Tableof Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

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

 

**For the quarterly period endedSeptember 30, 2010**

 

**OR**

** **

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

 

**For the transition periodfrom               to               **

 

**Commission File Number: 0-24081**

 

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                   | ** ** | **84-1010843**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |
| ** **                                                     | ** ** | ** **                           |
| **9777 Pyramid Court, Suite 100 Englewood, Colorado**     | ** ** | **80112**                            |
| (Address of principal executive offices)                       |       | (Zip Code)                           |

 

**(303) 802-1000**

(Registrant’s telephone number, including area code)

 

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 of1934 during 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 x No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).    Yes  o   No  o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer, or a smaller reportingcompany.  See definition of “largeaccelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 

| Large accelerated filer o                |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                  |   | Smaller reporting company x |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).   Yes o  No x

 

Asof October 28, 2010 there were 10,309,674 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, 2010**

**Table of Contents**

 
| ** ** | **PART I — FINANCIAL INFORMATION**                                                                                                                               | ** ** |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Item 1     | Financial Statements                                                                                                                                                       |       |
|       | Condensed  Consolidated Balance Sheets as of September  30, 2010 and  December 31, 2009 (Unaudited)                                                              |       |
|       | Condensed  Consolidated Statements of Operations for the Three and Nine Months Ended  September 30, 2010 and 2009 (Unaudited)                                         |       |
|       | Condensed  Consolidated Statements of Changes In  Stockholders’ Equity and Comprehensive Income (Loss) for the Nine Months  Ended September 30, 2010 (Unaudited) |       |
|       | Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended  September 30, 2010 and 2009 (Unaudited)                                                   |       |
|       | Notes to  Unaudited Condensed Consolidated Financial Statements                                                                                                            |       |
| Item 2     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                |       |
| Item 3     | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                |       |
| Item 4     | Controls and  Procedures                                                                                                                                                   |       |
| ** ** | ** **                                                                                                                                                                 | ** ** |
| ** ** | **PART II — OTHER  INFORMATION**                                                                                                                                 | ** ** |
| Item 1     | Legal Proceedings                                                                                                                                                          |       |
| Item 1A    | Risk Factors                                                                                                                                                               |       |
| Item 2     | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                               |       |
| Item 3     | Defaults  upon Senior Securities                                                                                                                                           |       |
| Item 4     | Submission  of Matters to a Vote of Security Holders                                                                                                                       |       |
| Item 5     | Other Information                                                                                                                                                          |       |
| Item 6     | Exhibits                                                                                                                                                                   |       |
|       |                                                                                                                                                                       |       |
| Signature  |                                                                                                                                                                       |       |

 

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**PART I — FINANCIAL INFORMATION**

** **

**ITEM 1.  FINANCIAL STATEMENTS**

 

**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| **ASSETS**                                                                                                                                                                                    | ** ** | ** **             |       |                  |       |
| Current assets:                                                                                                                                                                               |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                     |       | $                      | 10,701     |                  | $          | 5,369 |   |
| Contract receivables, net of allowance for  doubtful accounts of $520 at September 30, 2010 and December 31,  2009                                                                  |       | 4,531                  |       | 11,344                |       |
| Unbilled work-in-progress                                                                                                                                                                     |       | 3,651                  |       | 1,720                 |       |
| Deferred income taxes                                                                                                                                                                         |       | 8                      |       | 8                     |       |
| Prepaid and other current assets                                                                                                                                                              |       | 1,588                  |       | 1,909                 |       |
| Total current assets                                                                                                                                                                          |       | 20,479                 |       | 20,350                |       |
| Property and equipment, net                                                                                                                                                                   |       | 1,127                  |       | 1,196                 |       |
| Amortizable intangible assets, net                                                                                                                                                            |       | 1,323                  |       | 1,864                 |       |
| Goodwill                                                                                                                                                                                      |       | 22,175                 |       | 22,295                |       |
| Long-term restricted cash                                                                                                                                                                     |       | 50                     |       | 50                    |       |
| Other long-term assets                                                                                                                                                                        |       | 2                      |       | 82                    |       |
| Total assets                                                                                                                                                                                  |       | $                      | 45,156     |                  | $          | 45,837 |   |
|                                                                                                                                                                                          |       |                   |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                          |       |                   |       |                  |       |
| Current portion of capital lease obligations                                                                                                                                                  |       | $                      | 26         |                  | $          | 24 |   |
| Current portion of long-term debt                                                                                                                                                             |       | —                 |       | 333                   |       |
| Accounts payable and accrued liabilities                                                                                                                                                      |       | 4,957                  |       | 4,502                 |       |
| Dividends payable                                                                                                                                                                             |       | 506                    |       | —                |       |
| Deferred income taxes                                                                                                                                                                         |       | 22                     |       | 29                    |       |
| Unearned revenue                                                                                                                                                                              |       | 5,842                  |       | 10,688                |       |
| Total current liabilities                                                                                                                                                                     |       | 11,353                 |       | 15,576                |       |
| Long-term liabilities:                                                                                                                                                                        |       |                   |       |                  |       |
| Capital lease obligations, net of current portion                                                                                                                                             |       | 15                     |       | 35                    |       |
| Long-term debt, net of current portion                                                                                                                                                        |       | —                 |       | 1,500                 |       |
| Deferred income taxes                                                                                                                                                                         |       | 67                     |       | 257                   |       |
| Total liabilities                                                                                                                                                                             |       | 11,435                 |       | 17,368                |       |
|                                                                                                                                                                                          |       |                   |       |                  |       |
| Commitments and contingencies (Note 10)                                                                                                                                                       |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                    |       |                   |       |                  |       |
| Preferred stock, $0.001 par value; 2,000,000  shares authorized; no shares issued and outstanding as of September 30,  2010 and December 31, 2009                                   |       | —                 |       | —                |       |
| Common stock, $0.001 par value; 40,000,000 shares  authorized; 10,251,111 and 9,930,682 shares issued and outstanding as of September 30,  2010 and December 31, 2009, respectively |       | 10                     |       | 10                    |       |
| Additional paid-in capital                                                                                                                                                                    |       | 85,559                 |       | 83,499                |       |
| Accumulated other comprehensive loss                                                                                                                                                          |       | (3,232                 | )          | (3,242                | )          |
| Accumulated deficit                                                                                                                                                                           |       | (48,616                | )          | (51,798               | )          |
| Total stockholders’ equity                                                                                                                                                               |       | 33,721                 |       | 28,469                |       |
| Total liabilities and stockholders’ equity                                                                                                                                               |       | $                      | 45,156     |                  | $          | 45,837 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and services                                                    |       | $                                                        | 4,891      |                                                    | $          | 5,836 |   | $ | 16,184 |   | $ | 15,940 |   |
| Customer support                                                             |       | 4,353                                                    |       | 4,077                                                   |       | 12,519 |   | 12,445 |   |
| Total revenue                                                                |       | 9,244                                                    |       | 9,913                                                   |       | 28,703 |   | 28,385 |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING  EXPENSES**                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 1,964                                                    |       | 1,984                                                   |       | 6,071 |   | 5,726 |   |
| Costs of customer support, excluding depreciation  and amortization          |       | 1,250                                                    |       | 1,452                                                   |       | 3,536 |   | 4,286 |   |
| Sales and marketing                                                          |       | 1,760                                                    |       | 2,032                                                   |       | 5,521 |   | 5,861 |   |
| General and administrative                                                   |       | 1,321                                                    |       | 1,546                                                   |       | 4,271 |   | 4,378 |   |
| Product development                                                          |       | 982                                                      |       | 919                                                     |       | 3,311 |   | 2,300 |   |
| Depreciation                                                                 |       | 146                                                      |       | 160                                                     |       | 446 |   | 474 |   |
| Amortization                                                                 |       | 172                                                      |       | 194                                                     |       | 512 |   | 548 |   |
| Total costs of revenue and operating expenses                                |       | 7,595                                                    |       | 8,287                                                   |       | 23,668 |   | 23,573 |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Income from operations                                                       |       | 1,649                                                    |       | 1,626                                                   |       | 5,035 |   | 4,812 |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Other income (expense)                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest income                                                              |       | 6                                                        |       | 1                                                       |       | 10 |   | 24 |   |
| Interest expense                                                             |       | (20                                                      | )          | (145                                                    | )          | (81 | ) | (563 | ) |
| Foreign currency exchange gain (loss)                                        |       | 63                                                       |       | 226                                                     |       | (86 | ) | (436 | ) |
| Other income (expense), net                                                  |       | 49                                                       |       | 82                                                      |       | (157 | ) | (975 | ) |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Income before income taxes                                                   |       | 1,698                                                    |       | 1,708                                                   |       | 4,878 |   | 3,837 |   |
| Income tax expense                                                           |       | 122                                                      |       | 380                                                     |       | 688 |   | 438 |   |
| Net income                                                                   |       | $                                                        | 1,576      |                                                    | $          | 1,328 |   | $ | 4,190 |   | $ | 3,399 |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic income per common share                                                |       | $                                                        | 0.16       |                                                    | $          | 0.14 |   | $ | 0.42 |   | $ | 0.35 |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Diluted income per common share                                              |       | $                                                        | 0.15       |                                                    | $          | 0.13 |   | $ | 0.39 |   | $ | 0.34 |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Cash dividend declared per common share                                      |       | $                                                        | 0.05       |                                                    | $          | — |   | $ | 0.10 |   | $ | — |   |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average basic shares outstanding                                    |       | 10,157                                                   |       | 9,797                                                   |       | 10,067 |   | 9,780 |   |
| Weighted average diluted shares outstanding                                  |       | 10,807                                                   |       | 10,249                                                  |       | 10,717 |   | 10,024 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**AND COMPREHENSIVE INCOME (LOSS)**

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

**(unaudited)**

** **
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**        | ** ** | **Stockholders’** | ** ** |
| ** **                                                        | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income (Loss)** | ** ** | **(Deficit)**          | ** ** | **Equity** | ** ** |
|                                                              |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |
| **Balance at December 31, 2009**                             | ** ** | **9,930,682**         | ** ** | **$**       | **10**     | ** **        | **$**      | **83,499**             | ** ** | **$**                  | **(3,242** | **)**      | **$**      | **(51,798** | **)** | **$** | **28,469** | ** ** |
| Stock option exercises                                            |       | 264,356               |       | —      |       | 1,283             |       | —                 |       | —                 |       | 1,283      |       |
| Common Stock issued pursuant to the Employee Stock  Purchase Plan |       | 7,323                 |       | —      |       | 40                |       | —                 |       | —                 |       | 40         |       |
| Stock-based compensation expense                                  |       | —                |       | —      |       | 737               |       | —                 |       | —                 |       | 737        |       |
| Restricted stock issuance                                         |       | 48,750                |       | —      |       | —            |       | —                 |       | —                 |       | —     |       |
| Common stock cash dividends                                       |       | —                |       | —      |       | —            |       | —                 |       | (1,008                 | )          | (1,008     | )          |
| Comprehensive income (loss):                                      |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |
| Net income                                                        |       | —                |       | —      |       | —            |       | —                 |       | 4,190                  |       |       |       |
| Foreign currency translation adjustment                           |       | —                |       | —      |       | —            |       | 10                     |       | —                 |       |       |       |
| Comprehensive income                                              |       |                  |       |        |       |              |       |                   |       |                   |       | 4,200      |       |
| **Balance at September 30,  2010**                           | ** ** | **10,251,111**        | ** ** | **$**       | **10**     | ** **        | **$**      | **85,559**             | ** ** | **$**                  | **(3,232** | **)**      | **$**      | **(48,616** | **)** | **$** | **33,721** | ** ** |

