** | **2003**         | ** ** |
| **ASSETS**                                                                                                                                                                                      |       |              |       |             |       |
| Current assets:                                                                                                                                                                                 |       |              |       |             |       |
| Cash and cash equivalents                                                                                                                                                                       |       | $                 | 20,692     |             | $          | 17,999 |   |
| Current portion of restricted cash                                                                                                                                                              |       | 100               |       | 100              |       |
| Contract receivables, net of allowance of $44 and $65 at September 30,  2004 and December 31, 2003, respectively                                                                      |       | 2,209             |       | 9,292            |       |
| Unbilled work-in-progress                                                                                                                                                                       |       | 31                |       | 622              |       |
| Prepaid and other current assets                                                                                                                                                                |       | 1,167             |       | 868              |       |
| Total current assets                                                                                                                                                                            |       | 24,199            |       | 28,881           |       |
| Property and equipment, net                                                                                                                                                                     |       | 1,851             |       | 1,579            |       |
| Intangible assets, net                                                                                                                                                                          |       | 3,199             |       | 3,845            |       |
| Goodwill                                                                                                                                                                                        |       | 6,955             |       | 6,996            |       |
| Long-term restricted cash                                                                                                                                                                       |       | 400               |       | 400              |       |
| Total assets                                                                                                                                                                                    |       | $                 | 36,604     |             | $          | 41,701 |   |
|                                                                                                                                                                                            |       |              |       |             |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                  |       |              |       |             |       |
| Current liabilities:                                                                                                                                                                            |       |              |       |             |       |
| Current portion of long-term obligations                                                                                                                                                        |       | $                 | 31         |             | $          | 29 |   |
| Accounts payable and accrued liabilities                                                                                                                                                        |       | 2,739             |       | 3,044            |       |
| Unearned revenue                                                                                                                                                                                |       | 6,265             |       | 11,972           |       |
| Total current liabilities                                                                                                                                                                       |       | 9,035             |       | 15,045           |       |
| Long-term obligations                                                                                                                                                                           |       | 133               |       | 183              |       |
| Total liabilities                                                                                                                                                                               |       | 9,168             |       | 15,228           |       |
| Commitments and contingencies                                                                                                                                                                   |       |              |       |             |       |
| Stockholders’ equity:                                                                                                                                                                      |       |              |       |             |       |
| Common stock, $0.001 par value; 25,000,000 shares authorized; 15,963,809  and 15,778,540 shares issued and outstanding as of September 30, 2004  and December 31, 2003, respectively. |       | 16                |       | 16               |       |
| Additional paid-in capital                                                                                                                                                                      |       | 67,719            |       | 67,342           |       |
| Other comprehensive loss                                                                                                                                                                        |       | (7                | )          | —           |       |
| Accumulated deficit                                                                                                                                                                             |       | (40,292           | )          | (40,885          | )          |
| Total stockholders’ equity                                                                                                                                                                 |       | 27,436            |       | 26,473           |       |
| Total liabilities and stockholders’ equity                                                                                                                                                 |       | $                 | 36,604     |             | $          | 41,701 |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

1

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**EVOLVING SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands except per share data)**

**(unaudited)**

** **
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUE**                                                |       |                                       |       |                                      |       |   |   |   |   |
| License fees and services                                  |       | $                                          | 810        |                                      | $          | 3,948 |   | $ | 6,412 |   | $ | 12,133 |   |
| Customer support                                           |       | 4,929                                      |       | 3,200                                     |       | 10,354 |   | 10,045 |   |
| Total revenue                                              |       | 5,739                                      |       | 7,148                                     |       | 16,766 |   | 22,178 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                |       |                                       |       |                                      |       |   |   |   |   |
| Costs of license fees and services, excluding depreciation |       | 817                                        |       | 1,140                                     |       | 3,028 |   | 4,321 |   |
| Costs of customer support, excluding depreciation          |       | 2,011                                      |       | 1,427                                     |       | 5,906 |   | 4,401 |   |
| Sales and marketing                                        |       | 942                                        |       | 684                                       |       | 2,779 |   | 2,109 |   |
| General and administrative                                 |       | 1,100                                      |       | 891                                       |       | 2,969 |   | 2,742 |   |
| Product development                                        |       | 152                                        |       | 568                                       |       | 884 |   | 1,224 |   |
| Depreciation                                               |       | 272                                        |       | 269                                       |       | 811 |   | 918 |   |
| Restructuring and other expenses                           |       | —                                     |       | —                                    |       | — |   | 38 |   |
| Total costs of revenue and operating expenses              |       | 5,294                                      |       | 4,979                                     |       | 16,377 |   | 15,753 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Income from operations                                     |       | 445                                        |       | 2,169                                     |       | 389 |   | 6,425 |   |
| Other income, net                                          |       | 92                                         |       | 41                                        |       | 216 |   | 137 |   |
| Income before income taxes                                 |       | 537                                        |       | 2,210                                     |       | 605 |   | 6,562 |   |
| Provision for income taxes                                 |       | 20                                         |       | 126                                       |       | 12 |   | 126 |   |
| Net income                                                 |       | $                                          | 517        |                                      | $          | 2,084 |   | $ | 593 |   | $ | 6,436 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| **Basic income per common share**                          |       | $                                          | 0.03       |                                      | $          | 0.15 |   | $ | 0.04 |   | $ | 0.46 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| **Diluted income per common share**                        |       | $                                          | 0.03       |                                      | $          | 0.12 |   | $ | 0.03 |   | $ | 0.41 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average basic shares outstanding                  |       | 15,890                                     |       | 14,318                                    |       | 15,860 |   | 13,880 |   |
| Weighted average diluted shares outstanding                |       | 16,906                                     |       | 16,893                                    |       | 17,378 |   | 15,556 |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

2

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**EVOLVING SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |                                      |       |   |   |
| Net income                                                                         |       | $                                         | 593        |   | $ | 6,436 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                      |       |   |   |
| Depreciation                                                                       |       | 811                                       |       | 918 |   |
| Amortization of intangible assets                                                  |       | 646                                       |       | — |   |
| Loss on impairment and disposal of property and equipment                          |       | (3                                        | )          | (5 | ) |
| Bad debt recovery                                                                  |       | (21                                       | )          | (61 | ) |
| Change in operating assets and liabilities:                                        |       |                                      |       |   |   |
| Contract receivables                                                               |       | 7,104                                     |       | 10,214 |   |
| Unbilled work-in-progress                                                          |       | 591                                       |       | (291 | ) |
| Prepaid and other assets                                                           |       | (302                                      | )          | (97 | ) |
| Accounts payable and accrued liabilities                                           |       | (304                                      | )          | (1,010 | ) |
| Unearned revenue                                                                   |       | (5,707                                    | )          | (8,192 | ) |
| Long-term obligations                                                              |       | (27                                       | )          | 42 |   |
| Net cash provided by operating activities                                          |       | 3,381                                     |       | 7,954 |   |
|                                                                               |       |                                      |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                      |       |   |   |
| Purchase of property and equipment                                                 |       | (1,087                                    | )          | (301 | ) |
| Proceeds from sale of property and equipment                                       |       | 5                                         |       | 7 |   |
| Cash acquired in acquisition, net of cash paid                                     |       | 41                                        |       | — |   |
| Net cash used in investing activities                                              |       | (1,041                                    | )          | (294 | ) |
|                                                                               |       |                                      |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                      |       |   |   |
| Capital lease payments                                                             |       | (21                                       | )          | (25 | ) |
| Proceeds from the issuance of stock                                                |       | 377                                       |       | 1,109 |   |
| Net cash provided by financing activities                                          |       | 356                                       |       | 1,084 |   |
|                                                                               |       |                                      |       |   |   |
| **EFFECT OF EXCHANGE RATES ON CASH**                                               |       | (3                                        | )          | — |   |
|                                                                               |       |                                      |       |   |   |
| Net increase in cash and cash equivalents                                          |       | 2,693                                     |       | 8,744 |   |
| Cash and cash equivalents at beginning of period                                   |       | 17,999                                    |       | 8,601 |   |
| Cash and cash equivalents at end of period                                         |       | $                                         | 20,692     |   | $ | 17,345 |   |
|                                                                               |       |                                      |       |   |   |
| Supplemental disclosure of other cash and non-cash financing  transactions:        |       |                                      |       |   |   |
| Interest paid                                                                      |       | $                                         | 12         |   | $ | 14 |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

 

3

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**EVOLVINGSYSTEMS, INC.**

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

*InterimConsolidated Financial Statements*. The accompanying consolidated financialstatements of Evolving Systems, Inc. (“Evolving Systems” or the “Company”) havebeen prepared pursuant to the rules and regulations of the Securities andExchange Commission (“SEC”).  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) have been condensed or omitted pursuant tosuch rules and regulations. However, management believes that the disclosuresincluded in these financial statements are adequate to make the informationpresented not misleading. The unaudited consolidated financial statementsincluded in this document have been prepared on the same basis as the annualconsolidated financial statements, and in management’s opinion, reflect alladjustments, which include normal recurring adjustments, necessary for a fairpresentation in accordance with GAAP. The results for the three and nine monthsended September 30, 2004 are not necessarily indicative of the results that theCompany will have for any subsequent quarter or full fiscal year.  These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and the notes to those statements for the year ended December 31,2003 included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

*Use of Estimates*. Thepreparation of financial statements in conformity with GAAP requires theCompany’s management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period. Actual results could differfrom those estimates.

