**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| **ý** | ** ** | **Quarterly Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                                                                                       |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                         |
| ** ** | ** ** | **For the quarterly period ended March 31,  2006**                                                                                                                                                      |
|       |       |                                                                                                                                                                                                         |
| ** ** | ** ** | **OR**                                                                                                                                                                                                       |
| ** ** | ** ** | ** **                                                                                                                                                                                                   |
| **o**      | ** ** | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                                                                                      |
|       |       |                                                                                                                                                                                                         |
| ** ** | ** ** | **For the transition period from              to              ** |

 

**Commission File Number: 0-24081**

 

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes ýNo o

 

Indicateby check mark whether the registrant is a large accelerated filer, an acceleratedfiler, 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 |   | Accelerated filer o |   | Non-accelerated  filer ý |
|---------------------------------|--------|--------------------------|--------|------------------------------------|

 

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

 

As of April 25,2006 there were 16,189,782 shares outstanding of Registrant’s Common Stock (parvalue $0.001 per share).

 

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**March 31, 2006**

**Table of Contents**

 
| **PART I  – FINANCIAL INFORMATION** |
|-----------------------------------------------|
| Item 1                                        | Financial Statements |   |
|                                          | Condensed  Consolidated Balance Sheets as of March 31, 2006 and December 31,  2005 (Unaudited) |   |
|                                          | Condensed  Consolidated Statements of Operations for the Three Months Ended March 31,  2006 and 2005 (Unaudited) |   |
|                                          | Condensed  Consolidated Statements of Changes In  Stockholders’ Equity and Comprehensive Loss for the Three Months Ended March 31,  2006 (Unaudited) |   |
|                                          | Condensed  Consolidated Statements of Cash Flows for the Three Months Ended March 31,  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                                     |   |   |

 

2

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**PART I — FINANCIAL INFORMATION**

 

**Item 1. FinancialStatements**

 

**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                 |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                            |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                        | 5,829      |                        | $          | 3,883 |   |
| Contract receivables, net of allowance of $48 at March 31,  2006 and December 31, 2005                                                                                           |       | 7,837                    |       | 10,766                      |       |
| Unbilled work-in-progress                                                                                                                                                                  |       | 734                      |       | 1,147                       |       |
| Deferred foreign income taxes                                                                                                                                                              |       | 9                        |       | 5                           |       |
| Prepaid and other current assets                                                                                                                                                           |       | 1,395                    |       | 1,335                       |       |
| Total current assets                                                                                                                                                                       |       | 15,804                   |       | 17,136                      |       |
| Property and equipment, net                                                                                                                                                                |       | 1,601                    |       | 1,775                       |       |
| Amortizable intangible assets, net                                                                                                                                                         |       | 12,570                   |       | 13,350                      |       |
| Goodwill                                                                                                                                                                                   |       | 34,350                   |       | 34,073                      |       |
| Long-term restricted cash                                                                                                                                                                  |       | 300                      |       | 300                         |       |
| Other long-term assets                                                                                                                                                                     |       | 707                      |       | 764                         |       |
| Total assets                                                                                                                                                                               |       | $                        | 65,332     |                        | $          | 67,398 |   |
|                                                                                                                                                                                       |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                              |       |                     |       |                        |       |
| Current liabilities:                                                                                                                                                                       |       |                     |       |                        |       |
| Current portion of capital lease obligations                                                                                                                                               |       | $                        | 35         |                        | $          | 34 |   |
| Current portion of long-term debt                                                                                                                                                          |       | 1,250                    |       | 1,000                       |       |
| Accounts payable and accrued liabilities                                                                                                                                                   |       | 5,379                    |       | 6,084                       |       |
| Unearned revenue                                                                                                                                                                           |       | 9,677                    |       | 9,654                       |       |
| Total current liabilities                                                                                                                                                                  |       | 16,341                   |       | 16,772                      |       |
| Long-term liabilities:                                                                                                                                                                     |       |                     |       |                        |       |
| Capital lease obligations, net of current portion                                                                                                                                          |       | 62                       |       | 71                          |       |
| Long-term debt, net of current portion                                                                                                                                                     |       | 13,895                   |       | 14,373                      |       |
| Deferred foreign income taxes                                                                                                                                                              |       | 2,633                    |       | 2,777                       |       |
| Total liabilities                                                                                                                                                                          |       | 32,931                   |       | 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; 16,169,469 and 16,137,821 shares issued and outstanding as of March 31,  2006 and December 31, 2005, respectively |       | 16                       |       | 16                          |       |
| Additional paid-in capital                                                                                                                                                                 |       | 68,178                   |       | 67,891                      |       |
| Accumulated other comprehensive loss                                                                                                                                                       |       | (2,057                   | )          | (2,417                      | )          |
| Accumulated deficit                                                                                                                                                                        |       | (45,017                  | )          | (43,366                     | )          |
| Total stockholders’ equity                                                                                                                                                            |       | 21,120                   |       | 22,124                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                            |       | $                        | 65,332     |                        | $          | 67,398 |   |

 

The accompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

3

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| License fees and services                                                    |       | $                                                | 3,899      |   | $ | 5,081 |   |
| Customer support                                                             |       | 4,229                                            |       | 4,757 |   |
| Total revenue                                                                |       | 8,128                                            |       | 9,838 |   |
|                                                                         |       |                                             |       |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                                  |       |                                             |       |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 1,875                                            |       | 2,976 |   |
| Costs of customer support, excluding depreciation  and amortization          |       | 1,626                                            |       | 2,031 |   |
| Sales and marketing                                                          |       | 2,555                                            |       | 2,392 |   |
| General and administrative                                                   |       | 1,407                                            |       | 2,501 |   |
| Product development                                                          |       | 747                                              |       | 110 |   |
| Depreciation                                                                 |       | 293                                              |       | 376 |   |
| Amortization                                                                 |       | 897                                              |       | 1,421 |   |
| Restructuring and other                                                      |       | (14                                              | )          | (58 | ) |
| Total costs of revenue and operating expenses                                |       | 9,386                                            |       | 11,749 |   |
|                                                                         |       |                                             |       |   |   |
| Loss from operations                                                         |       | (1,258                                           | )          | (1,911 | ) |
|                                                                         |       |                                             |       |   |   |
| Other income (expense):                                                      |       |                                             |       |   |   |
| Interest income                                                              |       | 38                                               |       | 39 |   |
| Interest expense                                                             |       | (509                                             | )          | (429 | ) |
| Foreign currency exchange loss                                               |       | (1                                               | )          | (125 | ) |
| Other expense, net                                                           |       | (472                                             | )          | (515 | ) |
|                                                                         |       |                                             |       |   |   |
| Loss before income taxes                                                     |       | (1,730                                           | )          | (2,426 | ) |
|                                                                         |       |                                             |       |   |   |
| Income tax benefit                                                           |       | 79                                               |       | 278 |   |
|                                                                         |       |                                             |       |   |   |
| Net loss                                                                     |       | $                                                | (1,651     | ) | $ | (2,148 | ) |
|                                                                         |       |                                             |       |   |   |
| Basic and diluted loss per common share                                      |       | $                                                | (0.09      | ) | $ | (0.12 | ) |
|                                                                         |       |                                             |       |   |   |
| Weighted average basic and diluted shares  outstanding                       |       | 19,066                                           |       | 18,598 |   |

 

The accompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

4

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCHANGES IN STOCKHOLDERS’ EQUITY****AND 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 |       | 21,179                |       | —      |       | 38                |       | —                 |       | —                 |       | 38         |       |
| Stock-based compensation expense                                  |       | —                |       | —      |       | 236               |       | —                 |       | —                 |       | 236        |       |
| Comprehensive loss:                                               |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |
| Net loss                                                          |       | —                |       | —      |       | —            |       | —                 |       | (1,651                 | )          |       |       |
| Foreign currency translation adjustment                           |       | —                |       | —      |       | —            |       | 360                    |       | —                 |       |       |       |
| Comprehensive loss                                                |       |                  |       |        |       |              |       |                   |       |                   |       | (1,291     | )          |
| Balance at March 31, 2006                                    |       | 16,169,469            |       | $           | 16         |              | $          | 68,178                 |       | $                      | (2,057     | )          | $          | (45,017 | ) | $ | 21,120 |   |

 

The accompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

5

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                        |       |                                             |       |   |   |
| Net loss                                                                         |       | $                                                | (1,651     | ) | $ | (2,148 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                             |       |   |   |
| Depreciation                                                                     |       | 293                                              |       | 376 |   |
| Amortization of intangible assets                                                |       | 897                                              |       | 1,421 |   |
| Amortization of debt issuance costs                                              |       | 57                                               |       | 13 |   |
| Equity compensation                                                              |       | 236                                              |       | — |   |
| Interest expense added to debt principal                                         |       | —                                           |       | 317 |   |
| Gain on disposal of property and equipment                                       |       | (13                                              | )          | (11 | ) |
| Foreign currency transaction losses, net                                         |       | 1                                                |       | 125 |   |
| Benefit from foreign deferred income taxes                                       |       | (180                                             | )          | (465 | ) |
| Change in operating assets and liabilities:                                      |       |                                             |       |   |   |
| Contract receivables                                                             |       | 3,013                                            |       | 2,559 |   |
| Unbilled work-in-progress                                                        |       | 428                                              |       | 394 |   |
| Prepaid and other assets                                                         |       | (47                                              | )          | (86 | ) |
| Accounts payable and accrued liabilities                                         |       | (742                                             | )          | (553 | ) |
| Unearned revenue                                                                 |       | (15                                              | )          | (441 | ) |
| Other                                                                            |       | —                                           |       | (19 | ) |
| Net cash provided by operating activities                                        |       | 2,277                                            |       | 1,482 |   |
|                                                                             |       |                                             |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                        |       |                                             |       |   |   |
| Purchases of property and equipment                                              |       | (110                                             | )          | (158 | ) |
| Proceeds from sale of property and equipment                                     |       | 13                                               |       | 11 |   |
| Business combinations, net of cash acquired                                      |       | —                                           |       | (676 | ) |
| Net cash used in investing activities                                            |       | (97                                              | )          | (823 | ) |
|                                                                             |       |                                             |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                        |       |                                             |       |   |   |
| Capital lease payments                                                           |       | (8                                               | )          | (8 | ) |
| Principal payments on long-term debt                                             |       | (250                                             | )          | (2,889 | ) |
| Payment of amount due to Evolving Systems U.K.  sellers                          |       | —                                           |       | (2,616 | ) |
| Proceeds from issuance of common stock                                           |       | 51                                               |       | 56 |   |
| Net cash used in financing activities                                            |       | (207                                             | )          | (5,457 | ) |
|                                                                             |       |                                             |       |   |   |
| Effect of foreign exchange rate changes on cash                                  |       | (27                                              | )          | (109 | ) |
|                                                                             |       |                                             |       |   |   |
| Net increase (decrease) in cash and cash equivalents                             |       | 1,946                                            |       | (4,907 | ) |
| Cash and cash equivalents at beginning of period                                 |       | 3,883                                            |       | 11,386 |   |
| Cash and cash equivalents at end of period                                       |       | $                                                | 5,829      |   | $ | 6,479 |   |
|                                                                             |       |                                             |       |   |   |
| Supplemental disclosure of other cash and non-cash  financing transactions:      |       |                                             |       |   |   |
| Interest paid                                                                    |       | $                                                | 269        |   | $ | 114 |   |
| Income taxes paid                                                                |       | $                                                | 441        |   | $ | — |   |

 

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

 

6

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**EVOLVING SYSTEMS, INC.**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**(1) Basis of Presentation**

 

**Organization.**Evolving Systems, Inc. (“EvolvingSystems” or the “Company”) is a provider of software solutions and services tothe wireless, wireline and IP carrier markets. The Company’s customers arewireline, wireless and IP communications carriers worldwide. The Companydevelops, deploys, enhances, maintains and integrates complex, softwaresolutions for a range of Operations Support Systems (“OSS”) and Network SupportSystems (“NSS”). The Company offers software products and solutions in threecore areas — numbering solutions which enable carriers to comply withgovernment-mandated requirements regarding number portability and phone numberconservation; network mediation solutions supporting data collection forboth service assurance and billing applications; and a service activationsolution that is used to activate complex bundles of voice, video and dataservices.

 

Thecore Evolving Systems portfolio that includes ordering and provisioningsolutions for Local Number Portability (“LNP”), as well as a number inventoryand assignment platform, was expanded significantly in 2004 as a result ofthree acquisitions the Company made over a period of 12 months from November of2003 to November of 2004. Through the acquisition of CMS Communications, Inc.(“CMS”) in November 2003 the Company acquired a network mediation andservice assurance solution to add to its product portfolio. Additionally, withthe acquisition of Telecom Software Enterprises, LLC (“TSE”) in October 2004the Company added LNP and Wireless Number Portability (“WNP”) number orderingand provisioning testing products which provide new OSS system integrationcapabilities. Finally, in November 2004, the Company acquired TertioTelecoms Ltd. (“Evolving Systems U.K.”), a privately held supplier of OSSsoftware solutions to communication carriers throughout Europe, the MiddleEast, Africa and Asia, expanding its markets beyond North America. EvolvingSystems U.K.’s activation solution ***TertioTM,***andmediation solution ***EvidentTM***, strengthened theoverall product portfolio.

 

***Interim Consolidated Financial Statements***. 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 therelated rules and regulations of the Securities and Exchange Commission (“SEC”).Accordingly, certain information and note disclosures normally included infinancial statements prepared in accordance with GAAP have been condensed oromitted pursuant to such rules and regulations. However, managementbelieves that the disclosures included in these financial statements areadequate to make the information presented not misleading. The unauditedcondensed consolidated financial statements included in this document have beenprepared on the same basis as the annual consolidated financial statements, andin management’s opinion, reflect all adjustments, which include normalrecurring adjustments, necessary for a fair presentation in accordance withGAAP and SEC regulations for complete financial statements. The results for thethree months ended March 31, 2006 are not necessarily indicative of theresults that the Company will have for any subsequent quarter or full fiscalyear. These unaudited condensed consolidated financial statements should be readin conjunction with the audited consolidated financial statements and the notesto those statements for the year ended December 31, 2005 included in the Company’sAnnual Report on Form 10-K.

 

***Useof Estimates***. The preparation of financial statements in conformitywith GAAP requires management to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements, as well as thereported amounts of revenue and expenses during the reporting period. Significantestimates have been made by management with respect to revenue recognition forestimated hours to complete projects accounted for using the percentage ofcompletion method, allowance for doubtful accounts, income tax valuationallowance, fair values of long-lived assets, valuation of intangible assets andgoodwill, business combinations, capitalization of internal softwaredevelopment costs and fair value of stock-based compensation amounts. Actualresults could significantly differ from these estimates.

 

***Foreign Currency Translation***. The U.S. dollar isthe Company’s functional currency. The functional currency of the Company’sforeign operations, generally, is the respective local currency for eachforeign subsidiary. Assets and liabilities of foreign operations denominated inlocal currencies are translated at the spot rate in effect at the applicablereporting date. The consolidated statements of operations of the Company aretranslated at the average rate of exchange during the applicable period. Theresulting unrealized cumulative translation adjustment, net of applicableincome taxes, is recorded as a component of accumulated other comprehensiveloss in stockholders’ equity. Realized and unrealized transaction gains andlosses generated by transactions denominated in a currency different from thefunctional currency of the applicable entity are recorded in other income(expense) in the period in which they occur. Transaction gains for the threemonths ended March 31, 2006 and 2005 were $1,000 and $125,000,respectively.

 

***Principles of Consolidation***. The consolidatedfinancial statements include the accounts of the Company and its subsidiaries,all of which are wholly owned. All significant intercompany transactions andbalances have been eliminated in consolidation.

 

***Revenue Recognition****.*TheCompany recognizes revenue from two primary sources: license fees and services,and customer support, in accordance with Statement of Position (“SOP”) 97-2, “SoftwareRevenue Recognition,” as amended and interpreted by SOP 98-9, “Modification ofSOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.”  Staff Accounting

 

7

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Bulletin (“SAB”) No. 104,“Revenue Recognition,” provides further interpretive guidance for publiccompanies on the recognition, presentation and disclosure of revenue infinancial statements. In addition to the criteria described below, the Companyrecognizes revenue only when an agreement is signed, the fee is fixed ordeterminable and collectibility is reasonably assured.

 

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 services are determined to be essential to thefunctionality of the delivered software, revenue is recognized using thepercentage-of-completion method of accounting, in accordance with SOP 97-2 andSOP 81-1, “Accounting for Long-Term Construction Type Contracts.”  The percentage of completion for eachcontract is estimated based on the ratio of direct labor hours incurred tototal 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 billedin advance of services being performed are recorded as unearned revenue.Unbilled work-in-progress represents revenue earned but not yet billable underthe terms of the fixed-price contracts. All such amounts are expected to bebilled and collected within 12 months.

 

TheCompany may encounter budget and schedule overruns on fixed pricecontracts caused by increased labor, overhead or material costs. Adjustments tocost estimates are made in the periods in which the facts requiring suchrevisions become known. Estimated losses, if any, are recorded in the period inwhich current estimates of total contract revenue and contract costs indicate aloss.

 

Inarrangements where the services are not essential to the functionality of thesoftware, the Company recognizes license revenue upon delivery. To the extentthat Vendor Specific Objective Evidence (“VSOE”) of the fair value of theundelivered elements exists, fees from multiple element arrangements areunbundled and recorded as revenue as the elements are delivered. If VSOE forthe undelivered elements does not exist, fees from such arrangements aredeferred until the earlier of the date that VSOE does exist on the undeliveredelements or 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 professionalservices provided pursuant to time-and-materials based contracts and trainingservices are recognized as the services are performed, as that is when theCompany’s obligation to its customers under such arrangements is fulfilled.

