**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended June 30, 2006**

**OR**

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

**Forthe transition periodfrom               to               **

**CommissionFile Number: 0-24081**

**EVOLVING SYSTEMS, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                    |   | **84-1010843**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (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)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x  Noo

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer: in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o                                    Acceleratedfiler o                                              Non-acceleratedfiler x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o  No x

As of July 31, 2006 there were 16,212,091 sharesoutstanding of Registrant’s Common Stock (par value $0.001 per share).

 

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**EVOLVING SYSTEMS,INC.Quarterly Report on Form 10-QJune 30, 2006Table of Contents**
|            | **PART I — FINANCIAL INFORMATION**                                                                                                               |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1     | Financial  Statements                                                                                                                                 |
|       | Condensed  Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005  (Unaudited)                                                         |
|       | Condensed  Consolidated Statements of Operations for the Three and Six Months Ended June  30, 2006 and 2005 (Unaudited)                               |
|       | Condensed  Consolidated Statements of Changes In Stockholders’ Equity and Comprehensive  Loss for the Six Months Ended June 30, 2006 (Unaudited) |
|       | Condensed  Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006  and 2005 (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 — FINANCIALINFORMATION**

**Item 1.  Financial Statements**

**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands except share data)(unaudited)**
| ** **                                                                                                                                                                      | ** ** | **June 30,** | ** ** | **December 31,**                                                                        | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **2006**          | ** ** | **       2005       ** | ** ** |
| **ASSETS**                                                                                                                                                                      |       |              |       |                                                                                         |       |
| Current assets:                                                                                                                                                                 |       |              |       |                                                                                         |       |
| Cash and cash equivalents                                                                                                                                                       |       | $                 | 6,442      |                                                                                         | $          | 3,883 |   |
| Current portion of restricted cash                                                                                                                                              |       | 300               |       | —                                                                                       |       |
| Contract receivables, net of allowance of $68 at  June 30, 2006 and $48 at December 31, 2005                                                                          |       | 5,853             |       | 10,766                                                                                       |       |
| Unbilled work-in-progress                                                                                                                                                       |       | 1,143             |       | 1,147                                                                                        |       |
| Deferred foreign income taxes                                                                                                                                                   |       | 9                 |       | 5                                                                                            |       |
| Prepaid and other current assets                                                                                                                                                |       | 1,869             |       | 1,335                                                                                        |       |
| Total current assets                                                                                                                                                            |       | 15,616            |       | 17,136                                                                                       |       |
| Property and  equipment, net                                                                                                                                                    |       | 1,564             |       | 1,775                                                                                        |       |
| Amortizable  intangible assets, net                                                                                                                                             |       | 6,256             |       | 13,350                                                                                       |       |
| Goodwill                                                                                                                                                                        |       | 24,798            |       | 34,073                                                                                       |       |
| Long-term  restricted cash                                                                                                                                                      |       | —            |       | 300                                                                                          |       |
| Other long-term  assets                                                                                                                                                         |       | 547               |       | 764                                                                                          |       |
| Total assets                                                                                                                                                                    |       | $                 | 48,781     |                                                                                         | $          | 67,398 |   |
|                                                                                                                                                                            |       |              |       |                                                                                         |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                   |       |              |       |                                                                                         |       |
| Current  liabilities:                                                                                                                                                           |       |              |       |                                                                                         |       |
| Current portion of capital lease obligations                                                                                                                                    |       | $                 | 36         |                                                                                         | $          | 34 |   |
| Current portion of long-term debt                                                                                                                                               |       | 2,500             |       | 1,000                                                                                        |       |
| Accounts payable and accrued liabilities                                                                                                                                        |       | 5,084             |       | 6,001                                                                                        |       |
| Unearned revenue                                                                                                                                                                |       | 9,174             |       | 9,654                                                                                        |       |
| Total current liabilities                                                                                                                                                       |       | 16,794            |       | 16,689                                                                                       |       |
| Long-term  liabilities:                                                                                                                                                         |       |              |       |                                                                                         |       |
| Capital lease obligations, net of current portion                                                                                                                               |       | 53                |       | 71                                                                                           |       |
| Other long-term obligations                                                                                                                                                     |       | 402               |       | 83                                                                                           |       |
| Long-term debt, net of current portion                                                                                                                                          |       | 12,370            |       | 14,373                                                                                       |       |
| Deferred foreign income taxes                                                                                                                                                   |       | 1,098             |       | 2,777                                                                                        |       |
| Total liabilities                                                                                                                                                               |       | 30,717            |       | 33,993                                                                                       |       |
|                                                                                                                                                                            |       |              |       |                                                                                         |       |
| Commitments and  contingencies (Note 9)                                                                                                                                         |       |              |       |                                                                                         |       |
|                                                                                                                                                                            |       |              |       |                                                                                         |       |
| Series B  convertible redeemable preferred stock                                                                                                                                |       | 11,281            |       | 11,281                                                                                       |       |
|                                                                                                                                                                            |       |              |       |                                                                                         |       |
| Stockholders’  equity:                                                                                                                                                     |       |              |       |                                                                                         |       |
| Preferred stock, $0.001 par value; 2,000,000 shares  authorized; 966,666 shares of Series B issued and outstanding (shown above)                                                |       | —            |       | —                                                                                       |       |
| Common stock, $0.001 par value; 25,000,000 shares  authorized; 16,189,782 and 16,137,821 shares issued and outstanding as of  June 30, 2006 and December 31, 2005, respectively |       | 16                |       | 16                                                                                           |       |
| Additional paid-in capital                                                                                                                                                      |       | 68,420            |       | 67,891                                                                                       |       |
| Accumulated other comprehensive loss                                                                                                                                            |       | (450              | )          | (2,417                                                                                       | )          |
| Accumulated deficit                                                                                                                                                             |       | (61,203           | )          | (43,366                                                                                      | )          |
| Total stockholders’ equity                                                                                                                                                 |       | 6,783             |       | 22,124                                                                                       |       |
| Total liabilities and  stockholders’ equity                                                                                                                                |       | $                 | 48,781     |                                                                                         | $          | 67,398 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

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**EVOLVING SYSTEMS,INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands except per share data)(unaudited)**
| ** **                                                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and  services                                                   |       | $                                               | 3,966      |                                          | $          | 4,741 |   | $ | 7,865 |   | $ | 9,822 |   |
| Customer support                                                             |       | 4,274                                           |       | 5,185                                         |       | 8,503 |   | 9,942 |   |
| Total revenue                                                                |       | 8,240                                           |       | 9,926                                         |       | 16,368 |   | 19,764 |   |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING  EXPENSES**                                 | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Costs of license  fees and services, excluding depreciation and amortization |       | 1,657                                           |       | 2,393                                         |       | 3,532 |   | 5,369 |   |
| Costs of  customer support, excluding depreciation and amortization          |       | 1,551                                           |       | 1,636                                         |       | 3,177 |   | 3,667 |   |
| Sales and  marketing                                                         |       | 2,241                                           |       | 2,423                                         |       | 4,796 |   | 4,815 |   |
| General and  administrative                                                  |       | 1,381                                           |       | 1,481                                         |       | 2,788 |   | 3,982 |   |
| Product  development                                                         |       | 799                                             |       | 495                                           |       | 1,546 |   | 605 |   |
| Depreciation                                                                 |       | 283                                             |       | 384                                           |       | 576 |   | 760 |   |
| Amortization                                                                 |       | 893                                             |       | 1,395                                         |       | 1,790 |   | 2,816 |   |
| Impairment of  goodwill and intangible assets                                |       | 16,516                                          |       | —                                        |       | 16,516 |   | — |   |
| Restructuring  and other                                                     |       | (9                                              | )          | (4                                            | )          | (23 | ) | (63 | ) |
| Total costs of revenue  and operating expenses                               |       | 25,312                                          |       | 10,203                                        |       | 34,698 |   | 21,951 |   |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Loss from operations                                                         |       | (17,072                                         | )          | (277                                          | )          | (18,330 | ) | (2,187 | ) |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Other income  (expense):                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                                                              |       | 36                                              |       | 39                                            |       | 74 |   | 79 |   |
| Interest expense                                                             |       | (496                                            | )          | (407                                          | )          | (1,005 | ) | (837 | ) |
| Foreign currency  exchange loss                                              |       | (29                                             | )          | (60                                           | )          | (30 | ) | (186 | ) |
| Other expense,  net                                                          |       | (489                                            | )          | (428                                          | )          | (961 | ) | (944 | ) |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Loss before income  taxes                                                    |       | (17,561                                         | )          | (705                                          | )          | (19,291 | ) | (3,131 | ) |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Income tax benefit                                                           |       | (1,375                                          | )          | (16                                           | )          | (1,454 | ) | (294 | ) |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Net loss                                                                     |       | $                                               | (16,186    | )                                             | $          | (689 | ) | $ | (17,837 | ) | $ | (2,837 | ) |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted loss  per common share                                     |       | $                                               | (0.85      | )                                             | $          | (0.04 | ) | $ | (0.93 | ) | $ | (0.15 | ) |
|                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average basic and diluted shares outstanding                        |       | 19,090                                          |       | 18,639                                        |       | 19,078 |   | 18,619 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

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**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYAND COMPREHENSIVE 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,  2005                                     |       | 16,137,821            |       | $           | 16         |              | $          | 67,891                 |       | $                      | (2,417     | )          | $          | (43,366 | ) | $ | 22,124 |   |
| Stock option exercises                                            |       | 10,469                |       | —      |       | 13                |       | —                 |       | —                 |       | 13         |       |
| Common stock issued  pursuant to the Employee Stock Purchase Plan |       | 41,492                |       | —      |       | 73                |       | —                 |       | —                 |       | 73         |       |
| Stock-based  compensation expense                                 |       | —                |       | —      |       | 443               |       | —                 |       | —                 |       | 443        |       |
| Comprehensive loss:                                               |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |
| Net loss                                                          |       | —                |       | —      |       | —            |       | —                 |       | (17,837                | )          |       |       |
| Foreign currency  translation adjustment                          |       | —                |       | —      |       | —            |       | 1,967                  |       | —                 |       |       |       |
| Comprehensive loss                                                |       |                  |       |        |       |              |       |                   |       |                   |       | (15,870    | )          |
| Balance at June 30, 2006                                          |       | 16,189,782            |       | $           | 16         |              | $          | 68,420                 |       | $                      | (450       | )          | $          | (61,203 | ) | $ | 6,783 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

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**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)(unaudited)**
| ** **                                                                       | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                       | ** ** | **June 30,**              | ** ** |
| ** **                                                                       | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                       |       |                           |       |   |   |
| Net loss                                                                         |       | $                              | (17,837    | ) | $ | (2,837 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                           |       |   |   |
| Depreciation                                                                     |       | 576                            |       | 760 |   |
| Amortization of  intangible assets                                               |       | 1,790                          |       | 2,816 |   |
| Amortization of  debt issuance costs                                             |       | 134                            |       | 26 |   |
| Equity  compensation                                                             |       | 443                            |       | — |   |
| Impairment of  goodwill and intangible assets                                    |       | 16,516                         |       | — |   |
| Interest expense  added to debt principal                                        |       | —                         |       | 660 |   |
| Gain on disposal  of property and equipment                                      |       | (20                            | )          | (12 | ) |
| Foreign currency  transaction (gains) and losses, net                            |       | 30                             |       | 186 |   |
| Benefit from  foreign deferred income taxes                                      |       | (1,832                         | )          | (920 | ) |
| Change in  operating assets and liabilities:                                     |       |                           |       |   |   |
| Contract  receivables                                                            |       | 5,115                          |       | 4,858 |   |
| Unbilled  work-in-progress                                                       |       | 57                             |       | (53 | ) |
| Prepaid and  other assets                                                        |       | (384                           | )          | 51 |   |
| Accounts payable  and accrued liabilities                                        |       | (732                           | )          | (1,243 | ) |
| Unearned revenue                                                                 |       | (636                           | )          | (2,482 | ) |
| Other                                                                            |       | —                         |       | (20 | ) |
| Net cash  provided by operating activities                                       |       | 3,220                          |       | 1,790 |   |
|                                                                             |       |                           |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                       |       |                           |       |   |   |
| Purchases of  property and equipment                                             |       | (223                           | )          | (529 | ) |
| Proceeds from  sale of property and equipment                                    |       | 20                             |       | 18 |   |
| Business  combinations and earnout payments                                      |       | (151                           | )          | (365 | ) |
| Net cash used in  investing activities                                           |       | (354                           | )          | (876 | ) |
|                                                                             |       |                           |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                       |       |                           |       |   |   |
| Capital lease  payments                                                          |       | (17                            | )          | (15 | ) |
| Principal  payments on long-term debt                                            |       | (500                           | )          | (4,889 | ) |
| Payment of  amount due to Evolving Systems U.K. sellers                          |       | —                         |       | (2,616 | ) |
| Proceeds from  issuance of common stock                                          |       | 86                             |       | 63 |   |
| Net cash used in  financing activities                                           |       | (431                           | )          | (7,457 | ) |
|                                                                             |       |                           |       |   |   |
| Effect of  foreign exchange rate changes on cash                                 |       | 124                            |       | (276 | ) |
|                                                                             |       |                           |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                            |       | 2,559                          |       | (6,819 | ) |
| Cash and cash  equivalents at beginning of period                                |       | 3,883                          |       | 11,386 |   |
| Cash and cash  equivalents at end of period                                      |       | $                              | 6,442      |   | $ | 4,567 |   |
|                                                                             |       |                           |       |   |   |
| Supplemental disclosure  of other cash and non-cash financing transactions:      |       |                           |       |   |   |
| Interest paid                                                                    |       | $                              | 551        |   | $ | 147 |   |
| Income taxes paid                                                                |       | $                              | 499        |   | $ | — |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

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**EVOLVING SYSTEMS,INC.NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(1)  Basis of Presentation**

**Organization. **Evolving Systems, Inc.(“Evolving Systems” or the “Company”) is a provider of software solutions andservices to the wireless, wireline and IP carrier markets. The Company’scustomers are wireline, wireless and IP communications carriers worldwide. TheCompany develops, deploys, enhances, maintains and integrates complex, softwaresolutions for a range of Operations Support Systems (“OSS”). The Company offerssoftware products and solutions in three areas — a service activationsolution that is used to activate complex bundles of voice, video and dataservices; numbering solutions which enable carriers to comply withgovernment-mandated requirements regarding number portability, phone numberconservation, management and assignment; and mediation solutionssupporting data collection for both service assurance and billing applications.