 

*Foreign Currency Translation*. The rupee isthe functional currency for the Company’s Indian subsidiary. The Companytranslates asset and liability accounts to the U.S. dollar based on theexchange rate as of the balance sheet date, while statement of operations andcash flow statement amounts are translated to the U.S. dollar at theaverage exchange rate for the period. Exchange gains or losses resulting fromsuch translation are included as a separate component of stockholders’ equity.Transaction gains and losses are recognized in income during the period inwhich they occur. During the three and nine months ended September 30, 2004,the Company recognized a net transaction loss of approximately $1,000 and$3,000, respectively.

 

*Comprehensive Income*. The Company’scomprehensive income (loss) is comprised of its net income (loss) and foreigncurrency translation adjustment.  For the three and nine months endedSeptember 30, 2004, total comprehensive income was $517,000 and $586,000,respectively. For the three and nine months ended September 30, 2003,comprehensive income equaled net income of $2.1 million and $6.4 million,respectively, as there were no foreign currency translation adjustments duringthe periods.

 

*                Principles ofConsolidation*. Theconsolidated financial statements include the accounts of the Company and itssubsidiaries.  All significantinter-company transactions and balances have been eliminated.

 

*Revenue Recognition.*The Company derives revenue from two primary sources: licensefees/services and customer support.  Werecognize revenue in accordance with Statements of Position, or SOP 97-2 “SoftwareRevenue Recognition,” as amended and interpreted by SOP 98-9, “Modification ofSOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.”In addition we have adopted Staff Accounting Bulletin, or SAB, No. 104, “RevenueRecognition,” which provides further interpretive guidance for public companieson the recognition, presentation and disclosure of revenue in financialstatements.

 

                Themajority of our license fees and services revenue is generated from fixed-pricecontracts which provide for both licenses to our software products andservices. Revenue under these arrangements, where the services are essential tothe functionality of the delivered software, is recognized using thepercentage-of-completion method of accounting, in accordance with SOP 97-2 andSOP 81-1, “Accounting for Long-Term Construction Type Contracts.” Thepercentage of completion for each contract is determined based on the ratio ofdirect labor hours incurred to total estimated direct labor hours. Due to thefact that the estimated direct labor hours can have a significant impact onrevenue recognition, these estimates are critical and are reviewed bymanagement regularly. Amounts billed in advance of services being performed arerecorded as unearned revenue. Unbilled work-in-progress represents revenueearned but not yet billable under the terms of the fixed-price contractsand all such amounts are expected to be billed and collected during thesucceeding 12 months.

 

                Inarrangements where the services are not essential to the functionality of thedelivered software, we recognize license revenue when a license agreement hasbeen signed, delivery has occurred, the fee is fixed or determinable andcollectibility is reasonably assured. Where applicable, fees from multipleelement arrangements are unbundled and recorded as revenue as the elements aredelivered to the extent that vendor specific objective evidence (“VSOE”) offair value exists. If VSOE for the undelivered elements does not exist, fees

 

4

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from such arrangements are deferred until the earlier ofthe date that VSOE does exist on the undelivered elements or all of theelements have been delivered.

 

                Servicesrevenue provided under fixed-price contracts is generally recognizedusing the percentage-of-completion method of accounting described above.Revenue from professional services provided pursuant to time-and-materialscontracts and training services are recognized as the services are performed,as that is when our obligation to our customers under such arrangements isfulfilled.

 

                Customersupport and maintenance revenue is generally recognized ratably over theservice contract period. When maintenance or training services are bundled withthe original license fee arrangement, their fair value, based upon VSOE, isdeferred and recognized during the periods such services are provided.

 

                We may encounter budget and schedule overruns onfixed price contracts caused by increased material, labor or overhead costs.Adjustments to cost estimates are made in the periods in which the factsrequiring such revisions become known. Estimated losses, if any, are recordedin the period in which current estimates of total contract revenue and contractcosts indicate a loss.

 

**(2)  Earnings Per Common Share**

 

Basicearnings per common share (“EPS”) is computed by dividing net income by theweighted average number of common shares outstanding during the period. DilutedEPS is computed using the weighted average number of common shares plus alldilutive potential common shares outstanding during the period using thetreasury stock method unless the effect of the potential common shares isanti-dilutive.

 

                The reconciliation of basic and diluted weightedaverage common shares outstanding is as follows (in thousands):

 
| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Basic weighted average common shares outstanding     |       | 15,890                                     |       | 14,318                                    |       | 15,860 |   | 13,880 |   |
| Effect of dilutive securities - options and warrants |       | 1,016                                      |       | 2,575                                     |       | 1,518 |   | 1,676 |   |
| Diluted weighted average common shares outstanding   |       | 16,906                                     |       | 16,893                                    |       | 17,378 |   | 15,556 |   |

 

Optionsto purchase 442,000 and 409,000 shares of common stock were excluded from thedilutive stock calculation for the three and nine months ended September 30,2004, respectively, because their exercise prices were greater than the averagefair value of the Company’s stock for the period.

 

Optionsto purchase 3,900 and 166,000 shares of common stock were excluded from thedilutive common stock calculation for the three and nine months ended September30, 2003, respectively, because their exercise prices were greater than theaverage fair value of the Company’s stock for the period.

 

**(3)Stock-Based Compensation**

 

**               **The Company has elected tofollow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees,” or APB No. 25, and related interpretations in accounting for itsemployee stock options.  Under APB No.25, because the exercise price of the Company’s employee stock options isgenerally equal to the market price of the underlying stock on the date of thegrant, no compensation expense is recognized. Statements of Financial Accounting Standards No. 123, “Accounting forStock-Based Compensation” or SFAS No. 123, establishes an alternative method ofexpense recognition for stock-based compensation awards to employees based onestimated fair values.  The Companyelected not to adopt SFAS No. 123 for expense recognition purposes.

 

                In accordance with the interim disclosure provisionsof Statement of Financial Accounting Standards, or SFAS No. 148, “Accountingfor Stock Based Compensation Transition and Disclosure-an Amendment of SFAS No.123,” the pro forma effect on the Company’s net income had compensation expensebeen recorded for the three and nine months ended September 30, 2004 and 2003,respectively, as determined under the fair value method, as prescribed in SFASNo. 123, is shown below (in thousands, except per share data);

 

5

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| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income as reported                                       |       | $                                          | 517        |                                      | $          | 2,084 |   | $ | 593 |   | $ | 6,436 |   |
| Stock based compensation expense under the fair value method |       | (513                                       | )          | (1,169                                    | )          | (1,487 | ) | (2,345 | ) |
| Pro forma net income (loss)                                  |       | $                                          | 4          |                                      | $          | 915 |   | $ | (894 | ) | $ | 4,091 |   |
| Net income per common share as reported:                     |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                        |       | $                                          | 0.03       |                                      | $          | 0.15 |   | $ | 0.04 |   | $ | 0.46 |   |
| Diluted                                                      |       | $                                          | 0.03       |                                      | $          | 0.12 |   | $ | 0.03 |   | $ | 0.41 |   |
| Pro forma net income (loss)                                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                        |       | $                                          | 0.00       |                                      | $          | 0.06 |   | $ | (0.06 | ) | $ | 0.29 |   |
| Diluted                                                      |       | $                                          | 0.00       |                                      | $          | 0.05 |   | $ | (0.06 | ) | $ | 0.26 |   |

 

**(4) Concentration of Credit Risk**

 

For thethree months ended September 30, 2004, the Company recognized 72% (47%, 14% and11%) of total revenue from three significant customers (defined as contributingat least 10%), all in the telecommunications industry.  For the three months ended September 30, 2003,the Company recognized 75% (25%, 20%, 19% and 11%), of total revenue from foursignificant customers, all in the telecommunications industry.

 

For thenine months ended September 30, 2004, the Company recognized 72% (24%, 18%, 17%and 13%) of total revenue from four significant customers, all in thetelecommunications industry.  For thenine months ended September 30, 2003, the Company recognized 64% (24%, 23% and17%) of total revenue from three significant customers, all in thetelecommunications industry.

 

                As of September 30, 2004, three significant customersaccounted for approximately 80% (40%, 25% and 15%) of contractreceivables.  At December 31, 2003, threesignificant customers accounted for approximately 75% (34%, 29% and 12%) ofcontract receivables.