 

Customersupport, including maintenance revenue, is generally recognized ratably overthe service contract period. When maintenance is bundled with the originallicense fee arrangement, its fair value, based upon VSOE, is deferred andrecognized 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”). This statement replaced SFAS No. 123, *Accounting for Stock-Based Compensation* (“SFAS 123”) andsuperseded APB Opinion No. 25, *Accounting for StockIssued to Employees*. Under the modified prospective method ofadoption, the Company is required to apply a fair-value-based measurement methodin accounting for share-based payment transactions with employees and recordcompensation cost for all stock awards granted after January 1, 2006 andawards modified, repurchased, or cancelled after that date. In addition, theCompany is required to record compensation costs associated with the vesting ofunvested options outstanding at January 1, 2006 using the guidance underSFAS 123. From January 1, 2006, stock option grants and employee stockpurchase plan purchases will be accounted for under SFAS 123R. The Company usesthe Black-Scholes model to estimate the fair value of each option grant on thedate of grant. This model requires the use of estimates for expected term ofthe options and expected volatility of the price of the Company’s common stock.

 

**(2) Goodwilland Intangible Assets**

 

Changes in the carrying amounts of goodwill byreporting unit for the three months ended March 31, 2006 are as follows(in thousands):

 
| ** **                                 | ** ** | **License and  Services** | ** ** | **Customer  Support** | ** ** | **Total  Goodwill** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|-----------------------|------------|---------------------|------------|
| Balance as of December 31, 2005       |       | $                              | 18,530     |                  | $          | 15,543              |       | $ | 34,073 |   |
| Effects of foreign currency exchange rates |       | 150                            |       | 127                   |       | 277                 |       |
| Balance as of March 31, 2006          |       | $                              | 18,680     |                  | $          | 15,670              |       | $ | 34,350 |   |

 

The Company’s annual goodwill impairment test wasconducted as of July 31, 2005, and it was determined that goodwill was notimpaired as of the test date.Goodwill is assessed for impairment at each reporting period end if certainevents occurred indicating that an impairment may have occurred. From July 31,2005 through March 31, 2006, no events have occurred that managementbelieves may have impaired goodwill.

 

Identifiable intangibles are amortized overestimated finite lives of from one to seven years, and include the cumulativeeffects of changes in foreign currency exchange rates. The following tablesummarizes identifiable intangible assets (in thousands):

 

8

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| ** **                                    | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** |       |
|-----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Identifiable intangible assets:** | ** ** | **Gross  Amount**            | ** ** | **Accumulated  Amortization**   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** |   |
| Purchased software                            |       | $                            | 8,427      |                            | $          | 2,551 |   | $ | 5,876 |   | $ | 8,350 |   | $ | 2,090 |   | $ | 6,260 |   |
| Customer contracts                            |       | 2,016                        |       | 2,015                           |       | 1 |   | 1,997 |   | 1,968 |   | 29 |   |
| Purchased licenses                            |       | 1,335                        |       | 643                             |       | 692 |   | 1,335 |   | 576 |   | 759 |   |
| Trademarks and tradenames                     |       | 1,080                        |       | 255                             |       | 825 |   | 1,068 |   | 207 |   | 861 |   |
| Business partnerships                         |       | 1,347                        |       | 272                             |       | 1,075 |   | 1,332 |   | 222 |   | 1,110 |   |
| Customer relationships                        |       | 6,028                        |       | 1,927                           |       | 4,101 |   | 5,989 |   | 1,658 |   | 4,331 |   |
|                                          |       | $                            | 20,233     |                            | $          | 7,663 |   | $ | 12,570 |   | $ | 20,071 |   | $ | 6,721 |   | $ | 13,350 |   |

 

Amortizationexpense of identifiable intangible assets was $0.9 million and $1.4 million forthe three months ended March 31, 2006 and 2005, respectively.

 

** (3) Earnings Per Common Share**

 

Basicearnings per share (“EPS”) is computed by dividing net income or loss availableto common stockholders by the weighted average number of shares outstandingduring the period, including common stock issuable under participatingsecurities, such as the Series B Convertible Redeemable Preferred Stock (“Series BPreferred Stock”). Diluted EPS is computed using the weighted average number ofshares outstanding, including participating securities, plus all potentiallydilutive common stock equivalents. Common stock equivalents consist of stockoptions and shares held in escrow. The following is the reconciliation of thenumerators and denominators of the basic and diluted EPS computations (inthousands):

 
| ** **                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Weighted average common shares outstanding         |       | 16,166                                           |       | 15,988 |   |
| Participating securities                           |       | 2,900                                            |       | 2,610 |   |
| Basic weighted average common shares outstanding   |       | 19,066                                           |       | 18,598 |   |
| Effect of dilutive securities                      |       | —                                           |       | — |   |
| Diluted weighted average common shares outstanding |       | 19,066                                           |       | 18,598 |   |

 

Weightedaverage options to purchase 1.9 million shares of common stock were excludedfrom the dilutive stock calculation for the three months ended March 31,2006 and 2005 as their effect would have been anti-dilutive as a result of thenet loss for the periods. Weighted average options to purchase 2.4 million and 1.7million shares of common stock were excluded from the dilutive stockcalculation for the three months ended March 31, 2006 and 2005,respectively, because their exercise prices were greater than the average fairvalue of the Company’s stock for the periods. In addition, unrecognizedstock-based compensation costs were excluded from the dilutive stockcalculation for the three months ended March 31, 2006 as the effect wouldhave been anti-dilutive as a result of the net loss for the period.

 

**(4) Share-BasedCompensation**

 

TheCompany adopted SFAS 123R effectiveJanuary 1, 2006 using the modified prospective method. The Companypreviously applied the intrinsic-value-based method in accounting for the recognitionof stock-based compensation arrangements and the fair value method only fordisclosure purposes. Because the Company historically granted options withexercise prices equal to the fair value of the Company’s common stock at thegrant date, the adoption of SFAS 123R did not result in a significantadjustment to the financial statements. Further, as a result of the preceding,the Company’s statements of operations from January 1, 2006 forward willinclude charges for stock-based compensation. The Company recognized $0.2million, or $0.01 per share, of compensation expense in the statement ofoperations for the three months ended March 31, 2006 with respect to itsstock-based compensation plans. The following table summarizes stock-basedcompensation expenses recorded in the statement of operations (in thousands):

 

9

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| ** **                                                                 | ** ** | **Three Months  Ended  March 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Cost of license fee and services, excluding  depreciation and amortization |       | $                                                      | 17         |   |
| Cost of customer support, excluding depreciation and  amortization         |       | 2                                                      |       |
| Sales and marketing                                                        |       | 55                                                     |       |
| General and administrative                                                 |       | 151                                                    |       |
| Product development                                                        |       | 11                                                     |       |
|                                                                       |       | $                                                      | 236        |   |

 

**StockOption 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 issuanceunder the Option Plan. Subsequently, the Option Plan was amended, as approvedby the stockholders, to increase the number of shares available for issuance to8,350,000. Options issued under the Option Plan are at the discretion of theBoard of Directors, including the vesting provisions of each stock optiongranted. Options are granted with an exercise price equal to the market priceof the Company’s stock on the date of grant, generally vest over four years andexpire no more than ten years from the date of grant. The Option Planterminated on January 18, 2006; options granted before that date were notaffected by the plan termination.

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes model. The Black-Scholes model uses four assumptions to calculatethe fair value of each option grant. The expected term of share options grantedis derived from the simplified method prescribed by the SEC. The risk-freeinterest rate is based upon the rate currently available on zero-coupon U.S.Treasury instruments with a remaining term equal to the expected term of thestock options. The expected volatility is based upon historical volatility ofthe Company’s stock over a period equal to the expected term of the stockoptions. The expected dividend yield is zero and is based upon historical andanticipated payment of dividends. The weighted-average assumptions used in thefair value calculations are as follows:  

 
| ** **              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Expected term (years)   |       | 6.1                                              |       | 5 |   |
| Risk-free interest rate |       | 4.35                                             | %          | 3.46 | % |
| Expected volatility     |       | 121.14                                           | %          | 125.32 | % |
| Expected dividend yield |       | 0                                                | %          | 0 | % |

 

Thefollowing is a summary of stock option activity under the plan for the periodended March 31, 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                        |       | (27                        | )          | $                                       | 2.70       |                                                 |       |                            |       |   |
| Less options expired                          |       | (2                         | )          | $                                       | 6.17       |                                                 |       |                            |       |   |
| Less options exercised                        |       | (10                        | )          | $                                       | 1.20       |                                                 |       |                            |       |   |
| Options outstanding at March 31, 2006    |       | 4,255                      |       | $                                       | 3.14       |                                                 | 7.31       |                            | $          | 763 |   |
|                                          |       |                       |       |                                    |       |                                                 |       |                            |       |
| Options exercisable at March 31, 2006    |       | 3,103                      |       | $                                       | 3.46       |                                                 | 6.60       |                            | $          | 722 |   |

 

10

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Theweighted-average grant-date fair value of stock options granted during thethree months ended March 31, 2006 and 2005 was $2.05 and $2.96,respectively.