The Evolving Systems portfoliowhich included ordering and provisioning solutions for Local Number Portability(“LNP”), as well as a number inventory and assignment platform, was expandedsignificantly in 2004 as a result of three acquisitions the Company made over aperiod of 12 months from November of 2003 to November of 2004. Through theacquisition of CMS Communications, Inc. (“CMS”) in November 2003 the Companyacquired a network mediation and service assurance solution. With theacquisition of Telecom Software Enterprises, LLC (“TSE”) in October 2004 theCompany added LNP and Wireless Number Portability (“WNP”) number ordering andprovisioning testing products which provide new OSS system integrationcapabilities.  Finally, in November 2004,the Company acquired Tertio Telecoms Ltd. (“Evolving Systems U.K.”), aprivately held supplier of OSS software solutions to communication carriersthroughout Europe, the Middle East, Africa and Asia, expanding its marketsbeyond North America. Evolving Systems U.K.’s activation solution ***TertioTM,***and mediation solution ***EvidentTM***, strengthened the overallproduct portfolio.

***Interim Consolidated FinancialStatements***.  Theaccompanying unaudited condensed consolidated financial statements of EvolvingSystems have been prepared in accordance with accounting principles generallyaccepted in the United States of America (“GAAP”) and in conformity with theinstructions to Form 10-Q and Article 10 of Regulation S-X and the relatedrules and regulations 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, management believes that the disclosures included inthese financial statements are adequate to make the information presented notmisleading. The unaudited condensed consolidated financial statements includedin this document have been prepared on the same basis as the annualconsolidated financial statements, and in management’s opinion, reflect alladjustments, which include normal recurring adjustments, necessary for a fairpresentation in accordance with GAAP and SEC regulations for complete financialstatements. The results for the three and six months ended June 30, 2006 arenot necessarily indicative of the results that the Company will have for anysubsequent quarter or full fiscal year. These unaudited condensed consolidated financial statements should beread in conjunction with the audited consolidated financial statements and thenotes to those statements for the year ended December 31, 2005 included in theCompany’s Annual Report on Form 10-K.

***Useof Estimates***.  Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements, as well as the reported amounts of revenue andexpenses during the reporting period. Significant estimates have been made bymanagement with respect to revenue recognition for estimated hours to completeprojects accounted for using the percentage of completion method, allowance fordoubtful accounts, income tax valuation allowance, fair values of long-livedassets, valuation of intangible assets and goodwill, business combinations,capitalization of internal software development costs and fair value ofstock-based compensation amounts.  Actualresults could significantly differ from these estimates.

***Foreign Currency Translation***.  The U.S. dollar is the Company’s functionalcurrency.  The functional currency of theCompany’s foreign operations, generally, is the respective local currency foreach foreign subsidiary.  Assets andliabilities of foreign operations denominated in local currencies aretranslated at the spot rate in effect at the applicable reporting date.  The consolidated statements of operations ofthe Company are translated at the average rate of exchange during theapplicable period.  The resultingunrealized cumulative translation adjustment, net of applicable income taxes,is recorded as a component of accumulated other comprehensive loss instockholders’ equity.  Realized andunrealized transaction gains and losses generated by transactions denominatedin a currency different from the functional currency of the applicable entityare recorded in other income (expense) in the period in which they occur.

***Principles of Consolidation***.  The consolidated financial statements includethe accounts of the Company and its subsidiaries, all of which are whollyowned.  All significant intercompanytransactions and balances have been eliminated in consolidation.

***Goodwill and Intangible Assets***.  The Company accounts for goodwill inaccordance with Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets.” The Company’s reportingunits are tested annually, in accordance with SFAS No. 142, as of July 31to determine whether their carrying value exceeds their fair market value.Should this be the case, the value of the goodwill may be impaired and writtendown. Goodwill is also tested for impairment on an interim basis if an eventoccurs or circumstances change between annual tests that would more likely thannot reduce the fair value of the reporting unit

7

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belowits carrying amount. If the Company determines the fair value of the goodwillis less than the carrying value, an impairment loss is recognized in an amountequal to the difference. Impairment losses, if any, are reflected in operatingincome or loss in the consolidated statements of operations.  During the quarter ended June 30, 2006, theCompany recorded an impairment of goodwill. See Note 2 for further details.

The Company accounts for long-lived assets, includingamortizable intangible assets, in accordance with SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets” (“SFAS 144”).  Accordingly, the Company reviews finite-livedassets for impairment whenever an event occurs or circumstances change whichindicate that the carrying amount of such assets may not be fullyrecoverable.  Determination ofrecoverability is based on an estimate of undiscounted future cash flowsresulting from the use of the assets and its eventual disposition.  Measurement of an impairment loss is based onthe fair value of the asset compared to its carrying value.  If the Company determines the fair value ofthe asset is less than the carrying value, an impairment loss is incurred in anamount equal to the difference.  Impairment losses are reflected in operating income or loss in theconsolidated statements of operations. During the quarter ended June 30, 2006, the Company recorded animpairment of amortizable intangible assets. See Note 2 for further details.

***Revenue Recognition****. *The Company recognizes revenuefrom two primary sources: license fees and services, and customer support, inaccordance with Statement of Position (“SOP”) 97-2, “Software RevenueRecognition,” as amended and interpreted by SOP 98-9, “Modification of SOP97-2, Software Revenue Recognition, With Respect to Certain Transactions.”  Staff Accounting Bulletin (“SAB”)No. 104, “Revenue Recognition,” provides further interpretive guidance forpublic companies on the recognition, presentation and disclosure of revenue infinancial statements.  In addition to thecriteria described below, the Company recognizes revenue only when an agreementis signed, the fee is fixed or determinable and collectibility is reasonablyassured.

Themajority of the Company’s license fees and services revenue is generated fromfixed-price contracts, which provide for licenses to its software products andservices.   Generally, when the servicesare determined to be essential to the functionality of the delivered software,revenue is recognized using the percentage-of-completion method of accounting,in accordance with SOP 97-2 and SOP 81-1, “Accounting for Long-TermConstruction Type Contracts.”  Thepercentage of completion for each contract is estimated based on the ratio ofdirect labor hours incurred to total estimated direct labor hours.  Since estimated direct labor hours, andchanges thereto, can have a significant impact on revenue recognition, theseestimates are critical and are reviewed by management regularly.  Amounts billed in advance of services beingperformed are recorded as unearned revenue. Unbilled work-in-progressrepresents revenue earned but not yet billable under the terms of thefixed-price contracts. All such amounts are expected to be billed and collectedwithin 12 months.

The Company mayencounter budget and schedule overruns on fixed price contracts caused byincreased labor, overhead or material costs. Adjustments to cost estimates aremade in the periods in which the facts requiring such revisions become known.Estimated losses, if any, are recorded in the period in which current estimatesof total contract revenue and contract costs indicate a loss.

In arrangementswhere the services are not essential to the functionality of the software, theCompany recognizes license revenue upon delivery.  To the extent that Vendor Specific ObjectiveEvidence (“VSOE”) of the fair value of the undelivered elements exists, feesfrom multiple element arrangements are unbundled and recorded as revenue as theelements are delivered.  If VSOE for theundelivered elements does not exist, fees from such arrangements are deferreduntil the earlier of the date that VSOE does exist on the undelivered elementsor all of the elements have been delivered.

Servicesrevenue from fixed-price contracts is generally recognized using theproportional performance method of accounting, which is similar to thepercentage of completion method described above. Revenue from professional servicesprovided pursuant to time-and-materials based contracts and training servicesare recognized as the services are performed, as that is when the Company’sobligation to its customers under such arrangements is fulfilled.

Customer support, including maintenance revenue, isgenerally recognized ratably over the service contract period. When maintenanceis bundled with the original license fee arrangement, its fair value, basedupon VSOE, is deferred and recognized during the periods when services are provided.

***Stock-based Compensation. ***Effective January 1,2006, the Company adopted SFAS No. 123(Revised), *Share-BasedPayment* (“SFAS 123R”).  Thisstatement replaced SFAS No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”) and superseded APB Opinion No. 25, *Accounting for Stock Issued to Employees*. Under the modifiedprospective method of adoption, the Company is required to apply afair-value-based measurement method in accounting for share-based paymenttransactions with employees and record compensation cost for all stock awardsgranted after January 1, 2006 and awards modified, repurchased, or cancelledafter that date. In addition, the Company is required to record compensationcosts associated with the vesting of unvested options outstanding at January 1,2006 using the guidance under SFAS 123. From January 1, 2006, stock optiongrants and employee stock purchase plan purchases are accounted for under SFAS123R.  The Company uses the Black-Scholesmodel to estimate the fair value of each option grant on the date ofgrant.  This model requires the use ofestimates for expected term of the options and expected volatility of the priceof the Company’s common stock.

***Reclassification.*** Certain prior period balances have beenreclassified to conform to the current period’s presentation.

8

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***New Accounting Pronouncements. ***InJuly 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109” (“FIN 48”), which clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”).  FIN 48 also prescribes a recognition thresholdand measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  In addition, FIN 48 providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. The provisions of FIN 48 are effective for fiscal years beginning afterDecember 15, 2006.  The Company iscurrently evaluating the impact the adoption of FIN 48 will have on itsfinancial position and results of operations, if any.

**(2)Goodwill and Intangible Assets**

Changes in the carryingamounts of goodwill by segment for the three months ended June 30, 2006 are asfollows (in thousands):
|                                             | ** ** | **License and  Services** | ** ** | **Customer  Support** | ** ** | **Total  Goodwill** | ** ** |
|---------------------------------------------|------------|--------------------------------|------------|-----------------------|------------|---------------------|------------|
| Balance as of December  31, 2005            |       | $                              | 18,530     |                  | $          | 15,543              |       | $ | 34,073 |   |
| TSE earnout                                 |       | 2                              |       | 1                     |       | 3                   |       |
| Goodwill impairment  charge                 |       | (10,665                        | )          | —                |       | (10,665             | )          |
| Effects of foreign  currency exchange rates |       | 466                            |       | 921                   |       | 1,387               |       |
| Balance as of June 30, 2006                 |       | $                              | 8,333      |                  | $          | 16,465              |       | $ | 24,798 |   |

 

At June 30, 2006, theCompany recognized a goodwill impairment charge of approximately $10.7million.  Due to continued pricing pressures on services and consolidation in thetelecommunications industry, revenues and cash flows have been lower thanexpected in recent quarters and those lower operating results have negativelyimpacted the market price of our common stock. Based upon this trend, the Company reviewed its business plan during thesecond quarter of 2006.  As a result ofthese events, the Company determined that a triggering event had occurred andconducted an interim goodwill impairment analysis.  At June 30, 2006, a goodwill impairmentcharge of $10.7 million in its License and Services operating segment wasrecorded.  This goodwill impairmentrelated to goodwill that resulted from the Company’s acquisitions of CMS inNovember 2003, TSE in October 2004 and Evolving Systems U.K. in November2004.  The fair value of the Company’sreporting units were estimated using the expected present value of future cashflows and the valuation employed a combination of present value techniques tomeasure fair value and considered market factors.