 

                The loss of, or financial difficulty of, any of thesesignificant customers could have a significant adverse effect on the Company’sfuture results of financial operations and financial position.

 

**(5) Income Taxes**

 

Asof September 30, 2004 and December 31, 2003, the Company continued to maintain a full valuation allowanceon the balance of its net deferred tax asset due to the uncertainties relatedto the Company’s ability to utilize its net deferred tax asset.  The Company’s assessment of this valuationallowance was made using all available evidence, both positive and negative. Inparticular, the Company considered both its historical results and itsprojections of profitability.  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 on a more likely than not basis.  This assessment is made periodically, andfuture assessments could result in a conclusion that all or a portion of thenet deferred tax asset is realizable.

 

**(6) Restructuring and Other Expenses**

 

              Inearly 2002, management implemented a restructuring plan (the “Plan”) due to thedownturn in the telecommunications industry, the Company’s sharp decline in revenue,the FCC’s delay in ruling on wireless number portability and otherfactors.  The Plan included workforcereductions, restructuring of the Company’s headquarters building lease, theclosure of its satellite field offices and the write down of certain fixedassets, all of which were executed in 2002. At September 30, 2004 and December31, 2003, the remaining accrual related to the closure of the satelliteoffices.

 

*              Closureof satellite offices.*  The Company closed all of its satellite fieldoffices during 2002.  Because the coststo sublease or terminate these lease commitments are based on estimates, theCompany may incur additional costs related to the satellite office closures.  As of September 30, 2004 approximately$91,000 was included in accounts payable and accrued liabilities, andapproximately $21,000 was included in long-term obligations, related to theclosure of the satellite offices.

 

              Thefollowing table summarizes the change in the accrual balance since December 31,2003 (in thousands):

 

 

6

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| ** **                         | ** ** | **Closure of  Satellite  Offices** | ** ** |
|------------------------------------|------------|------------------------------------|------------|
| Accrual balance December 31, 2003  |       | $                                  |  175  |   |
| 1st quarter cash payments, net     |       | (19                                | )          |
| Accrual balance March 31, 2004     |       | 156                                |       |
| 2nd quarter cash payments, net     |       | (27                                | )          |
| Accrual balance June 30, 2004      |       | 129                                |       |
| 3rd quarter cash payments, net     |       | (17                                | )          |
| Accrual balance September 30, 2004 |       | $                                  |  112  |   |

 

**(7) Segment Information**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterprise andRelated Information,” the Company defines operating segments as components ofan enterprise for which separate financial information is available.  This information is reviewed regularly by thechief operating decision-maker, or decision-making group, to evaluateperformance and to make operating decisions. The Company has identified itsChief Executive Officer and Chief Financial Officer as its chief operatingdecision makers. These chief operating decision makers review revenues bysegment and review overall results of operations.

 

TheCompany currently operates its business as two operating segments based onrevenue type: license fees/services revenue and customer support revenue (asshown on the Consolidated Statements of Operations).  Licensefees and services revenue represents the fees received from the license ofsoftware products and those services directly related to the delivery of thelicensed products as well as custom development, integration services and timeand materials work.  Customer support revenue includes annual support fees, recurringmaintenance fees, fees for maintenance upgrades and warranty fees.  Warranty services are typically bundled witha license sale and the related revenue, based on VSOE, is deferred andrecognized ratably over the warranty period. The Companyprovides products and services solely within the United States geographic area,although it does have a product development facility in Bangalore, India.  Total assets by segment have not beenspecified because the information is not available to the chief operatingdecision-making group.

 

Revenueand costs of revenue information by segments are as follows (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                        | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Revenue**                                       | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and services                         |       | $                                          | 810        |                                      | $          | 3,948 |   | $ | 6,412 |   | $ | 12,133 |   |
| Customer support                                  |       | 4,929                                      |       | 3,200                                     |       | 10,354 |   | 10,045 |   |
|                                              |       | 5,739                                      |       | 7,148                                     |       | 16,766 |   | 22,178 |   |
|                                              |       |                                       |       |                                      |       |   |   |   |   |
| **Segment profit (loss), excluding depreciation** |       |                                       |       |                                      |       |   |   |   |   |
| License fees and services                         |       | (7                                         | )          | 2,808                                     |       | 3,384 |   | 7,812 |   |
| Customer support                                  |       | 2,918                                      |       | 1,773                                     |       | 4,448 |   | 5,644 |   |
|                                              |       | 2,911                                      |       | 4,581                                     |       | 7,832 |   | 13,456 |   |
|                                              |       |                                       |       |                                      |       |   |   |   |   |
| Other operating expenses                          |       | 2,194                                      |       | 2,143                                     |       | 6,633 |   | 6,075 |   |
| Depreciation                                      |       | 272                                        |       | 269                                       |       | 810 |   | 918 |   |
| Restructuring and other expense (benefit)         |       | —                                     |       | —                                    |       | — |   | 38 |   |
| Income from operations                            |       | $                                          | 445        |                                      | $          | 2,169 |   | $ | 389 |   | $ | 6,425 |   |

 

**(8) Commitments and Contingencies**

 

                Aspermitted under Delaware law, the Company has agreements with its officers anddirectors under which it agrees to indemnify them for certain events oroccurrences while the officer or director is, or was, serving at our request inthis capacity.  The term of theindemnification period is indefinite. There is no limit on the amount of future payments the Company could berequired to make

 

7

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under these indemnification agreements; however, itmaintains Directors’ and Officers’ insurance policies, as well as an EmploymentPractices Liability Insurance Policy, that may enable it to recover a portionof any future amounts paid. As a result of the Company’s insurance policycoverage, it believes the estimated fair value of these indemnificationagreements is minimal.  Accordingly, theCompany has no liabilities recorded for these agreements as of September 30,2004 and December 31, 2003.

                TheCompany subcontracts some of the development of deliverables under its customercontracts and it could be required to indemnify its customers for workperformed 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’s software arrangements generally includea product indemnification provision that will indemnify and defend a customer inactions brought against the customer that claim the Company’s products infringeupon a copyright, trade secret, or valid patent. Historically, the Company hasnot incurred any significant costs related to product indemnification claims,and as a result, does not maintain a reserve for such exposure.

                TheCompany enters into standard indemnification terms with its customers in theordinary course of business under which it agrees to indemnify its customersfor certain claims arising from performance under its contracts.  As these represent guarantees of its ownperformance, no liability has been recognized under FASB Interpretation (“FIN”)45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others.”

 

**(9)  Business Combination**

                OnNovember 3, 2003, the Company acquired all of the outstanding shares ofprivately-held CMS Communications, Inc. (“CMS”) of Columbus, Ohio in exchangefor 732,773 shares of Evolving Systems’ common stock.  The acquisitionwas accounted for using the purchase method of accounting and accordingly, theassets acquired and liabilities assumed were recorded at their respective fairvalues as of the acquisition date.  Theresults of CMS’ operations have been included in the consolidated financialstatements since the purchase date.

 

                CMSwas a provider of network management operations support software for majortelecommunications carriers.  In additionto adding complementary products and sharing many common customers, CMS broughta workforce that has experience with complex tier one telecommunicationssolutions. CMS’ network management products fit the Company’s solutionsbusiness model and provide the Company with additional opportunities to providesolutions to its tier one customers.

 

                Theaggregate purchase price of approximately $11.2 million included the issuanceof 732,773 shares of Evolving Systems, Inc. common stock in exchange for alloutstanding shares of CMS.  The fairvalue of Evolving Systems’ common stock was determined using an average priceof approximately $14.98 in accordance with EITF 99-12, “Determination of theMeasurement Date for the Market Price of Acquirer Securities Issued in aPurchase Business Combination,” which was the average closing price a few daysbefore and after the merger agreement.

 

**                ProForma Financial Information**

 

**               **The financial information in the table belowsummarizes the combined results of operations of Evolving Systems and CMS, on apro forma basis, as though the companies had been combined as of the beginningof the period presented below.  This proforma financial information is presented for informational purposes only and isnot necessarily indicative of the results of operations that would have beenachieved had the acquisition actually taken place as of the beginning of theperiod presented below.  The followingamounts are in thousands, except per share amounts.