 

As of March 31,2006, there were approximately $2.1 million of total unrecognized compensationcosts related to unvested stock options. These costs are expected to be recognizedover a weighted average period of 1.9 years.

 

Thetotal intrinsic value of stock option exercises was $13,000 and the total fairvalue of stock awards vested was $146,000 during the three months ended March 31,2006. The total intrinsic value of stock option exercises was $66,000 and thetotal fair value of stock awards vested was $610,000 during the three monthsended March 31, 2005.

 

Cashreceived from stock option exercises for the three months ended March 31,2006 was $13,000. The income tax benefits from stock options totaledapproximately $7,000 for the three months ended March 31, 2006.

 

**EmployeeStock Purchase Plan**

 

Underthe Employee Stock Purchase Plan (“ESPP”), the Company is authorized to issueup to 1,100,000 shares of common stock to its full-time employees, nearly allof whom are eligible to participate. Under the terms of the ESPP, employees may electto have up to 15% of their gross salaries withheld through payroll deduction topurchase the Company’s common stock, capped at $25,000 annually. The purchaseprice of the stock is 85% of the lower of the market price at the beginning orend of each three-month participation period. As of March 31, 2006, therewere 414,946 shares available for purchase. For the three months ended March 31,2006, the Company recorded compensation expense of $15,000 associated withgrants under the ESPP which includes the fair value of the look-back feature ofeach grant as well as the 15% discount on the purchase price. This expense willfluctuate each period based upon employee participation.

 

Thefair value of each grant made under the Company’s employee stock purchase planis estimated on the date of grant using the Black-Scholes model. TheBlack-Scholes model uses four assumptions to calculate the fair value of eachoption grant. The expected term of each grant is based upon the three-month(six-month in 2005) participation period of each grant. The risk-free interestrate is based upon the rate currently available on zero-coupon U.S. Treasuryinstruments with a remaining term equal to the expected term of each grant. Theexpected volatility is based upon historical volatility of the Company’s stock.The expected dividend yield is based upon historical and anticipated payment ofdividends. The weighted average assumptions used in the fair value calculationsare as follows:

 

| ** **              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Expected term (years)   |       | 0.25                                             |       | 0.5 |   |
| Risk-free interest rate |       | 4.79                                             | %          | 2.68 | % |
| Expected volatility     |       | 86.41                                            | %          | 99 | % |
| Expected dividend yield |       | 0                                                | %          | 0 | % |
|                    |       |                                             |       |   |   |

Cashreceived from employee stock plan purchases for the three months ended March 31,2006 was $38,000.

 

Thefollowing table illustrates the effect on net income (loss) if the fair value methodhad been applied to all share-based plans during the previous period (inthousands, except per share data):

 
| ** **                                                                                                                                 | ** ** | **Three Months  Ended  March 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                                                 | ** ** | ** **                                         | ** ** |
| Net loss, as reported                                                                                                                      |       | $                                                  | (2,148     | ) |
| Stock-based compensation expense that would have  been included in net loss if the fair-value-based method had been applied to  all awards |       | (608                                               | )          |
| Pro forma net loss                                                                                                                         |       | $                                                  | (2,756     | ) |
|                                                                                                                                       |       |                                               |       |
| Loss per common share, as reported:                                                                                                        |       |                                               |       |
| Basic and diluted                                                                                                                          |       | $                                                  | (0.12      | ) |
| Pro forma loss per common share:                                                                                                           |       |                                               |       |
| Basic and diluted                                                                                                                          |       | $                                                  | (0.15      | ) |

 

11

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**(5) Concentration of Credit Risk**

 

For the three months ended March 31, 2006 and2005, the Company recognized 26% (13% and 13%) and 26% (14% and 12%),respectively, of total revenue from two significant customers (defined ascontributing at least 10%) in the communications industry. One of thesecustomers is located in the U.S. while the other is an international customer.

 

As of March 31,2006, two significant customers accounted for approximately 29% (16% and 13%) ofcontract receivables. Both of these customers were located in the U.S. At December 31,2005, two significant customers accounted for approximately 38% (25% and 13%)of contract receivables. One of these customers was located in the U.S. while the other was an international customer.

 

**(6) Long-term Debt**

 

TheCompany’s notes payable consist of the following (in thousands):

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Senior note payable to financial institution,  interest at the one-month London InterBank Offered Rate (“LIBOR”) plus a  margin of 6.25%; however, the LIBOR rate cannot be less than 3.75%, interest  rate was 11.01% at March 31, 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. 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 |       | $                  | 8,250      |                  | $          | 8,500 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |               |       |                  |       |
| $4.5 million senior revolving credit facility  payable to financial institution, interest at one-month LIBOR plus 4.0%;  however, the LIBOR rate cannot be less than 3.75%, interest rate was 8.76% at  March 31, 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.                                                                                                                                                                                                                                                                                |       | 2,025              |       | 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | 15,145             |       | 15,373                |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Less current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       | (1,250             | )          | (1,000                | )          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Long-term debt, excluding current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | $                  | 13,895     |                  | $          | 14,373 |   |

 

The$8.3 million senior note payable and $4.5 million senior revolving creditfacility subject the Company to certain financial covenants. The agreementscontain a Minimum EBITDA covenant which specifies that the Company’s trailingtwelve months (TTM) EBITDA, as defined, shall not be less than $5.5 million at March 31,2006. This minimum EBITDA requirement increases to $6.0 million at September 30,2006, $6.5 million at March 31, 2007, $7.0 million at September 30,2007 and $7.25 million March 31, 2008. The agreements contain a LeverageRatio covenant which specifies a leverage ratio of senior debt to TTM EBITDA of2.5 to 1 as of March 31, 2006. This quarterly required leverage ratiodecreases to 2.25 to 1 at December 31, 2006, 2.0 to 1 at December 31,2007 and 1.75 to 1 at December 31, 2008. The agreements also contain aFixed Charge Coverage Ratio covenant which specifies that the ratio of TTMEBITDA less unfinanced capital expenditures and less income and franchise taxespaid in cash to fixed charges for the preceding twelve months cannot be lessthan 1.15 to 1 at March 31, 2006. Fixed charges are defined as total debtservice, dividends, repurchases or redemption of equity and/or distributions incash. This quarterly required fixed charge coverage ratio decreases to 1.2 to 1at September 30, 2006. The Company was in compliance with these covenantsas of March 31, 2006.

 

**(7) IncomeTaxes**

 

TheCompany recorded net income tax benefit of $79,000 and $278,000 for the threemonths ended March 31, 2006 and 2005, respectively. The net benefit duringthe three months ended March 31, 2006 and 2005 consisted of current incometax expense of approximately $84,000 and $190,000, respectively, and a deferredtax benefit of $163,000 and $468,000, respectively, both of which were relatedto the Company’s UK-based operations.

 

12

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Inconjunction with the acquisition of Evolving Systems U.K., certain identifiableintangible 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 March 31,2006 and December 31, 2005, this deferred tax liability was $2.9 millionand $3.1 million, respectively. 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.

 

Theaforementioned deferred tax liability will be recognized as a reduction of deferredincome tax expense as the identifiable intangibles are amortized.

 

As of March 31,2006 and December 31, 2005, the Company continued to maintain a fullvaluation allowance on its domestic net deferred tax asset as it determined itis more likely than not that the Company will not realize its domestic deferredtax assets. Such assets primarily consist of certain net operating losscarryforwards. The Company assessed the realizability of its domestic deferredtax assets using all available evidence. In particular, the Company consideredboth its historical results and its projections of profitability for thereasonably foreseeable future periods. The Company is required to reassess itsconclusions regarding the realization of its deferred tax assets at eachfinancial reporting date. A future evaluation could result in a conclusion thatall or a portion of the valuation allowance is no longer necessary which couldhave a material impact in the Company’s results of operations and financialposition.

 

**(8) SegmentInformation**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” the Company defines operating segments as componentsof an enterprise for which separate financial information is reviewed regularlyby the chief operating decision-making group, to evaluate performance and tomake operating decisions. The Company has identified its Chief ExecutiveOfficer and Chief Financial Officer as its chief operating decision-makers.These chief operating decision makers review revenues by segment and reviewoverall results of operations.

 

TheCompany currently operates its business as two operating segments based onrevenue type: license fees and services revenue and customer support revenue(as shown on the consolidated statements of operations). License fees andservices 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 revenue includes annual support fees,recurring maintenance fees, fees for maintenance upgrades and warranty services.Warranty services that are similar to software maintenance services aretypically bundled with a license sale and the related revenue, based on VSOE,is deferred and recognized ratably over the warranty period. Total assets bysegment have not been specified because the information is not available to thechief operating decision-making group.