Identifiable intangibles areamortized over estimated finite lives of from one to seven years, and includethe cumulative effects of changes in foreign currency exchange rates.  The following table summarizes identifiableintangible assets (in thousands):
| ** **                                | ** ** | **June 30, 2006** | ** ** | **December 31, 2005**            | ** ** | ** **                | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|---------------------------|------------|
| **Identifiable intangible  assets:** | ** ** | **Gross   Amount**          | ** ** | **Accumulated**

**Amortization**

**(1)** | ** ** | **Net  Carrying  Amount** | ** ** | ** **

**Gross  Amount** | ** ** | ** **

**Accumulated**

**Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Weighted-**

**Average**

**Amortization**

**Period**

**(1)** | ** ** |
| Purchased software                        |       | $                           | 1,596      |                                       | $          | —                    |       | $ | 1,596 |   | $ | 8,350 |   | $ | 2,090 |   | $ | 6,260 |   | 4.6 yrs |   |
| Customer contracts                        |       | —                      |       | —                                     |       | —                    |       | 1,997 |   | 1,968 |   | 29 |   | — |   |
| Purchased licenses                        |       | 227                         |       | —                                     |       | 227                       |       | 1,335 |   | 576 |   | 759 |   | 2.3 yrs |   |
| Trademarks and  tradenames                |       | 815                         |       | —                                     |       | 815                       |       | 1,068 |   | 207 |   | 861 |   | 7.0 yrs |   |
| Business partnerships                     |       | 114                         |       | —                                     |       | 114                       |       | 1,332 |   | 222 |   | 1,110 |   | 5.0 yrs |   |
| Customer relationships                    |       | 3,504                       |       | —                                     |       | 3,504                     |       | 5,989 |   | 1,658 |   | 4,331 |   | 5.5 yrs |   |
|                                      |       | $                           | 6,256      |                                       | $          | —                    |       | $ | 6,256 |   | $ | 20,071 |   | $ | 6,721 |   | $ | 13,350 |   | 5.3 yrs |   |

----

(1)  As a resultof the impairment of intangible assets, the Company established new costs basisfor amortizable intangible assets at June 30, 2006.  Therefore, there is no accumulatedamortization at June 30, 2006.

As a result of the events that led to a triggeringevent related to the goodwill impairment, the Company also reviewed intangibleassets for recoverability in accordance with SFAS 144.  An evaluation of product strategy anddevelopment plans resulted in the determination that the undiscounted cashflows associated with these assets would not be sufficient to recover thecarrying amounts of these assets.  As aresult of this review the Company recorded $5.8 million of intangible assetsimpairment.  This was comprised of $5.4million of purchased software and purchased license intangible assets in theLicense Fees and Services operating segment associated with the acquisitions ofCMS and TSE as well as $0.4 million of customer relationship and businesspartnership intangible assets in the

9

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CustomerSupport operating segment associated with the acquisition of Evolving U.K. The fair values of theCompany’s intangible assets were estimated using the expected present value offuture cash flows.

Prior to the impairment, the Company recordedamortization expense of identifiable intangible assets of $0.9 million and $1.8million for the three and six months ended June 30, 2006, respectively, and$1.4 million and $2.8 million for the three and six months ended June 30, 2005,respectively.  Expected future amortization expense related to identifiable intangibleassets based on carrying amount as of June 30, 2006 is as follows (inthousands):
| Period ending June 30: | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|
| 2007                                  |       | $          | 1,447      |   |
| 2008                                  |       | 1,404      |       |
| 2009                                  |       | 992        |       |
| 2010                                  |       | 764        |       |
| 2011                                  |       | 750        |       |
| Thereafter                            |       | 899        |       |
|                                  |       | $          | 6,256      |   |

 

**(3) Earnings PerCommon Share**

Basic earnings per share (“EPS”) is computed bydividing net income or loss available to common stockholders by the weightedaverage number of shares outstanding during the period, including common stockissuable under participating securities, such as the Series B ConvertibleRedeemable Preferred Stock (“Series B Preferred Stock”). Diluted EPS iscomputed using the weighted average number of shares outstanding, includingparticipating securities, plus all potentially dilutive common stockequivalents. Common stock equivalents consist of stock options and shares heldin escrow. The following is the reconciliation of the numerators anddenominators of the basic and diluted EPS computations (in thousands):
|                                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average common  shares outstanding        |       | 16,190                                          |       | 16,029                                        |       | 16,178 |   | 16,009 |   |
| Participating  securities                          |       | 2,900                                           |       | 2,610                                         |       | 2,900 |   | 2,610 |   |
| Basic weighted average  common shares outstanding  |       | 19,090                                          |       | 18,639                                        |       | 19,078 |   | 18,619 |   |
| Effect of dilutive  securities                     |       | —                                          |       | —                                        |       | — |   | — |   |
| Diluted weighted average common shares outstanding |       | 19,090                                          |       | 18,639                                        |       | 19,078 |   | 18,619 |   |

 

Weighted averageoptions to purchase 4.2 million shares of common stock were excluded from thedilutive share calculation for the three and six months ended June 30, 2006 astheir effect would have been anti-dilutive as a result of the net loss for theperiods.  Weighted average options topurchase 3.7 million and 1.7 million shares of common stock were excluded fromthe dilutive stock calculation for the three and six months ended June 30, 2005,respectively, as their effect would have been anti-dilutive as a result of thenet loss for the periods.

**(4)Share-Based Compensation**

The Company adoptedSFAS 123R effectiveJanuary 1, 2006 using the modified prospective method.  The Company previously applied theintrinsic-value-based method in accounting for the recognition of stock-basedcompensation arrangements and the fair value method only for disclosurepurposes.  Because the Companyhistorically granted options with exercise prices equal to the fair value ofthe Company’s common stock at the grant date, the adoption of SFAS 123R did notresult in a significant impact on the financial statements.  Further, as a result of the preceding, theCompany’s statements of operations from January 1, 2006 forward will includecharges for stock-based compensation. The Company recognized $207,000, or $0.01 per share, of compensationexpense in the statement of operations for the three months ended June 30, 2006and $443,000, or $0.02 per share, of compensation expense in the statement ofoperations for the six months ended June 30, 2006 with respect to itsstock-based compensation plans.  Thefollowing table summarizes stock-based compensation expenses recorded in thestatement of operations (in thousands):

10

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|                                                                            | ** ** | **Three Months  Ended  June 30, 2006** | ** ** | **Six Months  Ended  June 30, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                                     | 15         |                                                | $          | 32 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | 2                                                     |       | 4                                                   |       |
| Sales and  marketing                                                       |       | 51                                                    |       | 106                                                 |       |
| General and  administrative                                                |       | 128                                                   |       | 279                                                 |       |
| Product  development                                                       |       | 11                                                    |       | 22                                                  |       |
|                                                                       |       | $                                                     | 207        |                                                | $          | 443 |   |

 

**Stock Option Plan**

In January 1996, the Company’s stockholders approved“The Amended and Restated Stock Option Plan” (the “Option Plan”). Initially,3,150,000 shares were reserved for issuance under the Option Plan.  Subsequently, the Option Plan was amended, asapproved by the stockholders, to increase the number of shares available forissuance to 8,350,000. Options issued under the Option Plan are at thediscretion of the Board of Directors, including the vesting provisions of eachstock option granted. Options are granted with an exercise price equal to themarket price of the Company’s stock on the date of grant, generally vest overfour years and expire no more than ten years from the date of grant. The OptionPlan terminated on January 18, 2006; options granted before that date were notaffected by the plan termination.

The fair value of each optiongrant is estimated on the date of grant using the Black-Scholes model.  The Black-Scholes model uses four assumptionsto calculate the fair value of each option grant.  The expected term of share options granted isderived using the simplified method prescribed by the SEC Staff AccountingBulletin 107, “Share-Based Payment.”. The risk-free interest rate is based upon the rate currently availableon zero-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 the Company’s stockover a period equal to the expected term of the stock options.  The expected dividend yield is zero and isbased upon historical and anticipated payment of dividends.  The weighted-average assumptions used in the fairvalue calculations are as follows:  
|                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **              | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term (years)   |       | *                                               |       | 5                                             |       | 6.1 |   | 5 |   |
| Risk-free interest rate |       | *                                               |       | 3.72                                          | %          | 4.35 | % | 3.55 | % |
| Expected volatility     |       | *                                               |       | 125.20                                        | %          | 121.14 | % | 125.28 | % |
| Expected dividend yield |       | *                                               |       | 0                                             | %          | 0 | % | 0 | % |

----

*     None granted.

The following is a summary ofstock option activity under the plan for the period ended June 30, 2006: 
| ** **                                | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
|                                           | ** ** | **(in thousands)**         | ** ** | ** **                              | ** ** | **(Years)**                                          | ** ** | **(in thousands)**         | ** ** |
| Options outstanding at  December 31, 2005 |       | 4,279                      |       | $                                       | 3.14       |                                                 |       |                            |       |   |
| Options granted                           |       | 15                         |       | $                                       | 2.32       |                                                 |       |                            |       |   |
| Less options forfeited                    |       | (68                        | )          | $                                       | 2.51       |                                                 |       |                            |       |   |
| Less options  expired                     |       | (30                        | )          | $                                       | 3.76       |                                                 |       |                            |       |   |
| Less options  exercised                   |       | (10                        | )          | $                                       | 1.20       |                                                 |       |                            |       |   |
| Options outstanding at  June 30, 2006     |       | 4,186                      |       | $                                       | 3.15       |                                                 | 7.04       |                            | $          | 288 |   |
|                                      |       |                       |       |                                    |       |                                                 |       |                            |       |
| Options exercisable at June 30, 2006      |       | 3,127                      |       | $                                       | 3.44       |                                                 | 6.36       |                            | $          | 280 |   |

 

11

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The weighted-average grant-datefair value of stock options granted during the three and six months ended June30, 2006 was $0 and $2.05, respectively. The weighted-average grant-date fair value of stock options grantedduring the three and six months ended June 30, 2005 was $1.66 and $2.51,respectively.

As of June 30, 2006, there wereapproximately $1.7 million of total unrecognized compensation costs related tounvested stock options.  These costs areexpected to be recognized over a weighted average period of 1.7 years.

The total intrinsic value ofstock option exercises for the three months ended June 30, 2006 and 2005 was $0and $29,000, respectively.  The totalfair value of stock awards vested during the three months ended June 30, 2006and 2005 was $0.1 million and $0.6 million, respectively.

The total intrinsic value ofstock option exercises for the six months ended June 30, 2006 and 2005 was$13,000 and $95,000, respectively.  Thetotal fair value of stock awards vested during the six months ended June 30,2006 and 2005 was $0.3 million and $1.2 million, respectively.

The deferred income tax benefitsfrom stock options expense related to Evolving U.K. totaled approximately$7,000 and $14,000 for the three and six months ended June 30, 2006, respectively.

Cash received from stock optionexercises for the three months ended June 30, 2006 and June 30, 2005 was $0 and$8,000, respectively.  Cash received fromstock option exercises for the six months ended June 30, 2006 and June 30, 2005was $13,000 and $34,000, respectively.

**Employee Stock PurchasePlan**

Under the Employee Stock PurchasePlan (“ESPP”), the Company is authorized to issue up to 1,100,000 shares ofcommon stock to its full-time employees, nearly all of whom are eligible toparticipate. Under the terms of the ESPP, employees may elect to have up to 15%of their gross salaries withheld through payroll deduction to purchase theCompany’s common stock, capped at $25,000 annually. The purchase price of thestock is 85% of the lower of the market price at the beginning or end of eachthree-month participation period. As of June 30, 2006, there were 394,633shares available for purchase.  For thethree and six months ended June 30, 2006, the Company recorded compensationexpense of $10,000 and $25,000, respectively, associated with grants under theESPP which includes the fair value of the look-back feature of each grant aswell as the 15% discount on the purchase price. This expense will fluctuate each period based upon employeeparticipation.

The fair value of each grant madeunder the Company’s ESPP is estimated on the date of grant using theBlack-Scholes model.  The Black-Scholesmodel uses four assumptions to calculate the fair value of each optiongrant.  The expected term of each grant isbased upon the three-month (six-month in 2005) participation period of eachgrant.  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 grant.  The expected volatility is based uponhistorical volatility of the Company’s stock. The expected dividend yield is based upon historical and anticipatedpayment of dividends.  The weightedaverage assumptions used in the fair value calculations are as follows: 
|                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **              | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term (years)   |       | 0.25                                            |       | 0.5                                           |       | 0.25 |   | 0.5 |   |
| Risk-free interest rate |       | 5.17                                            | %          | 2.68                                          | %          | 4.98 | % | 2.68 | % |
| Expected volatility     |       | 78.36                                           | %          | 99                                            | %          | 82.30 | % | 99 | % |
| Expected dividend yield |       | 0                                               | %          | 0                                             | %          | 0 | % | 0 | % |

                Cash received from employeestock plan purchases for the three months ended June 30, 2006 and June 30, 2005was $35,000 and $0, respectively.  Cashreceived from employee stock plan purchases for the six months ended June 30,2006 and June 30, 2005 was $73,000 and $29,000, respectively.