 
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2003**                                   | ** ** | **2003**                                  | ** ** |
| Revenues                                    |       | $                                          | 7,917      |                                      | $          | 24,681 |   |
| Net income                                  |       | $                                          | 1,928      |                                      | $          | 6,133 |   |
|                                        |       |                                       |       |                                      |       |
| Weighted average basic shares outstanding   |       | 14,978                                     |       | 14,540                                    |       |
| Weighted average diluted shares outstanding |       | 17,626                                     |       | 16,289                                    |       |
|                                        |       |                                       |       |                                      |       |
| Basic income per share                      |       | $                                          | 0.14       |                                      | $          | 0.42 |   |
| Diluted income per share                    |       | $                                          | 0.12       |                                      | $          | 0.38 |   |

 

8

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#### **(10) Goodwill and Intangible Assets**

#### ** **

                During 2003, the Companyacquired goodwill and intangible assets as a result of its acquisition ofCMS.  Amortization of identifiable intangibles are expensed as “costs oflicense fees and services, excluding depreciation” and “costs of customersupport, excluding depreciation”. As ofSeptember 30, 2004 goodwill was $7.0 million and in accordance with SFAS No.142, will not be amortized but is subject to an annual impairment test toensure that an impairment of the carrying amount of the goodwill has notoccurred.  The goodwill is assessed forimpairment on an annual basis at the reporting unit level by applying a fair-value-basedtest. The Company’s annual impairment test was conducted as of July 31, 2004,and it was determined that goodwill was not impaired as of the test date.Additionally, goodwill is assessed for impairment at each reporting period endif certain events have occurred indicating that an impairment may haveoccurred. No events have occurred that management believes may have impairedgoodwill. Goodwill was reduced by $41,000 during the nine months endedSeptember 30, 2004, due primarily to distribution of the cash escrow account tothe Company in accordance with the acquisition agreement with CMS.

 

#### **(11) Subsequent Events**

#### ** **

                On October 15, 2004, the Company acquired privately-held TelecomSoftware Enterprises, LLC (“TSE”) for $1.5 million in cash plus a short-termnote payable of approximately $889,000.  TheCompany agreed to pay additional consideration of up to $3.5 million contingentupon the achievement of certain specified revenue and gross margin results. Upto $2.5 million of the contingent consideration may be payable over a 24 monthperiod from the closing date and additional contingent consideration of up to$1 million may be paid through the year 2011 if certain specified sales of TSEproducts occur. The acquisition will be treated as a purchase businesscombination and the results of operations will be combined from the purchasedate forward. This acquisition will result in amortizable intangible assets andgoodwill.

 

                OnNovember 2, 2004, the Company acquired UK-based Tertio Telecoms, Ltd., (“Tertio”)a privately held supplier of operations support systems (OSS) softwaresolutions to communication carriers throughout Europe, the Middle East, Africaand Asia.  Total GAAP consideration forTertio approximates $42.0 million, consisting of $11.0 million incash, approximately $16.0 million in seller-financed notes, approximately $13.5million in convertible preferred stock and approximately $1.5 million inestimated transaction-related costs. A portion of the seller-financed notes maybe exchanged for a convertible note at the option of the sellers. Such actionwould require a shareholder vote. In accordance with relevant accounting rules, sincethe preferred stock is convertible into shares of common stock at aconversion price of $3.50 per share, which was less than the market priceof the stock of $4.64 on the closing date, the Company will record a non-cashcharge related to the discount of the shares of approximately $3.3 million.This charge will have the effect of reducing net income applicable to commonshareholders.  Because we could berequired to redeem the Series B Convertible Preferred Stock in certaincircumstances, we will reflect the carrying amount of the Series B PreferredStock in the "mezzanine" section of our balance sheet. Theacquisition will be treated as a purchase business combination and the resultsof operations will be combined from the purchase date forward. This acquisitionwill result in significant amortizable intangibles and goodwill.

 

                These two acquisitions havereduced the Company’s working capital by approximately $17.4 million.  Inaddition to the $17.4 million cash outflows, the Company expects transactioncosts related to the acquisitions to approximate $1.5 million, most of whichshould be paid out in the fourth quarter of 2004 and the first quarter of 2005.  As a result of these transactions, theCompany expects to report significantly lower levels of working capital in thefuture than it has in the recent past. Management believes that the currentcash and cash equivalents, together with anticipated cash flows fromoperations, will be sufficient to meet working capital and capital expenditurerequirements for at least the next twelve months.

 

ITEM 2.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW

 

*This Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontains forward-looking statements that have been made pursuant to theprovisions of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based oncurrent 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 similar expressions areintended 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.  Risks and uncertainties of our*

 

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*business include those set forthin the Company’s Annual Report on Form 10-K for the year ended December 31,2003 under “Risk Factors” on pages 8 through 13 as well as additional risksdescribed in this Form 10-Q.  Unlessrequired by law, we undertake no obligation to update publicly anyforward-looking statements, whether as a result of new information, futureevents, or otherwise.  However, readersshould carefully review the risk factors set forth in other reports ordocuments the Company files from time to time with the Securities and ExchangeCommission, particularly the Quarterly Reports on Form 10-Q and any CurrentReports on Form 8-K.*

 

                EvolvingSystems, Inc. (“we”, “our”, “us”) is a provider of mission critical andcost-effective software solutions to tier one telecommunications companies. Wemaintain long-standing relationships with many of the largest wireline andwireless telecommunications providers in the United States. Our customers relyon us to develop, deploy, enhance, maintain and integrate complex, highlyreliable software solutions for a range of Operations Support Systems (“OSS”)and Network Support Systems (“NSS”). Our customers include four of the largestwireline carriers in North America, representing approximately 90 percent ofU.S. access lines, and four wireless carriers, representing more than 20percent of U.S. wireless subscribers. We offer software products and solutionsthat enable our customers to comply with government-mandated requirementsregarding local number portability (“LNP”) for wireline, and wireless numberportability (“WNP”). The principal products in this area perform ordering andprovisioning functions.  The acquisitionof TSE in October 2004 adds LNP and WNP ordering and provisioning testingproducts. These testing products also provide new OSS system integrationcapabilities. We also offer inventory and assignment software which supportscarriers’ compliance with the government phone number conservation mandates. Inaddition, we offer a variety of network assurance and data collection productsthat were added to our portfolio when we acquired CMS Communications Inc. (“CMS”)in November 2003. We are positioned as a provider of OSS, NSS and comprehensivesystems integration capabilities because these complementary competenciesenable us to address and implement solutions across a customer’sinfrastructure.

 

                Foundedin 1985, we initially focused on providing custom software development andprofessional services to a limited number of telecommunications companies. In1996, concurrent with the passage of the Telecommunications Act of 1996 (theTelecom Act), we made a strategic decision to add software products to ourestablished professional services offerings. Since that time we have built andacquired a strong product portfolio that includes, but is not limited to, LNPand WNP OSS and testing software that enables carriers to meet FederalCommunications Commission (“FCC”) requirements that consumers be permitted toretain their phone numbers when changing service providers; number inventoryand conservation software that addresses FCC mandates to extend the life of theNorth American Numbering Plan; and a solution for collecting traffic data offof network elements which provide comprehensive data collection capabilitiesand supports both service assurance requirements and network planning activities.Number portability is mandated and implemented for U.S. wireline carriers todayand was implemented by all U.S. wireless carriers for top-tier markets onNovember 24, 2003, with all remaining markets implemented 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 integrate our products into their existing OSSenvironments. In 2002, we initiated a restructuring plan, which, in addition tosignificant operational cost reductions and greater leverage of offshoredevelopment, included the reengineering of our business model to a solutionsstrategy.  The solutions business modelreflects a more balanced mix of services and products, as well as integrationand product enhancements for our customers’ back office to meet the specificrequirements of each customer. Solutions which include our intellectualproperty and extensions, enhancements and integration are typically licensed toour customers 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 focuses on providing our customers with highquality solutions that meet their specific needs, as quickly as feasible, atthe lowest possible price. We work with our customers using our domainknowledge to identify precisely what they want. We minimize the cost andmaximize the speed of delivery by using low-cost offshore development,incorporating our products and ***ServiceXpress*** tools into the solution, as well as thirdparty products and tools. We also provide efficient lifecycle support. Weachieve 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 believe is a fair margin. We strive to be a premier low-cost providerof high-quality, mission-critical software solutions for wireline andwireless telecommunications carriers.

 

                Afterwe deliver a solution to a customer, we pursue follow-on business that includessoftware development services, software enhancements to our products andrelated integration, as well as customer support and maintenance services.Because the solutions we provide usually perform functions that are requiredfor the operation of our customer’s business, we expect follow-on revenue tooccur for several years after an initial sale.

 

10

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                Whileproviding support and maintenance services, we may also become aware of newopportunities with our customers. This allows us to expand our productportfolio and ***ServiceXpress***tools to solve our customers’ needs, generally in their back office systemsenvironment.  Our ***ServiceXpress***strategy is currently used in support of most of our customer engagements.

 

**Critical Accounting Policies**

 

**               **Management’s Discussion and Analysis of Financial Condition and Resultsof Operations is based on our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America, or GAAP. We review the accounting policies we usein reporting our financial results on a regular basis. The preparation of ourconsolidated financial statements requires us to make estimates and judgmentsthat affect the reported amounts of assets, liabilities, revenue and expenses,and related disclosure of contingent assets and liabilities. In many cases, theaccounting treatment of a particular transaction is specifically dictated byGAAP and does not require our judgment in its application.  Our senior management has reviewed thesecritical accounting policies and related disclosures with our AuditCommittee.  We have identified thepolicies below as critical to our business operations and the understanding ofour results of operations.