 

Segmentinformation is as follows (in thousands):

 
| ** **                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Revenue**                                                                |       |                                             |       |   |   |
| License fees and services                                                  |       | $                                                | 3,899      |   | $ | 5,081 |   |
| Customer support                                                           |       | 4,229                                            |       | 4,757 |   |
|                                                                       |       | $                                                | 8,128      |   | $ | 9,838 |   |
|                                                                       |       |                                             |       |   |   |
| **Revenue less cost of revenue, excluding  depreciation and amortization** |       |                                             |       |   |   |
| License fees and services                                                  |       | $                                                | 2,024      |   | $ | 2,105 |   |
| Customer support                                                           |       | 2,603                                            |       | 2,726 |   |
|                                                                       |       | 4,627                                            |       | 4,831 |   |
|                                                                       |       |                                             |       |   |   |
| **Unallocated costs**                                                      |       |                                             |       |   |   |
| Other operating expenses                                                   |       | 4,709                                            |       | 5,003 |   |
| Depreciation and amortization                                              |       | 1,190                                            |       | 1,797 |   |
| Restructuring and other                                                    |       | (14                                              | )          | (58 | ) |
| **Loss from operations**                                                   |       | $                                                | (1,258     | ) | $ | (1,911 | ) |

 

13

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***Geographic Regions***

 

The Company, headquartered in Englewood, a suburb ofDenver, Colorado, uses the customer locations as the basis of attributingrevenues to individual countries. The Company now provides products andservices on a global basis through its London based Evolving Systems U.Ksubsidiary. Additionally, the Company’s personnel in Bangalore, India, provide softwaredevelopment services to the Company’s global operations. Financial informationrelating to the Company’s operations by geographic region is as follows (inthousands):

 
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| **Revenue**                          | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Americas                             |       | $                                                    | 3,450      |   | $ | 5,016 |   |
| Europe, Middle East, Africa and Asia |       | 4,678                                                |       | 4,822 |   |
| Total Revenue                        |       | $                                                    | 8,128      |   | $ | 9,838 |   |

 
| ** **                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| **Long-lived assets, net**           |       |               |       |                  |       |
| Americas                             |       | $                  | 12,706     |                  | $          | 13,172 |   |
| Europe, Middle East, Africa and Asia |       | 35,815             |       | 36,026                |       |
| Total long-lived assets, net         |       | $                  | 48,521     |                  | $          | 49,198 |   |

 

**(9) Commitmentsand Contingencies**

 

Aspermitted under Delaware law, the Company has agreements with its officers anddirectors under which it agrees to indemnify them for certain events oroccurrences while the officer or director is, or was serving, at the Company’srequest in this capacity. The term of the indemnification period is indefinite.There is no limit on the amount of future payments the Company could berequired to make under these indemnification agreements; however, the Companymaintains Director and Officer insurance policies, as well as an EmploymentPractices Liability Insurance Policy, that may enable it to recover aportion of any future amounts paid. As a result of the Company’s insurancepolicy coverage, it believes the estimated fair value of these indemnificationagreements is minimal. Accordingly, the Company has no liabilities recorded forthese agreements as of March 31, 2006 and December 31, 2005.

 

TheCompany enters into standard indemnification terms with its customers, asdiscussed below, in the ordinary course of business. Because the Company may subcontractthe development of its deliverables under its customer contracts, the Companycould be required to indemnify its customers for work performed by its subcontractors.Depending upon the nature of the customer indemnification, the potential amountof future payments the Company could be required to make under theseindemnification agreements may be unlimited. The Company may be ableto recover damages from a subcontractor if the indemnification to its customersresults from the subcontractor’s failure to perform. To the extent the Companyis unable to recover damages from its subcontractors, the Company could berequired to reimburse the indemnified party for the full amount. The Companyhas never incurred costs to defend lawsuits or settle claims relating toindemnification arising out of its subcontractors’ failure to perform. As aresult, the Company believes the estimated fair value of these agreements is minimal.Accordingly, the Company has no liabilities recorded for these agreements as ofMarch 31, 2006 and December 31, 2005.

 

TheCompany’s standard license agreements contain warranties that the software willbe free of material defects and will operate in accordance with the statedrequirements for a limited period of time. The warranty provisions require theCompany to cure any defects through any reasonable means. The Company believesthe estimated fair value of the warranty provisions in the license agreementsin place with its customers is minimal. Accordingly, the Company has notrecorded liabilities for these warranty provisions as of March 31, 2006and December 31, 2005.

 

TheCompany’s software arrangements generally include a product indemnificationprovision that the Company will indemnify and defend a customer in actionsbrought against the customer for claims that the Company’s products infringeupon a copyright, trade secret, or valid patent. Historically, the Company hasnot incurred any significant costs related to product indemnification claims.Accordingly, the Company has no liabilities recorded as of March 31, 2006and December 31, 2005.

 

Inrelation to the acquisitions of Evolving Systems U.K., Telecom SoftwareEnterprises, LLC (TSE) and CMS Communications, Inc. (CMS), the Companyagreed to indemnify certain parties of and from any losses, actions, claims,damages or liabilities (or actions in respect thereof) resulting from any claimraised by a third party. The Company does not believe that there will be anyclaims related to these indemnifications. Accordingly, the Company has noliabilities recorded for these agreements as of

 

14

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March 31, 2006 and December 31,2005.

 

Fromtime to time the Company is involved in various legal proceedings arising inthe normal course of business operations. We are not currently involved in anysuch proceedings.

 

15

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**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Special Note About Forward-LookingStatements**

 

*ThisQuarterly Report on Form 10-Q contains forward-looking statements thathave been made pursuant to the provisions of the Private Securities LitigationReform Act of 1995. These forward-looking statements are based on currentexpectations, estimates, and projections about Evolving Systems’ industry,management’s beliefs, and certain assumptions made by management. Forward-lookingstatements include our expectations regarding product, services, andmaintenance revenue, annual savings associated with the organizational changeseffected in prior years, 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 are intended to identifyforward-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 differmaterially from those expressed or forecasted in any forward-looking statements.Risks and uncertainties of our business include those set forth in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005 under“Item 1A. Risk Factors” as well as additional risks described in this Form 10-Q.Unless required by law, we undertake no obligation to update publicly anyforward-looking statements, whether as a result of new information, futureevents, or otherwise. However, readers should carefully review the risk factorsset forth in other reports or documents the Company files from time to timewith the Securities and Exchange Commission, particularly the Quarterly Reportson Form 10-Q and any Current Reports on Form 8-K.*

 

**OVERVIEW**

 

We area provider of software solutions and services to the wireless, wireline and IPcarrier market. We maintain long-standing relationships with many of thelargest wireline, wireless and IP communications carriers worldwide. Ourcustomers rely on us to develop, deploy, enhance, maintain and integratecomplex, highly reliable software solutions for a range of Operations SupportSystems (“OSS”) and Network Support Systems (“NSS”).

 

Werecognize revenue in accordance with the prescribed accounting standards forsoftware revenue recognition under generally accepted accounting principles. Asa result, our license fees and services revenues fluctuate from period toperiod as a result of the timing of revenue recognition on existing projects.

 

Duringthe three months ended March 31, 2006, we continued to make R&Dinvestments in our product portfolio and began to see some cross-selling of ourU.S. and U.K. products outside their traditional markets.

 

Effective January 1, 2006, we adopted SFAS No. 123(R),*Share-Based Payment*(“SFAS 123R”)*,*using the modified prospective method. Prior to January 1,2006, we applied the intrinsic-value-based method in accounting for employeestock-based compensation arrangements and the fair value method only fordisclosure purposes. Under these methods, stock-based compensation costs werenot recorded in the financial statements but were disclosed in the notes to thefinancial statements together with pro forma disclosure of earnings andearnings per share. Because the fair value recognition provisions ofSFAS 123R require recognition of stock-based compensation expense in thefinancial statements, the adoption of SFAS 123R negatively impacted ourresults of operations. For the three months ended March 31, 2006, werecorded $0.2 million of stock-based compensation expenses associated with ourstock option and employee stock purchase plans which were allocated to thevarious expense line items within our statement of operations. As we previouslyapplied the fair value method for disclosure purposes, we believe thedisclosure in previously issued reports are reasonably comparable to currentperiod recorded expenses except for the requirement to now estimate forfeituresin the amount of compensation expense recognized, as compared to recordingforfeitures as they occurred in our prior period pro forma disclosures. As of March 31,2006, there was $2.1 million of total unrecognized compensation costs relatedto unvested stock options. These costs are expected to be recognized over aweighted average period of 1.9 years. The following table summarizes thestock-based compensation expenses recorded in the statement of operations (inthousands).

 
| ** **                                                                 | ** ** | **Three Months  Ended  March 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Cost of license fee and services, excluding  depreciation and amortization |       | $                                                      | 17         |   |
| Cost of customer support, excluding depreciation and  amortization         |       | 2                                                      |       |
| Sales and marketing                                                        |       | 55                                                     |       |
| General and administrative                                                 |       | 151                                                    |       |
| Product development                                                        |       | 11                                                     |       |
|                                                                       |       | $                                                      | 236        |   |

 

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***CostReductions***

 

 During 2005, we implemented a number of costreducing strategies targeted at integrating our 2004 acquisitions. During thefirst quarter of 2005, we identified several duplicative roles that were eliminatedas a result of these acquisitions. In July 2005, we undertook additionalcost reduction measures that involved an additional 10% reduction in ourworkforce, including individuals at all levels of our U.S. and U.K. operations.In addition, we transitioned Evolving Systems U.K. third-party softwaredevelopment to our offshore development team in our India subsidiary. We havecontinued to increase utilization of our Evolving Systems India subsidiary whichnow employees over 100 people.