** **

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2010**                                                | ** ** | **2009** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         |       |                                                    |       |   |   |
| Net income                                                                         |       | $                                                       | 4,190      |   | $ | 3,399 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |                                                    |       |   |   |
| Depreciation                                                                       |       | 446                                                     |       | 474 |   |
| Amortization of intangible assets                                                  |       | 512                                                     |       | 548 |   |
| Amortization of debt issuance costs                                                |       | 64                                                      |       | 101 |   |
| Stock-based compensation                                                           |       | 737                                                     |       | 649 |   |
| Unrealized foreign currency transaction (gains)  and losses, net                   |       | 86                                                      |       | 436 |   |
| Benefit from foreign deferred income taxes                                         |       | (189                                                    | )          | (89 | ) |
| Change in operating assets and liabilities:                                        |       |                                                    |       |   |   |
| Contract receivables                                                               |       | 6,726                                                   |       | 3,022 |   |
| Unbilled work-in-progress                                                          |       | (1,908                                                  | )          | (142 | ) |
| Prepaid and other assets                                                           |       | 301                                                     |       | (188 | ) |
| Accounts payable and accrued liabilities                                           |       | 460                                                     |       | (573 | ) |
| Unearned revenue                                                                   |       | (4,778                                                  | )          | (4,381 | ) |
| Other long-term obligations                                                        |       | —                                                  |       | (1,069 | ) |
| Net cash provided by operating activities                                          |       | 6,647                                                   |       | 2,187 |   |
|                                                                               |       |                                                    |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         |       |                                                    |       |   |   |
| Purchase of property and equipment                                                 |       | (370                                                    | )          | (439 | ) |
| Common stock dividend                                                              |       | (502                                                    | )          | — |   |
| Net cash used in investing activities                                              |       | (872                                                    | )          | (439 | ) |
|                                                                               |       |                                                    |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         |       |                                                    |       |   |   |
| Capital lease payments                                                             |       | (18                                                     | )          | (15 | ) |
| Principal payments on long-term debt                                               |       | (1,811                                                  | )          | (3,073 | ) |
| Proceeds from the issuance of stock                                                |       | 1,323                                                   |       | 211 |   |
| Net cash used in financing activities                                              |       | (506                                                    | )          | (2,877 | ) |
|                                                                               |       |                                                    |       |   |   |
| Effect of exchange rate changes on cash                                            |       | 63                                                      |       | 499 |   |
|                                                                               |       |                                                    |       |   |   |
| Net decrease in cash and cash equivalents                                          |       | 5,332                                                   |       | (630 | ) |
| Cash and cash equivalents at beginning of period                                   |       | 5,369                                                   |       | 5,783 |   |
| Cash and cash equivalents at end of period                                         |       | $                                                       | 10,701     |   | $ | 5,153 |   |
|                                                                               |       |                                                    |       |   |   |
| Supplemental disclosure of other cash and non-cash  financing transactions:        |       |                                                    |       |   |   |
| Interest paid                                                                      |       | $                                                       | 19         |   | $ | 1,542 |   |
| Income taxes paid                                                                  |       | 290                                                     |       | 681 |   |
| Common stock dividend declared                                                     |       | 506                                                     |       | — |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

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**EVOLVING SYSTEMS, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 —BASIS OF PRESENTATION**

 

**Organization -**We are a provider ofsoftware solutions and services to the wireless, wireline and cable markets. Wemaintain long-standing relationships with many of the largest wireless,wireline and cable companies worldwide. Our customers rely on us to develop, deploy,enhance, maintain and integrate complex, highly reliable software solutions fora range of Operations Support Systems (“OSS”). We offer software products and solutions in four core areas:  service activation solutions used toactivate complex bundles of voice, video and data services for traditional andnext generation wireless and wireline networks; numbering solutions that enable carriers to comply withgovernment-mandated requirements regarding number portability as well asproviding phone number management and assignment capabilities; SIM cardactivation solutions used to dynamically allocate and assign resources to awireless device when it is first used, and mediation solutionssupporting data collection for both service assurance and billing applications.

 

**Interim Consolidated Financial Statements** — Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) and in conformity with the instructions to Form 10-Qand Article 10 of Regulation S-X and the related rules andregulations of the Securities and Exchange Commission (“SEC”).  Accordingly, certain information and notedisclosures normally included in financial statements prepared in accordancewith GAAP have been condensed or omitted pursuant to such rules andregulations. However, we believe that the disclosures included in thesefinancial statements are adequate to make the information presented not misleading.The unaudited condensed consolidated financial statements included in thisdocument have been prepared on the same basis as the annual consolidatedfinancial statements, and in our opinion reflect all adjustments, which includenormal recurring adjustments necessary for a fair presentation in accordancewith GAAP and SEC regulations for interim financial statements. The results forthe three and nine months ended September 30, 2010 are not necessarilyindicative of the results that we will have for any subsequent period.  These unaudited condensed consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and the notes to those statements for theyear ended December 31, 2009 included in our Annual Report on Form 10-K.

 

**Use ofEstimates -**The preparation of financial statements inconformity with accounting principles generally accepted in the U.S. requiresus to make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities, at thedate of the financial statements, as well as the reported amounts of revenueand expenses during the reporting period. We made estimates with respect torevenue recognition for estimated hours to complete projects accounted for usingthe percentage-of-completion method, allowance for doubtful accounts, incometax valuation allowance, fair values of long-lived assets, valuation ofintangible assets and goodwill, useful lives for property, equipment andintangible assets, business combinations, capitalization of internal softwaredevelopment costs and fair value of stock-based compensation amounts.  Actual results could differ from theseestimates.

 

**Foreign Currency Translation -**Our functional currency isthe U.S. dollar.  The functional currencyof our foreign operations is the respective local currency for each foreignsubsidiary.  Assets and liabilities offoreign operations denominated in local currencies are translated at the spotrate in effect at the applicable reporting date.  Our consolidated statements of operations aretranslated at the weighted average rate of exchange during the applicableperiod.  The resulting unrealizedcumulative translation adjustment, net of applicable income taxes, is recordedas a component of accumulated other comprehensive income (loss) in stockholders’equity.  Realized and unrealizedtransaction gains and losses generated by transactions denominated in acurrency different from the functional currency of the applicable entity arerecorded in other income (loss) in the period in which they occur.

 

**Principles of Consolidation -**The consolidated financialstatements include the accounts of Evolving Systems, Inc. andsubsidiaries, all of which are wholly owned. All significant intercompany transactions and balances have beeneliminated in consolidation.

 

**Goodwill -**Goodwill is the excess of acquisition cost ofan acquired entity over the fair value of the identifiable net assetsacquired.  Goodwill is not amortized, buttested for impairment annually or whenever indicators of impairment exist.These indicators may include a significant change in the business climate,legal factors, operating performance indicators, competition, sale ordisposition of a significant portion of the business or other factors. Forpurposes of the goodwill evaluation, we compare the fair value of each of ourreporting units to its respective carrying amount. If the carrying value of areporting unit were to exceed its fair value, we would then compare the fairvalue of the reporting unit’s goodwill to its carrying amount, and any excessof the carrying amount over the fair value would be charged to operations as animpairment loss.

 

**Intangible Assets -**Amortizable intangibleassets consist primarily of purchased software and licenses, customer contractsand relationships, trademarks and tradenames, and business partnershipsacquired in conjunction with our purchases of CMS Communications, Inc. (“CMS”),Telecom Software Enterprises, LLC (“TSE”) and Tertio Telecoms Ltd. (“EvolvingSystems U.K.”).  These definite lifeassets are amortized using the straight-line method over their estimated lives.

 

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We assess the impairment of identifiable intangibles if events orchanges in circumstances indicate that the carrying value of the asset may notbe recoverable. Factors that we consider significant which could trigger animpairment analysis include the following:

 

·                  Significantunder-performance relative to historical or projected future operating results;

 

·                  Significantchanges in the manner of use of the acquired assets or the strategy of theoverall business;

 

·                  Significantnegative industry or economic trends; and/or

 

·                  Significantdecline in our stock price for a sustained period.

 

If, as a result of the existence of one or more of the above indicatorsof impairment, we determine that the carrying value of intangibles and/orlong-lived assets may not be recoverable, we compare the estimated undiscountedcash flows expected to result from the use of the asset and its eventualdisposition to the asset’s carrying amount. If an amortizable intangible orlong-lived asset is not deemed to be recoverable, we recognize an impairmentloss representing the excess of the asset’s carrying value over its estimatedfair value.

 

**Fair Value of Financial Instruments -**The carryingamounts for certain financial instruments, including cash and cash equivalents,contract receivables and accounts payable, approximate fair value due to theirshort maturities.  We estimate the fairvalue of our debt based on current rates offered to us for debt of the sameremaining maturities, if available, or if not available, based on discountedfuture cash flows using current market interest rates.  As of September 30, 2010, we had no debtoutstanding. As of December 31, 2009, we estimated the fair value of ourfixed rate senior term loan and revolver were $0.3 million and $1.5 million,respectively.

 

**Revenue Recognition**- We recognize revenuewhen an agreement is signed, the fee is fixed or determinable andcollectability is reasonably assured. We recognize revenue from two primarysources: license fees and services, and customer support.   Themajority of our license fees and services revenue is generated from fixed-pricecontracts, which provide for licenses to our software products and services tocustomize such software to meet our customers’ use.   When the customization services aredetermined to be essential to the functionality of the delivered software, werecognize revenue using the percentage-of-completion method of accounting. Inthese types of arrangements, we do not typically have vendor specific objectiveevidence (“VSOE”) of fair value on the license fee/services portion (servicesare related to customizing the software) of the arrangement due to the largeamount of customization required by our customers; however, we do have VSOE forthe warranty/maintenance services based on the renewal rate of the first yearof maintenance in the arrangement. The license/services portion is recognizedusing the percentage-of-completion method of accounting and thewarranty/maintenance services are separated based on the renewal rate in thecontract and recognized ratably over the warranty or maintenance period. Weestimate the percentage-of-completion for each contract based on the ratio ofdirect labor hours incurred to total estimated direct labor hours and recognizerevenue based on the percent complete multiplied by the contract amountallocated to the license fee/services. Since estimated direct labor hours, and changes thereto, can have asignificant impact on revenue recognition, these estimates are critical and wereview them regularly. If the arrangement includes a customer acceptanceprovision, the hours to complete the acceptance testing are included in thetotal estimated direct labor hours; therefore, the related revenue isrecognized as the acceptance testing is performed. Revenue is not recognized infull until the customer has provided proof of acceptance on thearrangement.  We record amounts billed inadvance of services being performed as unearned revenue. Unbilledwork-in-progress represents revenue earned but not yet billable under the termsof the fixed-price contracts. All such amounts are expected to be billed andcollected within 12 months.

 

Wemay encounter budget and schedule overruns on fixed-price contracts causedby increased labor or overhead costs. We make adjustments to cost estimates inthe period in which the facts requiring such revisions become known. We recordestimated losses, if any, in the period in which current estimates of totalcontract revenue and contract costs indicate a loss. If revisions to costestimates are obtained after the balance sheet date but before the issuance ofthe interim or annual financial statements, we make adjustments to the interimor annual financial statements accordingly.

 

In arrangements where the services are not essential to thefunctionality of the delivered software, we recognize license revenue when alicense agreement has been signed, delivery and acceptance have occurred, thefee is fixed or determinable and collectability is reasonably assured. Whereapplicable, we unbundle and record as revenue fees from multiple elementarrangements as the elements are delivered to the extent that VSOE of fairvalue of the undelivered elements exist. If VSOE for the undelivered elementsdoes not exist, we defer fees from such arrangements until the earlier of the datethat VSOE does exist on the undelivered elements or all of the elements havebeen delivered.

 

Werecognize revenue from fixed-price service contracts using the proportionalperformance method of accounting, which is similar to thepercentage-of-completion method described above. We recognize revenue fromprofessional services provided pursuant to time-and-materials based contractsand training services as the services are performed, as that is when ourobligation to our customers under such arrangements is fulfilled.

 

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Werecognize customer support, including maintenance revenue, ratably over theservice contract period. When maintenance is bundled with the original licensefee arrangement, its fair value, based upon VSOE, is deferred and recognizedduring the periods when services are provided.

 

**Stock-based Compensation -** We account forstock-based compensation by applying a fair-value-based measurement method toaccount for share-based payment transactions with employees and directors andrecord compensation cost for all stock awards granted after January 1,2006 and awards modified, repurchased, or cancelled after that date. We recordcompensation costs associated with the vesting of unvested options on astraight-line basis over the vesting period. Stock-based compensation is a non-cash expense because we settle theseobligations by issuing shares of our common stock instead of settling suchobligations with cash payments.    We usethe Black-Scholes model to estimate the fair value of each option grant on thedate of grant.  This model requires theuse of estimates for expected term of the options and expected volatility ofthe price of our common stock.