The following table illustrates the effect on net lossif the fair value method had been applied to all share-based plans during theprevious periods (in thousands, except pershare data):

12

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|                                                                                                                                            | ** ** | **Three Months**                                           | ** ** | **Six Months**         | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                 | ** ** | **Ended**                                                       | ** ** | **Ended**                   | ** ** |
| ** **                                                                                                                                 | ** ** | **   June 30, 2005   ** | ** ** | **June 30, 2005** | ** ** |
| ** **                                                                                                                                 | ** ** | ** **                                                      | ** ** | ** **                  | ** ** |
| Net loss, as reported                                                                                                                      |       | $                                                               | (689       | )                           | $          | (2,837 | ) |
| Stock-based  compensation expense that would have been included in net loss if the  fair-value-based method had been applied to all awards |       | (617                                                            | )          | (1,225                      | )          |
| Pro forma net  loss                                                                                                                        |       | $                                                               | (1,306     | )                           | $          | (4,062 | ) |
|                                                                                                                                       |       |                                                            |       |                        |       |
| Loss per common share,  as reported:                                                                                                       |       |                                                            |       |                        |       |
| Basic and  diluted                                                                                                                         |       | $                                                               | (0.04      | )                           | $          | (0.15 | ) |
| Pro forma loss per  common share:                                                                                                          |       |                                                            |       |                        |       |
| Basic and diluted                                                                                                                          |       | $                                                               | (0.07      | )                           | $          | (0.22 | ) |

 

**(5) Concentration of Credit Risk**

For the three and six monthsended June 30, 2006, two significant customers (defined as contributing atleast 10%) accounted for  24% (13% and11%) and 25% (13% and 12%), respectively, of total revenue.  One ofthese customers is located in the U.S. while the other is in Europe.  For the three and six months endedJune 30, 2005, two significant customers (defined as contributing at least 10%)accounted for 27% (14% and 13%) and 26% (14% and 12%), respectively, of totalrevenue.  One of these customers is located in the U.S.while the other is in Europe.

As of June 30, 2006, five significant customersaccounted for approximately 62% (16%, 12%, 12%, 12% and 10%) of contractreceivables.  Three of these customerswere locatedin the U.S. while the other two were located in Europe and Asia.  At December 31, 2005, two significantcustomers accounted for approximately 38% (25% and 13%) of contractreceivables.  One of these customers was located in the U.S.while the other was in Europe.

**(6) Long-term Debt**

The Company’snotes payable consist of the following (in thousands):
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **June 30,** | ** ** | **December 31,**                                                            | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **2006**          | ** ** | **      2005      ** | ** ** |
| Senior  note payable to financial institution, interest at (1) the greater of 3.75%  or the one-month London InterBank Offered Rate (“LIBOR”) plus (2) a margin of  6.25%, interest rate was 11.49% at June 30, 2006, interest payments are due  monthly, principal installments are due quarterly with final maturity on  November 14, 2010. The margin of 6.25% can be reduced to 5.25% if the Company  meets and maintains certain financial requirements (not met as of June 30,  2006). Loan is secured by substantially all of the assets of Evolving Systems  and its U.S. subsidiaries and a pledge of stock of foreign subsidiaries of  Evolving Systems |       | $                 | 8,000      |                                                                             | $          | 8,500 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                                                                             |       |
| $4.5  million senior revolving credit facility payable to financial institution,  interest at (1) the greater of 3.75% or the one-month LIBOR plus (2) a margin  of 4.0%, interest rate was 9.24% at June 30, 2006, interest payments are due  monthly with final maturity on November 14, 2010. Loan is secured by  substantially all of the assets of Evolving Systems U.K.                                                                                                                                                                                                                                                                                               |       | 2,000             |       | 2,003                                                                            |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                                                                             |       |
| Long-term  unsecured subordinated notes payable, interest ranges from 11-14% with a  weighted average rate of 12.84%, accrued interest and principal are due in  full May 16, 2011                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |       | 4,870             |       | 4,870                                                                            |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                                                                             |       |
| Total notes payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       | 14,870            |       | 15,373                                                                           |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                                                                             |       |
| Less current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | (2,500            | )          | (1,000                                                                           | )          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                                                                             |       |
| Long-term debt, excluding current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       | $                 | 12,370     |                                                                             | $          | 14,373 |   |

 

13

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The $8.0 millionsenior note payable and $4.5 million senior revolving credit facility subjectthe Company to certain financial covenants. Certain of these covenants were amended effective June 30, 2006.  The Minimum Trailing Twelve Months EBITDAcovenant, as defined in the agreement, was amended as follows:
|                                                           | ** ** | **Original Covenant** | ** ** | **Amended Covenant** | ** ** |
|-----------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| June 30, 2006                                             |       | $                          | 5,500,000  |                      | $          | 4,500,000 |   |
| September 30, 2006 and  December 31, 2006                 |       | $                          | 6,000,000  |                      | $          | 4,325,000 |   |
| March 31, 2007                                            |       | $                          | 6,500,000  |                      | $          | 4,500,000 |   |
| June 30, 2007                                             |       | $                          | 6,500,000  |                      | $          | 4,850,000 |   |
| September 30, 2007                                        |       | $                          | 7,000,000  |                      | $          | 5,000,000 |   |
| December 31, 2007                                         |       | $                          | 7,000,000  |                      | $          | 5,200,000 |   |
| March 31, 2008 and June  30, 2008                         |       | $                          | 7,250,000  |                      | $          | 5,200,000 |   |
| September 30, 2008 and the end of each quarter thereafter |       | $                          | 7,250,000  |                      | $          | 5,400,000 |   |

 

The Fixed ChargeCoverage Ratio covenant, which is the ratio of trailing twelve months EBITDAless unfinanced capital expenditures and less income and franchise taxes paidin cash to fixed charges for the preceding twelve months, as further defined inthe agreement, was amended as follows:
|                                                            | ** ** | **Original Covenant** | ** ** | **Amended Covenant** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| September 30, 2006 and  the end of each quarter thereafter |       | 1.20  to 1                 |       | 1.15  to 1                |       |

 

Fixed charges aredefined as total debt service, dividends, repurchases or redemption of equityand/or distributions in cash.

The senior agreements contain a Leverage Ratiocovenant which specifies a leverage ratio of senior debt to trailing twelvemonths EBITDA of 2.5 to 1 as of June 30, 2006. This quarterly required leverage ratio decreases to 2.25 to 1 atDecember 31, 2006, 2.0 to 1 at December 31, 2007 and 1.75 to 1 at December 31,2008.

The senior agreements also limit capital expendituresto $1.4 million per year.

The Company was in compliance with all of itsfinancial covenants as of June 30, 2006.

As part of the amendment of its loan agreements withits senior lender, the Company was required to make a prepayment of principalon the Senior Note Payable of $1.0 million and pay a fee of $25,000 to thesenior lender.  These amounts were paidduring July 2006 and were reflected as current liabilities at June 30, 2006.

**(7) Income Taxes**

The Company recorded net income tax benefit of $1.4million and $1.5 million for the three and six months ended June 30, 2006,respectively.  The net benefit during thethree and six months ended June 30, 2006 consisted of current income taxexpense of approximately $290,000 and $374,000, respectively, and a deferredtax benefit of $1.6 million and $1.8 million, respectively, all of which wererelated to the Company’s UK-based operations.

The Company recorded net income tax benefit of $16,000and $294,000 for the three and six months ended June 30, 2005,respectively.  The net benefit during thethree and six months ended June 30, 2005 consisted of current income taxexpense of approximately $436,000 and $626,000, respectively, and a deferredtax benefit of $452,000 and $920,000, respectively, all of which were relatedto the Company’s UK-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded.  Since the amortization of these identifiableintangibles is not deductible for income tax purposes, a long-term deferred taxliability of $4.6 million was established at the acquisition date for theexpected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. As of June 30,2006 and December 31, 2005, this deferred tax liability was $1.4 million and$3.1 million, respectively.  Thisdeferred tax liability was reduced by $1.5 million as a result of the goodwilland intangible asset impairments recorded during the three months ended June30, 2006.  This deferred tax liability isrelated to Evolving Systems U.K., and has no impact on the Company’s ability torecover its U.S.-based deferred tax assets.

The deferred tax liability described above will berecognized as a reduction of deferred income tax expense as the identifiableintangibles are amortized.

As of June 30, 2006 and December 31, 2005, theCompany continued to maintain a full valuation allowance on its domestic net deferredtax asset as it determined it is more likely than not that the Company will notrealize its domestic deferred tax assets. Such assets primarily consist of net operating loss carryforwards.  The Company assessed the realizability of itsdomestic deferred tax assets using all available evidence.  In particular, the Company considered bothits historical results and its projections of profitability for reasonablyforeseeable future periods.  The Companyis required to reassess its conclusions regarding the realization of itsdeferred tax assets at each financial reporting date. A future evaluation couldresult in a conclusion that all or a portion of the valuation allowance is nolonger necessary which could have a material impact in the Company’s results ofoperations and financial position.

14

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**(8)Segment Information**

In accordance with SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information,” the Company definesoperating segments as components of an enterprise for which separate financialinformation is reviewed regularly by the chief operating decision-making group,to evaluate performance and to make operating decisions. The Company hasidentified its Chief Executive Officer and Chief Financial Officer as its chiefoperating decision-makers (CODM). These chief operating decision makers reviewrevenues by segment and review overall results of operations.

The Company currently operates its business as twooperating segments based on revenue type: license fees and services revenue andcustomer support revenue (as shown on the consolidated statements ofoperations).  License fees and services(L&S) revenue represents the fees received from the license of softwareproducts and those services directly related to the delivery of the licensedproducts, as well as fees for custom development, integration services and timeand materials work.  Customer support(CS) revenue includes annual support fees, recurring maintenance fees, fees formaintenance upgrades and warranty services. Warranty services that are similar to software maintenance services aretypically bundled with a license sale. Total assets by segment have not beendisclosed because the information is not available to the chief operatingdecision-making group.

Segment information is as follows (in thousands):
|                                                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                 | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenue**                                                                |       |                             |       |                           |       |   |   |   |   |
| License fees and services                                                  |       | $                                | 3,966      |                           | $          | 4,741 |   | $ | 7,865 |   | $ | 9,822 |   |
| Customer support                                                           |       | 4,274                            |       | 5,185                          |       | 8,503 |   | 9,942 |   |
|                                                                       |       | $                                | 8,240      |                           | $          | 9,926 |   | $ | 16,368 |   | $ | 19,764 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| **Revenue  less cost of revenue, excluding depreciation and amortization** |       |                             |       |                           |       |   |   |   |   |
| License fees and services                                                  |       | $                                | 2,309      |                           | $          | 2,348 |   | $ | 4,333 |   | $ | 4,453 |   |
| Customer support                                                           |       | 2,723                            |       | 3,549                          |       | 5,326 |   | 6,275 |   |
|                                                                       |       | 5,032                            |       | 5,897                          |       | 9,659 |   | 10,728 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| **Unallocated  costs**                                                     |       |                             |       |                           |       |   |   |   |   |
| Other operating expenses                                                   |       | 4,421                            |       | 4,399                          |       | 9,130 |   | 9,402 |   |
| Depreciation and amortization                                              |       | 1,176                            |       | 1,779                          |       | 2,366 |   | 3,576 |   |
| Impairment of goodwill and intangible assets                               |       | 16,516                           |       | —                         |       | 16,516 |   | — |   |
| Restructuring and other                                                    |       | (9                               | )          | (4                             | )          | (23 | ) | (63 | ) |
| **Loss from operations**                                                   |       | $                                | (17,072    | )                              | $          | (277 | ) | $ | (18,330 | ) | $ | (2,187 | ) |

 

***Geographic Regions***

The Company, headquarteredin Englewood, a suburb of Denver, Colorado, uses customer locations as thebasis of attributing revenues to individual countries.  The Company now provides products andservices on a global basis through its London based Evolving Systems U.K.subsidiary.  Additionally, the Company’spersonnel in Bangalore, India, provide software development services to theCompany’s global operations.  Financialinformation relating to the Company’s operations by geographic region, asreviewed by the CODM, is as follows (in thousands):

|                                      | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **Revenue**                          | ** ** | **L&S**                                         | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| Americas                             |       | $                                                   | 704        |   | $ | 2,661 |   | $ | 3,365 |   | $ | 1,373 |   | $ | 3,327 |   | $ | 4,700 |   |
| Europe, Middle East, Africa and Asia |       | 3,262                                               |       | 1,613 |   | 4,875 |   | 3,368 |   | 1,858 |   | 5,226 |   |
| Total Revenue                        |       | $                                                   | 3,966      |   | $ | 4,274 |   | $ | 8,240 |   | $ | 4,741 |   | $ | 5,185 |   | $ | 9,926 |   |

 