 

Ourcosts of revenue and operating expenses decreased $2.4 million, or 20%, to $9.4million for the three months ended March 31, 2006 from $11.8 million forthe three months ended March 31, 2005. These cost reduction measuresaccount for approximately $1.7 million of the total $2.4 million decrease inour costs of revenue and operating expenses for the three months ended March 31,2006 as compared to the three months ended March 31, 2005. Our intangibleamortization decreased $0.5 million as certain of our intangible assets fromour acquisitions became fully amortized. Professional and legal expensesdecreased $0.4 million due to reductions in accounting and legal costs. Stock-basedcompensation costs of $0.2 million resulting from the implementation of SFAS123R partially offset these decreases in expense.

 

**RESULTSOF OPERATIONS**

 

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

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **REVENUE**                                                                  |       |                                             |       |   |   |
| License fees and services                                                    |       | 48                                               | %          | 52 | % |
| Customer support                                                             |       | 52                                               | %          | 48 | % |
| Total revenue                                                                |       | 100                                              | %          | 100 | % |
|                                                                         |       |                                             |       |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                                  |       |                                             |       |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 23                                               | %          | 30 | % |
| Costs of customer support, excluding depreciation  and amortization          |       | 20                                               | %          | 21 | % |
| Sales and marketing                                                          |       | 32                                               | %          | 24 | % |
| General and administrative                                                   |       | 17                                               | %          | 25 | % |
| Product development                                                          |       | 9                                                | %          | 1 | % |
| Depreciation                                                                 |       | 4                                                | %          | 4 | % |
| Amortization                                                                 |       | 11                                               | %          | 15 | % |
| Restructuring and other                                                      |       | —                                           | %          | — | % |
| Total costs of revenue and operating expenses                                |       | 116                                              | %          | 120 | % |
|                                                                         |       |                                             |       |   |   |
| Loss from operations                                                         |       | (16                                              | )%         | (20 | )% |
|                                                                         |       |                                             |       |   |   |
| Interest income                                                              |       | 1                                                | %          | — | % |
| Interest expense                                                             |       | (6                                               | )%         | (4 | )% |
| Foreign currency exchange loss                                               |       | —                                           | %          | (1 | )% |
| Other expense, net                                                           |       | (5                                               | )%         | (5 | )% |
|                                                                         |       |                                             |       |   |   |
| Loss before income taxes                                                     |       | (21                                              | )%         | (25 | )% |
|                                                                         |       |                                             |       |   |   |
| Income tax benefit                                                           |       | 1                                                | %          | 3 | % |
|                                                                         |       |                                             |       |   |   |
| Net loss                                                                     |       | (20                                              | )%         | (22 | )% |

 

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***Revenue***

 

Revenueis comprised of license fees/services and customer 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 materials work. Customersupport revenue includes annualsupport, recurring maintenance, maintenance upgrades and warranty services. Warrantyservices consist of maintenance services and are typically bundled with alicense sale and the related revenue, based on VSOE, is deferred and recognizedratably over the warranty period. The following table presents theCompany’s approximate revenue by product group (in thousands):

 
| ** **          | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------|------------|--------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Numbering solutions |       | $                                                | 2,743      |   | $ | 3,790 |   |
| Mediation           |       | 1,146                                            |       | 1,855 |   |
| Activation          |       | 4,239                                            |       | 4,193 |   |
|                |       | $                                                | 8,128      |   | $ | 9,838 |   |

 

***License Fees and Services***

 

Licensefees and services revenue decreased 23% or $1.2 million to $3.9 million for thethree months ended March 31, 2006, from $5.1 million for the three monthsended March 31, 2005. The decrease in license fees and services revenue wasprimarily a result of a decrease of $0.5 million in revenue from our number solutionsproducts and a decrease of $0.7 million in revenue from our mediation productswhich were offset by an increase of $35,000 in revenue from our activationproducts. The decline in numbering solutions products was due to industryconsolidation and smaller overall license sales, which is reflective of thematurity of the narrowband numbering solutions market in the U.S. In addition,a contract signed for a numbering solutions product with an internationalcustomer was ended by mutual agreement pending availability of the productionversion of NumeriTrack® International i3.1. We continue to believe aninternational market exists for various of our numbering solution products andare continuing R&D investments to “internationalize” those products. Thedecline in mediation revenue is consistent with our focus on our coreactivation and numbering solutions products.

 

***Customer Support***

 

Customersupport revenue decreased $0.5 million, or 11%, to $4.2 million for the threemonths ended March 31, 2006, from $4.7 million for the three months ended March 31,2005. This $0.5 million decrease was due to industry consolidation and pricingpressures on support contract renewals.

 

***Costsof Revenue, Excluding Depreciation and Amortization***

 

Costsof revenue, excluding depreciation and amortization, consist primarily ofpersonnel costs, facilities costs, the costs of third-party software, partnercommissions and all other direct costs associated with these personnel. Totalcosts of revenue, excluding depreciation and amortization, were $3.5 millionand $5.0 million for the three months ended March 31, 2006 and 2005,respectively. These costs are discussed further below.

 

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

 

Costsof license fees and services, excluding depreciation and amortization, were $1.9million and $3.0 for the three months ended March 31, 2006 and 2005,respectively. The decrease of $1.1 million, or 37%, was primarily due to thedecline in sales of our numbering solutions products. As a percentage of licensefees and services revenue, costs of license fees and services, excluding depreciationand amortization, decreased to 48% for the three months ended March 31,2006 from 59% for the three months ended March 31, 2005. This decrease wasdue to cost reductions implemented during the second half of 2005 as well assavings from the increased utilization of our offshore development subsidiaryin Bangalore, India.

 

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

 

Costsof customer support, excluding depreciation and amortization were $1.6 millionand $2.0 million for the three months ended March 31, 2006 and 2005,respectively. As a percentage of customer support revenue, costs of customersupport revenue, excluding depreciation and amortization, decreased to 38% forthe three months ended March 31, 2006 from 43% for the three months ended March 31,2005. These decreases were due to cost reductions implemented during the secondhalf of 2005 as well as savings from increased utilization of our offshoredevelopment subsidiary in Bangalore, India.

 

***Salesand Marketing***

 

Salesand marketing expenses primarily consist of compensation costs, including bonusesand commissions, travel expenses, advertising and occupancy expenses. Sales andmarketing expenses increased $0.2 million, or 7%, to $2.6 million from $2.4million

 

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for the three monthsended March 31, 2006 and 2005, respectively. This increase was a result ofincreased technical sales personnel costs associated with our expanded salesand marketing efforts and stock-based compensation costs recorded during thethree months ended March 31, 2006. As a percentage of total revenue, salesand marketing expenses for the three months ended March 31, 2006 and 2005,increased to 32% from 24%, respectively. This increase was a result ofdecreased revenue, increased technical sales personnel costs associated withour expanded sales and marketing efforts and stock-based compensation costsrecorded during the three months ended March 31, 2006.

 

***Generaland Administrative***

 

Generaland administrative expenses consist principally of employee related costs andprofessional fees for the following departments: facilities, finance, legal,human resources, and executive management. General and administrative expenses decreased$1.1 million, or 44%, to $1.4 million from $2.5 million for the threemonths ended March 31, 2006 and 2005, respectively. As a percentage of totalrevenue, general and administrative expenses for the three months ended March 31,2006 and 2005, decreased to 17% from 25%, respectively. These decreases wereprimarily a result of cost saving measures implemented during the second halfof 2005, severance costs recorded during 2005 associated with the EvolvingSystems U.K. acquisition which were not incurred in 2006, and reductions inprofessional and legal fees. These reductions were offset by stock-basedcompensation costs recorded during the three months ended March 31, 2006.

 

***ProductDevelopment***

 

Productdevelopment expenses consist primarily of employee related costs and, in 2005,included offshore development and subcontractor expenses. Product developmentexpenses increased $0.6 million, or 579%, to $0.7 million from $0.1 million forthe three months ended March 31, 2006 and 2005, respectively. As apercentage of revenue, product development expenses for the three months ended March 31,2006 and 2005, increased to 9% from 1%, respectively. These increases were dueto product release enhancements as well as “internationalizing” certainnumbering solutions products.