 

**Income Taxes**- We record deferredtax assets and liabilities for the estimated future tax effects of temporarydifferences between the tax bases of assets and liabilities and amountsreported in the accompanying consolidated balance sheets, as well as operatingloss and tax credit carry-forwards. We measure deferred tax assets andliabilities using enacted tax rates expected to be applied to taxable income inthe years in which those temporary differences are expected to be recovered orsettled.  We reduce deferred tax assetsby a valuation allowance if, based on available evidence, it is more likelythan not that these benefits will not be realized.  We evaluate tax benefits recorded in ourconsolidated financial statements and record accruals for any amounts deemednot probable of being sustained.

 

We use a recognition threshold and a measurement attribute for thefinancial statement recognition and measurement of tax positions taken orexpected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likelythan not to be sustained upon examination by taxing authorities.

 

As of September 30, 2010 and December 31, 2009, we had noliability for unrecognized tax benefits. We do not believe there will be any material changes to our unrecognizedtax positions over the next twelve months.

 

**NOTE 2 —GOODWILL AND INTANGIBLE ASSETS**

 

We recorded goodwill as a result of three acquisitions which occurredover the period from November 2003 to November 2004. We acquired CMSin November 2003, TSE in October 2004 and Evolving Systems U.K. in November 2004.

 

Changes in the carrying amount of goodwill byreporting unit were as follows (in thousands):

 
| ** **                                             | ** ** | **License and Services** | ** ** | **Customer Support** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                             | ** ** | **US**                             | ** ** | **UK**                    | ** ** | **US**    | ** ** | **UK** | ** ** | **Goodwill** | ** ** |
| Balance as of December 31, 2009                   |       | $                                  | —     |                      | $          | 7,274     |       | $ | 6,033 |   | $ | 8,988 |   | $ | 22,295 |   |
| Effects of changes in foreign currency exchange  rates |       | —                             |       | (54                       | )          | —    |       | (66 | ) | (120 | ) |
| Balance as of September 30, 2010                  |       | $                                  | —     |                      | $          | 7,220     |       | $ | 6,033 |   | $ | 8,922 |   | $ | 22,175 |   |

 

We conducted our annual goodwill impairmenttest as of July 31, 2010, and we determined that goodwill was not impairedas of the test date. From July 31, 2010 through September 30, 2010,no events have occurred that we believe may have impaired goodwill.

 

We amortized identifiable intangible assetson a straight-line basis over estimated lives ranging from one to seven yearsand include the cumulative effects of foreign currency exchange rates.  As of September 30, 2010 and December 31,2009, identifiable intangibles were as follows (in thousands):

 
| ** **                | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** | **Weighted-**             | ** ** |
|---------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------|------------|
| ** **                | ** ** | **(1) Gross  Amount**       | ** ** | **Accumulated  Amortization**   | ** ** | **Net  Carrying  Amount** | ** ** | **(1)  Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Average  Amortization  Period** | ** ** |
| Purchased software        |       | $                                | 1,702      |                            | $          | 1,491                     |       | $ | 211 |   | $ | 1,712 |   | $ | 1,287 |   | $ | 425 |   | 4.6 yrs |   |
| Purchased licenses        |       | 227                              |       | 227                             |       | —                    |       | 227 |   | 227 |   | — |   | 2.3 yrs |   |
| Trademarks and tradenames |       | 709                              |       | 431                             |       | 278                       |       | 715 |   | 357 |   | 358 |   | 7.0 yrs |   |
| Business partnerships     |       | 116                              |       | 98                              |       | 18                        |       | 116 |   | 82 |   | 34 |   | 5.0 yrs |   |
| Customer relationships    |       | 3,161                            |       | 2,345                           |       | 816                       |       | 3,177 |   | 2,130 |   | 1,047 |   | 5.3 yrs |   |
|                      |       | $                                | 5,915      |                            | $          | 4,592                     |       | $ | 1,323 |   | $ | 5,947 |   | $ | 4,083 |   | $ | 1,864 |   | 5.2 yrs |   |

 

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(1)  Changes in intangible gross values as of September 30,2010 compared to December 31, 2009 are the direct result of changes inforeign currency exchange rates for the periods then ended.

 

Amortization expense of identifiable intangible assets was $0.2 millionfor the three months ended September 30, 2010 and 2009 and $0.5 millionfor the nine months ended September 30, 2010 and 2009, respectively.  As Evolving Systems U.K. uses the BritishPound Sterling as its functional currency, the amount of future amortizationactually recorded will be based upon exchange rates in effect at that time.Expected future amortization expense related to identifiable intangibles basedon our carrying amount as of September 30, 2010 was as follows (inthousands):

 
| **Twelve months ending September 30,** | ** ** | ** ** | ** ** |
|------------------------------------------------------------|------------|------------|------------|
| 2011                                                       |       | $          | 627        |   |
| 2012                                                       |       | 398        |       |
| 2013                                                       |       | 298        |       |
|                                                       |       | $          | 1,323      |   |

 

**NOTE 3 —EARNINGS PER COMMON SHARE**

 

Wecompute basic earnings per share (“EPS”) by dividing net income or lossavailable to common stockholders by the weighted average number of sharesoutstanding during the period, including common stock issuable underparticipating securities. We compute diluted EPS using the weighted averagenumber of shares outstanding, including participating securities, plus allpotentially dilutive common stock equivalents. Common stock equivalents consistof stock options.

 

Wehave a policy providing that unvested share-based payment awards that containnon-forfeitable rights to dividends or dividend equivalents, whether paid orunpaid, are participating securities and shall be included in the computationof both basic and diluted earnings per share.

 

Thefollowing is the reconciliation of the denominator of the basic and diluted EPScomputations (in thousands):

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| Basic income per common and preferred share:               |       |                                                 |       |                                                |       |   | ** ** | ** ** | ** ** |
| Net income available to common and preferred  stockholders |       | $                                                    | 1,576      |                                                | $          | 1,328 |   | $ | 4,190 |   | $ | 3,399 |   |
| Basic weighted average shares outstanding                  |       | 10,157                                               |       | 9,797                                               |       | 10,067 |   | 9,780 |   |
| Basic income per common and preferred share                |       | $                                                    | 0.16       |                                                | $          | 0.14 |   | $ | 0.42 |   | $ | 0.35 |   |
|                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Diluted income per common and preferred share:             |       |                                                 |       |                                                |       |   |   |   |   |
| Net income available to common and preferred  stockholders |       | $                                                    | 1,576      |                                                | $          | 1,328 |   | $ | 4,190 |   | $ | 3,399 |   |
| Weighted average common shares outstanding                 |       | 10,157                                               |       | 9,797                                               |       | 10,067 |   | 9,780 |   |
| Effect of dilutive securities — options               |       | 650                                                  |       | 452                                                 |       | 650 |   | 244 |   |
| Diluted weighted average shares outstanding                |       | 10,807                                               |       | 10,249                                              |       | 10,717 |   | 10,024 |   |
| Diluted income per common and preferred share              |       | $                                                    | 0.15       |                                                | $          | 0.13 |   | $ | 0.39 |   | $ | 0.34 |   |

 

Forthe three months ended September 30, 2010 and 2009, 0.4 million and 0.9million shares of common stock were excluded from the dilutive stockcalculation because their exercise prices were greater than the average fairvalue of our common stock for the period.

 

Forthe nine months ended September 30, 2010 and 2009, 0.4 million and 1.8million shares of common stock were excluded from the dilutive stockcalculation because their exercise prices were greater than the average fairvalue of our common stock for the period.

 

**NOTE 4 —SHARE-BASED COMPENSATION**

 

Weaccount for stock-based compensation by applying a fair-value-based measurementmethod to account for share-based payment transactions with employees anddirectors, and record compensation cost for all stock awards granted after January 1,2006 and awards modified, repurchased, or cancelled after that date, using themodified prospective method. We record compensation costs associated with thevesting of unvested options on a straight-line basis over the vesting period.We recognized $0.2 million for each of the three months ended September 30,2010 and 2009 and $0.7 million and $0.6 million for the nine month periodsended September 30, 2010 and 2009, respectively, of compensation expensein the consolidated statements of operations, with respect to our stock-basedcompensation plans.  The following tablesummarizes stock-based compensation expenses recorded in the consolidatedstatement of operations (in thousands):

 

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| ** **                                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| Cost of license fees and services, excluding depreciation  and amortization |       | $                                                    | 15         |                                                | $          | 16 |   | $ | 43 |   | $ | 51 |   |
| Cost of customer support, excluding depreciation  and amortization          |       | 7                                                    |       | 2                                                   |       | 14 |   | 6 |   |
| Sales and marketing                                                         |       | 26                                                   |       | 36                                                  |       | 84 |   | 107 |   |
| General and administrative                                                  |       | 164                                                  |       | 146                                                 |       | 510 |   | 417 |   |
| Product development                                                         |       | 29                                                   |       | 23                                                  |       | 86 |   | 68 |   |
|                                                                        |       | $                                                    |  241  |                                                | $          | 223 |   | $ | 737 |   | $ | 649 |   |

 

**Stock Incentive Plans**

 

In January 1996, our stockholders approved an Amended and RestatedStock Option Plan (the “Option Plan”). Under the Option Plan, as amended, 4,175,000 shares were reserved forissuance.  Options issued under the OptionPlan were at the discretion of the Board of Directors, including the vestingprovisions of each stock option granted. Options were granted with an exerciseprice equal to the closing price of our common stock on the date of grant,generally vest over four years and expire no more than ten years from the dateof grant. The Option Plan terminated on January 18, 2006; options grantedbefore that date were not affected by the plan termination.  At September 30, 2010 and December 31,2009, 1.4 million and 1.7 million options remained outstanding under the OptionPlan, respectively.

 

In March 2007, upon the hiring of our Vice President of World WideSales and Marketing, in accordance with NASDAQ Marketplace Rule 4350(i)(1)(a)(iv),the Board of Directors approved an inducement award under a stand-alone equityincentive plan.  We granted 50,000non-qualified options to purchase shares of our common stock at an exerciseprice equal to the closing price of our common stock on the date of grant.  The options vest over four years and expireten years from the date of grant. At September 30, 2010 and December 31,2009, 50,000 options remained outstanding under this plan.

 

In June 2007, our stockholders approved the 2007 Stock IncentivePlan (the “2007 Stock Plan”)with a maximum of 1,000,000 reserved for issuance.In June 2010, our stockholders approved an amendment to the 2007 StockPlan which increased the maximum shares that may be awarded under the plan to1,250,000. Awards permitted under the 2007 Stock Plan include:  Stock Options, Stock Appreciation Rights,Restricted Stock, Restricted Stock Units, Performance Awards and OtherStock-Based Awards.  Awards issued underthe 2007 Stock Plan are at the discretion of the Board of Directors.  As applicable, awards are granted with anexercise price equal to the closing price of our common stock on the date ofgrant, generally vest over four years for employees and one year for directorsand expire no more than ten years from the date of grant.  At September 30, 2010, there wereapproximately 0.2 million shares available for grant under the 2007 Stock Plan,as amended. At September 30, 2010 and December 31, 2009, 0.7 millionand 0.6 million options were issued and outstanding under the 2007 Stock Plan,respectively.

 

During the three and nine months ended September 30, 2010, weawarded a total of 0 and 48,750 shares of restricted stock to members of ourBoard of Directors and senior management. There were no issuances of restrictedstock during the three or nine months ended September 30, 2009. During thethree months ended September 30, 2010 and 2009, 11,000 and 10,000 sharesof restricted stock vested, respectively. During the nine months ended September 30, 2010 and 2009, 34,000and 31,000 shares of restricted stock vested, respectively. There were noforfeitures of restricted stock during the three or nine months ended September 30,2010 and 2009. The fair market value for share-based compensation expensing isequal to the closing price of our common stock on the date of grant.Stock-based compensation expense includes $51,000 and $0.2 million for thethree and nine months ended September 30, 2010, respectively, and $28,000and $84,000 for the three and nine months ended September 30, 2009,respectively, of expense related to restricted stock grants. The restrictionson the stock award are released generally over four years for senior managementand over one year for board members.