15

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|                                      | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| **Revenue**                          | ** ** | **L&S**                                       | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| Americas                             |       | $                                                 | 1,449      |   | $ | 5,367 |   | $ | 6,816 |   | $ | 3,046 |   | $ | 6,672 |   | $ | 9,718 |   |
| Europe, Middle East, Africa and Asia |       | 6,416                                             |       | 3,136 |   | 9,552 |   | 6,776 |   | 3,270 |   | 10,046 |   |
| Total Revenue                        |       | $                                                 | 7,865      |   | $ | 8,503 |   | $ | 16,368 |   | $ | 9,822 |   | $ | 9,942 |   | $ | 19,764 |   |

 
|                                      | ** ** | June 30, | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|---------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**      | ** ** | **2005**              | ** ** |
| **Long-lived  assets, net**          |       |          |       |                  |       |
| Americas                             |       | $             | 8,401      |                  | $          | 13,172 |   |
| Europe, Middle East, Africa and Asia |       | 24,217        |       | 36,026                |       |
| Total long-lived  assets, net        |       | $             | 32,618     |                  | $          | 49,198 |   |

 

Financial information relating to the Company’sproduct groupings is as follows (in thousands):
|                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **Revenue**          | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Activation           |       | $                                               | 4,341      |                                          | $          | 4,931 |   | $ | 8,551 |   | $ | 9,124 |   |
| Numbering  solutions |       | 2,588                                           |       | 3,957                                         |       | 5,332 |   | 7,747 |   |
| Mediation            |       | 1,311                                           |       | 1,038                                         |       | 2,485 |   | 2,893 |   |
|                 |       | $                                               | 8,240      |                                          | $          | 9,926 |   | $ | 16,368 |   | $ | 19,764 |   |

 

**(9) Commitments and Contingencies**

As permitted under Delaware law, the Company hasagreements with its officers and directors under which it agrees to indemnifythem for certain events or occurrences while the officer or director is, or wasserving, at the Company’s request in this capacity. The term of the indemnificationperiod is indefinite. There is no limit on the amount of future payments theCompany could be required to make under these indemnification agreements;however, the Company maintains Director and Officer insurance policies, as wellas an Employment Practices Liability Insurance Policy, that may enable it torecover a portion of any future amounts paid. As a result of the Company’sinsurance policy coverage, it believes the estimated fair value of theseindemnification agreements is minimal. Accordingly, the Company has noliabilities recorded for these agreements as of June 30, 2006 andDecember 31, 2005.

The Company enters into standard indemnification termswith its customers, as discussed below, in the ordinary course of business.Because the Company may subcontract the development of its deliverables underits customer contracts, the Company could be required to indemnify itscustomers for work performed by its subcontractors. Depending upon the natureof the customer indemnification, the potential amount of future payments theCompany could be required to make under these indemnification agreements may beunlimited. The Company may be able to recover damages from a subcontractor ifthe indemnification to its customers results from the subcontractor’s failureto perform. To the extent the Company is unable to recover damages from itssubcontractors, the Company could be required to reimburse the indemnifiedparty for the full amount. The Company has never incurred costs to defendlawsuits or settle claims relating to indemnification arising out of itssubcontractors’ failure to perform. As a result, the Company believes theestimated fair value of these agreements is minimal. Accordingly, the Companyhas no liabilities recorded for these agreements as of June 30, 2006 andDecember 31, 2005.

The Company’s standard license agreements containproduct warranties that the software will be free of material defects and willoperate in accordance with the stated requirements for a limited period oftime.  The product warranty provisionsrequire the Company to cure any defects through any reasonable means.  The Company believes the estimated fair valueof the product warranty provisions in the license agreements in place with itscustomers is minimal.  Accordingly, theCompany has not recorded liabilities for these product warranty provisions asof June 30, 2006 and December 31, 2005.

The Company’s software arrangements generally includea product indemnification provision that the Company will indemnify and defenda customer in actions brought against the customer for claims that the Company’sproducts infringe upon a copyright, trade secret, or valid patent.Historically, the Company has not incurred any significant costs related toproduct indemnification claims. Accordingly, the Company has no liabilitiesrecorded as of June 30, 2006 and December 31, 2005.

16

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In relation to the acquisitions of Evolving SystemsU.K., Telecom Software Enterprises, LLC (TSE) and CMS Communications, Inc.(CMS), the Company agreed to indemnify certain parties of and from any losses,actions, claims, damages or liabilities (or actions in respect thereof)resulting from any claim raised by a third party. The Company does not believethat there will be any claims related to these indemnifications. Accordingly,the Company has no liabilities recorded for these agreements as of June 30,2006 and December 31, 2005.

From time to time the Company is involved in variouslegal proceedings arising in the normal course of business operations. We arenot currently involved in any such proceedings.

17

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**Special Note About Forward-LookingStatements**

*This Quarterly Report on Form 10-Q containsforward-looking statements that have been made pursuant to the provisions ofthe Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based oncurrent expectations, estimates, and projections about Evolving Systems’industry, management’s beliefs, and certain assumptions made bymanagement.  Forward-looking statementsinclude our expectations regarding product, services, and maintenance revenue,annual savings associated with the organizational changes effected in prioryears, and short- and long-term cash needs. In some cases, words such as “anticipates”, “expects”, “intends”, “plans”,“believes”, “estimates”, variations of these words, and similar expressions areintended to identify forward-looking statements.  The statements are not guarantees of futureperformance and are subject to certain risks, uncertainties, and assumptionsthat are difficult to predict; therefore, actual results may differ materiallyfrom those expressed or forecasted in any forward-looking statements.  Risks and uncertainties of our businessinclude those set forth in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2005 under “Item 1A. Risk Factors” as well asadditional risks described in this Form 10-Q. Unless required by law, we undertake no obligation to update publiclyany forward-looking statements, whether as a result of new information, futureevents, or otherwise.  However, readersshould carefully review the risk factors set forth in other reports ordocuments the Company files from time to time with the Securities and ExchangeCommission, particularly the Quarterly Reports on Form 10-Q and anyCurrent Reports on Form 8-K.*

**OVERVIEW**

We are a providerof software solutions and services to the wireless, wireline and IP carriermarket. We maintain long-standing relationships with many of the largestwireline, wireless and IP communications carriers worldwide. Our customers relyon us to develop, deploy, enhance, maintain and integrate complex, highlyreliable software solutions for a range of Operations Support Systems (“OSS”).  Our activation solution is the leadingpackaged solution for activation in the wireless industry.

We recognize revenue inaccordance with the prescribed accounting standards for software revenuerecognition under generally accepted accounting principles.  As a result, our license fees and servicesrevenues fluctuate from period to period as a result of the timing of revenuerecognition on existing projects.

Effective January 1, 2006, we adopted SFASNo. 123(R), *Share-Based Payment*(“SFAS 123R”)*,*using the modified prospective method.  Prior to January 1, 2006, we applied theintrinsic-value-based method in accounting for employee stock-basedcompensation arrangements and the fair value method only for disclosure purposes.  Under these methods, stock-based compensationcosts were not recorded in the financial statements but were disclosed in thenotes to the financial statements together with pro forma disclosure ofearnings and earnings per share.  Becausethe fair value recognition provisions of SFAS 123R require recognition ofstock-based compensation expense in the financial statements, the applicationof SFAS 123R has and will negatively impact our results ofoperations.  For the three and six monthsended June 30, 2006, we recorded $207,000 and $443,000, respectively, ofstock-based compensation expenses associated with our stock option and employeestock purchase plans which were allocated to the various expense line itemswithin our statements of operations.  As wepreviously applied the fair value method for disclosure purposes, we believethe disclosure in previously issued reports are reasonably comparable tocurrent period recorded expenses except for the requirement to now estimateforfeitures in the amount of compensation expense recognized, as compared torecording forfeitures as they occurred in our prior period pro formadisclosures.   As of June 30, 2006, therewas $1.7 million of total unrecognized compensation costs related to unvestedstock options. These costs are expected to be recognized over a weightedaverage period of 1.7 years.  Thefollowing table summarizes the stock-based compensation expenses recorded inthe statements of operations (in thousands).
|                                                                            | ** ** | **Three Months  Ended  June 30, 2006** | ** ** | **Six Months  Ended  June 30, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                                     | 15         |                                                | $          | 32 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | 2                                                     |       | 4                                                   |       |
| Sales and  marketing                                                       |       | 51                                                    |       | 106                                                 |       |
| General and administrative                                                 |       | 128                                                   |       | 279                                                 |       |
| Product  development                                                       |       | 11                                                    |       | 22                                                  |       |
|                                                                       |       | $                                                     | 207        |                                                | $          | 443 |   |

 

18

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***Cost Reductions***

 During 2005, we implemented a number of costreducing strategies targeted at integrating our 2004 acquisitions includingidentification of several duplicative roles that were eliminated as a result ofthese acquisitions.  In July 2005, weundertook additional cost reduction measures that involved an additional 10%reduction in our workforce, including individuals at all levels of our U.S. andU.K. operations.  In addition, wetransitioned Evolving Systems U.K. third-party software development to ouroffshore development team in our India subsidiary.  We have continued to increase utilization ofour Evolving Systems India subsidiary which now employs over 100 people.

Our costs ofrevenue and operating expenses, net of the impairment of goodwill andintangible assets of $16.5 million, decreased $1.4 million, or 14%, to $8.8million for the three months ended June 30, 2006 from $10.2 million for thethree months ended June 30, 2005.  Thesecost reduction measures account for a significant portion of the decrease inour costs of revenue and operating expenses for the three months ended June 30,2006 as compared to the three months ended June 30, 2005.  Our intangible amortization decreased $0.5million over these periods as certain of our intangible assets from ouracquisitions became fully amortized. Stock-based compensation costs of $0.2 million resulting from theimplementation of SFAS 123R partially offset these decreases in expense.

***Impairmentof Goodwill and Intangible Assets***

We recognized agoodwill impairment charge of $10.7 million at June 30, 2006 related to ourLicense Fees and Services operating segment. The impairment resulted from thedecline in the fair value of goodwill initially recorded associated with ouracquisitions of Evolving Systems U.K., TSE and CMS.

In addition, werecorded an impairment of intangible assets of $5.8 million related tointangible assets acquired in the acquisitions of Evolving Systems U.K., CMSand TSE.  An evaluation of productstrategy and development plans resulted in the determination that theundiscounted cash flows associated with these assets would not be sufficient torecover the carrying amounts of these assets. This non-cash impairment charge resulted in acceleration of futureamortization expense associated with these assets.

19

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**RESULTS OF OPERATIONS**

The following table presents the Company’s unauditedconsolidated statements of operations reflected as a percentage of totalrevenue.
|                                                                              | ** ** | **Three Months Ended  June 30,**          | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **    2006    ** | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **REVENUE**                                                                  |       |                                                     |       |                                          |       |   |   |   |   |
| License fees and services                                                    |       | 48                                                       | %          | 48                                            | %          | 48 | % | 50 | % |
| Customer support                                                             |       | 52                                                       | %          | 52                                            | %          | 52 | % | 50 | % |
| Total revenue                                                                |       | 100                                                      | %          | 100                                           | %          | 100 | % | 100 | % |
|                                                                         |       |                                                     |       |                                          |       |   |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 |       |                                                     |       |                                          |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 20                                                       | %          | 24                                            | %          | 22 | % | 27 | % |
| Costs of customer support, excluding depreciation  and amortization          |       | 19                                                       | %          | 17                                            | %          | 19 | % | 19 | % |
| Sales and marketing                                                          |       | 27                                                       | %          | 24                                            | %          | 29 | % | 24 | % |
| General and administrative                                                   |       | 17                                                       | %          | 15                                            | %          | 17 | % | 20 | % |
| Product development                                                          |       | 10                                                       | %          | 5                                             | %          | 9 | % | 3 | % |
| Depreciation                                                                 |       | 3                                                        | %          | 4                                             | %          | 4 | % | 4 | % |
| Amortization                                                                 |       | 11                                                       | %          | 14                                            | %          | 11 | % | 14 | % |
| Impairment of goodwill and intangible assets                                 |       | 200                                                      | %          | —                                        | %          | 101 | % | — | % |
| Restructuring and other                                                      |       | —                                                   | %          | —                                        | %          | — | % | — | % |
| Total costs of  revenue and operating expenses                               |       | 307                                                      | %          | 103                                           | %          | 212 | % | 111 | % |
|                                                                         |       |                                                     |       |                                          |       |   |   |   |   |
| Loss from  operations                                                        |       | (207                                                     | )%         | (3                                            | )%         | (112 | )% | (11 | )% |
|                                                                         |       |                                                     |       |                                          |       |   |   |   |   |
| Interest income                                                              |       | —                                                   | %          | —                                        | %          | — | % | — | % |
| Interest expense                                                             |       | (6                                                       | )%         | (4                                            | )%         | (6 | )% | (4 | )% |
| Foreign currency exchange loss                                               |       | —                                                   | %          | —                                        | %          | — | % | (1 | )% |
| Other expense,  net                                                          |       | (6                                                       | )%         | (4                                            | )%         | (6 | )% | (5 | )% |
|                                                                         |       |                                                     |       |                                          |       |   |   |   |   |
| Loss before  income taxes                                                    |       | (213                                                     | )%         | (7                                            | )%         | (118 | )% | (16 | )% |
|                                                                         |       |                                                     |       |                                          |       |   |   |   |   |
| Income tax benefit                                                           |       | (17                                                      | )%         | —                                        | %          | (9 | )% | (2 | )% |
|                                                                         |       |                                                     |       |                                          |       |   |   |   |   |
| Net loss                                                                     |       | (196                                                     | )%         | (7                                            | )%         | (109 | )% | (14 | )% |