 

***Amortization***

 

Amortizationexpense consists of amortization of identifiable intangible assets acquiredthrough our acquisitions of CMS, TSE and Evolving Systems U.K. Amortizationexpense was $0.9 million and $1.4 million for the three months ended March 31,2006 and 2005, respectively. The decrease in amortization expense of $0.5million, or 37%, is a result of certain intangible assets becoming fullyamortized.

 

***InterestExpense***

 

Interestexpense was $0.5 million and $0.4 million for the three months ended March 31,2006 and 2005, respectively. The increase of $0.1 million, or 19%, related tohigher levels of debt, an increase in variable interest rates and increased amortizationof debt issuance costs.

 

***ForeignCurrency Exchange Loss***

 

Foreigncurrency transaction losses result from transactions denominated in a currencyother than the functional currency of the respective subsidiary and was $1,000and $125,000 for the three months ended March 31, 2006 and 2005,respectively. The losses were generated primarily through our Evolving SystemsU.K. subsidiary.

 

***IncomeTaxes***

 

Werecorded net income tax benefit of $79,000 and $278,000 for the three monthsended March 31, 2006 and 2005, respectively. The net benefit during thethree months ended March 31, 2006 and 2005 consisted of current foreign incometax expense of approximately $84,000 and $190,000, respectively, and a deferredforeign tax benefit of $163,000 and $468,000, respectively, both of which arerelated to the Company’s UK-based operations.

 

Inconjunction with the acquisition of Evolving Systems U.K., certain identifiableintangible assets were recorded. Since the identifiable intangible amortizationis not deductible for income tax purposes, a long-term deferred tax liabilityof $4.6 million was established at the acquisition date for the expecteddifference between what would be expensed for financial reporting purposes andwhat would be deductible for income tax purposes. As of March 31, 2006 andDecember 31, 2005, this deferred tax liability was $2.9 million and $3.1million, respectively. This deferred tax liability is carried on the books ofthe Company’s United Kingdom subsidiary, and has no impact on the Company’sability to recover its U.S.-based deferred tax assets. The aforementioneddeferred tax liability will be recognized as a reduction of deferred income taxexpense as the identifiable intangibles are amortized.

 

**FINANCIALCONDITION**

 

Ourworking capital position decreased to a negative $0.5 million as of March 31,2006 from a positive $0.4 million as of December 31, 2005. This decreaseof $0.9 million was primarily a result of our net loss for the three monthsended March 31, 2006. Contract receivables decreased $2.9 million duringthe three months ended March 31, 2006 primarily as a result of collectingannual support contracts which were billed as of December 31, 2005.

 

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**CONTRACTUALOBLIGATIONS**

 

Therehave been no material changes to the contractual obligations as disclosed inour 2005 Annual Report on Form 10-K.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Wehave historically financed operations through cash flows from operations andequity transactions. At March 31, 2006, our principal source of liquiditywas $5.8 million in cash and cash equivalents as well as $2.3 million availableunder our revolving line of credit. The $2.3 million in availability under ourrevolving line of credit reflects the reduced availability resulting fromstandby letters of credit of $0.2 million. The following table summarizes ourstatements of cash flows (in thousands):

 

| ** **               | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Cash provided (used) by: |       |                                             |       |   |   |
| Operating activities     |       | $                                                | 2,277      |   | $ | 1,482 |   |
| Investing activities     |       | (97                                              | )          | (823 | ) |
| Financing activities     |       | (207                                             | )          | (5,457 | ) |
| Effect of exchange rates |       | (27                                              | )          | (109 | ) |
| Net cash provided (used) |       | $                                                | 1,946      |   | $ | (4,907 | ) |

 

Netcash provided by operating activities for the three months ended March 31,2006 and 2005 was $2.3 million and $1.5 million, respectively. Net loss plusnon-cash operating adjustments was $0.4 million and $0.4 million for the threemonths ended March 31, 2006 and 2005, respectively. Changes in operatingassets and liabilities reflected a net increase in cash from operatingactivities of $2.6 million for the three months ended March 31, 2006 ascompared to $1.9 million for the three months ended March 31, 2005. Thesefluctuations were primarily attributable to 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.

 

Netcash used by investing activities during the three months ended March 31,2006 and 2005 was $0.1 million and $0.8 million. The cash used for the threemonths ended March 31, 2006 related primarily to purchases of property andequipment. The cash used for the three months ended March 31, 2005 relatedprimarily to net cash outflows of $0.7 million for the Evolving Systems U.K.and TSE acquisitions as well as purchase of property and equipment. Nocontingent consideration was earned by the TSE sellers during the three monthsended March 31, 2006; however, we anticipate there will be additionalconsideration earned during 2006 by the TSE sellers related to certainspecified gross margin results achieved from the sale of TSE products soldthrough the remainder of 2006.

 

Financingactivities in the three months ended March 31, 2006 and 2005, consistedprimarily of principal payments on notes payable. During the three months endedMarch 31, 2006, we paid $0.3 million in principal payments on the notespayable entered into in November 2005. During the three months ended March 31,2005, we paid $5.5 million in principal payments on obligations resulting fromour acquisitions during 2004. The restructuring of our debt during November 2005significantly reduced our short-term obligations under our long-term debtarrangements.

 

Webelieve that our current cash and cash equivalents, together with anticipatedcash flow from operations 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:

 

•                  Ourcash and cash equivalents balance at March 31, 2006 of $5.8 million.

 

•                  Theavailability under our revolving credit facility of $2.3 million at March 31,2006.

 

•                  Ourdemonstrated ability to generate positive cash flows from operations.

 

•                  Ourbacklog as of March 31, 2006 of approximately $16.5 million, including $3.8million in license fees and services and $12.7 million in customer support.

 

•                  Ourplanned capital expenditures.

 

•                  Ourcash forecast, which indicates that we will have sufficient liquidity to coveranticipated operating costs and capital expenditures as well as debt servicepayments.

 

We are exposed to foreigncurrency rate risks which impact the carrying amount of our foreignsubsidiaries and our consolidated equity, as well as our consolidated cashposition due to translation adjustments. For the three months ended March 31,2006, the effect of exchange rate changes resulted in a $27,000 reduction ofconsolidated cash. During the three months ended March 31, 2005, theeffect of

 

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exchange rate changes resulted in a $0.1 milliondecrease in consolidated cash. We do not currently hedge our foreign currencyexposure, but we will monitor rate changes and may hedge our exposures ifwe see significant negative trends in exchange rates.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

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

 

**CRITICAL ACCOUNTING POLICIES**

 

Thefollowing discussion addresses our most critical accounting policies, which arethose that are both important to the portrayal of our financial condition andresults of operations and that require significant judgment or use of complexestimates.

 

***Revenue Recognition***

 

Wederive revenue from two primary sources: license fees/services and customersupport. We recognize revenue in accordance with Statement of Position (“SOP”)97-2, “Software Revenue Recognition,” as amended and interpreted by SOP 98-9, “Modificationof SOP 97-2, Software Revenue Recognition, With Respect to CertainTransactions.” In addition we have applied Staff Accounting Bulletin (“SAB”) No. 104,“Revenue Recognition,” which provides further interpretive guidance for publiccompanies on the recognition, presentation and disclosure of revenue infinancial statements.

 

Themajority of our license fees and services revenue is generated from fixed-pricecontracts, which provide for licenses to its software products and related services.Generally, when we determine the services to be essential to the functionalityof the delivered software, we recognize the revenue using thepercentage-of-completion method of accounting, in accordance with SOP 97-2 andSOP 81-1, “Accounting for Long-Term Construction Type Contracts.”  We estimate the percentage of completion foreach contract based on the ratio of direct labor hours incurred to totalestimated direct labor hours. Since estimated direct labor hours and projectcosts, and changes thereto, can have a significant impact on revenuerecognition, these estimates are critical and are reviewed by managementregularly. Amounts billed in advance of services being performed are recordedas unearned revenue. Unbilled work-in-progress represents revenue earned butnot yet billable under the terms of the fixed-price contracts. All such amountsare expected to be billed and collected 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.

 

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

 

Werecognize services revenue provided under fixed-price contracts using thepercentage of completion method described above. We recognize revenue fromprofessional services provided pursuant to time-and-materials contracts andtraining services as the services are performed, as that is when our obligationto our customers under such arrangements is fulfilled.

 

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

 

**Stock-basedCompensation**

 

We account for stock-based compensation in accordancewith SFAS 123R. Under the fair value recognition provisions of thisstatement, share-based compensation cost is measured at the grant date based onthe value of the award and is recognized as expense over the vesting period. Determiningthe fair value of share-based awards at the grant date requires judgment,including estimating expected term of options, expected dividends and expectedvolatility of the stock price of our common stock. In addition, judgment is alsorequired in estimating the amount of share-based awards that are expected to beforfeited. If actual results differ significantly from these estimates,stock-based compensation expense and our results of operations could be significantlyimpacted.