 

•                  Revenuerecognition

 

•                  Allowancefor doubtful accounts

 

•                  Incometaxes

 

•                  Goodwilland intangible assets

Fora detailed discussion on the application of these accounting policies, see “Item7: Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in our Annual Report on Form 10-K for the year ended December 31,2003.

 

**Recent Developments**

 

                **Customer Support Revenue Deferral**

                During the first and second quarter of 2004, wedeferred the recognition of customer support revenue for one of our largestcustomers. Under this maintenance arrangement, the customer purchasedprofessional services, specified licensed software upgrades and supportservices.  Since fair value of theundelivered specified licensed software upgrades did not exist, all of therevenue related to this contract was deferred until the specified licensedsoftware upgrades were delivered and accepted by the customer.  During the third quarter, we delivered andobtained acceptance of the specified licensed software upgrades. Since vendorspecific objective evidence of fair value exists for all of the remainingundelivered elements in the arrangement, we recognized the residual amount ofrevenue for all delivered elements. During the third quarter we recognized approximately $2.0 million incustomer support revenue and $100,000 in license and services revenue related tothis arrangement. The remainder of the arrangement value will be recognized asthe related services are performed through July 2005.

 

                **Acquisition of TSE**

**               **On October 15, 2004, weacquired privately-held TSE for $1.5 million in cash plus a short-term notepayable of approximately $889,000. We agreed to pay additional contingentconsideration of up to $3.5 million payable upon the achievement of certainrevenue and gross margin results. Up to $2.5 million of the contingentconsideration may be payable over a 24 month period from the closing date andan additional amount of up to $1 million may be payable through the year 2011if certain specified sales of TSE products occur.  We believethat the sales of TSE products during the contingent consideration period willresult in positive cash flows even after the contingent consideration is paid.

TSEproducts are sold to U.S. wireline and wireless carriers, and provide forsimulation of the nation’s centralized network portability administrationcenter (“NPAC”) enabling a testing environment for critical back office systemsthat carriers use for enabling number portability. Other products in the TSEportfolio are used for enhanced integration between back office OSSsystems.  TSE has installed its productsat many of the leading wireless and wireline carriers in North America.

 

                **Acquisition of Tertio**

**               **On November 2, 2004, weacquired UK-based Tertio a privately held supplier of operations supportsystems (“OSS”) software solutions to communication carriers throughout Europe,the Middle East, Africa and Asia.  Totalconsideration for Tertio approximates $42.0million, consisting of $11.0 million in cash, approximately $16.0 million inseller-financed notes, approximately $13.5 million in convertible preferredstock and approximately $1.5 million in estimated transaction-related costs. Aportion of the seller-financed notes may be exchanged for a convertible note atthe option of the sellers. Such action would require a shareholder vote.

 

11

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Tertio’s activation andmediation solutions, *ProvidentTM* and *EvidentTM,* fit well with elements of our product portfolio,strengthening our current networkmediation and service assurance offerings. As a combined company we become a company with globalreach and a customer base that includes many of the world’s leadingcommunications carriers.

 

                **Offshore Development**

**               **InFebruary 2004, we formed Evolving Systems Networks India Private Limited, awholly owned subsidiary of Evolving Systems (Evolving Systems India).  For several years, offshore development,through a subcontractor, has been a key aspect of our low-cost,accelerated-deployment strategy.  Withthe formation of Evolving Systems India we expect to have more control andflexibility and lower costs than our previous outsourced development approachusing an offshore third party contractor. For the nine months ended September30, 2004, we estimate we have saved approximately $700,000 as a result oftransitioning our development work from our third-party subcontractor to ourIndian development team.

 

**Results of Operations**

 

                Thefollowing table presents the Company’s Consolidated Statements of Operationsreflected as a percentage of total revenue.

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUE**                                                |       |                                       |       |                                      |       |   |   |   |   |
| License fees and services                                  |       | 14                                         | %          | 55                                        | %          | 38 | % | 55 | % |
| Customer support                                           |       | 86                                         | %          | 45                                        | %          | 62 | % | 45 | % |
| Total revenue                                              |       | 100                                        | %          | 100                                       | %          | 100 | % | 100 | % |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                |       |                                       |       |                                      |       |   |   |   |   |
| Costs of license fees and services, excluding depreciation |       | 14                                         | %          | 16                                        | %          | 18 | % | 20 | % |
| Costs of customer support, excluding depreciation          |       | 35                                         | %          | 20                                        | %          | 35 | % | 20 | % |
| Sales and marketing                                        |       | 16                                         | %          | 10                                        | %          | 16 | % | 10 | % |
| General and administrative                                 |       | 19                                         | %          | 12                                        | %          | 18 | % | 12 | % |
| Product development                                        |       | 3                                          | %          | 8                                         | %          | 5 | % | 5 | % |
| Depreciation and amortization                              |       | 5                                          | %          | 4                                         | %          | 5 | % | 4 | % |
| Restructuring and other expenses                           |       | 0                                          | %          | 0                                         | %          | 0 | % | 0 | % |
| Total costs of revenue and operating expenses              |       | 92                                         | %          | 70                                        | %          | 97 | % | 71 | % |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) from operations                              |       | 8                                          | %          | 30                                        | %          | 3 | % | 29 | % |
| Other income, net                                          |       | 2                                          | %          | 1                                         | %          | 1 | % | 1 | % |
| Income (loss) before income taxes                          |       | 9                                          | %          | 31                                        | %          | 4 | % | 30 | % |
| Provision for income taxes                                 |       | 0                                          | %          | 2                                         | %          | 0 | % | 1 | % |
| Net income (loss)                                          |       | 9                                          | %          | 29                                        | %          | 4 | % | 29 | % |

 

**The three and nine monthsended September 30, 2004 compared to the three and nine months ended September30, 2003**

**Revenue**

                Revenueis comprised of license fees/services and customer support.  License fees and services revenue representthe fees we receive from the licensing of our software products and those servicesdirectly related to the delivery of the licensed product as well as integrationservices and time and materials work. Customer support revenue includes annualsupport fees, recurring maintenance fees, maintenance upgrades and warrantyfees.  Warranty services are typicallybundled with a license sale and the related revenue, based on VSOE, is deferredand recognized ratably over the warranty period.  Total revenue was $5.7 million and$7.1 million for the three months ended September 30, 2004 and 2003,respectively, and $16.8 million and $22.2 million for the nine months endedSeptember 30, 2004, respectively. The following tablepresents the Company’s revenue by product (in thousands).

 

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| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Number portability                |       | $                                          | 3,975      |                                      | $          | 4,195 |   | $ | 9,496 |   | $ | 13,442 |   |
| Number inventory and assignment   |       | 634                                        |       | 2,433                                     |       | 3,800 |   | 7,030 |   |
| Network assurance and fulfillment |       | 805                                        |       | —                                    |       | 2,484 |   | — |   |
| Other                             |       | 325                                        |       | 520                                       |       | 986 |   | 1,706 |   |
|                              |       | $                                          | 5,739      |                                      | $          | 7,148 |   | $ | 16,766 |   | $ | 22,178 |   |

 

**LicenseFees and Services**

 

License fees and services revenue decreased 79% to$810,000 for the three months ended September 30, 2004, from $3.9 millionfor the three months ended September 30, 2003. The decrease in license fees and services revenue is due to lowerrevenue from our number portability and inventory products.  This decline reflects lower sales ofenhancements due to industry upgrades implemented in 2003 and industryconsolidation.  In addition, WNP volumeshave been lower than anticipated which is reflected in the lower numberportability revenue.

License fees and services revenue decreased 47% to$6.4 million for the nine months ended September 30, 2004, from $12.1 millionfor the nine months ended September 30, 2003. The decrease in license fees and services revenue is due to lowerrevenue from our number portability and inventory products.  This decline is due to not having a contractin 2004 similar to a large LNP project that was completed during the ninemonths ended September 30, 2003 of approximately $1.6 million and lower salesof enhancements due to industry upgrades implemented in 2003 and industryconsolidation.  In addition, WNP volumeshave been lower than anticipated which is reflected in the lower numberportability revenue.

**Customer Support**

Customer support revenue increased 54% to $4.9 millionfor the three months ended September 30, 2004, from $3.2 million for the threemonths ended September 30, 2003.  Theincrease in customer support revenue for the three months ended September 30,2004 is primarily due to the aforementioned recognition of $2.0 million ofrevenue related to a large LNP arrangement and increased network assurancesupport revenue on products acquired in the CMS acquisition, partially offsetby reductions in certain customer support contracts.