 

***Revenue***

Revenue is comprised of license fees/services andcustomer support.  License fees andservices revenue represent the fees we receive from the licensing of oursoftware products and those services directly related to the delivery of thelicensed product as well as integration services and time and materialswork.  Customer support revenue includes annual support,recurring maintenance, maintenance upgrades and warranty services.  Warranty services consist of maintenanceservices and are typically bundled with a license sale and the related revenue,based on VSOE, is deferred and recognized ratably over the warranty period.  The following table presents the Company’sapproximate revenue by product group (in thousands):

|                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **          | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Activation          |       | $                                               | 4,341      |                                          | $          | 4,931 |   | $ | 8,551 |   | $ | 9,124 |   |
| Numbering solutions |       | 2,588                                           |       | 3,957                                         |       | 5,332 |   | 7,747 |   |
| Mediation           |       | 1,311                                           |       | 1,038                                         |       | 2,485 |   | 2,893 |   |
|                |       | $                                               | 8,240      |                                          | $          | 9,926 |   | $ | 16,368 |   | $ | 19,764 |   |

 

20

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***License Fees and Services***

Licensefees and services revenue decreased 16% or $0.8 million to $4.0 million for thethree months ended June 30, 2006, from $4.8 million for the three months endedJune 30, 2005.  The decrease in licensefees and services revenue was primarily a result of a decrease of $0.8 millionin revenue from our number solutions products, an increase of $0.4 million inrevenue from our mediation products and a decrease of $0.4 million in revenuefrom our activation products.  Thedecline in numbering solutions revenue was due to industry consolidation andsmaller overall license sales, which is reflective of the maturity of thenarrowband numbering solutions market in the U.S.  The increase in mediation revenue was aresult of an increase in subscriber licenses for an existing mediationcustomer.  The decline in activationrevenue was due to the timing of revenue recognition for activation projects inproduction as of June 30, 2006 compared to those in production at June 30,2005.

Licensefees and services revenue decreased 20% or $2.0 million to $7.8 million for thesix months ended June 30, 2006, from $9.8 million for the six months ended June30, 2005.  The decrease in license feesand services revenue was primarily a result of a decrease of $1.3 million inrevenue from our number solutions products, a decrease of $0.3 million inrevenue from our mediation products and a decrease of $0.4 million in revenuefrom our activation products.  Thedecline in numbering solutions revenue was due to the maturity of the US marketand the delay to market of our international NumeriTrack®.  In addition, a contract signed during the sixmonths ended June 30, 2006 with an international customer was ended by mutualagreement pending availability of the production version of our internationalNumeriTrack® product. We believe an international market exists for ourNumeriTrack® product and are continuing R&D investments to “internationalize”this product and expect it to be generally available by the end of September2006.  The decline in mediation revenueis consistent with our focus on our activation and numbering solutionsproducts.  The decline in activationrevenue was due to the timing of revenue recognition for activation projects inproduction as of June 30, 2006 compared to those in production at June 30,2005.

***Customer Support***

Customer support revenue decreased $0.9 million, or18%, to $4.3 million for the three months ended June 30, 2006, from $5.2million for the three months ended June 30, 2005.  The decrease in customer support revenue wasprimarily a result of a decrease of $0.6 million from our numbering solutionsproducts, a decrease of $0.1 million in our mediation products and a decreaseof $0.2 million in our activation products. The decrease in the numbering solutions revenue was due to industryconsolidation and smaller overall license sales, which is reflective of thematurity of the narrowband numbering solutions market in the U.S.  The decline in mediation revenue isconsistent with our focus on our activation and numbering solutions products.The decrease in activation revenue is a result of industry consolidation and pricing pressures on support contractrenewals.

Customer support revenue decreased $1.4 million, or14%, to $8.5 million for the six months ended June 30, 2006, from $9.9 millionfor the six months ended June 30, 2005. The decrease in customer support revenue was primarily a result of adecrease of $1.1 million from our numbering solutions products, a decrease of$0.1 million in our mediation products and a decrease of $0.2 million in ouractivation products.  The decrease in thenumbering solutions revenue was due to industry consolidation and smaller overalllicense sales, which is reflective of the maturity of the narrowband numberingsolutions market in the U.S.  The declinein mediation revenue is consistent with our focus on our activation andnumbering solutions products.  Thedecrease in activation revenue is a result of industry consolidation and pricing pressures on support contractrenewals.

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

Costs of revenue, excluding depreciation andamortization, consist primarily of personnel costs, facilities costs, costs ofthird-party software, partner commissions and all other direct costs associatedwith these personnel.  Partnercommissions increased over prior years as we entered into new partnership in emergingmarkets in an effort to expand the geographic reach of our products.   Costs of revenue, excluding depreciation andamortization, were $3.2 million and $4.0 million for the three months endedJune 30, 2006 and 2005, respectively, and $6.7 million and $9.0 million for thesix months ended June 30, 2006, respectively. These costs are discussed further below.

***Costs of License Fees andServices, Excluding Depreciation and Amortization***

Costs of license fees and services, excludingdepreciation and amortization, were $1.7 million and $2.4 for the three monthsended June 30, 2006 and 2005, respectively. The decrease of $0.7 million, or 31%, was primarily due to costreductions implemented during 2005.  As apercentage of license fees and services revenue, costs of license fees andservices, excluding depreciation and amortization, decreased to 42% for thethree months ended June 30, 2006 from 50% for the three months ended June 30,2005.  This decrease was due to cost reductions implemented during 2005 as well assavings from the increased utilization of our offshore development subsidiaryin Bangalore, India.

Costs of license fees and services, excludingdepreciation and amortization, were $3.5 million and $5.4 for the six monthsended June 30, 2006 and 2005, respectively. The decrease of $1.8 million, or 34%, was primarily due to costreductions implemented during 2005.  As apercentage of license fees and services revenue, costs of license fees andservices, excluding depreciation and amortization, decreased to 45% for thethree months ended June 30, 2006 from 55% for the three months ended June 30,2005.  This decrease was due to cost reductions implemented during 2005 as well assavings from the increased utilization of our offshore

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development subsidiary in Bangalore, India.

***Costs of Customer Support,Excluding Depreciation and Amortization***

Costs of customer support, excluding depreciation andamortization, decreased $0.1 million, or 5%, to $1.5 million for the threemonths ended June 30, 2006 from $1.6 million for the three months ended June30, 2005.  This decrease was primarilydue to cost reductions implemented during 2005. As a percentage of customer support revenue, costs of customer supportrevenue, excluding depreciation and amortization, increased to 36% for thethree months ended June 30, 2006 from 32% for the three months ended June 30,2005.  This increase was due to customersupport revenue declining faster that the associated costs during the threemonths ended June 30, 2006 as compared to the same period in 2005.

Costs of customer support, excluding depreciation andamortization, decreased $0.5 million, or 13%, to $3.2 million for the sixmonths ended June 30, 2006 from $3.7 million for the six months ended June30, 2005.  As a percentage of customersupport revenue, costs of customer support revenue, excluding depreciation andamortization, remained at 37% for the six months ended June 30, 2006 and 2005.

***Sales and Marketing***

Sales and marketing expenses primarily consist ofcompensation costs, including bonuses and commissions, travel expenses,advertising, marketing and occupancy expenses. Sales and marketing expenses decreased $0.2 million, or 8%, to $2.2million for the three months ended June 30, 2006 from $2.4 million for thethree months ended June 30, 2005.  Thisdecrease was a result of cost reduction implemented during 2005.  As a percentage of total revenue, sales andmarketing expenses for the three months ended June 30, 2006 and 2005, increasedto 27% from 24%, respectively.  Thisincrease was a result of revenue decreasing proportionally more that sales andmarketing expenses during the three months ended June 30, 2006 as compared tothe same period in 2005.

Sales and marketing expenses were $4.8 million for thesix months ended June 30, 2006 and 2005, respectively.  Costreductions implemented during 2005 were offset by sales and marketinginvestments made in Asia and Central and Latin America as well as stock basedcompensation expenses during the six months ended June 30, 2006.  As a percentage of total revenue, sales andmarketing expenses for the six months ended June 30, 2006 and 2005, increasedto 29% from 24%, respectively.  Thisincrease was a result of decreased revenue without proportional decreases insales and marketing expenses during the six months ended June 30, 2006 ascompared to the same period in 2005.

***General and Administrative***

General and administrative expenses consistprincipally of employee related costs and professional fees for the followingdepartments: facilities, finance, legal, human resources, and executivemanagement.  General and administrativeexpenses decreased $0.1 million, or 7%, to $1.4 million from $1.5million for the three months ended June 30, 2006 and 2005, respectively.  This decrease was primarily a result of costsaving measures implemented during 2005 and reductions in professional andlegal fees which were offset by stock-based compensation costs recorded duringthe three months ended June 30, 2006.  Asa percentage of total revenue, general and administrative expenses for thethree months ended June 30, 2006 and 2005, increased to 17% from 15%,respectively.  This increase was a resultof revenue decreasing proportionally more than general and administrativeexpenses during the three months ended June 30, 2006 as compared to the sameperiod in 2005.

General and administrative expenses decreased $1.2million, or 30%, to $2.8 million from $4.0 million for the six monthsended June 30, 2006 and 2005, respectively. As a percentage of total revenue, general and administrative expensesfor the six months ended June 30, 2006 and 2005, decreased to 17% from 20%,respectively.  These decreases wereprimarily a result of cost saving measures implemented during the first quarterof 2005 and reductions in professional and legal fees which were offset bystock-based compensation costs recorded during the six months ended June 30,2006.

***Product Development***

Product development expenses consist primarily ofemployee related costs and, in 2005, included offshore development andsubcontractor expenses.  Productdevelopment expenses increased $0.3 million, or 61%, to $0.8 million from $0.5million for the three months ended June 30, 2006 and 2005, respectively.  As a percentage of revenue, productdevelopment expenses for the three months ended June 30, 2006 and 2005,increased to 10% from 5%, respectively. These increases were due to product release enhancements as well as “internationalizing”our NumeriTrack® product.

Product development expenses increased $0.9 million,or 156%, to $1.5 million from $0.6 million for the six months ended June 30,2006 and 2005, respectively.  As apercentage of revenue, product development expenses for the six months endedJune 30, 2006 and 2005, increased to 9% from 3%, respectively.  These increases were due to product releaseenhancements as well as “internationalizing” our NumeriTrack® product.

***Amortization***

Amortization expense consists of amortization ofidentifiable intangible assets acquired through our acquisitions of CMS, TSEand Evolving Systems U.K.  Amortizationexpense was $0.9 million and $1.4 million for the three months ended June 30,2006

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and2005, respectively.  The decrease inamortization expense of $0.5 million, or 36%, is a result of certain intangibleassets becoming fully amortized.

Amortization expense was $1.8 million and $2.8 millionfor the six months ended June 30, 2006 and 2005, respectively.  The decrease in amortization expense of $1.0million, or 36%, is a result of certain intangible assets becoming fullyamortized.

***Impairment of Goodwill and Intangible Assets***

At June 30, 2006, we recorded a goodwill impairment of$10.7 million related to impairment of our License Fees and Services operatingsegment.  Continued pricing pressures and consolidationin the telecommunications industry negatively impacted our achievement offorecasted revenues associated with the acquisitions of CMS in November 2003,TSE in October 2004 and Evolving Systems U.K. in November 2004.  The market price of our common stock declinedas a result of our recent operating results. Based upon these events, we determined that a triggering event hadoccurred and we conducted an interim goodwill impairment analysis as of June30, 2006.  This goodwill impairmentanalysis resulted in the goodwill impairment charge noted above.  We estimated the fair value of each reportingunit using the expected present value of future cash flows and other marketfactors.

As a result of the events that led to a triggeringevent related to the goodwill impairment, we reviewed intangible assets inaccordance with FAS 144.  An evaluationof product strategy and development plans resulted in the determination thatthe undiscounted cash flows associated with these assets would not besufficient to recover the carrying amounts of these assets.  This review indicated that $5.8 million ofintangible assets related to the License Fees and Services and Customer Supportoperating segment were impaired.  Theimpaired intangible assets were purchased software purchased licenses andcustomer relationships which were acquired through our acquisitions of EvolvingSystems U.K., CMS and TSE.  This non-cashimpairment charge resulted in acceleration of $5.8 million in futureamortization expense associated with these assets.