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes model.  TheBlack-Scholes model uses four assumptions to calculate the fair value of eachoption grant.  The expected term of shareoptions granted is derived using the simplified method, which we adopted in January 2008.The risk-free interest rate is based upon the rate currently available onzero-coupon U.S. Treasury instruments with a remaining term equal to theexpected term of the stock options.  Theexpected volatility is based upon historical volatility of our common stockover a period equal to the expected term of the stock options.  The expected dividend yield is based uponhistorical and anticipated payment of dividends.  The weighted-average assumptions used in thefair value calculations are as follows:

 

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| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **              | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| Expected term (years)   |       | *                                                        |       | *                                                       |       | 5.9 |   | 5.3 |   |
| Risk-free interest rate |       | *                                                        |       | *                                                       |       | 2.5 | % | 2.4 | % |
| Expected volatility     |       | *                                                        |       | *                                                       |       | 73.8 | % | 78.0 | % |
| Expected dividend yield |       | *                                                        |       | *                                                       |       | 0.3 | % | 0 | % |

 

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* - None granted

 

The following is a summary of stock option activity under the plans forthe nine months ended September 30, 2010:

 
| ** **                                     | ** ** | **Number of  Shares  (in thousands)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (Years)** | ** ** | **Aggregate  Intrinsic  Value  (in thousands)** | ** ** |
|------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------------|------------|
| Options outstanding at December 31, 2009  |       | 2,264                                           |       | $                                       | 5.57       |                                                          |       |                                                 | $          | 4,304 |   |
| Options granted                                |       | 210                                             |       | $                                       | 6.28       |                                                          |       |                                                 |       |   |
| Less options forfeited                         |       | (8                                              | )          | $                                       | 6.14       |                                                          |       |                                                 |       |   |
| Less options exercised                         |       | (264                                            | )          | $                                       | 4.68       |                                                          |       |                                                 |       |   |
| Options outstanding at September 30, 2010 |       | 2,202                                           |       | $                                       | 5.74       |                                                          | 5.10       |                                                 | $          | 6,088 |   |
|                                           |       |                                            |       |                                    |       |                                                          |       |                                                 |       |
| Options exercisable at September 30, 2010 |       | 1,844                                           |       | $                                       | 5.97       |                                                          | 4.42       |                                                 | $          | 5,054 |   |

 

All stock option amountshave been adjusted for the reverse stock split.

 

There were no stock options granted during the three months ended September 30,2010 and 2009. The weighted-average grant-date fair value of stock optionsgranted during the nine months ended September 30, 2010 and 2009 was $3.89and $2.20, respectively.

 

As of September 30, 2010, there was approximately $1.0 million oftotal unrecognized compensation costs related to unvested stock options.  These costs are expected to be recognizedover a weighted average period of 2.0 years.

 

The total fair value of stock options vested during the three monthsended September 30, 2010 and 2009 was $0.2 million. The total fair valueof stock options vested during the nine months ended September 30, 2010and 2009 was $0.5 million and $0.7 million, respectively.

 

The deferred income tax benefits from stock option expense related toEvolving Systems U.K. totaled approximately $15,000 for the three months endedSeptember 30, 2010 and 2009. The deferred income tax benefits from stockoption expense related to Evolving Systems U.K. totaled approximately $45,000for the nine months ended September 30, 2010 and 2009.

 

Cash received from stock option exercises for the three months ended September 30,2010 and 2009 was $0.7 million and $0.2 million, respectively. Cash receivedfrom stock option exercises for the nine months ended September 30, 2010and 2009 was $1.3 million and $0.2 million, respectively.

 

**Employee Stock Purchase Plan**

 

Under the Employee Stock Purchase Plan (“ESPP”), we were previouslyauthorized to issue up to 1,100,000 shares of our common stock to full-timeemployees, nearly all of whom are eligible to participate. After the reversestock split, we are now authorized to issue up to 550,000 shares under theESPP. Under the terms of the ESPP, employees may elect to have up to 15% oftheir gross compensation withheld through payroll deduction to purchase ourcommon stock, capped at $25,000 annually and no more than 10,000 shares peroffering period. The purchase price of the stock is 85% of the lower of themarket price at the beginning or end of each three-month participation period.As of September 30, 2010, there were approximately 81,000 shares availablefor purchase.  For the three months endedSeptember 30, 2010 and 2009, we recorded compensation expense of $3,000and $5,000, respectively, and $10,000 and $16,000 for each of the nine monthperiods ended September 30, 2010 and 2009, respectively, associated withgrants under the ESPP which includes the fair value of the look-back feature ofeach grant as well as the 15% discount on the purchase price.  This expense fluctuates each period primarilybased on the level of employee participation.

 

The fair value of each purchase made under our ESPP is estimated on thedate of purchase using the Black-Scholes model. The Black-Scholes model uses four assumptions to calculate the fairvalue of each purchase.  The expectedterm of each purchase is based upon the three-month participation period of eachoffering.  The risk-free interest rate isbased upon the rate currently available on zero-coupon U.S. Treasuryinstruments with a remaining term equal to the expected term of each offering.  The expected volatility is based 

 

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upon historical volatility of our common stock.  The expected dividend yield is based uponhistorical and anticipated payment of dividends.  The weighted average assumptions used in thefair value calculations are as follows:

 
| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **              | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| Expected term (years)   |       | 0.25                                                     |       | 0.25                                                    |       | 0.25 |   | 0.25 |   |
| Risk-free interest rate |       | 0.2                                                      | %          | 0.2                                                     | %          | 0.1 | % | 0.1 | % |
| Expected volatility     |       | 60.1                                                     | %          | 66.0                                                    | %          | 62.3 | % | 65.2 | % |
| Expected dividend yield |       | 2.8                                                      | %          | 0                                                       | %          | 0.8 | % | 0 | % |

 

Cash received from employee stock plan purchases for the three monthsended September 30, 2010 and 2009 was $13,000 and $16,000, respectively.  Cash received from employee stock planpurchases for the nine months ended September 30, 2010 and 2009 was$40,000 and $51,000, respectively. 

 

We issued shares related to the ESPP of approximately 2,000 and 9,000for the three months ended September 30, 2010 and 2009, respectively. Weissued shares related to the ESPP of approximately 7,000 and 32,000 for thenine months ended September 30, 2010 and 2009, respectively. 

 

**NOTE 5 —CONCENTRATION OF CREDIT RISK**

 

Forthe three months ended September 30, 2010 and 2009, two significantcustomers (defined as contributing at least 10%) accounted for 28% (18% and10%) and 28% (15% and 13%), respectively, of total revenue.  For the three months ended September 30,2010, these customers are a large telecommunications operator in the U.S. and alarge telecommunications operator in Canada. For the three months ended September 30,2009, these customers were a large telecommunications operator in the U.S. anda large telecommunications operator in Asia. For the nine months ended September 30,2010 and 2009, one significant customer accounted for 16% and 20% of totalrevenue, respectively. This customer is a large telecommunications operator inthe U.S. 

 

Asof September 30, 2010, one significant customer accounted forapproximately 10% of contract receivables and unbilled work-in-progress.  This customer is a large telecommunicationsoperator in Indonesia.  AtDecember 31, 2009, one significant customer accounted for approximately38% of contract receivables and unbilled work-in-progress.  This customer is a large telecommunicationsoperator located in the U.S. 

 

**NOTE 6 —LONG-TERM DEBT**

 

Long-termdebt consists of the following (in thousands):

 
| ** **                                                                                                                                                                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                   | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| Senior term loan with financial institution, interest at a fixed rate  of 8.25%, principal installments and interest payments are due monthly with  final maturity on February 22, 2010. The loan is secured by  substantially all of our assets.                                                                                       |       | $                      | —     |                  | $          | 333 |   |
|                                                                                                                                                                                                                                                                                                                                         |       |                   |       |                  |       |
| $3.5 million U.K.  revolving credit facility payable to financial institution, interest at Prime  Rate plus 0.5%; interest rate was 3.75% at September 30, 2010 and  December 31, 2009. Interest is payable monthly with remaining principal  due February 22, 2011. The loan is secured by substantially all of our  assets. |       | —                 |       | 1,500                 |       |
| Total debt                                                                                                                                                                                                                                                                                                                                   |       | —                 |       | 1,833                 |       |
| Less current portion                                                                                                                                                                                                                                                                                                                         |       | —                 |       | (333                  | )          |
| Long-term debt, excluding current portion                                                                                                                                                                                                                                                                                                    |       | $                      | —     |                  | $          | 1,500 |   |

 

Our $2.5 million U.S. revolving creditfacility (“U.S. Revolving Facility”) bears interest at Prime Rate plus0.5%.  Prime Rate was 3.25% as of September 30,2010.  Borrowings under the revolvingfacilities are limited to a percentage of our eligible accounts receivable andcash.  The U.S. Revolving Facility issecured by all assets of Evolving Systems, Inc. and is subject to certainaffirmative and negative covenants, including financial covenants related tomaintaining a specified ratio of debt to EBITDA, as defined, minimum EBITDA,minimum liquidity, and a specified fixed charge ratio.  All accrued interest on outstandingborrowings under the U.S. Revolving Facility is paid monthly, with anyoutstanding balance due with a final maturity of February 22, 2011.  As of September 30, 2010, we had $2.5million in availability, but no borrowing outstanding under this U.S. RevolvingFacility.

 

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Our $3.5 million U.K. Revolving Facilitybears interest at Prime Rate plus 0.5%. Prime Rate was 3.25% as of September 30, 2010.  Borrowings under the U.K. Revolving Facilityare limited to a percentage of our eligible accounts receivable and cash.  The U.K. Revolving Facility is secured by allassets of Evolving Systems Holdings Ltd. and Evolving Systems Ltd. and issubject to certain affirmative and negative covenants, including financialcovenants related to maintaining a specified ratio of debt to EBITDA, asdefined, minimum EBITDA, minimum liquidity, and a specified fixed charge ratio.All accrued interest on outstanding borrowings under the U.K. RevolvingFacility is paid monthly, with any outstanding balance due with a finalmaturity of February 22, 2011.  Asof September 30, 2010, we had $3.5 million in availability but noborrowings outstanding under this U.K. Revolving Facility.

 

Wewere in compliance with all of our debt covenants as of September 30, 2010and December 31, 2009.

 

**NOTE 7 —INCOME TAXES**

 

Werecorded net income tax expense of $122,000 and $380,000 for the three monthsended September 30, 2010 and 2009, respectively.  The net expense during the three months endedSeptember 30, 2010 consisted of income tax expense of $185,000 and adeferred tax benefit of $63,000. The current tax expense consists of income taxfrom our U.K.-based operations, Alternative Minimum Tax (“AMT”) andunrecoverable foreign withholding tax in the U.S. and Minimum Alternative Tax (“MAT”)from our Indian operations. The deferred tax benefit was related to intangibleassets from our U.K.-based operations. The net expense during the three monthsended September 30, 2009 consisted of income tax expense of $444,000 and adeferred tax benefit of $64,000. The current tax expense consists of income taxfrom our U.K.-based operations, AMT and unrecoverable foreign withholding taxin the U.S. and MAT from our Indian operations.

 

Werecorded net income tax expense of $688,000 and $438,000 for the nine monthsended September 30, 2010 and 2009, respectively.  The net expense during the nine months ended September 30,2010 consisted of income tax expense of $877,000 and a deferred tax benefit of$189,000. The current tax expense consists of income tax from our U.K.-basedoperations, AMT and unrecoverable foreign withholding tax in the U.S. and MATfrom our Indian operations. The deferred tax benefit was related to intangibleassets from our U.K.-based operations. The net expense during the nine monthsended September 30, 2009 consisted of income tax expense of $610,000 and adeferred tax benefit of $172,000. The current tax expense consists of incometax from our U.K.-based operations, AMT and unrecoverable foreign withholdingtax in the U.S. and MAT from our Indian operations.

 

Inconjunction with the acquisition of Evolving Systems U.K., we recorded certainidentifiable intangible assets.  Sincethe amortization of these identifiable intangibles is not deductible for incometax purposes, we established a long-term deferred tax liability of $4.6 millionat the acquisition date for the expected difference between what would beexpensed for financial reporting purposes and what would be deductible forincome tax purposes. As of September 30, 2010 and December 31, 2009,this component of the deferred tax liability was $0.4 million and $0.5 million,respectively.  This deferred taxliability relates to Evolving Systems U.K., and has no impact on our ability torecover U.S.-based deferred tax assets. This deferred tax liability will be recognized as a reduction ofdeferred income tax expense as the identifiable intangibles are amortized.