Customer support revenue increased 3% to $10.4 millionfor the nine months ended September 30, 2004, from $10.0 million for the ninemonths ended September 30, 2003.  Theincrease in customer support revenue for the nine months ended September 30,2004 is primarily due to increased network assurance support revenue onproducts acquired in the CMS acquisition partially offset by reductions incertain customer support contracts.

**Costsof Revenue, Excluding Depreciation**

Costs of revenue, excluding depreciation, consistprimarily of personnel costs, including employees of Evolving Systems India,facilities costs, the costs of third-party software and all other directcosts associated with these personnel. Total costs of revenue, excludingdepreciation, were $2.8 million and $2.6 million for the three monthsended September 30, 2004 and 2003, respectively, and $8.9 million and $8.7million for the nine months ended September 30, 2004 and 2003, respectively.

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

                Costsof license fees and services, excluding depreciation, were $817,000 and$1.1 million for the three months ended September 30, 2004 and 2003,respectively.  The decrease of $323,000,or 28%, was due to fewer license and services projects resulting in a reductionof labor costs. As a percentage of license fees and services revenue, costs oflicense fees and services, excluding depreciation, increased to 101% for thethree months ended September 30, 2004 from 29% for the three months endedSeptember 30, 2003.  The increase as apercentage of license fees and services revenues was due to a decrease inrevenue which exceeded the decrease in costs during the three months endedSeptember 30, 2004.

                Costsof license fees and services, excluding depreciation, were $3.0 millionand $4.3 million for the nine months ended September 30, 2004 and 2003,respectively.  The decrease of $1.3 million,or 30%, was due to fewer license and services projects resulting in a reductionof labor costs.  As a percentage oflicense fees and services revenue, costs of license fees and services,excluding depreciation, increased to 47% for the nine months ended September30, 2004 from 36% for the nine months ended September 30, 2003.  The increase as a percentage of license feesand services revenues was due to a decrease in revenue which exceeded thedecrease in costs during the nine months ended September 30, 2004.

 

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                **Costs of Customer Support, ExcludingDepreciation**

 

                Costsof customer support, excluding depreciation, were $2.0 million and$1.4 million for the three months ended September 30, 2004 and 2003, respectively.  The increase of $584,000, or 41%, is due toamortization of intangibles related to our acquisition of CMS in November 2003and increased hours worked on customer support projects to support the networkassurance product acquired from CMS.  Asa percentage of customer support revenue, costs of customer support, excludingdepreciation, decreased to 41% for the three months ended September 30, 2004from 45% for the three months ended September 30, 2003.  The decrease as a percentage of customer supportrevenue in the second quarter of 2004 compared to 2003 is due to increasedrevenue related to the aforementioned recognition of $2.0 million ofcustomer support revenue related to a large LNP arrangement, partially offset by increased expenses.

**               **Costs of customer support, excluding depreciation, were$5.9 million and $4.4 million for the nine months ended September 30,2004 and 2003, respectively.  Theincrease of $1.5 million, or 34%, is due to amortization of intangibles relatedto our acquisition of CMS in November 2003 and increased hours worked oncustomer support projects to support the network assurance product acquiredfrom CMS.  As a percentage of customersupport revenue, costs of customer support, excluding depreciation, increasedto 57% for the nine months ended September 30, 2004 from 44% for the ninemonths ended September 30, 2003.  Theincrease as a percentage of customer support revenue in the first threequarters of 2004 compared to 2003 is due to the aforementioned increased costs.

 

**Sales and Marketing**

Sales and marketing expenses primarily consist ofcompensation costs, including bonuses and commissions, travel expenses,advertising and occupancy expenses. Sales and marketing expenses were $942,000 and $684,000 for the threemonths ended September 30, 2004 and 2003, respectively. The increase of$258,000, or 38%, is due to increased employee-related costs as well as travelexpenses related to our acquisition of CMS in November 2003 and increasedheadcount related to ramping up our sales staff for direct sales and a newfocus on channel sales.  As a percentageof total revenue, sales and marketing expenses increased to 16% for the threemonths ended September 30, 2004 from 10% for the three months ended September30, 2003.  The increase as a percentageof revenue is due to the aforementioned increase in expenses and decreasedrevenue in the third quarter of 2004 compared to 2003.

Sales and marketing expenses were $2.8 million and $2.1million for the nine months ended September 30, 2004 and 2003, respectively.The increase of $671,000, or 32%, is primarily due to increasedemployee-related costs and travel expenses related to our acquisition of CMS inNovember 2003 and ramping up our sales staff. As a percentage of total revenue, sales and marketing expenses increasedto 16% for the nine months ended September 30, 2004 from 10% for the ninemonths ended September 30, 2003.  Theincrease as a percentage of revenue is due to the aforementioned increase inexpenses and decreased revenue in the first three quarters of 2004 compared to2003.

**General and Administrative**

General and administrative expenses consist principallyof employee related costs and professional fees for the following departments;facilities, finance, legal, human resources, and executive management.  General and administrative expenses were $1.1million and $891,000 for the three months ended September 30, 2004 and2003, respectively.  The increase of$209,000 is primarily due to increased professional fees related to Sarbanes-Oxleycompliance and business development activity, offset by decreased bonusexpense.  As a percentage of totalrevenue, general and administrative expenses increased to 19% for the threemonths ended September 30, 2004 from 12% for the three months ended September30, 2003.  The increase as a percentageof revenue is due to the aforementioned increase in expenses and decreasedrevenue in the third quarter of 2004 compared to 2003.

General and administrative expenses were$3.0 million and $2.7 million for the nine months ended September 30, 2004and 2003, respectively.  The increase of$227,000, or 8%, is primarily due to increased professional fees related toSarbanes-Oxley compliance and business development activity, offset bydecreased bonus expense.  As a percentageof total revenue, general and administrative expenses increased to 18% for thenine months ended September 30, 2004 from 12% for the nine months endedSeptember 30, 2003.  The increase as apercentage of revenue is due to the aforementioned increase in expenses anddecreased revenue in the first three quarters 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 $152,000 and $568,000 for the threemonths ended September 30, 2004 and 2003, respectively. The decrease of$416,000, or 73%, is due to decreased hours spent on development of our ***ServiceXpress*** toolkit, as theproject was completed during the period. As a percentage of revenue, product development expenses decreased to 3%for the three months ended September 30, 2004 from 8% for the three monthsended September 30, 2003.  The decrease asa percentage of revenue is due to the decreased hours worked in the thirdquarter of 2004 compared to 2003.

Product development expenses were $884,000 and $1.2million for the nine months ended September 30, 2004 and 2003, respectively.The decrease of $340,000, or 28%, is due to decreased hours spent ondevelopment of our ***ServiceXpress*** toolkit as theproject was completed during the period, offset by training and recruitingcosts related to our newly formed Bangalore, India subsidiary.  As a percentage of revenue, productdevelopment expenses remained at 5% for the nine months ended September 30,2004 and 2003.  The constant as apercentage of revenue is due to the decreased product development costs anddecreased revenue in the first three quarters of 2004 compared to 2003.

 

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**Restructuring and Other Expense**

                Restructuring andother expenses of $38,000 were recorded for the nine months ended September 30,2003, in accordance with the Company’s restructuring plan, as follows:

 

•                  *Workforce reductions.*  All workforce reductions related to our restructuring plan were completed in 2002.During the the first half of 2003, we recorded a benefit of $93,000, related tothe settlement of severance liabilities. At September 30, 2004 there was no remaining liability related to theseworkforce reductions.

 

•                  *Closureof satellite offices.*  Weclosed all 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 during the firstquarter of 2003; the 2003 expense is related to an adjustment of our estimateof our office closure liability due to lower than expected subleaseincome.  At September 30, 2004,approximately $91,000 was included in accounts payable and accrued liabilities,and approximately $21,000 was included in long-term obligations related tothese office closures, which will be paid over the remaining lease terms,ranging from 1 month to 19 months.

 

**Other Income, Net**

 

Otherincome, net, was $92,000 and $41,000 for the three months ended September 30,2004 and 2003, respectively.  Theincrease is due to higher interest income as a result of increased cashbalances for the three months ended September 30, 2004 compared to thecomparable period in 2003.

Otherincome, net, was $216,000 and $137,000 for the nine months ended September 30,2004 and 2003, respectively.  Theincrease is due to higher interest income as a result of increased cashbalances for the nine months ended September 30, 2004 compared to thecomparable period in 2003.

 

**Income Taxes**

Werecorded income tax expense of $20,000 and $12,000 for three and nine months ended September 30, 2004, respectively. The ninemonth expense is net of a benefit of $14,000 due to a refund that was collectedon a prior year amended federal tax return.

 

**Liquidity and Capital Resources**

#### ** **

                Wehave historically financed operations through cash flows from operations andequity transactions.  At September 30,2004, our principal source of liquidity was $20.7 million in cash and cashequivalents, representing 57% of total assets. Working capital at September 30, 2004 was $15.2 million compared to$13.8 million at December 31, 2003.