***Interest Expense***

Interest expense was $0.5 million and $0.4 million forthe three months ended June 30, 2006 and 2005, respectively.  The increase of $0.1 million, or 22%, relatedto higher levels of debt, an increase in variable interest rates and increasedamortization of debt issuance costs.

Interest expense was $1.0 million and $0.8 million forthe six months ended June 30, 2006 and 2005, respectively.  The increase of $0.2 million, or 20%, relatedto higher levels of debt, an increase in variable interest rates and increasedamortization of debt issuance costs.

***Foreign Currency Exchange Loss***

Foreign currency transactionlosses resulted from transactions denominated in a currency other than thefunctional currency of the respective subsidiary and were $29,000 and$60,000 for the three months ended June 30, 2006 and 2005, respectively.  The losses were generated primarily throughthe remeasurement of certain non-functional currency denominated financialassets and liabilities of our Evolving Systems U.K. subsidiary.

Foreign currency transactionlosses were $30,000 and $0.2 million for the six months ended June 30, 2006 and2005, respectively.  The losseswere generated primarily through the remeasurement of financial assets andliabilities of our Evolving Systems U.K. subsidiary.

***Income Taxes***

We recorded net income tax benefit of $1.4 million andnet income tax benefit of $16,000 for the three months ended June 30, 2006 and2005, respectively.  The net income taxexpense during the three months ended June 30, 2006 consisted of current foreignincome tax expense of approximately $290,000 and a deferred foreign tax benefitof $1.6 million both of which are related to the Company’s UK-basedoperations.  The net income tax benefitduring the three months ended June 30, 2005 consisted of current foreign incometax expense of approximately $436,000 and a deferred foreign tax benefit of$452,000 both of which are related to the Company’s UK-based operations.

We recorded net income tax benefit of $1.5 million andnet income tax benefit of $294,000 for the six months ended June 30, 2006 and2005, respectively.  The net income taxexpense during the six months ended June 30, 2006 consisted of current foreignincome tax expense of approximately $374,000 and a deferred foreign tax benefitof $1.8 million both of which are related to the Company’s UK-basedoperations.  The net income tax benefitduring the six months ended June 30, 2005 consisted of current foreign incometax expense of approximately $626,000 and a deferred foreign tax benefit of$920,000 both of which are related to the Company’s UK-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded.  Since the identifiable intangibleamortization is not deductible for income tax purposes, a long-term deferredtax liability of $4.6 million was established at the acquisition date for theexpected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. As of June 30,2006 and December 31, 2005, this deferred tax liability was $1.4 million and$3.1 million, respectively.  Thisdeferred tax liability was reduced by $1.5 million as a result of the goodwilland

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intangibleimpairment charges recorded as of June 30, 2006.  This deferred tax liability is carried on thebooks of the Company’s United Kingdom subsidiary, and has no impact on theCompany’s ability to recover its U.S.-based deferred tax assets.  The aforementioned deferred tax liabilitywill be recognized as a reduction of deferred income tax expense as theidentifiable intangibles are amortized.

**FINANCIAL CONDITION**

Our working capital position decreased to a negative$1.2 million as of June 30, 2006 from a positive $0.4 million as of December31, 2005.  This decrease of $1.6 millionwas primarily a result of the prepayment of $1.0 million on our senior notepayable during July 2006 which was recorded as a current liability at June 30,2006.  Contract receivables decreased$4.9 million during the six months ended June 30, 2006 as a result ofcollecting annual support contracts which were billed as of December 31, 2005as well as the timing of billings and collections.

**CONTRACTUALOBLIGATIONS**

There have been no material changes to the contractualobligations as disclosed in our 2005 Annual Report on Form 10-K.

**LIQUIDITY AND CAPITAL RESOURCES**

We have historically financed operations through cashflows from operations and equity transactions. At June 30, 2006, our principal source of liquidity was $6.4 million incash and cash equivalents as well as $2.3 million available under our revolvingline of credit.  The $2.3 million inavailability under our revolving line of credit reflects the reducedavailability resulting from standby letters of credit of $0.2 million.  The following table summarizes our statementsof cash flows (in thousands):

|                           | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------|------------|-----------------------------------------------|------------|
| ** **                | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Cash provided (used)  by: |       |                                          |       |   |   |
| Operating  activities     |       | $                                             | 3,220      |   | $ | 1,790 |   |
| Investing  activities     |       | (354                                          | )          | (876 | ) |
| Financing  activities     |       | (431                                          | )          | (7,457 | ) |
| Effect of  exchange rates |       | 124                                           |       | (276 | ) |
| Net cash provided  (used) |       | $                                             | 2,559      |   | $ | (6,819 | ) |

 

Net cash provided by operatingactivities for the six months ended June 30, 2006 and 2005 was $3.2 million and$1.8 million, respectively.  Net lossplus non-cash operating adjustments was a negative $0.2 million for the sixmonths ended June 30, 2006 compared to a positive $0.7 million for the sixmonths ended June 30, 2005.  Changes inoperating assets and liabilities reflected a net increase in cash fromoperating activities of $3.4 million for the six months ended June 30, 2006 ascompared to $1.1 million for the six months ended June 30, 2005.  These fluctuations were primarily attributableto a decrease in amortization expense and the timing of billings andcollections for existing projects which vary based upon the specific billingschedules in each contract and affect the reported amounts of contractreceivables, unbilled work-in-process and unearned revenue.

Net cash used by investing activities during the sixmonths ended June 30, 2006 and 2005 was $0.4 million and $0.9 million.  The cash used for the six months ended June30, 2006 related primarily to purchases of property and equipment of $0.2million and payment of TSE contingent consideration of $0.2 million.  The cash used for the six months ended June30, 2005 related primarily to purchase of property and equipment of $0.5million and net cash outflows of $0.4 million for the Evolving Systems U.K. andTSE acquisitions.

Financing activities in the six months ended June 30,2006 and 2005, consisted primarily of principal payments on notes payable andamounts due Evolving U.K. sellers. During the six months ended June 30, 2006, we paid $0.5 million inprincipal payments on the senior term note entered into in November 2005.During the six months ended June 30, 2005, we paid $7.5 million in principalpayments on obligations resulting from our acquisitions during 2004.  The restructuring of our debt during November2005 significantly reduced our short-term obligations under our long-term debtarrangements.

We believe that our current cash and cash equivalents,together with anticipated cash flow from operations and availability under ourrevolving line of credit will be sufficient to meet our working capital,capital expenditure and financing requirements for at least the next twelvemonths. In making this assessment we considered the following:

·                  Our cash andcash equivalents balance at June 30, 2006 of $6.4 million.

·                  The availabilityunder our revolving credit facility of $2.3 million at June 30, 2006.

·                  Our demonstratedability to generate positive cash flows from operations.

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·                  Our backlog asof June 30, 2006 of approximately $14.6 million, including $3.6 million in licensefees and services and $11.0 million in customer support.

·                  Our plannedcapital expenditures.

·                  Our cashforecast which indicates that we will have sufficient liquidity to coveranticipated operating costs and capital expenditures as well as debt servicepayments.

We are exposed to foreign currency rate risks which impact the carryingamount of our foreign subsidiaries and our consolidated equity, as well as ourconsolidated cash position due to translation adjustments.  For the six months ended June 30, 2006, theeffect of exchange rate changes resulted in a $0.1 million increase toconsolidated cash.  During the six monthsended June 30, 2005, the effect of exchange rate changes resulted in a $0.3million decrease in consolidated cash. We do not currently hedge our foreign currency exposure, but we monitorrate changes and may hedge our exposures if we see significant negative trendsin exchange rates.

**OFF-BALANCE SHEET ARRANGEMENTS**

We have no off-balance sheet arrangements that have amaterial current effect or that are reasonably likely to have a material futureeffect on our financial condition, changes in financial condition, revenues orexpenses, results of operations, liquidity, capital expenditures, or capitalresources.

**CRITICAL ACCOUNTING POLICIES**

The following discussionaddresses our most critical accounting policies, which are those that are bothimportant to the portrayal of our financial condition and results of operationsand that require significant judgment or use of complex estimates.

***Revenue Recognition***

We derive revenue from twoprimary sources: license fees/services and customer support.  We recognize revenue in accordance withStatement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amendedand interpreted by SOP 98-9, “Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions.” In addition we have appliedStaff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” whichprovides further interpretive guidance for public companies on the recognition,presentation and disclosure of revenue in financial statements.

Themajority of our license fees and services revenue is generated from fixed-pricecontracts, which provide for licenses to its software products and relatedservices.   Generally, when we determinethe services to be essential to the functionality of the delivered software, werecognize the revenue using the percentage-of-completion method of accounting,in accordance with SOP 97-2 and SOP 81-1, “Accounting for Long-Term ConstructionType Contracts.”  We estimate thepercentage of completion for each contract based on the ratio of direct laborhours incurred to total estimated direct labor hours.  Since estimated direct labor hours andproject costs, and changes thereto, can have a significant impact on revenuerecognition, these estimates are critical and are reviewed by managementregularly.  Amounts billed in advance ofservices being performed are recorded 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.

We may encounterbudget and schedule overruns on fixed-price contracts caused by increasedlabor, overhead or material costs. We record adjustments to cost estimates inthe periods in which the facts requiring such revisions become known to us. Werecord estimated losses, if any, in the period in which current estimates oftotal contract revenue and contract costs indicate a loss.

In arrangements where theservices are not essential to the functionality of the delivered software, werecognize license revenue when a license agreement has been signed, deliveryhas occurred, the fee is fixed or determinable and collectibility is reasonablyassured. Where applicable, fees from multiple element arrangements areunbundled and recorded as revenue as the elements are delivered to the extentthat vendor specific objective evidence (“VSOE”) of fair value of the undeliveredelements exist. If VSOE for the undelivered elements does not exist, fees fromsuch arrangements are deferred until the earlier of the date that VSOE doesexist on the undelivered elements or all of the elements have been delivered.

We recognize services revenueprovided under fixed-price contracts using the percentage of completionmethod described above. We recognize revenue from professional servicesprovided pursuant to time-and-materials contracts and training services as theservices are performed, as that is when our obligation to our customers undersuch arrangements is fulfilled.

We generally recognize customersupport and maintenance revenue ratably over the service contract period. Whenmaintenance or training services are bundled with the original license feearrangement, their fair value, based upon VSOE, is deferred and recognizedduring the periods such services are provided.

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**Stock-based Compensation**

We account for stock-based compensation in accordancewith SFAS 123R. Under the fair value recognition provisions of thisstatement, we measure share-based compensation cost at the grant date based onthe value of the award and we recognize it as expense over the vestingperiod.  Determining the fair value ofshare-based awards at the grant date requires judgment, including estimatingexpected term of options, expected dividends and expected volatility of thestock price of our common stock.  Inaddition, judgment is also required in estimating the amount of share-basedawards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-basedcompensation expense and our results of operations could be significantlyimpacted.

***Allowance for Doubtful Accounts***

We make judgments related to ourability to collect outstanding accounts receivable. We provide allowances forreceivables when their collection becomes doubtful by recording an expense.Generally, we determine the allowance based on our assessment of therealization of receivables using historical information and current economictrends, including assessing the probability of collection from customers. Ifthe financial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments owed to us, we would be requiredto increase the allowance for doubtful accounts. We evaluate the adequacy ofthe allowance regularly and make adjustments accordingly. Adjustments to theallowance for doubtful accounts could materially affect our results ofoperations.

***Income Taxes***

We account for income taxes inaccordance with Statement of Financial Accounting Standards (“SFAS”)No. 109, “Accounting for Income Taxes.” Significant judgment is requiredin determining our provision for income taxes. We assess the likelihood thatour deferred tax asset will be recovered from future taxable income, and to theextent we believe that recovery is not likely, we establish a valuationallowance. We consider future taxable income projections, historical resultsand ongoing tax planning strategies in assessing the recoverability of deferredtax assets. However, adjustments could be required in the future if wedetermine that the amount to be realized is less or greater than the amountthat we recorded. Such adjustments, if any, could have a material impact on ourresults of our operations.

***Goodwill***

We account for goodwill in accordance with Statementof Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and OtherIntangible Assets.”  We test ourreporting units annually in accordance with SFAS No. 142 during the thirdfiscal quarter of each year to determine whether their carrying value exceedstheir fair market value. Should this be the case, the value of the goodwill maybe impaired and written down.  We alsotest goodwill for impairment on an interim basis if an event occurs orcircumstances change between annual tests that would more likely than notreduce the fair value of the reporting unit below its carrying amount. If wedetermine the fair value of the goodwill is less than the carrying value, werecognize an impairment loss in an amount equal to the difference. Impairmentlosses, if any, are reflected in operating income or loss in the consolidatedstatements of operations.