 

Asof September 30, 2010 and December 31, 2009 we continued to maintaina full valuation allowance on the domestic net deferred tax asset as we havedetermined it is more likely than not that we will not realize our domesticdeferred tax assets.  Such assetsprimarily consist of certain net operating loss carryforwards.  We assessed the realizability of our domesticdeferred tax assets using all available evidence.  In particular, we considered both historicalresults and projections of profitability for the reasonably foreseeable futureperiods.  We are required to reassess ourconclusions regarding the realization of our deferred tax assets at eachfinancial reporting date. A future evaluation could result in a conclusion thatall or a portion of the valuation allowance is no longer necessary, which couldhave a material impact on our results of operations and financial position.

 

As of September 30, 2010 and December 31, 2009, we had noliability for unrecognized tax benefits. We do not believe there will be any material changes in our unrecognizedtax positions over the next twelve months.

 

We conduct business globally and, as a result, Evolving Systems, Inc.or one or more of our subsidiaries file income tax returns in the U.S. federaljurisdiction and various state and foreign jurisdictions.  In the normal course of business, we aresubject to examination by taxing authorities throughout the world, namely theUnited Kingdom, Germany and India.

 

**NOTE 8 —STOCKHOLDERS’ EQUITY**

 

**Common Stock Dividend**

 

OurBoard of Directors declared a third quarter cash dividend of $.05 per share,payable October 15, 2010, to stockholders of record September 10,2010. The dividend was accrued as of September 30, 2010 for $0.5 millionand paid on October 15, 2010. Previously, our Board of Directors declareda second quarter cash dividend of $.05 per share, payable July 15, 2010,to stockholders of record June 10, 2010. The dividend was accrued as of June 30,2010 for $0.5 million and paid on July 15, 2010.

 

Anydetermination to declare a future quarterly dividend, as well as the amount ofany cash dividend which may be declared, will be based on our financialposition, earnings, earnings outlook and other relevant factors at that time.

 

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**Certain****Anti-TakeoverProvisions/Agreements with Stockholders**

 

Our restated certificate of incorporation allows the board of directorsto issue up to 2,000,000 shares of preferred stock and to determine the price,rights, preferences and privileges of those shares without any further vote oraction by our stockholders. The rights of the holders of our common stock willbe subject to, and may be adversely affected by, the rights of the holders ofany preferred stock that may be issued in the future. Issuance of preferredstock, while providing desired flexibility in connection with possibleacquisitions and other corporate purposes could make it more difficult for athird party to acquire a majority of our outstanding voting stock. As of September 30,2010 and December 31, 2009, no shares of Preferred Stock are outstanding.

 

In addition, we are subject to the anti-takeover provisions ofSection 203 of Delaware General Corporation Law which prohibit us fromengaging in a “business combination” with an “interested stockholder” for aperiod of three years after the date of the transaction in which theperson became an interested stockholder, unless the business combination isapproved in the prescribed manner. The application of Section 203 andcertain provisions of our restated certificate of incorporation, including aclassified board of directors, may have the effect of delaying or preventingchanges in control of our management, which could adversely affect the marketprice of our common stock by discouraging or preventing takeover attempts thatmight result in the payment of a premium price to our stockholders.

 

OnMarch 4, 2009 our Board of Directors adopted a Stockholder Rights Plan(the “Rights Agreement) that is designed to strengthen the ability of the Boardof Directors to protect Evolving Systems’ stockholders.  The RightsAgreement was not adopted in response to any unsolicited offer or takeoverattempt. Under the plan, each common stockholder at the close of business onMarch 16, 2009 received a dividend of one right for each share of ourcommon stock held of record on that date.  Each right will entitle theholder to purchase, in certain circumstances, two one-hundredths of a share ofnewly-created Series C junior participating preferred stock for an initialpurchase price of $8.00 per share. The rights distribution was not taxable tostockholders and the distribution of rights under the plan will not interferewith the Company’s business plans or be dilutive to or affect our reported pershare results. The rights will generally become exercisable ten business daysafter any person becomes the beneficial owner of 22.5% (see below for increasesto this percentage) or more of our common stock or has commenced a tender orexchange offer which, if consummated, would result in any person becoming thebeneficial owner of 22.5% or more of our common stock.

 

OnDecember 10, 2009, the Board of Directors approved an amendment to theRights Agreement.  The amendment increased, from 22.5% to 25.0%, thepercentage of our common stock that a person or group of affiliated orassociated persons may beneficially own without triggering the exercisabilityof the Rights Agreement.  All other provisions of the Rights Agreementremain unchanged.

 

OnDecember 11, 2009, we received a letter from the Singer Trust informing usthat as the result of the appointment of John B. Spirtos to our Board ofDirectors and our approval of the amendment to the Rights Agreement the SingerTrust would vote in favor of the reelection of Philip Neches and RichardRamlall to our Board of Directors at our 2010 annual meeting of stockholdersand the Singer Trust would not seek or otherwise support additional stockholderprotections or reforms at the meeting.

 

OnApril 20, 2010, our Board of Directors approved an amendment to the RightsAgreement increasing, from 25.0% to 29.0%, the percentage of the our commonstock, that a person or group of affiliated or associated persons maybeneficially own without triggering the exercisability of the Rights Agreement.All other provisions of the Rights Agreement remain unchanged.

 

OnApril 20, 2010, we entered into an agreement with the Singer Trust (the “Trust”),to increase the size of the Compensation Committee of the Board of Directorsfrom three (3) members to four (4) and, for so long as the Trust isthe beneficial holder of twenty percent (20%) or more of our common stock,there would be at least two (2) persons to the Compensation Committee whohave been nominated to the Board of Directors by the Trust. We also agreed thatall action by the Compensation Committee would require unanimous approval ofthe members. The Trust agreed that it would vote its shares at the 2010 annualmeeting of stockholders in favor of a proposal to amend the Company’s 2007Stock Incentive Plan to provide that, exclusive of shares of Common Stocksubject to awards existing as at April 20, 2010 (which shares, when nolonger subject to such awards, may not be added to the Plan’s share reserve),the total number of shares of Common Stock authorized for issuance under theplan would be 250,000 shares and to provide for certain other amendments.

 

**NOTE 9 —SEGMENT INFORMATION**

 

Wedefine operating segments as components of our enterprise for which separatefinancial information is reviewed regularly by the chief operatingdecision-makers to evaluate performance and to make operating decisions. Wehave identified our Chief Executive Officer and Chief Financial Officer as ourchief operating decision-makers (“CODM”). These chief operating decision makersreview revenues by segment and review overall results of operations.

 

Wecurrently operate our business as two operating segments based on revenuetype:  license fees and services revenueand customer support revenue (as shown on the consolidated statements ofoperations).  License fees and services (“L&S”)revenue represents the fees received from the license of software products andthose services directly related to the delivery of the licensed products, suchas fees for custom development and integration services.  Customer support (“CS”) revenue includesannual support fees, recurring maintenance fees, fees for maintenance upgradesand warranty services.  Warranty servicesthat are similar to software maintenance services are typically bundled with alicense sale. Total assets by segment have not been disclosed as theinformation is

 

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notavailable to the chief operating decision-makers.

 

Segmentinformation is as follows (in thousands):

 
| ** **                                                                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Revenue**                                                                 | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** |   |   |   |
| License fees and services                                                   |       | $                                                        | 4,891      |                                                    | $          | 5,836 |   | $ | 16,184 |   | $ | 15,940 |   |
| Customer support                                                            |       | 4,353                                                    |       | 4,077                                                   |       | 12,519 |   | 12,445 |   |
| Total revenue                                                               |       | 9,244                                                    |       | 9,913                                                   |       | 28,703 |   | 28,385 |   |
|                                                                        |       |                                                     |       |                                                    |       |   |   |   |   |
| **Revenue less costs of revenue,  excluding depreciation and amortization** |       |                                                     |       |                                                    |       |   |   |   |   |
| License fees and services                                                   |       | 2,927                                                    |       | 3,852                                                   |       | 10,113 |   | 10,214 |   |
| Customer support                                                            |       | 3,103                                                    |       | 2,625                                                   |       | 8,983 |   | 8,159 |   |
|                                                                        |       | 6,030                                                    |       | 6,477                                                   |       | 19,096 |   | 18,373 |   |
| **Unallocated Costs**                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Other operating expenses                                                    |       | 4,063                                                    |       | 4,497                                                   |       | 13,103 |   | 12,539 |   |
| Depreciation and amortization                                               |       | 318                                                      |       | 354                                                     |       | 958 |   | 1,022 |   |
| Interest income                                                             |       | (6                                                       | )          | (1                                                      | )          | (10 | ) | (24 | ) |
| Interest expense                                                            |       | 20                                                       |       | 145                                                     |       | 81 |   | 563 |   |
| Foreign currency exchange (gain) loss                                       |       | (63                                                      | )          | (226                                                    | )          | 86 |   | 436 |   |
| **Income before income taxes**                                              |       | $                                                        | 1,698      |                                                    | $          | 1,708 |   | $ | 4,878 |   | $ | 3,837 |   |

 

***Geographic Regions***

 

We are headquartered in Englewood, a suburb ofDenver, Colorado.  We use customerlocations as the basis for attributing revenues to individual countries.  We provide products and services on a globalbasis through our headquarters and our London-based Evolving Systems U.K.subsidiary.  Additionally, personnel inBangalore, India provide software development services to our globaloperations.  Financial informationrelating to operations by geographic region is as follows (in thousands):

 
| ** **     | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------|------------|----------------------------------------------------------|------------|
| ** **     | ** ** | **2010**                                                 | ** ** | **2009** | ** ** |
| ** **     | ** ** | **L&S**                                              | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**    |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| United States  |       | $                                                        | 599        |   | $ | 2,120 |   | $ | 2,719 |   | $ | 335 |   | $ | 2,208 |   | $ | 2,543 |   |
| United Kingdom |       | 626                                                      |       | 501 |   | 1,127 |   | 673 |   | 553 |   | 1,226 |   |
| Indonesia      |       | —                                                   |       | 155 |   | 155 |   | 1,342 |   | 28 |   | 1,370 |   |
| Other          |       | 3,666                                                    |       | 1,577 |   | 5,243 |   | 3,486 |   | 1,288 |   | 4,774 |   |
| Total revenues |       | $                                                        | 4,891      |   | $ | 4,353 |   | $ | 9,244 |   | $ | 5,836 |   | $ | 4,077 |   | $ | 9,913 |   |

** **
| ** **     | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------|------------|---------------------------------------------------------|------------|
| ** **     | ** ** | **2010**                                                | ** ** | **2009** | ** ** |
| ** **     | ** ** | **L&S**                                             | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**    |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| United States  |       | $                                                       | 2,251      |   | $ | 6,280 |   | $ | 8,531 |   | $ | 1,681 |   | $ | 7,114 |   | $ | 8,795 |   |
| United Kingdom |       | 2,008                                                   |       | 1,500 |   | 3,508 |   | 1,998 |   | 1,572 |   | 3,570 |   |
| Indonesia      |       | 2,194                                                   |       | 279 |   | 2,473 |   | 2,169 |   | 83 |   | 2,252 |   |
| Other          |       | 9,731                                                   |       | 4,460 |   | 14,191 |   | 10,092 |   | 3,676 |   | 13,768 |   |
| Total revenues |       | $                                                       | 16,184     |   | $ | 12,519 |   | $ | 28,703 |   | $ | 15,940 |   | $ | 12,445 |   | $ | 28,385 |   |

 

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| ** **                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| **Long-lived assets, net** |       |                   |       |                  |       |
| United States              |       | $                      | 6,621      |                  | $          | 6,759 |   |
| United Kingdom             |       | 17,812                 |       | 18,422                |       |
| Other                      |       | 192                    |       | 174                   |       |
|                       |       | $                      | 24,625     |                  | $          | 25,355 |   |

 
| ** **          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **          | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Revenue**         |       |                                                     |       |                                                    |       |   |   |   |   |
| Activation          |       | $                                                        | 5,083      |                                                    | $          | 6,429 |   | $ | 16,420 |   | $ | 16,945 |   |
| Numbering solutions |       | 3,710                                                    |       | 3,050                                                   |       | 10,877 |   | 9,821 |   |
| Mediation           |       | 451                                                      |       | 434                                                     |       | 1,406 |   | 1,619 |   |
| Total revenues      |       | $                                                        | 9,244      |                                                    | $          | 9,913 |   | $ | 28,703 |   | $ | 28,385 |   |

 

**NOTE 10 — COMMITMENTS AND CONTINGENCIES**

 

**(a)           Other Commitments**

 

Aspermitted under Delaware law, we have agreements with officers and directorsunder which we agree to indemnify them for certain events or occurrences whilethe officer or director is, or was, serving at our request in this capacity.The term of the indemnification period is indefinite. There is no limit on theamount of future payments we could be required to make under theseindemnification agreements; however, we maintain Director and Officer insurancepolicies, as well as an Employment Practices Liability Insurance Policy, thatmay enable us to recover a portion of any amounts paid. As a result of ourinsurance policy coverage, we believe the estimated fair value of theseindemnification agreements is minimal. Accordingly, there were no liabilitiesrecorded for these agreements as of September 30, 2010 orDecember 31, 2009. 