 

***Allowance forDoubtful Accounts***

 

Wemake judgments related to our ability to collect outstanding accountsreceivable. We provide allowances for receivables when their collection becomesdoubtful by recording an expense. Generally, we determine the allowance basedon our assessment of the

 

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realization ofreceivables using historical information and current economic trends, includingassessing the probability of collection from customers. If the financial conditionof our customers were to deteriorate, resulting in an impairment of theirability to make payments owed to us, we would be required to increase theallowance for doubtful accounts. We evaluate the adequacy of the allowanceregularly and make adjustments accordingly. Adjustments to the allowance fordoubtful accounts could materially affect our results of operations.

 

***Income Taxes***

 

Weaccount for income taxes in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 109, “Accounting for Income Taxes.” Significantjudgment is required in determining our provision for income taxes. We assessthe likelihood that our deferred tax asset will be recovered from futuretaxable income, and to the extent we believe that recovery is not likely, weestablish a valuation allowance. We consider future taxable income projections,historical results and ongoing tax planning strategies in assessing therecoverability of deferred tax assets. However, adjustments could be requiredin the future if we determine that the amount to be realized is less or greaterthan the amount that we recorded. Such adjustments, if any, could have amaterial impact on our results of our operations.

 

***IntangibleAssets***

 

Weaccount for our purchase of an acquired company in accordance with SFAS No. 141,“Business Combinations.”  We allocate thecost of an acquired company to the tangible and identifiable intangible assetsand liabilities acquired, with the remaining amount being recorded as goodwill.We amortize certain intangible assets over their estimated lives, whilein-process research and development is recorded as a one-time charge to productdevelopment expense in the statements of operations on the acquisition date.

 

Weassess the impairment of identifiable intangibles if events or changes incircumstances indicate that the carrying value of the asset may not berecoverable. Factors that we consider important which could trigger animpairment review include the following:

 

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

 

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

 

•                  Significantnegative industry or economic trends;

 

•                  Significantdecline in our stock price for a sustained period; and

 

•                  Ourmarket capitalization relative to net book value.

 

If wedetermine that the carrying value of intangibles and/or long-lived assets may notbe recoverable based on the existence of one or more of the above indicators ofimpairment, we measure any impairment based on the estimated discounted cashflows expected to result from the use of the asset and its eventual dispositionand compare that to the asset’s carrying amount. Any impairment loss recognizedwould represent the excess of the asset’s carrying value over its estimatedfair value. Significant estimates and judgments are required when estimatingsuch fair values. If we determine that the intangibles are impaired, we wouldrecord an impairment charge and the amount could be material.

 

***BusinessCombinations***

 

Accountingfor business 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 inference to other transactionsand other data. As a result, the amounts determined by us for such items as accountsreceivable, identifiable intangible assets, goodwill, and deferred revenue arenot individually the result of an arm’s length transaction, but are the resultof management 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. Inaddition, the acquisitions of CMS, TSE and Evolving Systems U.K.have resulted in goodwill. Such goodwill is subject to review forimpairment at least annually, or more frequently if circumstances warrant.Because the review is a fair value-based review, there is a high degreeof subjective judgment required. If we determine that the fair values do notsupport the carrying value of the goodwill, we would record an impairmentcharge and the amount could be material.

 

***Capitalizationof Internal Software Development Costs***

 

Weexpend amounts on research and development (“R&D”) for new products and/orfor enhancements of existing products. For internal development of softwareproducts that we will license to third parties, we follow Statement ofFinancial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costsof Computer Software to Be Sold, Leased, or Otherwise Marketed” (“SFAS 86”).SFAS 86 requires that the cost of developing software be expensed prior toestablishing 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

 

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significant judgments.This decision could significantly affect earnings during the development period.Further, once capitalized, the software costs are generally amortized on astraight-line basis over the estimated economic life of the product. Thedetermination of the expected useful life of a product is highly judgmental.Finally, capitalized software costs must be assessed for impairment if factsand circumstances warrant such a review. We did not capitalize any internalsoftware R&D costs during the years ended December 31, 2005,2004, or 2003. In addition, we did not have any capitalized internal softwareR&D costs included in our December 31, 2005 and 2004 ConsolidatedBalance Sheets. We believe that during these periods no material internalsoftware R&D costs were required to be capitalized. Our conclusion isprimarily based on the fact that the feature-rich, pre-integrated,and highly-scalable nature of our products requires that our developmentefforts include complex design, coding and testing methodologies, which includenext generation software languages and development tools. Development projectsof this nature carry a high degree of development risk. Substantially all ofour internal software R&D efforts are of this nature, and therefore, webelieve the period between achieving technological feasibility and the generalrelease of the software to operations is so short that any costs incurredduring this period are not material.

 

**Item 3. Quantitativeand Qualitative Market Risk Disclosures**

 

In theordinary course of business, we are exposed to certain market risks, includingchanges in interest rates and foreign currency exchange rates. Uncertaintiesthat are either non-financial or non-quantifiable such as political, economic,tax, other regulatory, or credit risks are not included in the followingassessment of market risks.

 

***InterestRate Risks***

 

Ourcash balances are subject to interest rate fluctuations and as a result,interest income amounts may fluctuate from current levels. We are exposedto interest rate risk related to our $8.5 million senior secured term note and$4.5 million revolving credit facility entered into in November 2005. Theseobligations are variable interest rate notes based on short-term LIBOR. Fluctuationsin LIBOR affect our interest rate risk. Assuming no change in the amountsoutstanding, a hypothetical 10% increase in variable interest rates wouldincrease our annual interest expense by approximately $1.1 million.

 

***Foreign Currency 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 operatingsubsidiaries are exposed to foreign currency risk to the extent that we enterinto transactions 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 exposed toforeign 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 aretranslated into U.S. dollars for inclusion in our consolidated financialstatements. 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 negativeimpact on earnings and equity with respect to our holdings solely as a resultof foreign 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:** | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------|------------|--------------------------|------------|-----------------------------|------------|
| Great British Pound  |       | 0.57488                  |       | 0.58126                     |       |
| Indian Rupee         |       | 44.46421                 |       | 45.04505                    |       |

 
| ** **              | ** ** | **Three months ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| **Average rates:** | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| Great British Pound     |       | 0.57085                          |       | 0.52856 |   |
| Indian Rupee            |       | 44.25245                         |       | 43.71068 |   |

 

At the present time, we do not hedge our foreign currencyexposure or use derivative financial instruments that are designed to reduceour long-term exposure to foreign currency exchange risk. To the extent thattranslation and transaction gain and losses become significant, we willconsider various options to reduce this risk.

 

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**Item 4. Controlsand Procedures**

 

*Evaluation of disclosure controlsand procedures.*  Wemaintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) underthe Securities 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, our ChiefExecutive 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,and there can be no assurance that any design will succeed in achieving itsstated goals under all potential future conditions.

 

*Changes in internal control over financialreporting.*Duringthe fiscal quarter ended March 31, 2006, there were no changes in ourinternal controls over financial reporting or in other factors that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II — OTHER INFORMATION**

 

**Item 1. LegalProceedings**

 

Fromtime to time we are involved in various legal proceedings arising in the normalcourse of business operations. We are currently not aware of any legalproceedings that would have a material effect on our business, financialcondition or results of operations.

 

**Item 1A. RiskFactors**

 

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 December 31,2005 under “Item 1A. Risk Factors.”

 

***Consolidation in the Communications Industry May Impact ourFinancial Performance***

 

Thecommunications industry has experienced and continues to experience significantconsolidation, both in the United States and internationally. Theseconsolidations are causing our existing and potential customers to re-evaluatetheir OSS solutions and their capital expenditures. The result of suchconsolidations may be fewer potential customers requiring OSS solutions aswell as combining companies choosing a competitive OSS solution used by one ofthe combining companies. In addition, larger communications companies generallyhave stronger purchasing power, which can result in reduced prices for ourproducts, lower margins on our products and longer 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 have a negative impact on our financialperformance, particularly in any fiscal quarter. This negative impact, in turn,could result in noncompliance by the Company with certain financial covenantsgoverning our senior secured notes. If we were unsuccessful in amending theagreements or obtaining a waiver from our senior lender, these violations couldresult in such notes becoming immediately due and payable. We can give noassurance that we would be successful in amending the agreements or obtaining awaiver of any covenant violation.

 

**Item 2.  Changesin Securities**

 

None

 

**Item 3.  Defaultson Senior Securities**

 

None

 

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**Item 4.  Submissionof Matters to a Vote of Security Holders**

 

None

 

**Item 5.  OtherInformation**

 

None

 

**Item 6. Exhibits**

 

(a)          Exhibits

 

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

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

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

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

 

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**SIGNATURE**

 

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

 
| Date: May 5,  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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