Assessing goodwill for impairment involves a highdegree of subjective judgment. Estimates of fair value are primarily based onthe present value of future cash flows and other market factors. Changes in ourjudgments and projections could result in a significantly different estimate ofthe fair value of the reporting units and could result in an impairment ofgoodwill.  As a result of the purchaseprice allocations from our prior acquisitions, our goodwill is included invarious reporting units.  We recorded animpairment of goodwill at June 30, 2006. See Impairment of Goodwill and Intangible Assets within the Results ofOperations section of MD&A.

***Intangible Assets***

We assess the impairment ofidentifiable intangibles in accordance with SFAS 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets” (“SFAS 144”).  As a result, we review finite-lived assetsfor impairment whenever an event occurs or circumstances change which indicatesthat the carrying amount of such assets may not be fully recoverable.  Determination of recoverability is based onan estimate of undiscounted future cash flows resulting from the use of theassets and its eventual disposition. Measurement of an impairment loss is based on the fair value of theasset compared to its carrying value.  Ifwe determine the fair value of the asset is less than the carrying value, animpairment loss is incurred in an amount equal to the difference.  Significantestimates and judgments are required when estimating fair values.  Impairment losses are reflected in operatingincome or loss in the consolidated statements of operations. Factors that we consider important which couldtrigger an impairment review include the following:

·                  Significant under-performance relative tohistorical or projected future operating results;

·                  Significant changes in the manner of use of theacquired assets or the strategy of the overall business;

·                  Significant negative industry or economic trends;

·                  Significant decline in our stock price for asustained period; and

·                  Our market capitalization relative to net bookvalue.

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We recorded animpairment of intangibles at June 30, 2006. See Impairment of Goodwill and Intangible Assets within the Results ofOperations section of MD&A.

***Business Combinations***

We account for our purchase of anacquired company in accordance with SFAS No. 141, “Business Combinations.”  We allocate the cost of an acquired companyto the tangible and identifiable intangible assets and liabilities acquired,with the remaining amount being recorded as goodwill.  We amortize certain intangible assets over theirestimated lives, while in-process research and development is recorded as aone-time charge to product development expense in the statements of operationson the acquisition date.

Accounting forbusiness combinations, including the allocation of the purchase price toacquired assets and assumed liabilities based on their estimated fair values,requires us, in certain circumstances, to estimate fair values for items thathave no ready market or for which no independent market exists. We use our bestjudgment to determine a fair value based upon discounted present value ofestimated future cash flows, inference to other transactions and other data. Asa result, the amounts determined by us for such items as accounts receivable,identifiable intangible assets, goodwill, and deferred revenue are notindividually the result of an arm’s length transaction, but are the result ofmanagement estimates of the fair value and the allocation of the purchaseprice. Accordingly, revenue recognized related to fulfillment of assumedcontractual obligations is based on fair value estimates made by us.

***Capitalization of Internal SoftwareDevelopment Costs***

We expend amounts on research and development (“R&D”)for new products and/or for enhancements of existing products. For internaldevelopment of software products that we will license to third parties, wefollow Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accountingfor the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed” (“SFAS86”). SFAS 86 requires that the cost of developing software be expensed priorto establishing technological feasibility, and those costs be capitalized oncetechnological feasibility has been established. Capitalization ceases upongeneral release of the software. The determination of whether internal softwareR&D costs are subject to capitalization is, by its nature, highlysubjective and involves significant judgments. This decision couldsignificantly affect earnings during the development period.  Further, oncecapitalized, the software costs are generally amortized on a straight-linebasis over the estimated economic life of the product. The determination of theexpected useful life of a product is highly judgmental. Finally, capitalizedsoftware costs must be assessed for impairment if facts and circumstanceswarrant such a review. We did not capitalize any internal software R&Dcosts during the six months ended June 30, 2006 or 2005. In addition, wedid not have any capitalized internal software R&D costs included in ourJune 30, 2006 or December 31, 2005 Consolidated Balance Sheets. We believe thatduring these periods no material internal software R&D costs were requiredto be capitalized. Our conclusion is primarily based on the fact that thefeature-rich, pre-integrated, and highly-scalable nature ofour products requires that our development efforts include complex design,coding and testing methodologies, which include next generation softwarelanguages and development tools. Development projects of this nature carry ahigh degree of development risk. Substantially all of our internal softwareR&D efforts are of this nature, and therefore, we believe the periodbetween achieving technological feasibility and the general release of thesoftware to operations is so short that any costs incurred during this periodare not material.

**Item 3.  Quantitative and Qualitative Market RiskDisclosures**

In the ordinary course ofbusiness, we are exposed to certain market risks, including changes in interestrates and foreign currency exchange rates. Uncertainties that are eithernon-financial or non-quantifiable such as political, economic, tax, other regulatory,or credit risks are not included in the following assessment of market risks.

***Interest Rate Risks***

Our cash balances are subject tointerest rate fluctuations and as a result, interest income amounts mayfluctuate from current levels.  We are exposedto interest rate risk related to our $8.0 million senior secured term note and$2.0 million outstanding on our revolving credit facility entered into inNovember 2005.  These obligations arevariable interest rate notes based on short-term LIBOR.  Fluctuations in LIBOR affect our interestrate risk.  Assuming no change in theamounts outstanding, a hypothetical 10% increase in our existing variableinterest rates would increase our annual interest expense by approximately $0.1million.

***ForeignCurrency Risk***

We are exposed to unfavorable fluctuations of the U.S.dollar (our functional currency) against the currencies of our operatingsubsidiaries. Any increase (decrease) in the value of the U.S. dollaragainst any foreign currency that is the functional currency of one of ouroperating subsidiaries will cause the parent company to experience unrealizedforeign currency translation losses (gains) with respect to amountsalready invested in such foreign currencies. In addition, we and our operating subsidiariesare exposed to foreign currency risk to the extent that we enter intotransactions denominated in currencies other than our respective functionalcurrencies, such as accounts receivable (including intercompany amounts) thatare denominated in a currency other than their own functional currency. Changesin exchange rates with respect to these items will result in unrealized (basedupon period-end exchange rates) or realized foreign currency transaction gainsand losses upon settlement of the transactions. In addition, we are

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exposedto foreign exchange rate fluctuations related to our operating subsidiaries’monetary assets and liabilities and the financial results of foreignsubsidiaries and affiliates when their respective financial statements are translatedinto U.S. dollars for inclusion in our consolidated financial statements.Cumulative translation adjustments are recorded in accumulated othercomprehensive income (loss) as a separate component of equity. As a resultof foreign currency risk, we may experience economic loss and a negative impacton earnings and equity with respect to our holdings solely as a result offoreign currency exchange rate fluctuations.

The relationship between the Great British pound,Indian rupee and the U.S. dollar, which is our functional currency, is shownbelow, per one U.S. dollar:
| Spot rates:     | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Great British  Pound |       | 0.55068                     |       | 0.58126                         |       |
| Indian Rupee         |       | 46.25347                    |       | 45.04505                        |       |

 
|                         | ** ** | **Three months ended**                                            | ** ** |
|-------------------------|------------|-----------------------------------------------------------------------------|------------|
| **Average rates:** | ** ** | **    June 30, 2006    ** | ** ** | **June 30, 2005** | ** ** |
| Great British  Pound    |       | 0.54819                                                                     |       | 0.53873 |   |
| Indian Rupee            |       | 45.27345                                                                    |       | 43.69534 |   |

 

At the present time, we do not hedgeour foreign currency exposure or use derivative financial instruments that are designedto reduce our long-term exposure to foreign currency exchange risk.  To the extent that translation andtransaction gain and losses become significant, we will consider variousoptions to reduce this risk.

**Item 4.  Controls and Procedures**

*Evaluation of disclosure controlsand procedures.*  We maintain “disclosure controlsand procedures,” as such term is defined in Rule 13a-15(e) under theSecurities Exchange Act of 1934 (the “Exchange Act”), that are designed toprovide reasonable assurance that information required to be disclosed by us inreports that we file or submit under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in Securities andExchange Commission rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure.

Our management, with the participation of the ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof our disclosure controls and procedures as of the end of the period coveredby this Quarterly Report on Form 10-Q.  Based on that evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were effective as of the end of such period.

In designing and evaluating our disclosure controlsand procedures, management recognized that disclosure controls and procedures,no matter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the disclosure controls andprocedures are met.  Additionally, in designing disclosure controls andprocedures, our management necessarily was required to apply its judgment inevaluating the cost-benefit relationship of possible disclosure controls andprocedures. The design of any disclosure controls and procedures also is basedin part upon certain assumptions about the likelihood of future events, andthere can be no assurance that any design will succeed in achieving its statedgoals under all potential future conditions.

*Changes in internal control over financialreporting. *During thethree and six months ended June 30, 2006, there were no changes in our internalcontrols over financial reporting or in other factors that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

**PART II — OTHERINFORMATION**

**Item 1.  Legal Proceedings**

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

**Item 1A.  Risk Factors**

ThisQuarterly Report on Form 10-Q should be read in conjunction with the riskfactors defined in our Annual Report on Form 10-K for the year ended December31, 2005 under “Item 1A. Risk Factors.”

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***Consolidationin the Communications Industry May Impact our Financial Performance***

The communicationsindustry has experienced and continues to experience significant consolidation,both in the United States and internationally. These consolidations are causing our existing and potential customers tore-evaluate their OSS solutions and their capital expenditures.  The result of such consolidations may befewer potential customers requiring OSS solutions as well as combiningcompanies choosing a competitive OSS solution used by one of the combiningcompanies.  In addition, largercommunications companies generally have stronger purchasing power, which canresult in reduced prices for our products, lower margins on our products andlonger sales cycles.  Because of theuncertainty resulting from these consolidations and the variations in ourquarterly operating results, it is extremely difficult for us to forecast ourquarterly and annual revenue and we have discontinued providing revenueguidance.  All of these factors can havea negative impact on our financial performance, particularly in any fiscalquarter.  This negative impact, in turn,could result in noncompliance by the Company with certain financial covenantsgoverning our senior secured notes.  Wesuccessfully amended our covenants effective June 30, 2006.  However, if we were unsuccessful in amendingthe agreements or obtaining a waiver from our senior lender in future reportingperiods, these violations could result in such notes becoming immediately dueand payable.  We can give no assurancethat we would be successful in amending the agreements or obtaining a waiver ofany covenant violation.

***Risk Related to Continued NASDAQListing***

Recently, the trading price for our common stockdeclined, and we cannot assure our investors that the trading price will notdecline further, possibly below $1.00.  If our stock price remained belowthe minimum bid price of $1.00 for 30 consecutive business days, it wouldresult in the NASDAQ Stock Market (“NASDAQ”) initiating de-listing proceduresfor our stock.  If NASDAQ were to initiate delisting procedures, we wouldhave a period of 180 calendar days from receiving notice from NASDAQ to achievecompliance with the listing requirements.  If we do not achieve complianceduring this period, we would be afforded an additional 180 day complianceperiod if we demonstrated that we met the criteria for initial listing setforth in Marketplace Rule 4310(c) (except for the bid price requirement setforth in Rule 4310(c)(4)) on the last day of the first compliance period.Compliance can be achieved during any compliance period by meeting the minimum$1.00 bid price for 10 consecutive business days.  Compliance with the $1.00 minimum bid pricewould terminate the NASDAQ de-listing procedures.

If we did not meet the NASDAQ’s initial listingcriteria required to obtain an additional 180 day compliance period and ourstock were to be delisted, trading in our common stock would continue to beconducted in the Over-The-Counter (OTC) market.  As a result, an investorcould find it more difficult to dispose of or obtain accurate quotations as tothe market value of our common stock.  In addition, in the event ourcommon stock were to be delisted, broker-dealers would have certain additionalregulatory burdens imposed upon them, which might discourage them fromeffecting transactions in our common stock, further limiting the liquidity ofour stock.

**Item 2.  Changes in Securities**

None

**Item 3.  Defaults on Senior Securities**

None

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

We held our Annual Meeting of Stockholders onJune 1, 2006. According to the final proxy tally received from theCompany’s transfer agent, the results of the voting on Proposals 1 and 2,as described in the Company’s Proxy Statement, were as follows:

**Proposal #1: Election of Directors**

George A. Hallenbeck was re-elected to serve athree-year term until 2009.

For 14,755,455

Withheld 1,647,021

David J. Nicol was re-elected to serve a three-yearterm until 2009.

For 16,001,971

Withheld 400,505

**Proposal #2: Ratification of IndependentRegistered Public Accounting Firm**

KPMG LLP was ratified as the independent registeredpublic accounting firm for the year ending December 31, 2006.

For 16,218,558

Against 165,403

Abstain 18,515

 

**Item 5.  Other Information**

None

**Item 6.  Exhibits**

(a)          Exhibits

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**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
| Date: August 14, 2006 | /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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