 

Weenter into standard indemnification terms with customers and suppliers, in theordinary course of business, for third party claims arising under ourcontracts. In addition, as we may subcontract the development of deliverablesunder customer contracts, we could be required to indemnify customers for workperformed by subcontractors. Depending upon the nature of the indemnification,the potential amount of future payments we could be required to make underthese indemnification agreements may be unlimited. We may be able to recoverdamages from a subcontractor or other supplier if the indemnification resultsfrom the subcontractor’s or supplier’s failure to perform. To the extent we areunable to recover damages from a subcontractor or other supplier, we could berequired to reimburse the indemnified party for the full amount. We have neverincurred costs to defend lawsuits or settle claims relating to anindemnification. As a result, we believe the estimated fair value of theseagreements is minimal. Accordingly, there were no liabilities recorded forthese agreements as of September 30, 2010 or December 31, 2009. 

 

Ourstandard license agreements contain product warranties that the software willbe free of material defects and will operate in accordance with the statedrequirements for a limited period of time. The product warranty provisions require us to cure any defects throughany reasonable means.  We believe theestimated fair value of the product warranty provisions in the licenseagreements in place with our customers is minimal.  Accordingly, there were no liabilitiesrecorded for these product warranty provisions as of September 30, 2010 orDecember 31, 2009. 

 

Oursoftware arrangements generally include a product indemnification provisionwhereby we will indemnify and defend a customer in actions brought against thecustomer for claims that our products infringe upon a copyright, trade secret,or valid patent of a third party. We have not historically incurred anysignificant costs related to product indemnification claims. Accordingly, therewere no liabilities recorded for these indemnification provisions as of September 30,2010 or December 31, 2009. 

 

Inrelation to the acquisitions of Evolving Systems U.K., TSE and CMS, we agreedto indemnify certain parties from any losses, actions, claims, damages orliabilities (or actions in respect thereof) resulting from any claim raised bya third party.  We do not believe thatthere will be any claims related to these indemnifications. Accordingly, therewere no liabilities recorded for these agreements as of September 30, 2010or December 31, 2009. 

 

**(b)           Litigation**

 

We are involved in various legal matters arising in the normal courseof business.  Losses, including estimatedcosts to defend, are recorded for these matters to the extent they wereprobable of loss and the amount of loss could be reasonably estimated. 

 

**NOTE 11 — RELATED PARTY TRANSACTIONS**

 

Effective October 15, 2009, George A.Hallenbeck resigned from our Board of Directors and we entered into aconsulting agreement with him to provide consulting services.Mr. Hallenbeck is one of the founders of the Company. Under the consultingagreement, we will pay Mr. Hallenbeck an annual fee of $10,000 for hisservices through May 31, 2012. We had current obligations in 

 

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the consolidated balance sheets under the agreementof $2,500 and $2,000 as of September 30, 2010 and December 31, 2009,respectively. We recorded approximately $2,500 and $7,500 of general andadministrative expense in the consolidated statements of operations, related tothis agreement, for the three and nine months ended September 30, 2010,respectively.

 

Effective March 12, 2010, Stephen K. Gartside, Jr.,Chairman of the Board, resigned from our Board of Directors We entered into aconsulting agreement with Mr. Gartside to provide consulting services tous. Under the consulting agreement we will pay Mr. Gartside a fee of$7,000 for his services through December 31, 2010. We had currentobligations in the consolidated balance sheets under the agreement of $2,333 asof September 30, 2010. We recorded approximately $2,333 and $4,666 ofgeneral and administrative expense in the consolidated statements ofoperations, related to this agreement, for the three and nine months endedSeptember 30, 2010, respectively.

 

**NOTE 12 — SUBSEQUENT EVENTS**

 

OnNovember 4, 2010, our Board of Directors declared a fourth quarter cashdividend of $.05 per share, payable January 14, 2011, to stockholders ofrecord December 10, 2010. 

 

OnOctober 21, 2010, Bruce W. Armstrong resigned from our Board of Directors.Mr. Armstrong was also a member of our Compensation Committee and ourNominating and Governance Committee. There were no disagreements withmanagement. Also effective October 21, 2010, our Board of Directorsadopted a resolution reducing the size of our Board of Directors from 8 to 7members. 

 

We evaluated our September 30, 2010financial statements for subsequent events. We are not aware of any additionalsubsequent events which would require recognition or disclosure in theconsolidated financial statements.

 

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

 

**SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS**

 

*This Quarterly Report on Form 10-Q contains forward-lookingstatements that have been made pursuant to the provisions of the PrivateSecurities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations,estimates, and projections about Evolving Systems’ industry, management’sbeliefs, and certain assumptions made by management.  Forward-looking statements include ourexpectations regarding product, services, and maintenance revenue, annualsavings associated with the organizational changes effected in prior years, andshort- and long-term cash needs.  In somecases, words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “estimates”,variations of these words, and similar expressions are intended to identifyforward-looking statements.  Thestatements are not guarantees of future performance and are subject to certainrisks, uncertainties, and assumptions that are difficult to predict; therefore,actual results may differ materially from those expressed or forecasted in anyforward-looking statements.  Risks anduncertainties of our business include those set forth in our Annual Report on Form 10-Kfor the year ended December 31, 2009 under “Item 1A. Risk Factors” as wellas additional risks described in this Form 10-Q.  Unless required by law, we undertake noobligation to update publicly any forward-looking statements, whether as aresult of new information, future events, or otherwise.  However, readers should carefully review therisk factors set forth in other reports or documents we file from time to timewith the Securities and Exchange Commission, particularly the Quarterly Reportson Form 10-Q and any Current Reports on Form 8-K.*

 

**OVERVIEW**

 

Weare a leading provider of software solutions and services to the wireless,wireline and cable markets. We maintain long-standing relationships with manyof the largest wireless, wireline and cable companies worldwide. Our customersrely on us to develop, deploy, enhance, maintain and integrate complex,reliable software solutions for a range of Operations Support Systems (“OSS”).  Our activation solution is the leadingpackaged solution for activation in the wireless industry. 

 

Werecognize revenue in accordance with the prescribed accounting standards forsoftware revenue recognition under generally accepted accounting principles.  Our license fees and services revenuesfluctuate from period to period as a result of the timing of revenuerecognition on existing projects. 

 

**RECENT DEVELOPMENTS**

 

Consolidatedrevenue decreased to $9.2 million from $9.9 million for three months endedSeptember 30, 2010 and 2009, respectively. Consolidated revenue increasedto $28.7 million from $28.4 million for nine months ended September 30,2010 and 2009, respectively.  The decrease in revenue for the three monthsended September 30, 2010 is primarily due to lower Tertio serviceactivation revenue. The growth during the nine months ended September 30,2010 is primarily the result of increased revenue from our *Dynamic SIMAllocation**TM* (“DSA”) solution and International *NumeriTrack*partially offset by decreases in Tertio serviceactivation and mediation revenue. 

 

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We reported net income of $1.6 million and $4.2 million for the threeand nine months ended September 30, 2010, respectively compared to $1.3million and $3.4 million for the three and nine months ended September 30,2009, respectively. This is the tenth consecutive quarter in which we havereported net income.  Our twelve monthbacklog decreased to $13.8 million as of September 30, 2010, compared to$16.8 million as of September 30, 2009. 

 

We have operations in foreign countries where the local currency isused to prepare the financial statements which are translated into ourreporting currency, U.S. Dollars. Changes in the exchange rates between thesecurrencies and our reporting currency are partially responsible for some of thechanges from period to period in our financial statement amounts. The chartbelow summarizes how our revenue and expenses would change had they beenreported on a constant currency basis. The constant currency basis assumes thatthe exchange rate was constant for the periods presented (in thousands).

 
| ** **                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                              | ** ** | **2010 vs. 2009**                          | ** ** | **2010 vs. 2009**                         | ** ** |
| ** **                              | ** ** | **Increase/(Decrease)**                              | ** ** |
| ** **                              | ** ** | ** **                                           | ** ** | ** **                                          | ** ** |
| Revenue                                 |       | $                                                    | (287       | )                                                   | $          | (230 | ) |
| Costs of revenue and operating expenses |       | (232                                                 | )          | 79                                                  |       |
| Operating income (loss)                 |       | $                                                    | (55        | )                                                   | $          | (309 | ) |

 

The net effect of our foreign currencytranslations for the three months ended September 30, 2010 was a $0.3million decrease in revenue and a $0.2 million decrease in operating expensesversus the three months ended September 30, 2009. The net effect of ourforeign currency translations for the nine months ended September 30, 2010was a $0.2 million decrease in revenue and a $79,000 increase in operatingexpenses versus the nine months ended September 30, 2009.

 

**RESULTSOF OPERATIONS**

 

Thefollowing table presents the unaudited consolidated statements of operationsreflected as a percentage of total revenue.

 
| ** **                                                                   | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                               |       |                                                    | ** ** | ** ** |   |   |   |
| License fees and services                                                    |       | 53                                                       | %          | 59                                                      | %          | 56 | % | 56 | % |
| Customer support                                                             |       | 47                                                       | %          | 41                                                      | %          | 44 | % | 44 | % |
| Total revenue                                                                |       | 100                                                      | %          | 100                                                     | %          | 100 | % | 100 | % |
| ** **                                                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING  EXPENSES**                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 21                                                       | %          | 20                                                      | %          | 21 | % | 20 | % |
| Costs of customer support, excluding depreciation  and amortization          |       | 13                                                       | %          | 15                                                      | %          | 12 | % | 15 | % |
| Sales and marketing                                                          |       | 19                                                       | %          | 20                                                      | %          | 19 | % | 21 | % |
| General and administrative                                                   |       | 14                                                       | %          | 16                                                      | %          | 15 | % | 15 | % |
| Product development                                                          |       | 11                                                       | %          | 9                                                       | %          | 11 | % | 8 | % |
| Depreciation                                                                 |       | 2                                                        | %          | 2                                                       | %          | 2 | % | 2 | % |
| Amortization                                                                 |       | 2                                                        | %          | 2                                                       | %          | 2 | % | 2 | % |
| Total costs of revenue and operating expenses                                |       | 82                                                       | %          | 84                                                      | %          | 82 | % | 83 | % |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Income from operations                                                       |       | 18                                                       | %          | 16                                                      | %          | 18 | % | 17 | % |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Other income (expense)                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest income                                                              |       | 0                                                        | %          | 0                                                       | %          | 0 | % | 0 | % |
| Interest expense                                                             |       | (0                                                       | )%         | (1                                                      | )%         | (0 | )% | (2 | )% |
| Foreign currency exchange gain (loss)                                        |       | 0                                                        | %          | 2                                                       | %          | (1 | )% | (1 | )% |
| Other income (expense), net                                                  |       | 0                                                        | %          | 1                                                       | %          | (1 | )% | (3 | )% |
|                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Income before income taxes                                                   |       | 18                                                       | %          | 17                                                      | %          | 17 | % | 14 | % |
| Income tax expense                                                           |       | 1                                                        | %          | 4                                                       | %          | 3 | % | 2 | % |
| Net income                                                                   |       | 17                                                       | %          | 13                                                      | %          | 14 | % | 12 | % |

 

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***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 thoseservices directly related to the delivery of the licensed product as well asintegration and consulting services. Customer support revenue includes annual support, recurring maintenance,maintenance upgrades and warranty services. Warranty services consist of maintenance services and are typicallybundled with a license sale and the related revenue, based on Vendor-SpecificObjective Evidence (“VSOE”), and is deferred and recognized ratably over thewarranty period.  The following tablepresents our revenue by product group (in thousands):

 
| ** **          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **          | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Revenue**         |       |                                                     |       |                                                    |       |   |   |   |   |
| Activation          |       | $                                                        | 5,083      |                                                    | $          | 6,429 |   | $ | 16,420 |   | $ | 16,945 |   |
| Numbering solutions |       | 3,710                                                    |       | 3,050                                                   |       | 10,877 |   | 9,821 |   |
| Mediation           |       | 451                                                      |       | 434                                                     |       | 1,406 |   | 1,619 |   |
| Total revenues      |       | $                                                        | 9,244      |                                                    | $          | 9,913 |   | $ | 28,703 |   | $ | 28,385 |   |

 

Revenuefor the three months ended September 30, 2010 and 2009 was $9.2 millionand $9.9 million, respectively. Revenue for the nine months ended September 30,2010 and 2009 was $28.7 million and $28.4 million, respectively. Decreasedrevenue during the three months ended September 30, 2010 was primarily dueto decreased sales related to our Tertio service activation products.  Increased revenue during the nine monthsended September 30, 2010 compared to 2009 is primarily due to increasedrevenue from our DSA and International *NumeriTrack*products partially offset by decreased sales related to our Tertio serviceactivation products.