 

                Duringthe nine months ended September 30, 2004 our cash and cash equivalentsincreased to $20.7 million from $18.0 million at December 31, 2003.  This increase is primarily a result ofapproximately $3.4 million in cash provided by operations for the nine monthsended September 30, 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 andservices.  Cash used by investingactivities of $1.0 million was primarily due to capital expenditures fordomestic internal hardware that improved performance and reliability of ourproduct development environment, as well as computers equipment for the startup of Evolving Systems India. Cash provided by financing activities of $356,000included proceeds related to the exercise of approximately 168,000 stockoptions.

 

                Aspreviously mentioned, we acquired two companies, TSE and Tertio, subsequent toSeptember 30, 2004.  In thosetransactions we paid cash of $1.5 million and $11.0 million for TSE and Tertio,respectively. The TSE transaction also includes a short-term note payable ofapproximately $889,000 and contingent consideration of up to $3.5 million ifcertain revenue and gross margin results are achieved. The acquisition ofTertio also includes the issuance of seller-financed notes of approximately$16.0 million, including a short-term note of $4.0 million and a long-term noteof approximately $12.0 million.  We may call a special stockholders’ meeting in early 2005 to requestapproval to convert the long-term note to some combination of straight debtwith a lower interest rate or convertible debt with a significantly lowerinterest rate. The specific combination will be determined in the first quarterof 2005. If the note is converted to convertible debt it would reduce ourlong-term debt and related interest costs

 

                These twoacquisitions have reduced our working capital by approximately $17.4million.  Inaddition to the cash outflows listed above, we expect transaction costs relatedto the acquisitions to approximate $1.5 million, most of which should be paidout in the fourth quarter of 2004 and the first quarter of 2005.  As a result of these transactions, we expectto report significantly lower levels of working capital in the future than wehave in the recent past.

 

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                Webelieve that our current cash and cash equivalents, together with anticipatedcash flows from operations will be sufficient to meet our working capital andcapital expenditure requirements for at least the next twelve months. In makingthis assessment we considered the following:

 

**•**                  Ourcash and cash equivalents balance at September 30, 2004 of $20.7 million.

 

•                  Ourcash generated by operating activities of $3.4 million for the nine monthsended September 30, 2004 and $6.9 million for the year ended December 31, 2003.

 

•                  Ourcumulative profitability over the last nine quarters and anticipatedprofitability for the calendar year 2004 before any charges related toacquisitions or acquisition accounting.

 

•                  Ourbacklog of approximately $6.5 million, including $1.1 million in license feesand services and $5.4 million in customer support at September 30, 2004. As ofSeptember 30, 2004, approximately $1.5 million of the backlog has not beencollected.

 

•                  TSE andTertio have historically been profitable companies, generating positive cashflows and our expectation they will continue to generate positive cash flowsfrom operations.

 

•                  Ourcash forecast for the combined company is sufficient to cover anticipatedoperating costs as well as debt service payments.

 

                Notwithstandingthese assessments, we may require additional funds to support our businessobjectives through equity or debt financing. Specifically, additional funds maybe needed to support our growth through merger and acquisition. There can be noassurance that additional financing will be available at all or that ifavailable, such financing will be obtainable on terms favorable to us and wouldnot be dilutive.

 

**Factors That Might AffectOperating Results**

 

These results should be readin conjunction with the risk factors defined in the Company’s Annual Report onForm 10-K for the year ended December 31, 2003. Statements contained in thisQuarterly Report with respect to future revenue and expenses are “forward-lookingstatements” within the meaning of Section 21E of the Securities Exchange Act of1934, as amended. Actual results may differ. Among the factors that could causeactual results to differ are those described below and in more detail in ourAnnual Report on Form 10-K.

 

Ouroperating results have fluctuated significantly in the past and are likely tocontinue to fluctuate significantly in the future. Fluctuations in operatingresults may cause volatility in the price of our common stock. These quarterlyfluctuations may result from a number of factors, including:

 

•                  *Relianceon few customers.*  Asignificant portion of our revenue and contracts receivable has been and isexpected to continue to be derived from a small number of customers.Accordingly, the loss of any significant customer, delays in collections,delivery or acceptance of any of our products or delays in the performance ofservices could have a material adverse effect on our business, financialcondition and results of operations.

 

•                  *Adversetrends in the telecommunications industry.*  Due to a major downturn in thetelecommunications industry which began in the second half of 2000 (andcontinues to the present), many of the companies in the telecommunicationsindustry have declared bankruptcy, delayed payments to their suppliers ordelayed additional purchases.

 

•                  *Maturemarket for number portability products.*  The market for our number portabilityproducts is mature and there can be no assurances that we will successfullyidentify new product opportunities or will achieve market acceptance of newproducts brought to the market.  If ourproducts do not perform satisfactorily, or if we have delays in productdevelopment, our business, financial condition and results of operations couldbe materially harmed.

 

•                  *Quarterly Fluctuations in Revenue as a Result of Revenue RecognitionRules.*Many of our contracts are for large, complexprojects where software and services are provided over a period of manymonths.  Recently, our customers havebeen requesting more customization of our software and services to their exactneeds.  As a result, revenue recognitionunder our contracts may vary depending upon the particular software revenuerecognition rule that applies.  Forexample, in late 2003 we entered into a contract which contained customersupport, services and software releases. Because of the applicability ofcertain accounting rules, we were required to defer the revenue under thatcontract until the software was accepted by the customer; the expensesincurred, however, were expensed as they occured.  This accounting treatment has had asignificant impact on our quarterly results of operations.

 

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•                  *Shifting in customer spending.* Whilecarriers are projected to spend more on systems for data services they areplanning on spending less on support services for voice services. As we extendour products to address more data and next generation services it could impactresults in the near term.

 

•                  *Integrationof TSE and Tertio.* The integration of TSE and Tertio may present risksand we may be unable to achieve the product, financial or strategic goalsintended at the time of the acquisitions. The risks we may encounter in thesetransactions include:

 

•                  we mayhave difficulty assimilating the operations and personnel of TSE or Tertio;

 

•                  we mayhave difficulty in maintaining controls, procedures and policies during thetransition and integration;

 

•                  customersof TSE or Tertio may decide not to renew their contracts with the combinedentity and other ongoing business may be disrupted by transition andintegration issues;

 

•                  thefinancial and strategic goals for the acquired and combined businesses may notbe achieved;

 

•                  duediligence processes may have failed to identify significant issues with productquality, intellectual property ownership, product architecture, legal andfinancial contingencies, and product development, or other unidentified issues;

 

•                  significantexit charges may be sustained if products acquired in business combinations areunsuccessful;

 

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

 

•                  certainmanagement and other employees of TSE and Tertio may be critical to the successof the company, and we do not know if we will be successful in retaining theseindividuals in the combined companies;

 

•                  we mayincur impairment charges in the future related to our goodwill and intangibleassets if we do not achieve our expected cash flows or growth rates; and

 

•                  the price of our stock may go down as stockholders receiving stock inconnection with the purchase of Tertio, elect to sell their shares, or themarketplace does not favorably view the transaction;

 

•                  Risks related specificallyto Tertio.

 

•                  *Risk of Doing Business Internationally.*  Historically sales of our products havebeen limited to customers in the United States. Our only internationalexperience has been with our Indian offshore development subsidiary. Theacquisition of Terito will result in the addition of significant sales andoperations outside the United States. If we are unable to manage our sales andoperations on a global basis, our financial condition or results of operationscould be materially adversely affected.

•                  *Background*.  In consideration for our acquisition ofTertio, we made a cash payment of $11.0 million, issued 966,666 shares of newlyissued Series B Convertible Preferred Stock, issued a short term secured notewith a principal amount of $4.0 million bearing interest at 5.5% per annum andissued long term secured notes with an aggregate principal amount ofapproximately $12.0 million bearing interest at 11% per annum.  Subject to stockholder approval, the longterm secured notes may be exchanged for notes convertible into shares of ourcommon stock which would bear interest at the applicable federal rate —currently about 4.6%.

•                  *Dilution*. Each share of Series BConvertible Preferred Stock is convertible into three shares of our commonstock which could result in the issuance of up to 2,900,000 shares of ourcommon stock.  Under certaincircumstances [including stockholder approval of an amendment to ourCertificate of Incorporation to increase the number of authorized shares of ourcommon stock and approval permitting holders to exchange long term notes intoconvertible notes] all but 1000 shares of the Series B Preferred Stock aremandatorily convertible into our common stock. If either the Series B Convertible Preferred Stock or the convertiblenotes are converted into shares of common stock, there will be a significantdilutive effect on the ownership interests and voting rights of our existingstockholders.