 

***License Fees and Services***

 

License fees and services revenue decreased $0.9 million, or 16%, to$4.9 million for the three months ended September 30, 2010 from $5.8million for the three months ended September 30, 2009.  Changes in license fees and services revenuefor the three months ended September 30, 2010 compared to the three monthsended September 30, 2009 included a decrease of $1.6 million in revenuefrom our activation products, partially offset by an increase of $0.6 millionin revenue from our numbering solutions products and an increase of $0.1million in revenue from our mediation products. This growth in our numbering solutions and mediation product groups isdue to increased revenue from International *NumeriTrack* andour legacy numbering and mediation products. The decrease in revenue from ouractivation products is due primarily to decreased sales of our Tertio serviceactivation products.

 

License fees and services revenue increased $0.3 million, or 2%, to$16.2 million for the nine months ended September 30, 2010 from $15.9million for the nine months ended September 30, 2009.  Changes in license fees and services revenuefor the nine months ended September 30, 2010 compared to the nine monthsended September 30, 2009 included an increase of $1.2 million in revenuefrom our numbering solutions products, an increase of $0.4 million in revenuefrom our mediation products, partially offset by a decrease of $1.4 million inrevenue from our activation products. This growth in the numbering and mediation product groups is primarilydue to increased revenue from International *NumeriTrack* andour legacy numbering and mediation products. The decrease in activation revenueis due primarily to lower sales of our Tertio service activation products,partially offset by an increase in revenue from our DSA product.

 

***Customer Support***

 

Customer support revenue increased $0.3 million, or 7%, to $4.4 millionfor the three months ended September 30, 2010 from $4.1 million for thethree months ended September 30, 2009. Changes in customer support revenue for the three months endedSeptember 30, 2010 compared to the three months ended September 30,2009 included an increase in revenue from our activation products of $0.3million and an increase of $0.1 million from our numbering solutions products.These increases were partially offset by a decrease of $0.1 million in revenuefrom our mediation products.  The growthin customer support for our activation and numbering solutions products is dueto increased revenue from DSA and our legacy numbering products. The decreasein revenue from our mediation products is due to support contracts that werenot renewed by customers.

 

Customer support revenue increased $0.1 million, or 1%, to $12.5 millionfor the nine months ended September 30, 2010 from $12.4 million for thenine months ended September 30, 2009. Changes in customer support revenue for the nine months endedSeptember 30, 2010 compared to the nine months ended September 30,2009 included an increase in revenue from our activation products of $0.7million, partially offset by a decrease of $0.6 million in revenue from ourmediation products.  The growth in

 

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customer support for our activation product group is due to increasedrevenue from DSA. The decrease in revenue from our mediation products is due tosupport contracts that were not renewed by customers.

*** ***

***Costs of Revenue, Excluding Depreciation and Amortization***

 

Costsof revenue, excluding depreciation and amortization, consist primarily ofpersonnel costs and other direct costs associated with these personnel, facilitiescosts, costs of third-party software and partner commissions.  Costs of revenue, excluding depreciation andamortization, were $3.2 million and $3.4 million for the three months ended September 30,2010 and 2009, respectively. Costs of revenue, excluding depreciation andamortization, were $9.6 million and $10.0 million for the nine months ended September 30,2010 and 2009, respectively.

 

***Costs of License Fees and Services, ExcludingDepreciation and Amortization***

 

Costsof license fees and services, excluding depreciation and amortization, remainedat $2.0 million for the three months ended September 30, 2010 and2009.  As a percentage of license feesand services revenue, costs of license fees and services, excludingdepreciation and amortization, increased to 40% for the three months ended September 30,2010 from 34% for the three months ended September 30, 2009.  The increase as a percentage of revenue isprimarily the result of increased hours to deliver projects with less revenue,partially offset by lower partner commissions and lower occupancy costs relatedto new office leases at our U.K. and India offices.

 

Costsof license fees and services, excluding depreciation and amortization,increased $0.4 million, or 6%, to $6.1 million for the nine months ended September 30,2010 from $5.7 million for the nine months ended September 30, 2009.  The increase in costs is primarily the resultof increased labor costs to support higher revenue and higher travel expensesfrom increased onsite involvement from our DSA implementations, partiallyoffset by lower partner commissions and lower occupancy costs related to newoffice leases at our U.K. and India offices. As a percentage of license feesand services revenue, costs of license fees and services, excludingdepreciation and amortization, increased to 38% for the nine months ended September 30,2010 from 36% for the nine months ended September 30, 2009.  The increase as a percentage of revenue isprimarily the result of increased employee costs and increased travel expensespartially offset by the aforementioned increased revenue during the period.

 

***Costs of Customer Support, Excluding Depreciationand Amortization***

 

Costsof customer support, excluding depreciation and amortization, decreased $0.2million, or 14%, to $1.3 million for the three months ended September 30,2010 from $1.5 million for the three months ended September 30,2009.  As a percentage of customersupport revenue, costs of customer support revenue, excluding depreciation andamortization, decreased to 29% for the three months ended September 30,2010 from 36% for the three months ended September 30, 2009.  The decrease in costs of customer support andthe decrease as a percentage of revenue are primarily the result of decreasedemployee costs.

 

Costsof customer support, excluding depreciation and amortization, decreased $0.8million, or 17%, to $3.5 million for the nine months ended September 30,2010 from $4.3 million for the three months ended September 30,2009.  As a percentage of customersupport revenue, costs of customer support revenue, excluding depreciation andamortization, decreased to 28% for the nine months ended September 30,2010 from 34% for the nine months ended September 30, 2009.  The decrease in costs of customer support andas a percentage of revenue, are primarily the result of decreased employeecosts.

 

***Sales and Marketing***

 

Salesand marketing expenses primarily consist of compensation costs, includingincentive compensation and commissions, travel expenses, advertising, marketingand facilities expenses. Sales and marketing expenses decreased $0.2 million,or 13%, to $1.8 million for the three months ended September 30, 2010 from$2.0 million for the three months ended September 30, 2009.  As a percentage of total revenue, sales andmarketing expenses decreased to 19% for the three months ended September 30,2010 from 20% for the three months ended September 30, 2009. The decreasein costs and as a percentage of revenue is primarily due to lower incentivecompensation and technical sales support.

 

Salesand marketing expenses decreased $0.4 million, or 6% to $5.5 million for thenine months ended September 30, 2010 from $5.9 million for the nine monthsended September 30, 2009.  As apercentage of total revenue, sales and marketing expenses decreased to 19% forthe nine months ended September 30, 2010 from 21% for the nine monthsended September 30, 2009. The decrease in costs and as a percentage ofrevenue is primarily due to lower incentive compensation and technical salessupport.

 

***General and Administrative***

 

Generaland administrative expenses consist principally of employee related costs andprofessional fees for the following departments: facilities, finance, legal,human resources, and certain executive management.  General and administrative expenses decreased$0.2 million, or 15%, to $1.3 million from $1.5 million for the threemonths ended September 30, 2010 and 2009, respectively.  As a percentage of total revenue, general andadministrative expenses for the three months ended September 30, 2010 and2009 decreased to 14% for the three months ended September 30, 2010 from16% for the three months ended September 30,

 

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2009.  The decrease in costs and as a percentage ofrevenue is primarily from decreased incentive compensation expenses due tolower revenue and decreased professional fees.

 

Generaland administrative expenses decreased $0.1 million, or 2%, to $4.3 million from$4.4 million for the nine months ended September 30, 2010 and 2009,respectively.  The decrease in costs isprimarily from decreased incentive compensation expenses and decreasedprofessional fees. As a percentage of total revenue, general and administrativeexpenses for the nine months ended September 30, 2010 and 2009 remained at15%.

 

***Product Development***

 

Productdevelopment expenses consist primarily of employee related costs andsubcontractor expenses.  Productdevelopment expenses increased $0.1 million, or 7%, to $1.0 million from $0.9million for the three months ended September 30, 2010 and 2009,respectively.  As a percentage ofrevenue, product development expenses for the three months ended September 30,2010 and 2009, increased to 11% from 9%, respectively.  The increase in expenses and as a percentageof revenue is primarily due to increased development work on our DSA product.

 

Productdevelopment expenses increased $1.0 million, or 44%, to $3.3 million from $2.3million for the nine months ended September 30, 2010 and 2009,respectively.  As a percentage ofrevenue, product development expenses for the nine months ended September 30,2010 and 2009, increased to 11% from 8%, respectively.  The increase in expenses and as a percentageof revenue is primarily due to an increased development work on our DSA productand development of new features on our legacy numbering products.

 

***Depreciation***

 

Depreciation expense consists of depreciation of long-lived propertyand equipment.  Depreciation expensedecreased to $146,000 for the three months ended September 30, 2010 from$160,000 for the three months ended September 30, 2009. As a percentage oftotal revenue, depreciation expense for the three months ended September 30,2010 and 2009 remained at 2%.

 

Depreciation expense decreased to $446,000 for the nine months ended September 30,2010 from $474,000 for the nine months ended September 30, 2009. As apercentage of total revenue, depreciation expense for the nine months ended September 30,2010 and 2009 remained at 2%.

 

***Amortization***

 

Amortizationexpense consists of amortization of identifiable intangible assets acquiredthrough our acquisitions of Evolving Systems U.K., TSE and CMS.  Amortization expense remained at $0.2 millionfor the three months ended September 30, 2010and 2009. As a percentage ofrevenue, amortization expense for the three months ended September 30,2010 and 2009 remained at 2%.

 

Amortizationexpense remained at $0.5 million for the nine months ended September 30,2010 and 2009. As a percentage of revenue, amortization expense for the ninemonths ended September 30, 2010 and 2009 remained at 2%.

 

***Interest Expense***

 

Interestexpense includes interest expense on our long-term debt and capital leaseobligations as well as amortization of debt issuance costs.  Interest expense was $20,000 and $145,000 forthe three months ended September 30, 2010 and 2009, respectively. Thedecrease of $125,000 is due to the retirement of our subordinated debt during2009 and the retirement of our senior term loan in the first quarter of 2010.

 

Interestexpense was $81,000 and $0.6 million for the nine months ended September 30,2010 and 2009, respectively. The decrease of $0.5 million is due to theretirement of our subordinated debt during 2009 and the retirement of oursenior term loan in first quarter of 2010.

 

***Foreign Currency Exchange Gain (Loss)***

 

Foreigncurrency transaction gains (losses) resulted from transactions denominated in acurrency other than the functional currency of the respective subsidiary andwere $0.1 million and $0.2 million for the three months ended September 30,2010 and 2009, respectively and $(0.1) million and ($0.4) million for the ninemonths ended September 30, 2010 and 2009, respectively.  The gains (losses) were generated primarilythrough the re-measurement of certain non-functional currency denominatedfinancial assets and liabilities of our Evolving Systems U.K. and India subsidiaries.