•                  *Influence of Convertible Preferred Stockholders*.If the Series B Convertible Preferred Stock and the convertible notes are exchangedfor shares of common stock, then the holder and their affiliates would hold inexcess of twenty percent (and possibly up to thirty-three percent) of theoutstanding shares of our common stock. Such ownership interests could effectively deter a third party frommaking an offer to buy us, which might involve a premium over our current stockprice or other benefits for our stockholders, or otherwise prevent changes inthe control or management of the Company. In addition, there

 

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areno restrictions, in the form of a standstill agreement or otherwise, on theability of the holders of the Convertible Preferred Stock or their affiliatesto purchase additional securities of the Company and thereby further increasetheir ownership interests.

 

•                  *Indebtedness*.  The indebtedness incurred with respect to theshort and the long term secured notes is material in relation to our currentlevel of indebtedness, our ability to service the debt from our operating cashflow and our ability to repay the debt in full at maturity.  If we do not obtain stockholder approval topermit holders to exchange some or all of the long term notes into convertiblenotes, we will be required to service the full amount of the long term debt andrelated interest payments.  No assurancecan be given that sufficient funds will be available to meet our operatingneeds, or to pay the interests on the short and the long term securednotes.  The notes are secured by ageneral lien on all of our assets.  If weare unable to pay the notes as they become due, the holders thereof couldforeclose on all of our assets.

•                  *Preferential Rights of the Series B Convertible PreferredStock*.  The holder of the Series B ConvertiblePreferred Stock will have preferential rights with respect to distributionsupon a liquidation of the Company, including certain businesscombinations.  Accordingly, nodistributions upon liquidation may be made to the holders of common stock untilthe holders of the Series B Convertible Preferred Stock have been paid theirliquidation preference.  As a result, itis possible that, on liquidation, all amounts available for the holders ofequity of the Company would be paid to the holders of the Series B ConvertiblePreferred Stock, and that the holders of common stock would not receive anypayment.  Additionally, in connectionwith the Tertio acquisition we are obligated to file and keep effective aregistration statement providing for the resale of the shares or our commonstock issuable upon the conversion of the Series B Convertible PreferredStock.  If the Securities and ExchangeCommission refuses to declare the registration statement effective or we failto keep the registration statement effective, the holders of the Series BConvertible Preferred Stock will have the right to cause us repurchase theshares of the Series B Convertible Preferred Stock for $3.89 per share (on anas converted basis), or approximately $11.3 million. If we are required to makethis payment, it would have a significant impact on our liquidity.

•                  *NASDAQRequirements.*NASDAQ Rule 4350(i)(1)(C) requires that a companywhose stock is traded on NASDAQ obtain stockholder approval in connection withthe acquisition of another company involving the issuance or potential issuanceof common stock equal to 20% or more of its common stock.  The issuance of the Series B ConvertiblePreferred Stock alone, does not exceed this 20% threshold.  However, because the issuance of the sharesof common stock upon conversion of the Series B Convertible Preferred Stock andthe convertible notes would, collectively, result in us issuing in excess of20% of our outstanding shares of common stock, we are required under the NASDAQrules to seek stockholder approval for the conversion of the long term notesinto convertible notes.  No assurancescan be given that our stockholder will approve such conversion.  If our stockholders do not approve suchconversion, the long term notes will remain outstanding until December 31, 2007(unless earlier repaid) and our ability to continue to service such debt couldadversely effect our financial condition

 

•                  *RisksAssociated with Offshore Development.*  During 2004, we transitioned work that hadbeen performed by our Indian subcontractor to our newly formed Indiansubsidiary.  Any failure by us toadequately manage our offshore development process could negatively impact ourability to satisfy our customer contracts.

 

Other factors that might affect operatingresults:

 

•                  the size of new contractsand when they are signed; our rate of progress under our contracts;

•                  the timing of customer andmarket acceptance of our products and service offerings;

•                  actual or anticipatedchanges in government laws and regulations related to the telecommunicationsmarket;

•                  judicial or administrativeactions about these laws or regulations;

•                  the nature and pace ofenforcement of the Telecommunications Act of 1996;

•                  product lifecycles;

•                  the mix of products andservices sold;

•                  changes in demand for ourproducts and services;

•                  the timing of third-partycontractors’ delivery of software and hardware;

•                  budgeting cycles of ourcustomers;

•                  changes in the renewal ratesof support agreements;

•                  level and timing of expensesfor product development and sales, general and administrative expenses;

•                  competition by existing andemerging competitors in the telecommunications software markets;

•                  our success in developingand selling new products, controlling cost, attracting and retaining qualifiedpersonnel and expanding our sales and customer focused programs;

•                  software defects and otherproduct quality problems;

•                  changes in our strategy;

 

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•                  the extent of industryconsolidation; and

•                  general economic conditions.

 

Our expense levels are basedin significant part on our expectations regarding future revenue. Our revenueis difficult to forecast as the market for our products and services is rapidlyevolving, and our sales cycle and the size and timing of significant contractsvary substantially among customers. Accordingly, we may be unable to adjustspending in a timely manner to compensate for any unexpected shortfall inrevenue. Any significant shortfall from anticipated levels of demand for ourproducts and services could have a material adverse effect on our business,financial condition and results of operations.

 

Based on all of theforegoing, we believe it is possible for future revenue, expenses and operatingresults to vary significantly from quarter to quarter. As a result,quarter-to-quarter comparisons of operating results are not necessarilymeaningful or indicative of future performance. Furthermore, we believe that itis possible that in any given quarter, including the current quarter, ouroperating results could differ from the expectations of public market analystsor investors. In such event, or in the event that adverse conditions prevail,or are perceived to prevail, with respect to our business or generally, themarket price of our common stock would likely go down.

 

ITEM  3. QUANTITATIVE AND QUALITATIVE MARKET RISK DISCLOSURES

 

                **Foreign Exchange Risk**

Ourinternational business is subject to risks, including, but not limited to,unique economic conditions, changes in political climate, differing taxstructures, other regulations and restrictions, and foreign exchange ratevolatility.  Accordingly, our futureresults could be adversely impacted by changes in these or other factors.

**Interest Rate Risk**

Inthe ordinary course of business we are exposed to the risk of changes ininterest rates.  Our cash balances aresubject to interest rate fluctuations and as such, interest income amounts mayfluctuate from current levels.

 

For additional information aboutEvolving Systems’ risk factors see Evolving Systems’ Annual Report on Form 10-Kfor the year ended December 31, 2003.

##### ** **

ITEM 4.    CONTROLS AND PROCEDURES 

 

                    (a) Evaluation of disclosure controls and procedures. As of September 30, 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 are 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.

##### ** **

##### **PARTII.  OTHER INFORMATION**

 

ITEM 1. LEGAL PROCEEDINGS

 

Fromtime to time we are involved in various legal proceedings arising in the normalcourse of business operations.   We arecurrently not aware of any legal proceedings that would have a material effecton our business, financial condition or results of operations.

 

ITEM 2. CHANGES INSECURITIES

 

            None

 

ITEM 3. DEFAULTS ON SENIORSECURITIES

 

            None

 

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ITEM 4. SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

 

                                    None

 

ITEM 5. OTHER INFORMATION

 

            None

 

 

ITEM 6. EXHIBITS AND REPORTSON FORM 8-K

 

(a)          Exhibits

 

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

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

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

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

 

(b)         Reports on Form8-K

 

On July15, 2004, we filed a Current Report on Form 8-K that the AuditCommittee and the Board of Directors of Evolving Systems, Inc. (the “Company”)approved the decision to change the Company’s independent registered publicaccounting firm.  The Company’s Board of Directors, upon therecommendation of the Audit Committee, dismissed PricewaterhouseCoopers LLP (“PricewaterhouseCoopers”)and appointed KPMG LLP (“KPMG”) as the Company’s independent registered publicaccounting firm for the current fiscal year ending December 31, 2004.

 

On July29, 2004, we furnished a Current Report on Form 8-K announcing financialresults for the second quarter of 2004.

 

                                                                        On August 31, 2004, we furnished aCurrent Report on Form 8-K that George A. Hallenbeck, Chairman of the Board andChief Technology Officer of the Company entered into an agreement to sell up to490,000 common shares of the Company owned by Mr. Hallenbeck. Under the Plan,Mr. Hallenbeck may sell up to 10,000 shares on pre-determined days, with amaximum of 20,000 shares every other week, and a minimum sales price of $5.00per share, over a period commencing October 4, 2004 and ending September 20,2005.

 

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###### **SIGNATURE**

 

            Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| Date: November 15, 2004 | /s/ BRIAN R. ERVINE                           |
|-------------------------|-----------------------------------------------|
|                    | Brian R. Ervine                               |
|                    | Executive Vice President,  Chief              |
|                    | Financial and  Administrative Officer,        |
|                    | Treasurer and Assistant  Secretary            |
|                    | (Principal Financial and  Accounting Officer) |

 

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