 

***Income Taxes***

 

Werecorded net income tax expense of $122,000 and $380,000 for the three monthsended September 30, 2010 and 2009, respectively.  The net expense during the three months endedSeptember 30, 2010 consisted of income tax expense of $185,000 and adeferred tax benefit of $63,000. The current tax expense consists of income taxfrom our U.K.-based operations, Alternative Minimum Tax (“AMT”) andunrecoverable foreign withholding tax in the U.S. and Minimum Alternative Tax (“MAT”)from our Indian operations. The deferred tax benefit was related to intangibleassets from our U.K.-based operations. The net expense during the three 

 

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monthsended September 30, 2009 consisted of income tax expense of $444,000 and adeferred tax benefit of $64,000. The current tax expense consists of income taxfrom our U.K.-based operations, AMT and unrecoverable foreign withholding taxin the U.S. and MAT from our Indian operations. Our effective tax rate of 7%for the three months ended September 30, 2010 was down from an effectivetax rate of 22% for the three months ended September 30, 2009.  This decrease in our effective tax raterelates principally to increased earnings in the U.S., which has the lowest taxrate of all of our jurisdictions and lower unrecoverable foreign withholding inthe U.S. Our current effective tax rate of 7% includes the utilization of ourU.S. net operating losses.

 

Werecorded net income tax expense of $688,000 and $438,000 for the nine monthsended September 30, 2010 and 2009, respectively.  The net expense during the nine months ended September 30,2010 consisted of income tax expense of $877,000 and a deferred tax benefit of $189,000.The current tax expense consists of income tax from our U.K.-based operations,AMT and unrecoverable foreign withholding tax in the U.S. and MAT from ourIndian operations. The deferred tax benefit was related to intangible assetsfrom our U.K.-based operations. The net expense during the nine months ended September 30,2009 consisted of income tax expense of $610,000 and a deferred tax benefit of$172,000. The current tax expense consists of income tax from our U.K.-basedoperations, AMT and unrecoverable foreign withholding tax in the U.S. and MATfrom our Indian operations. Our effective tax rate of 14% for the nine monthsended September 30, 2010 was up from an effective rate of 11% for the ninemonths ended September 30, 2009. This increase in our effective tax rate relates principally to increasedearnings in the U.K., which has the highest tax rate of all of ourjurisdictions.

 

Inconjunction with the acquisition of Evolving Systems U.K., we recorded certainidentifiable intangible assets.  Sincethe amortization of these identifiable intangibles is not deductible for incometax purposes, we established a long-term deferred tax liability of $4.6 millionat the acquisition date for the expected difference between what would beexpensed for financial reporting purposes and what would be deductible forincome tax purposes. As of September 30, 2010 and December 31, 2009,this component of the deferred tax liability was $0.4 million and $0.5 million,respectively.  This deferred taxliability relates to Evolving Systems U.K., and has no impact on our ability torecover U.S.-based deferred tax assets. This deferred tax liability will be recognized as a reduction ofdeferred income tax expense as the identifiable intangibles are amortized.

 

**FINANCIALCONDITION**

 

Ourworking capital position increased $4.3 million to $9.1 million as of September 30,2010 from $4.8 million as of December 31, 2009.

 

**CONTRACTUALOBLIGATIONS**

 

Duringthe third quarter we renewed our office lease at our Bath, England locationthrough September 26, 2015.

 

Therehave been no other material changes to the contractual obligations as disclosedin our 2009 Annual Report on Form 10-K.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Wehave historically financed operations through cash flows from operations andequity transactions.  At September 30,2010, our principal source of liquidity was $10.7 million in cash and cashequivalents, $4.5 million in contract receivables, net of allowance, as well as$6.0 million available under our revolving credit facilities.

 

Netcash provided by operating activities for the nine months ended September 30,2010 and 2009 was $6.6 million and $2.2 million, respectively.  The increase in cash provided by operatingactivities for the nine months ended September 30, 2010 was due primarilyto improved financial results, the timing of billings and collections and thepayment of $1.1 million of accrued interest on our subordinated debtobligations during the nine months ended September 30, 2009.

 

Netcash used in investing activities during each of the nine months ended September 30,2010 and 2009 was $0.9 million and $0.4 million, respectively.  The increase in cash used for the nine monthsended September 30, 2010 versus 2009 was related to the cash dividend thatwas paid during the quarter.

 

Netcash used in financing activities for the nine months ended September 30,2010 and 2009 was $0.5 million and $2.9 million, respectively.  The decrease in cash used in financingactivities is due to the retirement of our senior and subordinated debt, onwhich we paid less during 2010 and increased cash provided from the exercise ofstock options.

 

Webelieve that our current cash and cash equivalents, together with anticipatedcash flow from operations and availability under our revolving lines of creditwill be sufficient to meet our working capital, capital expenditure andfinancing requirements for at least the next twelve months. In making thisassessment we considered the following:

 

·                  Our cash and cashequivalents balance at September 30, 2010 of $10.7 million;

 

·                  The availability under ourrevolving credit facilities of $6.0 million at September 30, 2010;

 

·                  Our working capital balanceof $9.1 million;

 

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·                  Our demonstrated ability togenerate positive cash flows from operations;

 

·                  The declaration of ourfourth quarter cash dividend of $.05 per share and the possibility of futuredividends;

 

·                  Our backlog as of September 30,2010 of approximately $13.8 million, including $5.7 million in license fees andservices and $8.1 million in customer support.

 

We are exposed to foreigncurrency rate risks which impact the carrying amount of our foreignsubsidiaries and our consolidated equity, as well as our consolidated cashposition due to translation adjustments. For the nine months ended September 30, 2010, the effect ofexchange rate changes resulted in a $0.1 million increase to consolidatedcash.  During the nine months ended September 30,2009, the effect of exchange rate changes resulted in a $0.5 million increasein consolidated cash.  We do notcurrently hedge our foreign currency exposure, but we monitor rate changes andmay hedge our exposures if we see significant negative trends in exchangerates.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

Wehave no off-balance sheet arrangements that have a material current effect orthat are reasonably likely to have a material future effect on our financialcondition, changes in financial condition, revenues or expenses, results ofoperations, liquidity, capital expenditures or capital resources.

 

**ITEM 3.  QUANTITATIVE ANDQUALITATIVE MARKET RISK DISCLOSURES**

 

In the ordinary course of business, we are exposed to certain marketrisks, including changes in interest rates and foreign currency exchange rates.Uncertainties that are either non-financial or non-quantifiable such aspolitical, economic, tax, other regulatory, or credit risks are not included inthe following assessment of market risks.

 

***Interest Rate Risks***

 

Our cash balances are subject to interest rate fluctuations and as aresult, interest income amounts may fluctuate from current levels.  We could be exposed to interest rate riskrelated to our senior revolving credit facilities entered into in February 2008.  These obligations are variable interest ratenotes based on Prime Rate.  Fluctuationsin Prime Rate affect our interest rates. There was no balance outstanding onour credit facilities as of September 30, 2010. As of December 31,2009, there was $1.5 million outstanding on our senior revolving creditfacilities.

 

***Foreign Currency Risk***

 

Weare exposed to favorable and unfavorable fluctuations of the U.S. dollar (ourfunctional currency) against the currencies of our operating subsidiaries. Anyincrease (decrease) in the value of the U.S. dollar against any foreigncurrency that is the functional currency of one of our operating subsidiarieswill cause the parent company to experience unrealized foreign currencytranslation losses (gains) with respect to amounts already invested insuch foreign currencies.  In addition, weand our operating subsidiaries are exposed to foreign currency risk to theextent that we enter into transactions denominated in currencies other than ourrespective functional currencies, such as accounts receivable (includingintercompany amounts) that are denominated in a currency other than their ownfunctional currency. Changes in exchange rates with respect to these items willresult in unrealized (based upon period-end exchange rates) or realized foreigncurrency transaction gains and losses upon settlement of the transactions. Inaddition, we are exposed to foreign exchange rate fluctuations related to ouroperating subsidiaries’ monetary assets and liabilities and the financialresults of foreign subsidiaries and affiliates when their respective financialstatements are translated into U.S. dollars for inclusion in our consolidatedfinancial statements. Cumulative translation adjustments are recorded inaccumulated other comprehensive income (loss) as a separate component ofequity. As a result of foreign currency risk, we may experience economic lossand a negative impact on earnings and equity with respect to our holdingssolely as a result of foreign currency exchange rate fluctuations.

 

Therelationship between the British Pound Sterling, Indian rupee and the U.S.dollar, which is our functional currency, is shown below, per one U.S. dollar:

 

 
| ** **           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------|------------|------------------------|------------|-----------------------|------------|
| **Spot rates:** | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| Great British pound  |       | 0.63257                |       | 0.62792               |       |
| Indian rupee         |       | 44.88330               |       | 46.75082              |       |

 
| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Average rates:** | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| Great British pound     |       | 0.64552                                                  |       | 0.60943                                                 |       | 0.65258 |   | 0.65070 |   |
| Indian rupee            |       | 46.63700                                                 |       | 48.75878                                                |       | 46.13421 |   | 49.51497 |   |

 

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Atthe present time, we do not hedge our foreign currency exposure or usederivative financial instruments that are designed to reduce our long-termexposure to foreign currency exchange risk. To the extent that translation and transaction gain and losses becomesignificant, we will consider various options to reduce this risk. 

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

Wemaintain “disclosure controls and procedures,” as such term is defined inRule 13a-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”), that are designed to provide reasonable assurance that informationrequired to be disclosed by us in reports that we file or submit under theExchange Act is recorded, processed, summarized, and reported within the timeperiods specified in Securities and Exchange Commission rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding required disclosure. 

 

Ourmanagement, including our Chief Executive Officer and Chief Financial Officer,has evaluated the effectiveness of our disclosure controls and procedures as ofthe end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures wereeffective as of the end of such period. 

 

Indesigning and evaluating our disclosure controls and procedures, managementrecognized that disclosure controls and procedures, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our managementnecessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures. The design of anydisclosure controls and procedures also is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. 

 

Duringthe three months ended September 30, 2010, there were no changes in ourinternal controls over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act) or in other factors that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting. 

 

**PART II — OTHER INFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

We are involved in various legal matters arising in the normal courseof business.  Losses, including estimatedcosts to defend, are recorded for these matters to the extent they wereprobable of loss and the amount of loss could be reasonably estimated. 

 

**ITEM 1A.  RISK FACTORS**

 

Duringthe second, third and fourth quarter of 2010, our Board of Directors declared acash dividend of $.05 per share. The decision to pay dividends in the futurewill depend on general business conditions, the impact of such payment on ourfinancial condition and other factors our Board of Directors may consider to berelevant. In addition, since our revolving credit facility currently prohibitsus from declaring dividends to our common stockholders, any future dividendpayments would need to be approved, in the same manner as our prior dividends,by the financial institution which issued our revolving credit facility. If weelect to pay future dividends, this could reduce our cash reserves to levelsthat may be inadequate to fund expansions to our business plan or unanticipatedcontingent liabilities. 

 

OnSeptember 8, 2010 we announced that we retained the investment bankingfirm of Lazard Frères & Co. LLC. (“Lazard”) as our exclusive financialadviser in response to unsolicited strategic interest.  Lazard isassisting us in evaluating our options to enhance value for ourstockholders.  We can make no assurance that engaging Lazard will resultin a merger or other transaction. Should no transaction result from ourengagement with Lazard, it is possible that the market price of our commonstock might decline. 

 

This Quarterly Report on Form 10-Qshould be read in conjunction with the risk factors defined in our AnnualReport on Form 10-K for the year ended December 31, 2009 under “Item1A. Risk Factors.” 

 

**ITEM 2.  UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS**

 

None 

 

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES**

 

None 

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

None

 

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**ITEM 5.  OTHER INFORMATION**

 

None

 

**ITEM 6.  EXHIBITS**

 

(a)          Exhibits

 

Exhibit 10.23 —Agreement entered into withSinger Children’s Management Trust, as filed as Exhibit 10.1 to theCompany’s Form 8-K filed April 20, 2010 and incorporated herein byreference

Exhibit 31.1 — Certification pursuant toSection 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 — Certification pursuant toSection 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 — Certification pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 — Certification pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Date:  November 4, 2010 | /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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